The Holes in a Krispy Kreme Rally


By Dennis Milton Is this Wall Street's idea of "addition by subtraction"? Shares of beleaguered doughnut chain Krispy Kreme (KKD) moved solidly higher on Jan. 18 after it was reported that Scott Livengood retired as chairman, CEO, and president. Investors may have also been relieved by Krispy Kreme's announcement that its credit-facility lenders have agreed not to declare it in default of its loans -- arising from its failure to deliver financial statements -- for another week.

Amid the Street's apparent cheer at the news, we at Standard & Poor's Equity Research Services are keeping our 3-STARS (hold) opinion on Krispy Kreme shares. The stock has fallen nearly 75% from its record high of August, 2003. Our rating reflects investor concerns regarding declining average unit volumes, the negative impact of low-carbohydrate diets on sales trends, and concerns about Krispy Kreme's accounting practices.

We still see strong growth prospects for the Krispy Kreme brand over the longer term, especially in international markets, but in light of recent operating difficulties, we expect expansion to slow significantly over the next several years. We also have concerns regarding store-level profitability, as Krispy Kreme attempts to properly align its distribution system with lower sales-growth assumptions.

DOWNWARD RESTATEMENT. Livengood's departure comes at a time when sales at Krispy Kreme stores have consistently fallen year-over-year. For the eight weeks ended Dec. 26, 2004, systemwide average unit volumes have dropped by nearly one-fifth. Besides the sales slide, Krispy Kreme is facing other challenges. It received a formal Securities & Exchange Commission inquiry in July, 2004, for its accounting related to the acquisition of certain franchisee markets.

Most recently, Krispy Kreme announced it would restate its fiscal 2004 (ending January) earnings downward due to purchase-accounting revisions and warned that future quarterly statements might also be affected by similar issues. It has also warned that its failure to file financial statements in a timely matter might create issues with the SEC, the New York Stock Exchange, and creditors.

While the shares have enjoyed a short-term bump higher, they remain well below those of their peers on a valuation basis, trading at around eight times S&P's fiscal 2005 (ending January) free-cash-flow estimate. Our 12-month target price of $12 is well below our calculation of intrinsic value based on our

discounted cash-flow model. This reflects uncertainty surrounding Krispy Kreme's financial statements and our concerns regarding future store-level profitability

Note: Dennis Milton is a Standard & Poor's Equity Analyst. He has no affiliation with any of the companies discussed in this article. He has no stock ownership or financial interest in any of the companies discussed in this article. Standard & Poor's other affiliates may provide services to the companies that are the subject of this report. Price charts and required disclosures for all STARS-ranked companies can be found at www.spsecurities.com

Required Disclosures

5-STARS (Strong Buy): Total return is expected to outperform the total return of the S&P 500 Index by a wide margin, with shares rising in price on an absolute basis.

4-STARS (Buy): Total return is expected to outperform the total return of the S&P 500 Index, with shares rising in price on an absolute basis.

3-STARS (Hold): Total return is expected to closely approximate the total return of the S&P 500 Index, with shares generally rising in price on an absolute basis.

2-STARS (Sell): Total return is expected to underperform the total return of the S&P 500 Index and share price is not anticipated to show a gain.

1-STARS (Strong Sell): Total return is expected to underperform the total return of the S&P 500 Index by a wide margin, with shares falling in price on an absolute basis.

As of December 31, 2004, SPIAS and their U.S. research analysts have recommended 26.5% of issuers with buy recommendations, 61.3% with hold recommendations and 12.2% with sell recommendations.

All of the views expressed in this research report accurately reflect the research analysts' personal views regarding any and all of the subject securities or issuers. No part of the analysts' compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this research report.

Additional information is available upon request to Standard & Poor's, 55 Water Street, New York, NY 10041.

Other Disclosures

This research report was prepared by Standard & Poor's Investment Advisory Services LLC ("SPIAS"), and may have been provided to you either by: (i) Standard & Poor's under a license agreement with The McGraw-Hill Companies, Inc., which holds the copyright to this report; or (ii) a Standard & Poor's client who is granted a sub-license by Standard & Poor's. This equity research report and recommendations are performed separately from any other analytic activity of Standard & Poor's. Standard & Poor's equity research analysts have no access to non-public information received by other units of Standard & Poor's. Standard & Poor's does not trade in its own account. SPIAS is affiliated with various entities, which may perform services for companies covered by the recommendations in this report. Each such affiliate is operationally independent from SPIAS.

Disclaimers

This material is based upon information that we consider to be reliable, but neither SPIAS nor its affiliates warrant its completeness or accuracy, and it should not be relied upon as such. Assumptions, opinions and estimates constitute our judgment as of the date of this material and are subject to change without notice. Past performance is not indicative of future results.

This material is not intended as an offer or solicitation for the purchase or sale so any security or other financial instrument. Securities, financial instruments or strategies mentioned herein may not be suitable for all investors. This material does not take into account your particular investment objectives, financial situations or needs and is not intended as a recommendation of particular securities, financial instruments or strategies to you. Before acting on any recommendation in this material, you should consider whether it is suitable for your particular circumstances and, if necessary, seek professional advice. Analyst Milton follows shares of restaurant companies for Standard & Poor's Equity Research Services


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