Krispy Kreme Doughnuts
My Review of Krispy Kreme

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By cal8b
July 18, 2001

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[Note: The author regrets there was an error in the number of shares outstanding. He has posted a correction here.]

Mmm Donuts....

I must admit that I had not studied KKD enough to really comment on the company; I apologize for that.

I read the 10-Q that ended the April time frame and I thought I would make some fundamental comments about KKD. (If you have not read it, it is actually one of the better reports I have read.)

A couple of points are in order:

1. The dilution has been astounding. They have gone from 20,724 K shares (basic; diluted is 22,502K) on April 30, 2000 to 26,567 K shares (basic; diluted is 28,839) on April 29, 2001 to 26,804 (basic is only number reported) on June 5. Now granted, they had a secondary sale that raised 17.7 million dollars and they bought digital java with 27K shares and cash over the last year, but this still seems like they are giving the company away to the option holders.

2. Nothing stands out as a monstrous red flag that points to a Boston Chicken-like demise in the immediate future.

For those who have not read the report, they break the operation into three parts. Since we are trying to determine what a fair price for the company is, we can use this to determine how they can achieve the growth that is priced into the stock. The three divisions are:

1. Company stores. This division has had nice comp store growth of 13.1% over the last year. This represents the donut sales from the company owned stores. There are currently 63 company stores.
2. Franchise. This division collects franchise start-up fees and collects a percentage based on the sales from the franchise stores. There are currently 117 franchise stores; they added 6 in the last quarter and plan on adding 32 (Q says mostly franchise) stores over the next year.
3. KKM+D Equipment and Mix sales. These sales are to both franchisees and company stores (the consolidated backs out the sales to company stores).

Looking at the three divisions gives me an idea about the growth prospects for the company.

                         APR 2000                   APR 2001     
Division           Revs        OP Income     Revs        OP Income
Company Store     50,956          6,660     60,694          9,463
Franchise          2,000          1,000      3,006          1,968
KKM+D             46,922          2,718     58,464          3,823
Consolidated     (29,008)                  (34,243)
Unallocated/general              (4,702)                   (6,572)
Total             70,870          5,676     87,921          8,632

With 63 company stores (this is tricky because not all company stores are 100% owned by KKD and the percentage ownership determines the percentage sales that are booked) they are generating probably more than $1 million a quarter in sales per store. This is approximately $11,000 per store per day in sales. I think that the sales growth can continue but I doubt that the comp growth can continue. Each store can generate between 4 thousand to 10 thousand dozen donuts a day at peak capacity; with $11,000 per day in business, this is not close to max capacity of the larger stores, but could be getting close on the smaller stores. If they continue the torrid pace of 13.1% comps, they could have quarterly sales of $69 million in one year. Margins improved from 13% to 15.6% due to scale and a 2% price increase. I do not think that they will increase prices in the next year (total guess) and I think that a 15% margin is great, so I will only increase this to 16.0% giving this division a operating income of $11 million.

The Franchise fees do not really add too much to the top line, but are significant because of their high margins. By increasing the number of franchises, the margins should improve and the gross numbers should also improve. If they go from 117 now to 149 next year the fees should increase, but the increase should be almost proportional to the store increase. Next year in this quarter I could see them with revenues of around 4 million and operating income of around 3 million in the best case.

KKM+D depends on how many stores open in the quarter and how many donuts all of the stores sell. System wide in the April 2000 quarter they sold $103,347 K, in the April 2001 quarter they sold $140,350 K. This is an increase of $37.003 million quarter-over-quarter, or 36%. They accomplished this with an increase of 28 stores over last year. So on a 36% increase in donuts sold, they increased the KKM+D by 25%. Since they opened about the same number of new stores (the equipment sales) as last year, this tells me that equipment sales are a significant contributor to this division. If they sold the same amount of equipment as last year this quarter, and the mix sales are proportional to the end donut sales, this means that they sold about $15 million of equipment each quarter and about $32 million in mix in April 2000 but $43 million in the April 2001 quarter. If we assume that comp sales will increase by 13.1% and that they open all new franchise stores and these stores do about what a current store does, then they could see revenues of $15 million (equipment), $8 million (new store mix sales), and $49 million. This would give them sales of $72 million next year. Since the margins improved from 5.8% last year to 6.5% this year, I assume that the mix margins improve with scale. On sales of $72 million I could see margins of 7.5% as an outside possibility. This would give them a net of $5.4 million.

The consolidated should increase proportionally to the same-store sales increase, so I guess that it would be $39 million.

The general expenses have increased; I would expect this trend to continue as the firm gets larger. Pulling a number out of the air, I am going to guess that they increase less than they have in the past, and make the number 7.5 million. (Remember that this is supposed to be optimistic.)

So to summarize what I think is possible but optimistic:

                        APR 2001                   cal8 2002 est     
Division           Revs         OP Income     Revs        OP Income
Company Store     60,694          9,463     69,000        11,000 
Franchise          3,006          1,968      4,000         3,000
KKM+D             58,464          3,823     72,000         5,400
Consolidated     (34,243)                  (39,000)
Unallocated/general              (6,572)                  (7,500)
Total             87,921          8,632    106,000        11,900

They made approximately $1 million in the latest quarter in interest; I will assume that this will continue. This gives them pretax pre depreciation income of almost $13 million a quarter. If they have $2 million in depreciation and are taxed at 40%, this gives them an income of $6.6 million a quarter. If the share count does not increase (improbable at best) this is an EPS of 23 cents. An annualized EPS would then be $0.92. This gives them a future PE of 40. I think that this is too high for a donut company, but I agree with historymatters that this may not be the best short I have seen. If I were long, I would sell, if I were short I would cover (they say that the second and third quarters are their best seasonal quarters, so you are playing with fire). This has the potential to blow up to higher highs, but I do not think that any more price appreciation is warranted.

Sorry for the length and lack of clear-cut conclusion. If you see errors please point them out, I would like to hear from those of you who know this company better than me.