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Enjoy Krispy Kreme's doughnuts; skip the stock
The doughnut company has a turnaround management team in place, and some investors may wonder if this is a chance to buy at the bottom. It's not.
By Robert Walberg
Few things in the investment world are as exciting and rewarding as correctly identifying a turnaround candidate shortly before it actually turns around. That's one reason investors and financial reporters have focused on the Krispy Kreme Doughnuts (KKD, news, msgs) story since the beleaguered company ousted Chairman and CEO Scott Livengood and replaced him with turnaround specialist Stephen Cooper.
If the management change represents the bottom for this former highflier, it could be poised to post the kind of eye-popping gains recorded by other turnaround situations like Ask Jeeves (ASKJ, news, msgs), which has soared 3,298% from its bottom, Kmart Holdings (KMRT, news, msgs), up 450%, and Martha Stewart Living Omnimedia (MSO, news, msgs), up 240%.
But as legendary investor Warren Buffett has pointed out, most turnarounds don't ever turn around. For every successful turnaround, there are many more failures. Polaroid, Enron, WorldCom, Boston Market and theglobe.com are just some of the names that never got back on track. A few more high-profile turnaround candidates that have yet to reward investors include Gateway (GTW, news, msgs), Lucent Technologies (LU, news, msgs) and Sun Microsystems (SUNW, news, msgs). Meanwhile, investors betting on a reversal in any of these companies have lost real dollars and real opportunities because their money is tied up in these stinkers.
In which camp does Krispy Kreme fall?
Last year, I identified Krispy Kreme as a potential value play in the restaurant group. And, yes, I was wrong. The company missed earnings projections as its business rapidly deteriorated. Sales have slowed considerably as Krispy Kreme has continued to pursue a rapid growth strategy with little regard for generating returns and little concern about stealing sales from existing locations. Just how bad is it? Well, in the eight weeks ended Dec. 26, the company said sales at all outlets declined 18%. Average weekly sales per factory store fell 25%.
Blaming Dr. Atkins
Former CEO Livengood and his old management team would like you to believe that its sales problems stemmed from the low-carb diet craze.
That's ridiculous. People who buy doughnuts aren't worried about carbs, sugar, calories and fat. They just want a treat. Even if the low-carb craze hurt, why have companies like Dunkin' Donuts and Panera Bread (PNRA, news, msgs) continued to grow? The problem at Krispy Kreme has less to do with Dr. Atkins' eating plan or the South Beach Diet than it does with reckless store growth.
In a little more than eight years, Krispy Kreme went from being a small, regional chain from Winston-Salem, N.C., to a nationwide phenomenon. The store count soared from fewer than 100 to more than 430. The company also now sells its doughnuts in roughly 20,000 outside locations ranging from grocery stores to gas stations.
Seduced by its early success, the company started to grow simply for growth's sake. With such widespread growth and distribution, Krispy Kreme gained brand recognition, but it lost much of the buzz that surrounded it when it first started to expand. No more long lines at its late-night drive-through windows. No more double-digit sales gains.
Management compounded the excessive-growth problem by spending millions to bail out underperforming franchises. Don't look for the new management team to make the same mistake. To the contrary, look for Cooper (who will be paid $760 an hour plus expenses) to move quickly to reduce the store count, possibly by as many as 100 shops.
A problem list that's growing
While closing underperforming units would be a wise next step, it'll probably push down cash flow from operations. And that's problematic for a company with little cash on hand and mounting obligations. According to CIBC World Markets, Krispy Kreme has:- $112 million in debt (including a $91 million bank facility near default).
- $155 million in lease obligations.
- $114 million in commodity purchase commitments.
- Total cash obligations: Nearly $380 million.
CIBC notes that this total doesn't include significant off-balance-sheet, franchisee-related obligations.
These are the problems we know about. Toss in a Securities and Exchange Commission inquiry into accounting, numerous class-action lawsuits and the fact that the company restated fiscal 2004 results and is apt to make additional restatements in the months to come, and the picture looks even worse. In short, the new management team has a big mess on its hands, and it's not at all clear that Krispy Kreme will be able to escape bankruptcy, despite Cooper's recent claims.
Are the problems insurmountable? Probably not. But until we know the actual financials and get a better sense of the new management team's recovery plan, why nibble at the stock?
The stock doesn't deserve its premium
Let's add another argument against buying Krispy Kreme now: The stock isn't cheap, even at a selling price of just under $9 a share. In fact, at 22 times estimated fiscal 2005 earnings and 15 times trailing 12-month cash flow, the stock trades at a premium to its sector and the market. And remember, its earnings estimates are far from solid. This quarter's mean earnings estimate has tumbled from a gain of 18 cents 90 days ago to a loss of 2 cents.
Clearly, the risks associated with the stock don't warrant premiums of any kind. Neither does the fact that the company's profit margin, return on equity and return on assets are all well below industry norms. Deep discounts would be more appropriate. For that to be the case, however, the stock must fall considerably from current levels. How far down is tough to say, but another 20% to 30% decline (to as low as $6.20) would seem reasonable, if not conservative.
Krispy Kreme has a strong brand and a great, great product. Yet management has made some reckless decisions that leave the company on the brink of extinction. It's possible that Kripsy Kreme will do a Kmart and rebound significantly. That's why the company is paying Cooper $760 an hour plus expenses -- which could generate earnings for him of more than $1.4 million a year.
Still, there's just not enough evidence to suggest that a turnaround is imminent. So enjoy the doughnuts while you still can, but do yourself a favor and avoid the stock.
At the time of publication, Robert Walberg neither owned nor controlled shares in any equities mentioned in this column.
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