Adding Doughnuts To Your Portfolio May Increase Your Profits

| About: Dunkin' Brands (DNKN)
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Over the last six months, the market has witnessed two "giants amongst doughnuts" enjoy quite a delicious run up. Krispy Kreme (KKD) soared over 116% while its competitor, Dunkin' Donuts (NASDAQ:DNKN), rose just over 23%. While those are encouraging gains, one wise question to pose may be: Can KKD, with its worst years in the rear-view mirror, and DNKN, with its planned expansion into California, continues to rise? The short answer, I think, is yes. If they plan and execute their expansions wisely (and not recklessly as KKD did under former CEO Scott Livengood), then these doughnut chains should continue growing and yielding gains for investors - whether or not you prefer plain or glazed.

Krispy Kreme, the 75 year old Winston-Salem, N.C. based company that boasts in bright red and green neon lights "Hot Donuts Now" as it fries up the sugary morsels, is planning a big expansion - but in a little way. By "little way" what I am referring to is the size of the proposed new outlets, which will be roughly 2,300 square feet, complete with a production line that can make 110 dozen doughnuts an hour. These outlets will be called, "small free-standing factory shops," and unlike the previous larger locations, which are roughly 4,000 square feet and served as retail and wholesale centers, these smaller shops will be retail outlets only.

KKD's earlier expansion beyond the South East turned out to be disastrous. As the company opened new retail/wholesale locations across the country, its stock soared above $50.00 per share and became one of the darlings on Wall Street. But the hype and the lines around the block of newly opened KKD outlets faded, and its stock and retail outlets began to crumble and close. By February 2009, the stock hit a low of $1.01 per share.

Interestingly, one of the reasons of the demise of the previous KKD expansion was that these outlets served both retail and wholesale customers. Not only did that business model over-saturate the new markets, but it basically undercut local franchisees by selling in bulk to the giant supermarkets and convenience stores in the area. The other issue that led to the demise of these franchises was that the company required them to purchase the equipment and batter at what the franchisees felt was at over-inflated prices. Hopefully, KKD as a company has learned its lesson. A leaner, less expensive operation that doesn't undercut its retailer by saturating the market with its product will bring healthy profits for the company, franchisees, and investors.

KKD has 740 stores in 21 countries; 506 outlets are international, with Saudi Arabia leading the way with 95 units. The company plans overseas expansion, and is focusing on emerging markets where it has inked development deals with franchises in Russia, the Philippines, India, the UK, along with 15 locations in Singapore. KKD looks to expand its market in the U.S. with 400 new locations planned by 2017. Today KKD seems to be a company no longer just on the mend; and with President and CEO James H. Morgan now securely at the helm, the company is leaner and primed for growth. The new smaller store will offer lower breakeven points and should be able to generate greater investment returns for franchisees. Currently KKD retail-only outlets average $32,000 to $34,000 in sales per week. According to Mr. Morgan, customers want their Krispy Kremes fresh from the fryer, "Consumers tell us they want more doughnuts, more doughnuts hot and the special experience and reward they get from visiting Krispy Kreme. And they tell us they would eat more doughnuts if we would simply provide them with a reason to do so."

Wall Street sees KKD as strong takeover target. The company's profits have risen significantly from its pretax profit of $418,000 in fiscal 2010 to $8.9 million in fiscal 2011, to $30.4 million in 2012. However, the 2012 sales included a $6.2 million non-recurring gain on the company's sale of its 30 percent interest in franchises in Mexico.

On January 19, Zacks upgraded KKD to a strong buy primarily due to the company's strong momentum prompting the analysts to raise earnings expectations. KKD, which has a market cap of $864.61 million, closed on Friday, February 1st at $12.98 per share, just shy of its 52-week high of $13.19, and has a very low P/E of just 5.81. KKD sells for 21.5 times this year's earnings with a growth rate of 25%.

No doubt it is good to see the company finally coming back from its earlier disaster under the leadership of then CEO, Scott Livengood, that almost bankrupted the company, but I question whether the stock's rise is running out of steam. Even though it does sell coffee and other drinks, KKD is a one-product company: Fresh hot donuts. And that alone limits the growth of the company. It worries me that when the "Hot Donuts Now" sign is turned off, the bulk of the customers will be turned off too. To some extent this may have happened during its frenzied expansion when people tasted KKD donuts that were not fresh out of the fryer (think flat cola and the unpleasant, overly-sweet taste).

