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KKD As a Case Study in (mis) Valuation

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By Gordon66
May 28, 2004

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I'm wondering where you'll be in a year, two, three, five years from now when KK is still performing the same way as today? Doubt we'll be able to find or hear from you." -- hokieharry to Gordon66, May 28, 2001.

Greetings everyone,

I am returning for brief visit on this the third year anniversary of my first post on the KKD board. It has become quite fashionable to bash KKD as of late with overtones of "I told you so". But at the risk of piling on, I will add to this chorus with my own thoughts on what happened to KKD in the wake of its historic rise through the first half of 2001.

I will start with a little of my own personal history following KKD, and then explain why I think KKD presents a particularly interesting case study in the importance of analyzing a company's valuation before becoming a long term investor in the stock.

Three years ago I became interested in KKD as an apparent mania. Identifying and trading on manias was (and still is) a little hobby of mine. The stock had tripled in its first year to $20 and in so doing attracted the interest of short sellers. Those early shorts lost their shirts. On wave after wave of short covering, the stock rose from $20 to $25 to $30 to $35 and was closing in on $40 (all prices are split adjusted). At the time of my first post the stock stood at $37, a 7 fold increase over it's IPO price of a year earlier. It also had a trailing price to earnings ratio of 118, despite managerial guidance for future growth in the 25-30% range. This resulted in a PEG ratio of about 4.

KKD's current price of $21 is now 40% below where it was on my first post to this board. While the stock may yet rebound, I think it is safe to say that this 3-year performance is a grave disappointment to long term buy & and holders that kept holding after May of 2001. If the posts on this board were any judge, most were expecting a continuation of the stock's meteoric rise.

What makes KKD an interesting valuation story is that over this three-year period there were no unforeseeable setbacks in the business. Quite the contrary, KKD grew sales, and especially earnings, much faster than management had been projecting in May of 2001. Sales grew at a compounded rate of 30% over this period, and earnings rose at 45%!

Sure, the recent earnings miss and lowered guidance for this year caught the market by surprise, and really crushed the stock. But why would anyone feel it was safe to assume, three years ago, this sort of thing could or would never happen? Virtually all companies disappoint sooner or later, which is exactly why "pricing to perfection" by awarding even a great growth company a triple digit P/E is almost always unwise. It is worth noting that KKD's growth was decelerating at a good clip even before this quarter's earnings miss. Putting in a correction for the litigation payout in 4q2003, per share earnings growth went from 66% (2001 to 2002), to 51% (2002 to 2003), to 35% (2003 to 2004), to a projected 27% (2004 to 2005). Even right before the earnings miss KKD had a trailing P/E of 35, which some might argue is a bit high for a company projecting 27% earnings growth with this kind of deceleration trajectory. When a stock that is richly valued disappoints the ensuing correction is extremely severe, as we have seen.

Furthermore, the root cause of the miss (at least according to KKD management) did not come out of the blue, but was a lively topic of debate even 3 years ago. The most common rap against KKD's business model back then was that they sold doughnuts for Christ sakes. I hardly need to point out that doughnuts are fat- and sugar-laden food with no redeeming nutritional qualities that is totally discretionary (Unlike coffee, which contains an addictive, performance enhancing drug, or fast food, which at least makes a rough approximation of a normal meal). The surprise is not that people suddenly woke up to the idea that having doughnuts as a regular part of one's diet just might not be a good thing; rather, the surprise is that it took so long for this to happen. It is ironic that KKD, which got so much benefit from being a fad (not to say the doughnuts don't taste exceptionally good), should run so squarely into another fad, the low-carb movement diet. The other common rap was that as KKD attempted to scale many fold from 200 stores (it had to able to grow that much to be worth a P/E of 118) that it would get increasing difficult to grow on a percentage wise basis, both due to plain mathematics (adding 40 stores to a base of 400 requires twice as much senior management attention as adding 20 to a base of 200) and because available locations would inevitably get less attractive as the best locations got taken.

So how can we explain that if we look at the four year period starting from three years ago plus projecting one year going forward (i.e., including 2005 fiscal year with its lowered guidance) KKD's business performance will have exceeded estimates by a wide margin (growth of earnings of 40% compounded from 2002-2005 versus 25% projected in 2001), but the stock nevertheless now stands 40% lower than it was back then? One must acknowledge that this is a pretty puzzling combination of facts: better than expected business performance, disastrous stock performance.

