It's said that Krispy Kreme Doughnuts (NYSE:KKD) founder Vernon Rudolph, besieged by passersby lured into the entrance of his wholesale doughnuts business by the delicious aroma of hot doughnuts, eventually cut a hole in his wall so that the fresh concoctions could be passed directly to customers from the production floor.
Since those days in the late 1930s, Krispy Kreme has wrestled with its identity, which is part packaged goods consumer company, selling doughnuts in grocery and convenience stores, and part retail doughnut shop. After some 77 years in business, the split personality is very much in existence: The two types of business divided company shop revenues 50/50 in fiscal 2013.
Up until a few years ago, Krispy Kreme was content to stick to this model. Stores were configured to honor that initial serendipity, with a typical location running in excess of 5,000 square feet, containing a doughnut shop at the front, and a visible "factory" or "commissary" (Krispy Kreme company terms) seen through a large glass wall, churning out wholesale doughnuts en masse.
Yet recently, international expansion has influenced the company's perceptions on format. In countries like Qatar, South Korea, Indonesia, and Australia, the American doughnut is a novelty, not a mainstay snack. So instead of trying to establish 50% of its revenue as packaged goods, Krispy Kreme has opted to use a "hub and spoke" format for franchise expansion, where a centrally located bakery supplies doughnuts to several locations in a given city.
This international experience, which has proven the relative ease of geographical growth given a small store footprint and a strong franchisee base, seems to have convinced management that new U.S. locations don't necessarily have to adhere to the hybrid format. Thus the company originated a new, free-standing "small factory store" in order to fuel growth.
Shrinking locations show promise
The company launched its first prototype in January 2013. A little over a year later, Krispy Kreme has eight company-owned small factory stores, with 10 to 15 projected to be opened during the current fiscal year (2015), and 20 to 25 projected to be opened by franchisees during the year.
The new store format has several advantages for the company. Most significantly, the stores produce a decent amount of revenue given their size. According to the management, these units are grossing nearly $30,000 a week, which is about 85% of the average $35,000 gross of all Krispy Kreme units. These weekly sales levels will likely decline, as the typical new Krispy Kreme store enjoys a roughly 18-month "honeymoon period" upon opening, in which local interest generates higher initial sales.
Even so, the new stores seem poised to comfortably bring in more than the long-term $20,000 weekly gross sales projected by the company for this format. At that sales level, given a "build to suit" scenario in which a franchisee leases a freestanding building from its landlord, the locations are projected to return 20% annually on a franchisee's cash investment -- a very attractive return on investment for established franchisees looking to increase profits.
Easier financing, better focus
Other aspects of the freestanding stores will appeal to franchisees as well. First, it's easier for a franchisee to secure debt capital for, say, four locations at 2,300 square feet each than it is for two traditional store formats at 5,000 square feet. That's because the lender's risk gets diversified: four separate sources of cash flow, each with their own collateral, often look more promising to a banker than one or two larger locations.
In addition, established franchisees will likely gravitate toward fine-tuning their locations to more resemble the hub-and-spoke configuration being used internationally, which means they won't have to worry about running a wholesale business with each location. Simplifying a business model in this way will make it much easier for franchisees to focus on increasing sales per square foot.
As you might guess, this change to Krispy Kreme's business brings it more directly into the competitive orbit of Dunkin' Brands Group (NASDAQ:DNKN) Dunkin' Donuts stores, which range in size from 1,200 to 2,500 feet, and which follow a model not too different from the hub-and-spoke design. Dunkin' Brands calls its hubs "Centralized Manufacturing Locations," or CMLs, but the concept is the same: enable expansion of more numerous outlets by separating production from retail sales.
Also in a nod to Dunkin' Brands, management's strategy shift might entice smaller operators to join up under the Krispy Kreme banner. While well-capitalized franchisee groups provide the foundation for a franchise's growth, smaller operators can boost the top line with additional revenue. As Dunkin' Donuts has shown throughout its history, a fair amount of smaller mom-and-pop franchisees can be a viable option for expansion.
Within roughly two business quarters, we should be able to better discern the ROI for Krispy Kreme small-factory stores, as the first wave of this format will be coming off their honeymoon sales periods. Based on initial results, however, and the go-ahead to build between 30 to 40 stores between the company and its franchisees -- or between 11%-15% of the current domestic store base -- look for Krispy Kreme to shrink in order to grow for the next three to five years at least.
Asit Sharma has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.