I believe the company's best avenue for expansion is the route it is currently taking by focusing on the emerging markets while moving slowing in expanding in the U.S. I think that outside of the South East, people still have a bad taste in their mouths about KKD and its doughnuts, and that trying to expand too quickly in the North East or the West Coast could once again bring the company down. I believe the stock is priced where it should be - and unless there is more buy-out chatter, I think the stock is sitting at its high end for the time being. I would wait on the sidelines for a good dip before buying. Bottom line: Buy the doughnuts when they're hot, watch the stock.

Dunkin' Brands Group, the restaurant operators of Dunkin' Donuts and Baskin-Robbins Ice Cream, continues to look west for expansion - namely California. The company, based in Canton, MA, announced plans to open 115 franchises in the So-Cal counties of Los Angeles, Riverside, San Diego, San Bernardino, Ventura, and Orange with the first store slated to be open in 2015. With eyes on the future, DNKN looks to open upwards of 1,000 stores in California. This will not be the first attempt for Dunkin' Donuts to crack the California market. Like KKD, Dunkin' Donuts opened branches in the Southland, and like KKD, it was forced to close a short time later. However, this is a different Dunkin' Donuts than before - as of July 2011 it became a publicly held company raising over $400 million.

The bulk of Dunkin' Donuts outlets can be found in New England and New York, where people don't necessarily swear by the donuts but more by its coffee - 1.5 billion cups of brewed coffee sold each year. Yes, Dunkin' is known for its coffee that tastes somewhere between the harsh strong Starbucks and the weaker convenience store coffee found at 7-11.

There is little doubt that California is doughnut country; every strip center seems to have one. They've become the equivalent of pizza parlors in Brooklyn, NY. And these doughnut shops, which number roughly 2,400, were built mostly by a network of Cambodian immigrants who have banded together and worked long hours to fry up a better tasting doughnut, putting the larger California chain doughnut shops, like Winchell's, on its heels. The question is can DNKN crack the California doughnut market, or will it be beaten back again by the local doughnut vendors (which 80% are Cambodian owned)?

I don't think DNKN sees the small operations as its competition: While these operators sell their delicious artery-clogging sugary goodness, coffee sales are primarily an after-thought. DNKN on the other hand is the largest retailer serving coffee by the cup. Roughly 60% of DNKN sales are from its coffee and other drinks, which really means Dunkin is not going up against the small independent doughnut shops as much as it is planning on cutting into the coffee sales of Starbucks (NASDAQ:SBUX) and McDonald's (NYSE:MCD). Starbucks has roughly 18,000 stores throughout the world, with 11,000 in the U.S. Today there are 10,479 Dunkin' Donut locations worldwide, with 7,306 in the U.S. and 3,173 overseas. Baskin-Robbins has a total of 6,980 locations, 2,463 in the U.S. and 4,517 overseas, giving DNKN a total of 17,459 locations.

DNKN, a $3.88 billion market cap company, announced fourth quarter earnings tripled to $34.3 million or $0.32 per share, up from $11.6 million or $0.10 per share compared to fourth quarter 2011, stating an increase in traffic and sales. Revenue rose 4.8% to $658.2 million from $628.2 million in 2011. The company announced it boosted its quarterly dividend from $0.15 to $0.19 per share. Tuesday, February 29th, analysts at UBS increased the price target from $36.00 to $41.00. On January 31st, Jags Report stated that Argus also raised its price target from $38.00 to $42.00, while separately Miller Tabak cut DNKN from a buy to a hold.

DNKN stock closed on Friday, February 1st at $37.10, about $3.00 below its all-time high. It has a high P/E ratio of 38.78 compared to its competitors like Starbucks at 30.55, MCD at 17.9, Einstein Noah Restaurant Group (NASDAQ:BAGL) at 14.16, and KKD at 5.81, but if its expansion proves successful the P/E ratio would be justified.

This is more than a tale of two doughnut shops. KKD and DNKN, though both doughnut sellers, are very different companies. KKD is in the business to sell hot fresh doughnuts while trying to rebuild a tarnished image, while DNKN sees itself growing worldwide with its coffees leading the way, making it far more than just a purveyor of circular, glazed treats. I do like the company and its efforts to grow, and I like that DNKN has given back some of the profits to the investors in stock dividends.

My concern with DNKN is whether or not it can actually compete with SBUX and MCD, especially beyond the east coast; and I think the company is betting heavily that it can. If DNKN bets correctly the stock might actually be a bargain. But if history repeats itself and the company fails once again in the California market, the stock could easily tumble. However, it plays out in the next few years, even with its high PE ratio, I am long on DNKN, and a hold on KKD.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.