A Tasty Treat

Krispy Kreme Doughnuts (US: KKD) is a leading US manufacturer of donuts. The last few years have however been a tumultuous time for the company. After pursuing an ambitious expansion plan, earnings have suffered due to falling margins and softening demand. To compound matters, the company has delayed filing financial statements with the SEC (Securities and Exchange Commission) whilst an investigation of accounting procedures is conducted. Despite these challenges, we believe that the initiatives currently being implemented by new management will drive an earnings recovery. We are firm proponents of brand value and view the company's fall from grace as a contrarian's buying opportunity.

The foundations of Krispy Kreme date back to 1937 when Veron Rudolph began selling donuts to grocery stores and local customers in Old Salem, North Carolina. During the 1960's the company rapidly expanded throughout the South East of the US. After being sold to Beatrice Foods in 1976, a group of franchisee owners bought the company back six years later. Today the Group has a total of 276 US stores, 177 of which are franchisee-owned. Internationally KKD also has a presence in Canada, Australasia, Ireland, and the UK.

The company's growth strategy was rewarded handsomely by the market. KKD listed on the NYSE in April 2000 at US$8, and increased by more than six fold over the next three and a half years. KKD reached an all-time-high of US$49.75 in August 2003. While it is not unusual for a stock to outperform over an extended period, at some point market conditions inevitably turn, with the result often being a deep correction. This has certainly proven true in the case of KKD, with a protracted bear market wrecking havoc with the share price. In the 18 months following the all-time-high, the company's valuation tumbled by 90 percent as the promise of double digit sales growth evaporated.

In May of last year KKD slashed their full year earnings forecast by 10 percent, due to the impact of low-carbohydrate dietary trends. Management attributed quarterly losses to impairment charges and the cost of closing stores. Then in the third quarter KKD reported net losses of US$3 million compared with US$14.5 million the previous year.

Late last year, the company announced an investigation by the SEC into accounting irregularities. KKD came under scrutiny over the way it accounts for buying back franchises from owners, which included some corporate insiders. KKD has been accused of inflating historical earnings by not amortising the cost of these repurchases. Shareholders are now suing KKD for failing to adequately disclose problems within the group. Not surprisingly new management has been ushered in to address the company's problems. In January 2005 corporate turnaround specialist Mr Stephen Cooper was appointed as CEO.

In April this year KKD confirmed it would miss key deadlines for regulatory filings and show mounting losses when the reports are eventually submitted. The company expects the restatement to reduce 2004 net income by between US$5.2 million and US$6.2 million. Revenues in the fourth quarter may decline 16 percent around US$153 million while full year revenues are expected to have increased by around 4 percent to around US$685 million.

We believe that much of the negative sentiment towards KKD over the past six months has been driven by market uncertainty surrounding the size of the earnings adjustments. Whilst a restatement of full year numbers is far from positive, the impending adjustment has now been fully flagged to the market. We expect Krispy Kremes will finalise full year numbers within the coming weeks, and believe their release will bolster market sentiment towards the shares.

Accounting concerns aside, we believe the root of the company's problems were caused by a strategy of growth for growth's sake. In a little more than eight years, KKD went from being a small, successful regional chain to a nationwide phenomenon in the US. In the process brand recognition increased exponentially but management failed to control costs, margins, and sales growth.

We expect that an increasing focus on cost control will be a primary focus of the new CEO. We expect Mr Cooper to quickly identify under-performing stores to be shut down, thereby removing a significant drain on cash flow. In the past, KKD has spent millions on bailing out poorly performing franchises.

Mr Cooper has already taken action in this regard, rationalising the workforce and reducing headcount in the corporate, manufacturing and distribution divisions. These actions will produce annual pre-tax savings of around US$7.4-million. In addition KKD closed a third doughnut-making commissary in April, leaving fifteen such facilities around the country.

With costs being taken out of the business to bolster earnings, we are encouraged that funding uncertainties have also been removed. In April KKD's lenders approved a new US$225 million credit line. The proceeds of the loan were used to repay the company's US$90m outstanding (and overdue) credit facility, and bolster cash balances.

Despite the problems experienced by Krispy Kreme in recent years, the company remains highly cash generative. Any earnings restatement that does occur will not affect this aspect of the business. Last year KKD generated full-year cash flow of US$95.6 million. Because the company is investing less in expansion, we expect free cash flow levels to increase substantially. We are therefore comfortable that balance sheet strength and liquidity measures will improve further going forward.

We have great confidence in the ability of management to return KKD to earnings growth, through a clear focus on driving down costs and emphasising the profit potential of any new store openings, both in the US and internationally. We acknowledge the shares are not without risk, trading on a multiple of 20 times estimated earnings for the year ended 30 January 2005. However, we believe the strength of the company's brand and the various recovery initiatives in place will underpin future profitability, and ultimately a re-rating of the shares.

Over the past three months, we have been encouraged to witness the shares stabilise. In the process, a base of support has formed between US$6 and US$5 which in our opinion marks the end of the bear market decline. While further consolidation may take place around current levels, we believe that downside risk is now limited. A break above resistance at US$9.50 would suggest that upward momentum was returning to the shares. KKD holds solid upside potential from current levels in our opinion. Accordingly, we recommend Members purchase the stock on the NYSE up to US$8.35. Please note that we consider KKD to be a speculative recommendation and should only be acted upon by those Members with a penchant for risk.