The Krispy Kreme (KKD) doughnut is an easily conjured image amongst many Americans. When the Krispy Kreme Doughnuts Now sign lights up, consumers act in Pavlovian fashion, mouths watering, unable to resist the urge to buy at least one freshly made doughnut. The sign and the doughnuts are certainly a staple in the company's branding and recognition marketing technique. But is the stock as irresistible as the doughnut? I've decided to take a closer look after the stock passed a screen I've developed for value-based stocks with growing EPS. (The product, by the way, also passed a taste test). The screen itself consists of:
- Security Type: Common Stock - I am interested in investing in US-based companies.
- P/E (Intra-day/ TTM): Less than or equal to 11 - I want a company with a lower than average P/E to give it some 'value' and room for the stock price to grow. Following the screen, I must compare this to the industry and historical average. KKD: 2.63 TTM
- Note: Krispy Kreme actually trades at 22.41 TTM earnings multiples when excluding a significant tax break received in 2011. Real earnings per share from operations were $.027 in the trailing twelve months (available on businessweek). Always do your own financial calculations!
- EPS Growth (Past 3 Years): Greater than or equal to 30 - I want a growing company to promote growth in the stock price moving forward. KKD: +239%
- Return on Equity (TTM): Greater than or equal to 25 - I want a company creating significant returns on equity. KKD: 93.75% TTM
- Return on Investment: Greater than or equal to 10 - I want a company creating significant returns on investment. KKD: 80.97%
- Debt to Total Capitalization: Less than or Equal to 22% - I want a company that is not significantly leveraged with debt, although, some debt to leverage growth is not terrible. KKD: 9.84%.
The Krispy Kreme doughnut is iconic: there is nothing quite like freshly made Krispy Kreme doughnuts rolling off the in-store factory line. The company's principal business is both owning and franchising Krispy Kreme stores; it generates revenue through Company Stores, Domestic Franchises, International Franchises, and the Krispy Kreme supply chain. Stores have two formats: factory stores (have a doughnut-making production line and serve both on-premise and through wholesale distribution) and satellite shops (only on-premise service).
Krispy Kreme exhibited growth in Q1, but not as much as analysts expected. Revenues increased 3.7%,, as Company stores, domestic franchises, and international franchises all saw increased revenues. Overall, same store sales rose 2.1% (14th consecutive quarterly increase). Same store sales rose for domestic franchises and company stores, but fell 7.4% in the international franchising segment due to comparisons to high initial opening sales ("honeymoon effects") and cannibalization as markets develop. Meanwhile, margins were mixed as direct operating expenses fell to 81.7% of revenues compared to 83.2% but general and administrative expenses increased to 6% from 5.4%.
In terms of growth, management expects FY 2013 operating income between $29 million and $33 million, compared to $25.6 million for FY 2012; FY 2013 EPS between $.21 and $.24 is to be expected according to analysts. Moving forward, the company is focusing on increasing its coffee penetration from its current percent of 4% of retail sales to 12% by the end of fiscal 2015 - this should increase margins, have a meaningful impact on same-store sales (doughnuts and coffee are complementary products), and ultimately increase profitability. Iced coffee is also debuting. The challenge moving forward is channeling the message to guests that a good cup of coffee can be acquired at Krispy Kreme.
Furthermore, Krispy Kreme is growing both domestically and internationally and is actively finding suitors for franchises. Krispy Kreme is focusing on developing a newer, smaller factory store, which should reduce costs while allowing penetration into markets out of reach of a current factory store. Domestically, franchisees expect to open between 10 and 15 US shops this year. Aggressively expanding overseas, specifically in India, Krispy Kreme recently entered into an agreement with Citymax Hotels for the development of 80 franchises in the next 5 years. International agreements in Moscow have also been reached. Krispy Kreme will need to keep an eye on its international franchise same store sales number, indicating sales growth internationally at stores open for more than one year. Although openings can fuel growth, in the long-term established stores must be able to increase sales to generate revenue growth. Given that Krispy Kreme is clearly investing in foreign markets, international same store sales are indicative of long-term growth for the company.
An interesting note here is that the returns and P/E in the initial screen above are tilted in KKD's favor due to a favorable tax deferral. For example, return on equity is 94% while return on investment is 80% for the trailing twelve months, but in the most recent quarter return on equity is actually closer to 10% and return on investment is at 9%. Real P/E, without the tax deferral, is actually 22, not the listed 2 by Fidelity and other brokers. Forward P/E is similar for FY 2013; for FY 2014, forward P/E is at 17.6 on expected earnings of $0.35.
When calculating PEG, earnings are actually expected to decrease this year compared to last (partly due to capital expenditures and expansion), but after that an explosive 35% of earnings growth is expected in the next 3-5 years. Taking a PE of 22 and dividing by 35 yields a PEG of .63, which is somewhat undervalued. This, however, is ignoring a year of decreased earnings and requires KKD to grow by 35% following that.
Compared to competitor Dunkin Donuts (DNKN), KKD's P/E is much lower (22 vs. Dunkin's intraday 57). Nearly all of Dunkin's financial ratios are higher, which is mostly related to Dunkin's more stable EPS growth, increasing EPS this year and further out (albeit at a slower pace than KKD's projected 3-5 year pace), steadier revenue growth for the past five years (Dunkin's +1.71% versus Krispy Kreme's -2.65%), and nearly double the profit margins (Dunkin's 10.73% vs. Krispy Kreme's 5.55%). Dunkin's higher margins and sales can be attributed to its focus on coffee, and increased customer traffic by serving more than just coffee.
Overall, Krispy Kreme has prepared itself for growth by aggressively expanding. But, based on selling almost solely doughnuts and declining international same store sales, the company may not be able to generate long term growth gains after consumers' initial lust for doughnuts tapers off following store openings. Anecdotally, Krispy Kreme doughnuts are delicious - but I couldn't envision myself eating one every single day, and I imagine that many consumers feel the same. Its current price marks a P/E of 22 and a forward P/E of 17; while these P/Es may turn out to be warranted due to future growth, the company isn't in value territory based on these prices. While competitor Dunkin' Doughnuts trades at a premium compared to Krispy Kreme, I find the premium warranted and do not anticipate the ratios converging (at least in the near term). A quick look at the stock's chart illustrates consolidation between $6 and $6.50 for the past two months, indicating that the market is more or less satisfied with the current valuation; unless there is a catalyst that will markedly affect earnings, I foresee the stock continuing to trend sideways.