Be Careful Trying To Time A Bottom At Krispy Kreme Doughnuts

Aug.30.14 | About: Krispy Kreme (KKD)

Summary

Krispy Kreme Doughnuts has been riding solid profit growth over the past few years, rewarding shareholders with a sharply higher market valuation.

However, the company's profit growth has slipped in the latest fiscal quarter, leading to a sell-off in its stock.

Investors should avoid being early and should wait for Krispy Kreme Doughnuts' growth to re-accelerate prior to betting on the story.

Shareholders in Krispy Kreme Doughnuts (NYSE: KKD) have enjoyed strong upside over the past five years, with the company's stock price up more than 400%, thanks to gradually improving profitability as well as a sizable expansion of its store base, part of its bid to keep pace with growing competitors like Dunkin' Brands (NASDAQ: DNKN) and Starbucks (NASDAQ: SBUX). However, 2014 has been a more difficult campaign for Krispy Kreme Doughnuts due to a downshift in its sales and profit growth in its latest fiscal quarter, a trend that caused management to slightly lower its earnings per share forecast for the current year, a decision that led to a subsequent sell-off in its shares. The company was particularly hurt by negative comparable store sales growth in its franchised operations, which limited growth in sales of supplies to its associated franchisees, Krispy Kreme Doughnuts' largest source of income. However, with its sales and profit still on an upswing, is Krispy Kreme Doughnuts a good bet at its discounted price?

What's the value?

Krispy Kreme Doughnuts is one of the country's largest doughnut chains, operating a network of roughly 260 domestic stores as well as almost 600 stores in select international markets like Saudi Arabia and South Korea. While Krispy Kreme Doughnuts only recently started growing its domestic base of stores again after a multi-year hiatus, it has seemingly never missed a beat in its international segment, consistently growing the number of locations year after year. The net result for Krispy Kreme Doughnuts has been a solidly upward trajectory for its overall sales tallies, up 32.8% over the past four fiscal years.

In its latest fiscal year, it was more of the same for Krispy Kreme Doughnuts, evidenced by a 5.6% top-line gain that was aided by higher comparable store sales in its domestic operations and an 11% expansion of its global store base. More importantly, Krispy Kreme Doughnuts took advantage of slightly higher average prices, partially due to the introduction of premium priced beverage offerings, to generate a roughly 170 basis point pickup in its adjusted operating margin, leading to a 26.1% gain in operating income. Not surprisingly, the higher profit led to better operating cash flow, fueling the company's various growth initiatives, including its development of a small-format store concept that will hopefully allow for an expansion of its presence in smaller markets.

Looking into the crystal ball

Of course, the question for investors is whether Krispy Kreme Doughnuts can continue generating profit growth in the foreseeable future, thereby providing a solid basis for a higher market valuation. Based on the company's results in its latest fiscal quarter, the answer seems to be yes, evidenced by a 6.6% increase in adjusted operating income during the period that benefited from slightly higher sales and a 70 basis point improvement in its operating margin. On the downside, though, the company's customer traffic volumes declined during the period, down an estimated 3.8%, indicating that future sales growth may be a bit more of a challenge than it has been over the past few years.

Part of Krispy Kreme's problem seems to be the like-minded growth ambitions of the company's major competitors, including Dunkin' Brands. The owner of the Dunkin' Donuts brand has remained in expansion mode lately, consistently adding more stores to a network that tips the scales at over 18,000 worldwide locations. While the company's Dunkin' Donuts unit has struggled with negative comparable store sales in its international segment during FY2014, its larger U.S. segment has fared better, reporting a 1.8% increase in comparable store sales, helped by a menu evolution that has focused on higher priced beverage and sandwich options. As a result, Dunkin' Brands was able to post an increase in adjusted operating income during the period, up 4.9%, funding its continued growth across the country, including a major development push in California.

Likewise, Starbucks has continued to grow in FY2014, adding stores in all of its major geographies, including a roughly 6% addition to its store base in its Americas segment. The company's larger store base, combined with a global comparable store sales gain of 6%, has led to solid profit growth, up 24.9% for the period. More importantly, Starbucks' profit machine produced higher cash flow, which is providing the capital to aggressively expand its offerings in the food area as it tries to lower its dependence on coffee sales, highlighted by its recent introduction of an assortment of new breakfast sandwiches. Starbucks' goal is undoubtedly to keep its sales growth on an upward trajectory and give customers less of an incentive to go elsewhere for their impulse food purchases, like to Krispy Kreme Doughnuts.

The bottom line

Krispy Kreme Doughnuts is certainly cheaper than it was at the start of 2014 after a double-digit stock price decline. That being said, the company is still priced at a forward P/E multiple of roughly 24, a relatively pricey level if Krispy Kreme Doughnuts is unable to improve upon the mid-single digit profit growth rate generated in its latest fiscal quarter. In addition, Krispy Kreme Doughnuts seems to be struggling to grow its customer base, perhaps due to the richer food offerings being rolled out at some of its competitors. As such, investors should probably wait for profit growth to accelerate back into the double-digit range prior to wagering real money on the story.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.