So, I've been reading the work of many value investors lately, including Buffett's BH Shareholder Letters, Graham's Intelligent Investor, Klarman's Risk-Averse Investing, and finally Mohnish Pabrai's Dhandho Investor.
I have to say Pabrai's writing style is much richer than the previous three. Admittedly, investing can be dull when one thinks in the abstract about it, but he makes it come alive.
Anyways, I'm telling you why I don't like Krispy Kreme Doughnuts (KKD) today. I'm going to focus on some of the main threads I have been reading about lately, primarily strong brand (economic moat), consistent earnings growth, and discount to intrinsic value. I don't recommend shorting KKD (I'm not a short kind of guy), and although I like several factors, it's not worth establishing a position in.
First, I'll tell you why I like the company.
1. Strong Brand - Have you ever eaten a Krispy Kreme doughnut? They're delicious! And there is nothing more exciting that seeing the illuminated "Hot Now" sign outside any KK window.
2. International Growth - While MCD and YUM get all the attention for their international growth, Krispy Kreme has grown its stores from 120 to 460 in the last 5 years (Total current store count of 700).
3. Paying Down Debt - Interest Payments decreased from $10mm to $1mm in two years.
4. Growing Earnings - Earnings grew from $400k to $8.8mm to $30mm ($30mm is adjusted to ignore a one-time $130mm deferred tax gain)
5. Plans to incorporate beverages, especially coffee - Doughnuts account for 88% of KKD's sales, and given that DNKN derives 60% of it revenues on higher margins from coffee, beverage offerings are scheduled to increase beginning in 2012 (right now)
6. Limited Analyst Coverage - Six analysts cover the stock, none of which are from a bulge bracket bank. The fewer eyes on the stock, the less popularity it currently has. If larger bank analysts begin coverage, then institutional investor attention may come with it
7. Low Institutional Investor Holdings - 35% is low, and institutional investor attention drives the price higher, faster
So, it's safe to say the company has some positive momentum. After all, its gained 300%+ since its March 2009 lows. There are some red flags which give me pause as I consider KKD.
1. The P/E is artificially low - Due to the tax savings outlined in point four, the adjusted P/E should be ~13.
2. The CEO has limited experience as a quick-service restaurant operators (from KK website):
James Morgan, CEO - Mr. Morgan has served as Chairman of the Board of Krispy Kreme since 2005; Chief Executive Officer of Krispy Kreme since 2008; President of Krispy Kreme from January 2008 to November 2011; Vice Chairman of the Board of Krispy Kreme from 2004 to 2005; Chairman of Covenant Capital, LLC, an investment management firm from 2001 to 2008; Chairman and Chief Executive Officer of Wachovia Securities, Inc. from April to December 1999; and employed by Interstate/Johnson Lane, an investment banking and brokerage firm, from 1990 to 1999 in various capacities, including as Chairman and Chief Executive Officer, and led the transition during the merger of Interstate/Johnson Lane and Wachovia Corporation in 1999.
In his defense, KKD claims he turned around Interstate/Johnson Lane. KKD is a turnaround story, because it was saddled with substantial debt as part of an LBO in the late 2000's. So, maybe some merit there. His CFO has experience with Oakwood Homes, while his VP of Operations has experience with McDonald's, Chief Marketing Officer has experience with Fuddrucker's, Noodles and Co., Red Robin, and Sonic. Finally, their International head has experience with Yum Brands internationally.
3. Non-Recession-Proof - Doughnuts are not nearly as essential to one's diet as a burger or sandwich is, no matter how unhealthy. So, I worry that in a downturn doughnuts will lose favor, especially if KKD cannot incorporate coffee into its sales.
4. Declining International Same-store Sales - From 2010-2012, sales have decreased at least 11% each year. Since they have so many stores abroad and it is a big part of their growth strategy, this worries me as well. Management has attributed the declines to "cannibalization" from other nearby Krispy Kremes and the decline of "honeymoon effects" from new store openings/promotions.
5. Low Margins on Company Stores - With essentially 0- -2% margins for stores the company has equity stakes in, it may indicate that other franchised stores are similarly unprofitable. Without profitable and thus happy franchisees, the brand cannot expand.
6. Store set-up creates scalability issues - While management currently aims to decrease the square footage of each of its stores, the requirements for building stores with the capability of producing doughnuts on-site potentially make adding new stores more difficult. Also, efforts to have stores without "Hot Now" doughnuts could damage part of their brand and makes them no different from Dunkin' Donuts.
So, there are reasons why this is a good or bad investment, but the fact the low P/E is misrepresentative of KKD's true value hinders its discount to DNKN and SBUX. With both its competitors expanding rapidly overseas (DNKN expects to open 600 new stores in the next year), and KKD only planning to expand to 900 stores by 2017, the growth curves are obviously on different levels.
Additional trouble in Europe, which now seems increasingly likely, and slowdowns in economic activity in China, point to the possibility that jumping in on KKD right now, after such a long bull run, may be ill-advised.