The simple solution to this puzzle is that back in May of 2001 KKD's stock price was demonstrably irrational. As legendary value investor Benjamin Graham once said, in the short term the market is a voting machine, but in the long term it is a weighing machine. When the voting machine gets out of whack with the weighing machine, as occurs in the case of a mania, poor long-term performance inevitably ensues as the voting machine valuation converges to the weighing machine valuation.

Back in 2001, I, along with a cadre of other valuation bears, tried very hard to get KKD bulls to at least think about the mathematical assumptions about future growth that were implied by a P/E of 118. We mainly got met with arguments about how great the business was (rather than how great the valuation was relative to the prospects of the business).

I will grant that it might be argued that KKD was simply mismanaged over the last three years, and that's why it is selling now for about half what it was. In fact, in this commentary Bill Mann claims that in the quest to grow fast at all costs, KKD took on too much debt, issued too much stock, took too much equity in franchises, expanded into iffy locations, and so forth. I think this analysis is largely correct. In fact, in August of 2001, I expressed skepticism at why management had suddenly decided they could grow KKD at 35% going forward, compared to the 25% they had been projecting. My point was that the exceedingly high stock price had backed management into a corner, and they had no choice but to somehow grow the company much faster than originally planned.

While trying to grow too fast may have indeed been bad for the long term value of KKD, where would KKD be today if it had only grown EPS at, say, a sustainable 25% a year? It's forward P/E might be 50-75% higher now due to the company being on a more sustainable growth path, but the "E" in P/E would be a third lower, so this would largely net out. The stock would still have been a very poor performer. The fact is, management was in a very tough situation in the wake of the 7-fold price stock price increase, and so they may perhaps be forgiven heaving a Hail-Mary pass in the attempt to live up to an impossible valuation.

So, to summarize, over the last three years and including the next year's projections, KKD's business performance has been great, at least as great as KKD bulls were predicting three years ago. And in fact, much better than I had thought it would be. But that doesn't matter when irrational assumptions are built into the valuation.

There are many ways one can analyze a growth stock's valuation to determine if it might be irrational, and in fact a number such analyses were offered on this very board. Here is a valuation analysis by jswanni that uses projected cash flow to illuminate the highly optimistic assumptions that were then built into KKD's price three years ago.

Here is another superb analysis, by Cal8. As one note, his analysis failed to account for a split, so the stock was actually twice as expensive as he concluded it was.

In this post I took the simple approach of making rough assumptions about EPS growth and plausible terminal P/E ratios over a five-year horizon. As one scenario, I argued that a compression of KKD's P/E to 30 or lower was inevitable (the forward P/E now stands at about 20), and if so, even a 32% compounded EPS growth would leave the stock going sideways for 5 years. Another equally reasonable scenario had the stock being cut in half over 5 years.

Another way to get reasonable bounds on a company's valuation is to do a comparables analysis to see how a stock would perform if the company were to follow the same long term growth trajectory of other similar previous companies. In this post, I presented an analysis that showed that none of the past superstars in the restaurant sector would have produced market beating returns going forward if they had been awarded a triple digit P/E at the same stage in their growth trajectory as KKD was at in May of 2001.

The moral of the KKD story is that it is essential to estimate reasonable bounds on how a growth stock should be priced before becoming a long term buyer of the stock, especially when it has the hall marks of a mania (i.e., a multi-fold increase with no correspondingly dramatic change in business fundamentals, a great growth "story", a cult-like consumer following that is also buying the company's stock). No matter how much an investor may love a business, buying the stock of that business without doing a valuation analysis is just like writing out a blank check. There may be occasions where doing a valuation analysis is extremely difficult, for example when there is no track record of earnings, or the business model is unusual, or growth rates could fall in dramatically wide range based on changes in technology or market conditions. But none of this was the case with KKD in late May of 2001, and this is why KKD makes a particularly fascinating case study of irrational pricing. It was not as if the company couldn't be valued using traditional metrics (as was the case with most of the dot.coms), but rather, the market simply chose not to do so.


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