By David Shook In the wake of Enron's collapse and accusations of financial shenanigans at many other companies, investors these days are looking for balance sheets and business models they can easily grasp. So what could be more appealing than coffee and doughnuts, or Starbucks (SBUX) and Krispy Kreme (KKD)?
The two companies share some important similarities. Both have become icons for America's quick-fix snack habits, hooking millions of consumers on their products. Both have benefited in the past year from being in recession-proof businesses. As stocks, the two have also been hot-growth names that occasionally get pummeled as investors bail out (Starbucks, now at $23, has actually done better year-to-date than Krispy, now at $37.50).
As investments, however, they have some major differences -- in growth prospects, competitive position, and valuation. Especially in this rocky climate, Starbucks likely has more advantages for investors to consider.
A MATURE BREW. Their most significant divergence is that the two companies are probably at very different stages in their life cycle. In many ways, Krispy Kreme, which went public two years ago and launched a bold expansion strategy using the proceeds, looks like Starbucks 10 years ago. Back then, Starbucks had as many doubters as coffee fans. Critics said its $4 gourmet lattes would be a '90s phenomenon. Now, it's clear that Starbucks is more like McDonald's in the '80s: Well-liked by consumers worldwide and found on every street corner.
Starbucks' strategy of selling premium coffee with piped-in jazz music, comfortable seating, and well-trained staffers has clearly paid off. In its most recent quarter, which ended Dec. 31, 2001, sales increased 26%, to $910 million, up from $722 million for the same period the year earlier. Net earnings for the quarter were $68.4 million, or 17 cents per share, an increase of 40% (including a $13.4 million gain from the partial sale of Starbucks Japan), compared to $49 million, or a split-adjusted 12 cents a share a year earlier.
And just like with '80s-era McDonald's, international growth seems to be next on Starbucks' list. It's jumping into Mexico City, Tokyo, Athens, and Hong Kong, along with many other European, Asian, and Latin American markets. It already has more than 650 coffee shops outside the U.S. and plans to open 100 more this year. Moreover, the coffee brewer still sees plenty of expansion opportunities in the U.S. Starbucks has 3,154 stores in North America and plans to open 525 more this year.
SQUEEZED SHORTS. Krispy Kreme, by contrast, is still trying to prove itself. It's a much smaller company, although its rapid sales growth has already given it a 118% market gain over the past year. Its sudden rise has brought doubters out of the woodwork -- short sellers who love to bet against it, figuring a rocket stock like Krispy Kreme has to fall eventually.
However, since the company's initial public offering less than two years ago, short-sellers have been squeezed repeatedly. Krispy has continued to defy critics as the stock climbs steadily, buoyed by robust earnings growth each quarter. Comparable store sales jumped 13.1% in its most recent quarter, vs. 2% for Starbucks.
Now comes the hard part: It's still unclear just how far Krispy can take its concept of providing sugary, fat-laden doughnuts for the masses. It has 218 stores and expects to have 59 new full-service bakeries and 10 to 15 smaller shops this year, all in North America. Systemwide sales for the fourth quarter ended Feb. 3 increased 46%, to $183 million, according to the company's preliminary estimates.
And Krispy expects to meet earnings estimates for the 2002 fiscal year when it announces bottom-line profits on Mar. 8. It aims to report earnings of 44 cents a share for the 2002 fiscal year and 61 cents a share in the 2003 fiscal year.
GOLDEN BEANS. That's attractive growth, but investors have already priced it into the stock. Starbucks, which is up 17% this year, has a price-to-earnings ratio of 42, while Krispy Kreme, which has slid 15% year to date, has a p-e of 96. That leaves room for a lot more downside if the doughnut maker can't deliver on its ambitious targets.
Starbucks is also the more financially sound of the two -- an important consideration in this skittish business climate. The Seattle-based coffee king ended the year with more than $300 million in cash and virtually no debt. Also, it consistently posts free cash flow -- a measure of how much more money a company makes than it spends each quarter.
Krispy Kreme, by contrast, has just $45 million in cash and about $9 million in debt. Nor has it been able to post free cash flow every quarter. "Starbucks has always been cash-flow positive. The company just has the model down right," says Doug Cristopher, analyst for Crowell Weedon & Co.
DIXIE SHOWDOWN. Finally, Starbucks benefits from less competition than Krispy Kreme, analysts say. Small gourmet chains such as Timothy's World Coffee, a Canadian company with stores along the East Coast, haven't been able to compete with Starbucks in the U.S. Timothy's closed its U.S. operations in January, citing the sluggish economy.
Meanwhile, Krispy Kreme's main competitor, Dunkin' Donuts, a division of British food-and-spirits giant Allied Domecq, has been pushing into North Carolina-based Krispy Kreme's home turf -- the American South. Massachusetts-based Dunkin' doughnuts says it plans to open more than 300 new stores south of the Mason-Dixon line, setting itself up for a head-to-head run against Krispy Kreme.
While Starbucks can rely on overseas growth, Krispy Kreme doesn't have a clear global strategy. The global doughnut market, with more than $5 billion in annual sales, is almost entirely contained in North America, and it isn't clear how much of an appetite Europeans, Asians, and Latin Americans will have for Krispy Kreme, says Greg Schroeder, analyst for Fulcrum Global Partners in New York. "Outside the U.S., there just isn't a big market for doughnuts," he says. "Coffee on the other hand is a global commodity. Europeans and Japanese drink more than we do."
While 2002 is likely to be a strong year for both companies, regardless of how quickly the recession ends, the fact remains that coffee and doughnuts don't represent the same value for investors. They may go hand-in-hand in the morning -- Starbucks serves Krispy Kreme doughnuts in many of its java joints -- but just as caffeine-addicted weight-watchers might buy the coffee and shun the doughnuts, Starbucks may also be the wiser choice for investors. Shook covers the markets in our daily Street Wise column