Krispy Kreme: A 6-Point Inspection

Aug.30.14 | About: Krispy Kreme (KKD)


Krispy Kreme sells donuts through its stores and through other retailers.

Krispy Kreme demonstrated fundamental improvement over the last five years, including the elimination of long-term debt.

Krispy Kreme is currently overvalued along with competitor Dunkin' Brands.

Long-term investors should develop a guide or a list of questions to help them in their stock market research. The six questions below can help you get started to guide your research of any company. Let's research Krispy Kreme (NYSE: KKD) based on these criteria.

1) What does the company do?

When you buy shares of a company you effectively become part owner of the business, and business owners should know what they sell. With that said, Krispy Kreme and its franchisees sell donuts through retail stores and to other retailers via its wholesale channel. Franchisees operate roughly 89% of Krispy Kreme's 855 locations.

2) What do the fundamentals look like?

Krispy Kreme's revenue increased 33% over the past five years. Its net income went from $0 in 2010 to $34 million in 2014. Krispy Kreme's free cash flow increased 175% over the past five years. Same store sales increases of its company and domestic franchised stores, which comprised roughly 69% of sales in 2013, contributed to the growth in overall revenue during that time. Store expansion and lower interest due to lowering of long-term debt over the past five years also contributed to top and bottom line expansion.

Krispy Kreme increased its revenue and net income 1% and 21%, respectively, in the most recent quarter. Its free cash flow declined 28% during that time. Once again, store expansion and domestic same store sales contributed to the increases in revenue and net income. Free cash flow declined due to expansion in capital expenditures and unfavorable accruals.

Krispy Kreme's most recent balance sheet is in good shape with its $44 million in cash comprising 17% of stockholder's equity. Krispy Kreme sports no long-term debt which represents a good thing. Long-term debt creates interest expense which chokes out long-term profitability and cash flow. Investors should always look for long-term debt to equity ratios of 50% or less.

3) How much management-employee ownership is there?

Investors should always look for companies with management that owns a huge amount of the company's stock. Managers with a stake in the company will make sure that the bottom line is maximized resulting in an increased stock price and enhancing their personal wealth. In other words, their interests are aligned with their shareholders.

Krispy Kreme's proxy statement reveals that directors and executive officers own 8% of the company. Specifically, James Morgan, Krispy Kreme's Executive Chairman, owns 2% of the company. He definitely holds an incentive to make sure Krispy Kreme goes in the right direction.

4) How does its "Report of Independent Registered Public Accounting Firm" stack up?

Every year external auditors come in and audit a company's financial statement and internal financial controls. Generally, they write a letter to the board of directors and issue a clean opinion on those items using language such as "unqualified" or "fairly presents". If you see words such as qualified or adverse then deeper issues such as financial manipulation may be happening.

Last year, Krispy Kreme's external auditors issued a clean opinion on both its financial statements and its internal financial controls.

5) What types of risk does it have?

Investors need to weigh the various risks concerning their businesses such as political risk, competitive standing, and market price risk. Krispy Kreme maintains an international franchise presence which means it possesses some political risk.

Krispy Kreme stands at a huge competitive disadvantage to its publicly traded competitor Dunkin' Brands (NASDAQ: DNKN). While Krispy Kreme's operating margin has been steadily rising since 2010, it clocked in at 10% last year vs. 72% for the Dunkin' Donuts portion of Dunkin' Brands' business. Dunkin' Brands sports a 99% franchise model that allows Dunkin' Donuts to keep a larger portion of revenue as operating income. However, Dunkin' Brands sports a long-term debt to equity ratio of nearly 500%!

Krispy Kreme trades at a P/E ratio of 33 vs. 18 for the S&P 500 and 31 for Dunkin' Brands. Krispy Kreme trades at a forward P/E of 26 versus 17 for the S&P 500, meaning you are paying more in terms of margins.

6) What does its forward analysis look like?

With Krispy Kreme's sky high valuation, investors may want to sit this one out and wait for a correction. Investing in this company when the market price risk is lower may prove the more prudent move. Also, with increasing consumer preferences for healthier food choices, this company may be facing long-term headwinds.

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.