Krispy Kreme Worth a Nibble?

Reckless Krispy wrecks the party
When I heard that corporate triage expert Stephen Cooper had been appointed to the hot seat at Krispy Kreme Doughnuts (NYSE:KKD), my first thought was: "It's about time!"

Here was a venerable 67-year-old American institution that had more than doubled its revenue and number of stores over the past three years. At the same time, it had piled up $146 million worth of debt (at last count) to finance its store-opening habit, it had overpaid franchisees to take over their stores in a state of misguided optimism, and it had managed to get into trouble with the Securities and Exchange Commission by charging costs to capital instead of to expenses. All in a short span of three years!

Agreeing with Bill Mann's incisive analysis of Krispy Kreme's negative cash generation in fiscal 2004, I ran some projections for fiscal years 2005 through 2007 making several assumptions. (See the chart at the end of this article.) I think that at $9.00, the company is worth buying. if you have the stomach to weather the storm for three more years. Here's how I think the company can turn things around, provided that Cooper cracks the whip.

1. Krispy Kreme will need to close 40 of its 400 stores in fiscal 2005 and another 30 in fiscal 2006, gradually reducing its total to 330. Dumping the most unprofitable outlets will reduce debt, stop cannibalization, and reverse the decline in comps.
   
   
2. I've assumed average sales per location at $1.75 million in fiscal 2005, slightly below the $1.77 million average over the past five years and well below the $1.86 million that the company averaged at its 357 stores in fiscal 2003. I've also assumed modest comps growth of 3% and 4% for the 2006 and 2007 fiscal years, taking sales per store from $1.75 million to $1.81 million in '06 and to $1.89 in '07. In the wonder years, Krispy Kreme was averaging more than 10% comps growth, while the number was closer to 2% for the first half of fiscal '04. (Second-half results have been held back.) Considering that Allied Domecq's (NYSE:AED) stellar Dunkin' Donuts is sporting comps growth of 6.9%, and given that Krispy Kreme isn't in that deep of a financial hole, it seems reasonable that Krispy Kreme can achieve 3% growth with fewer stores.
   
   
3. I'm forecasting margins at 18% for fiscal years '05 and '06, a figure that's also way below the five-year average of 19.5%. In fiscal '07, I'm assuming that margins improve slightly on better comps.
   
   
4. I was also encouraged that Krispy Kreme has kept its selling, general, and administrative expenses (a component part of expenses, essentially overheads associated with day-to-day business activity outside of inventory costs) at an average of 6.4% of sales in the growth years. Even so, I've figured SG&A at 7% for fiscal 2005-2007, keeping in mind the huge consultant bills that Cooper and gang are going to send in. Operating margins at 11% thus look achievable.
   
   
5. Up to August 2004, Krispy Kreme had recorded $9.5 million in store-closing costs for five outlets. That number includes $1.9 million in ancillary costs, about $5.6 million (74%) in asset or investment losses, and the remainder in early termination of leases, severance payouts, and other closing costs. Going forward, I've estimated a loss of $1.5 million per store closed, taking charges of $60 million in fiscal '05 and $45 million in fiscal '06. I've also projected a lower tax bite, assuming that the expense portion of the losses (26%) would be allowed to be set off against operating income in those years.
   
   
6. I'm assuming a reduction of debt from $132 million today to $100 million in fiscal '06 and $70 million in fiscal '07, with no capital expenditures toward new plants, machinery for new stores, or acquisitions. All the dough from store sales goes back to the bankers. (In the past three years, Krispy Kreme has spent all of its capex on opening new stores; maintenance has not been a prominent feature.) In the absence of capex in fiscal 2005-2007, I've not included it as a significant assumption.
   
   
7. I've intentionally left out SEC reinstatements; I'm assuming that fiscal '04 profit would be wiped out and then some. At the company's current price price, though, the market seems to have pretty much wiped out profits for the previous year as well!

If these estimates pan out, Krispy Kreme should earn a decent $35 million in fiscal '07, or $0.57 a share at 62 million shares outstanding. It would find itself in much the same situation that existed around fiscal '02 -- 330 stores, a leaner balance sheet, a price-to-earnings ratio of 15.8, and a market cap of 89% of sales. That would make the company -- especially one with such strong brand loyalty -- definitely worth a nibble.

Strategic concerns
Even though fiscal discipline should get Krispy Kreme back on track, it faces some other concerns, too.

First, it competes against the 800-pound gorilla known as Dunkin Donuts, with all of Allied Domecq's cash and muscle behind it. The competitor increased revenue by 9% last fiscal year, grew same-store sales by 6.9%, and turbocharged growth at 13% in its coffee segment, where Krispy Kreme isn't even considered to be a competitive threat. Meanwhile, Dunkin' Donuts is also making serious inroads into Krispy Kreme's traditional strongholds.

Second, Krispy Kreme is a product company vulnerable to changing demographics. As a result, it often gets saddled with unused capacity at many locations. Then there's the cannibalization and overexposure caused by selling doughnuts through multiple channels, which helped put the company in its current mess. Part of Krispy Kreme's allure -- and the reason for its premium pricing -- is the quality and freshness of its doughnuts. You tend to lose some of that when the product gets sold under a private label in the supermarket.

Cooper is a restructuring specialist. His first tasks are to comply with the SEC and get the house in order. And the company's recent decision to postpone the launch of a healthier doughnut suggests that marketing strategy and growth are not likely to be high on anyone's agenda for a while.

The cost-cutting exercise has already started, and even though growth and other strategic concerns are far from being solved, Krispy Kreme looks like an excellent value pick at a market cap of $555 million -- if the company is up to the challenge of shedding some flab and attacks all its strategic concerns. To do so is a lofty, but attainable, order.

Krispy Kreme remains a Motley Fool Stock Advisor recommendation.

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Fool contributor Bobby Shethia owns shares of Krispy Kreme. He and his 7-year-old think a pack of Krispy Kremes is a well-balanced meal. The Motley Fool has a disclosure policy.