Be Careful Betting On More Upside For Krispy Kreme Doughnuts

| About: Krispy Kreme (KKD)
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Summary

Doughnut chain operator Krispy Kreme Doughnuts has struggled to find operating profit growth in FY2014, hurt by rising promotional and store support costs.

The company's financial performance has led to an up-and-down year for its stock price in 2014.

With a forward P/E multiple of roughly 29, the company seems a bit pricey relative to its current growth in operating profit and investors should probably avoid the story.

Shareholders in doughnut chain operator Krispy Kreme Doughnuts (NYSE: KKD) have enjoyed a nice stock price run over the past five years, up roughly 500%. The company has benefited from improved customer traffic volume trends in its domestic store base, partially due to new product development in the beverage area, a trend that has helped it to post a sizable uptick in its adjusted operating profitability during that time period.

However, 2014 has been a tougher slog for the company's shares, as more promotional spending and higher store support costs have cut into its operating margin, leading to a generally below-expected profit performance in FY2014. On the upside, though, Krispy Kreme Doughnuts continues to post top-line growth, up 3.7%, providing hope for continued profit growth in the future, which ostensibly would be capable of supporting a rising market valuation. So, at current prices, is the company a good bet for investors?

What's the value?

Krispy Kreme Doughnuts is a growing player in the fast food segment of the restaurant business, operating a network of nearly 900 stores around the world that sell the company's trademark doughnuts, as well as a broadening assortment of supporting food and beverage items. The company has anecdotally taken advantage of growing international demand for its doughnuts, a favorable trend that has allowed it to increase its global store base by 42% over the past five fiscal years. The net result for Krispy Kreme Doughnuts has been an upward trajectory for its overall sales and operating profit, funding a further expansion of its store network as management tries to drive toward its goal of 1,300 total stores by 2017.

In its latest fiscal year, it was a continuation of the growth story for Krispy Kreme Doughnuts, highlighted by a 5.6% top-line gain that was a function of an increase in its overall store base and higher comparable store sales in its domestic operation. More importantly, the company benefited from a rise in average customer transaction prices, aided in part by a 3% menu price increase in February 2013, which helped it to post improved adjusted operating profitability, up roughly 170 basis points. Consequently, Krispy Kreme Doughnuts generated a strong 26.1% gain in operating income, providing more capital to invest in its growth initiatives, including a foray into the ready-to-drink beverage area.

Looking into the crystal ball

The question for investors is whether Krispy Kreme Doughnuts can continue to post profit growth in the future, thereby providing a foundation for a higher market valuation. Unfortunately, things aren't looking great on that score, judging by the company's aforementioned decline in operating profitability in FY2014, a performance that management attributed to its strategy of creating customer traffic momentum through a relatively greater amount of promotional spending. While the strategy yielded positive comparable store sales growth for Krispy Kreme Doughnuts' domestic store base, up 2.8%, the growth came at the cost of operating margin contraction, culminating in flat profit growth compared to the prior-year period.

Part of the company's problem is that competitors continue to try to use upgraded food product offerings as a way of enticing customers and winning incremental market share. Case in point is Starbucks (NASDAQ: SBUX), the kingpin of the coffee house concept, which recently completed the rollout of its La Boulange brand of baked goods to its entire domestic store base, more than 14,000 stores at last count. While the company's focus is probably always going to be on coffee, currently accounting for more than 70% of its total sales, a greater amount of food sales is undoubtedly part of management's strategy to continue delivering a favorable profit growth trajectory, a strategy that will likely make life difficult for smaller competitors, like Krispy Kreme Doughnuts.

The bottom line

Krispy Kreme Doughnuts is forecasting continued top-line growth going forward, thanks to management plans for a roughly 10% addition to its global store base and its expectation for promotional activity to drive continued comparable store sales growth. That being said, operating profit growth seems to be a more uncertain proposition for the company, given the unfavorable trend in overhead costs that have led to reduced operating profitability in FY2014. As such, Krispy Kreme Doughnuts seems to have more downside risk than upside potential at a forward P/E multiple of roughly 29 and investors should probably avoid the story at current prices.

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.