Krispy Kreme's Fair Value: Zero

I actually think that it is a matter of time before Krispy Kreme's (NYSE: KKD  ) management team finally gets it. Keep in mind that the team that does finally understand how to run a successful, profitable, self-sustaining Krispy Kreme may not include current CEO Scott Livengood or any of his existing managers. Actually, for whatever reason, the more I dig into this company's financials, the more the words "three-card monte" keep popping into my head. Someone's going to get it. Someone's going to remember what made Krispy Kreme such a regional powerhouse. It may not be the people running the joint now, and it may be too late.

Actually, my fondest hope is that McDonald's (NYSE: MCD  ) buys Krispy Kreme. But what would they pay for it? What would any smart investor looking to buy this whole company pay for it? I've pondered this very question for weeks now, and one of the answers I keep coming up with is "zero."

Keep in mind, this is one of the answers, and it's a bit of a worst-case scenario: big restatements, continued requirements for massive capital reinvestments, and, most important, enduring incompetence and skeeziness from the executive suite. With Livengood taking on Chief Operating Officer John Tate's job in the near term after the latter made an escape to a job at Restoration Hardware (Nasdaq: RSTO  ) , and with PricewaterhouseCoopers refusing to complete its review of Krispy Kreme's quarterly financial statements, pessimism is warranted. Of course, I have other answers as to the company's value that are not zero, but almost all of them are below the current price.

I can hear the indignation now: "Where were you when Krispy Kreme was much higher? Now you're negative on the company?!?" Uh-huh, but this isn't a new thing: I started looking cross-eyed at Krispy Kreme in 2000. Back then people were calling it the next Starbucks (Nasdaq: SBUX  ) . To me it smelled like something else: the next Boston Chicken. And well, well, well, here we are. While a big SEC inquiry over the company spending millions to buy back poorly performing stores from franchisees may not necessarily connote wrongdoing, it most certainly does point to a company that has lost its way.

What is Krispy Kreme?
There have been thousands of Monday morning quarterbacks who have offered opinions both learned and ignorant as to the seeds of the troubles at Krispy Kreme: The company got greedy and grew too fast, it diluted its brand by putting Krispy Kreme doughnuts in places like grocery stores and gas stations, it is a fad. High oil prices, low-carb craze -- all have contributed to the downfall of Krispy Kreme.

Now take a pen and mark through all of them except for "the company got greedy and grew too fast." The rest of the items are excuses and misunderstanding, not reasons.

Consider the "dilution" issue -- to understand why this is wrong you have to know what Krispy Kreme is. It isn't a brand company like Coca-Cola (NYSE: KO  ) or PepsiCo (NYSE: PEP  ) . Krispy Kreme is a product company. It makes doughnuts: really, really good doughnuts. If you think that this is a branding company, think back to when most of the country started to become aware of Krispy Kreme. It wasn't some smart advertising and branding campaign; it was when Rosie O'Donnell started lamenting on live TV that these fantastic doughnuts she'd had in the South weren't available in Manhattan. This wasn't some slick branding -- Krispy Kreme is a product company. The company has always sought to offer its wares through as many channels as possible.

I am a child of North Carolina. I used to be able to buy Krispy Kreme doughnuts as part of my school lunch. We could get 'em at the grocery store, in Pantry (Nasdaq: PTRY  ) stores, wherever. If you look at Krispy Kreme stores in many places, you'll see that they're set up not as retail outlets but as distribution centers. For decades the point-of-production sales were almost tertiary to the company's distribution business.

The Livengood discount
As for the last two rationales given for Krispy Kreme's difficulties -- the "low-carb craze" and "high oil prices" -- those are excuses offered up by the current management so that it can dodge blame for its own failings. And failings they have been. Here's why I think the company may actually be worth nothing: because companies are valued on their ability to generate future free cash flow that goes to the benefit of shareholders. When the current management shows its willingness to pay $32 million to bail out underperforming franchises rather than just letting them fail, you have to wonder how much of its free cash is or will be put to the benefit of shareholders.

That's what those who argue that Krispy Kreme is undervalued because it made $50 million in operating cash flow in the first half of the year are missing. First of all, about $4 million of that free cash came from employee exercise of stock options, so this should be ignored in calculating free cash. Second, $25 million of the remaining $46 million went to pay down debt, though this is somewhat skewed because more than $17 million went to a sale-leaseback scheme involving six franchises, so in practical terms, the company used about $8 million to pay down debt, with the other $17 million, which was accounted under financing cash flows, actually being an investment. Add that to the capital expenditures listed by the company, and you have $38.9 million plus $17 million, or $56 million. The imponderable, given the massive fluctuations because of all those repurchases, is this: How much of those operating cash flows are maintenance (required to keep existing stores running), and how much is growth? If the majority of its capital expenditures is for maintenance, then an argument can be made that Krispy Kreme's equity, under current management, has no value whatsoever.

That's the problem here -- the management has screwed up in massive fashion, and it is trying to clean up its mess by buying back overpriced franchises. That's a total loser of a strategy, for though store buybacks can be made to seem profitable from an accounting perspective, overpaying to re-buy bad previous capital decisions will cumulatively destroy a company's financial standing. It's not fixing anything; it's compounding earlier mistakes. As long as the company does this, its free cash flow is of suspect value.

This, of course, is fixable. But as long as Livengood and his staff favor good numbers and growth above all else, it's unlikely to happen. The fix would look like this: Allow underperforming franchises to fail, while paying close attention to economic improvements at other pre-existing stores. Slow down growth and use capital expenditures to pay down debt and to place stores where management thinks that the chance of success is very, very high.

For a company that has decided to grow via franchising, though, the problem with the above is that it will make the numbers for a considerable period of time look simply awful. Lone Star Steakhouse (Nasdaq: STAR  ) did this exact thing, and while the company was getting healthier, its numerical performance, especially the top line, seemed to get worse. The company would end up smaller, maybe even smaller than it is today, but it would create earnings that have the benefit of being economically meaningful, unlike Krispy Kreme's condition at present.

Should management determine that its path to health is to continue apace and grow its way out of its problems (again, very attractive for franchising companies) in a hope that it can recapture the lightning in a bottle that Krispy Kreme enjoyed in the past few years, I foresee many more problems, even a potential collapse. Which way will the company go? I wish I knew. If they get religion on good corporate governance soon, their value may be well higher than zero, or even where it is right now.

Bill Mann owns shares of McDonald's. His addiction to Krispy Kreme doughnuts may be best described as "pathological." The Fool has a disclosure policy.


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