The Rise -- and Rise -- of Krispy Kreme


By Amey Stone and David Shook Krispy Kreme Doughnuts (KKD) is the kind of stock that lots of folks (especially reporters like us) point to as an example of how overvalued shares have become. Oh, it has slipped from its high of $43, all right. But at $31, it still has a price-earnings multiple of about 80 times 2001 earnings. Even with analysts projecting 30% to 35% earnings growth going forward, that's pretty pricey for a doughnut maker.

We'll admit it up front: People have been declaring Krispy Kreme overvalued since soon after it went public in April, 2000, at $21. Yet shares have, for the most part, kept rising. In 2001, it has split two-for-one twice and done a secondary offering that nearly doubled the number of shares traded. And it's still up 45% this year.

All year long it has been a target of short sellers, who borrow the stock, sell it, then hope it falls in value so they can pay it back later and pocket the difference. Since so many investors continue to believe, as we do, that it's overvalued, the more pertinent issue is: When might the stock come back to earth?

THE ANTI-TECH STOCK. One thing that might humble the mighty doughnut maker would be, ironically, an economic rebound. That would spark new earnings growth at some formerly hot high-tech companies. If tech names returned to triple-digit revenue growth, Krispy Kreme's 13% same-store sales growth might not look so exciting, and its ardent investor base may start straying.

Greg Schroeder of Fulcrum Global Partners, who recommends that investors sell Krispy Kreme stock, believes that much of the recent volume in KKD can be attributed to former technology and Internet investors looking for exciting growth opportunities in a down-to-earth company that has broad consumer appeal. Kind of reminiscent of what attracted them to Yahoo! (YHOO) and Amazon (AMZN) in 1999, isn't it?

Krispy Kreme has certainly proven to be an anti-tech stock. Just take a look at the Krispy Kreme Euphoria Yardstick -- the KREMEY -- an index that BusinessWeek Online first postulated last year (see BW Online, 10/20/01, "How Far Have Net Stocks Fallen? The KREMEY Knows"). We noticed the doughnut stock's tendency to trade counter to Internet stocks back then. When we wrote that story, an investment of $5,400 made on the day Krispy Kreme went public would have grown to $23,130, while a comparable investment in a basket of Internet stocks would have fallen in value to $2,379.

BIG LEAP. This general trend continued (see table). The initial $5,400 investment in the KREMEY (made up of former dot-com high-flyers Amazon, America Online, eBay, eToys, E*Trade, CNET, iVillage, Priceline, TheStreet.com, and Yahoo!), is now worth just $1,268, a 76% drop since KKD went public on April 5, 2000. Meantime, the $5,400 investment in KKD has climbed in value to $31,000, a 575% gain.

Granted, it's a pretty big leap to think that Krispy Kreme shares would fall just because tech stocks rebound. "I can't imagine that if the economy recovers that people will immediately go chasing dot-coms that don't make money," says Andrew Wolf, an analyst at BB&T Capital Markets, who rates the stock a buy and has a $38 price target. "People have learned that a good doughnut chain has more earnings growth than a good dot-com."

So what else might leaven Krispy Kreme's shares? Another culprit could be a slipup in company fundamentals. After all, expectations are running pretty high. Schroeder points out that for the last five quarters, the company has exceeded guidance it gave to analysts. In the second quarter, it reported profits of $5.9 million, or $0.10 a share, up about 60% from the second quarter last year and beating consensus analysts estimates of $0.09. Revenues grew 28%, to $90 million, in the quarter, and Krispy Kreme raised its guidance for the rest of the year.

BREWING BETTER COFFEE. Krispy Kreme plans to deliver more growth, not only by opening new stores in this country (it operates 192 stores in 31 states) but also by expanding overseas. It has a new head of international development in place, and on Aug. 29 it announced it would be opening its first non-U.S. store in Toronto in early 2002. Also driving more growth: In February it bought Digital Java, a Chicago coffee company, which will expand and improve the quality of its beverage offerings, says Krispy Kreme marketing head Stan Parker.

So what could stand in Krispy Kreme's way? It hasn't proven it can innovate, contends Kenneth Kimmel, a vice-president at rival Dunkin' Donuts. (Dunkin' Donuts is a subsidiary of British conglomerate Allied Domecq, and it had $2.5 billion in sales in its 2001 fiscal year vs. roughly $335 million for Krispy Kreme in the past year.) To keep customers coming back, Kimmel thinks Krispy will have to expand its product line. He also thinks its strategy of selling its doughnuts through other retail outlets could backfire if the company can't maintain quality.

Most of the analysts who cover Krispy Kreme (especially the ones from firms that helped bring the company public) aren't worried about Krispy's strategy, or its high valuation. "I think the earnings have grown into the valuation quite well," says JP Morgan analyst John Ivankoe. "Next year, I believe earnings will catch up further with the stock." That means he expects earnings to grow so fast that even if the shares keep rising, some day in the future the stock price will no longer seem so inflated relative to earnings.

"If fundamentals stay this strong, the stock will continue to do well," says Wolf. "In my experience with growth stocks, good fundamentals almost always trumps valuation."

Nonetheless, Krispy Kreme shareholders should be prepared for an eventual downturn -- just in case. The company has consistently strong returns, operating margins that are steadily increasing, and a product that produces mild euphoria in thousands of consumers and investors alike. Like a sugar high, it's great while it lasts, but it's unlikely to go on forever.

An Apr. 5 investment of $5,400 in:

Today would be worth:

GainLloss:

Gain/Loss percentage:

Krispy Kreme (KKD)

The KREMEY

$31,114

$1,268

$25,714

-$4,100

576%

-77%

The KREMEY comprises 10 shares each of

Yahoo! (YHOO), Amazon (AMZN), TheStreet.com (TSCM), eBay (EBAY), Priceline

(PCLN), CNET (CNET), E*Trade (EGRP), eToys (ETYS), iVillage (IVIL), and

America Online (AOL). Here's how they've done individually:

Ticker

Cost /Share Price

% of Total

Current Value

Gain / Loss

Gain / Loss %

AMZN

$62.00

6.6%

$90.00

-$530.00

-85.48%

AOL

$63.00

27.2%

$373.10

-$256.90

-40.78%

CNET

$44.00

6.6%

$90.00

-$350.00

-79.55%

EBAY

$83.00

40.7%

$558.30

-$271.70

-32.73%

ET

$24.00

4.7%

$64.20

-$175.80

-73.25%

IVIL

$13.00

0.7%

$9.90

-$120.10

-32.73%

PCLN

$72.00

4.1%

$56.30

-$663.70

-73.25%

TSCM

$7.00

0.9%

$11.80

-$58.20

-92.38%

YHOO

$165.00

8.5%

$117.00

$1,533.00

-83.14%

EToys (defunct)

NA

-$80.00

Previous Gain/Loss

+$0.00

Total*

$1,290.60

-$4,062

-77%

*Estimate

When not ducking out for Krispy Kreme fixes, Stone and Shook cover the markets for BusinessWeek Online in New York


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