Fat Prophets take a loss

Swimming with great white sharks can be either an extremely exhilarating experience...or potentially fatal. It is for this reason that our more speculative recommendations carry the great white label. While substantial upside exists, the associated risk is far greater than that represented by our core portfolio holdings.

"...the market's revived appreciation of risk will undoubtedly make life tougher for the heavily geared company"

With that in mind, we originally recommended doughnut giant, Krispy Kreme (KKD), back in 2005. Prior to our recommendation, the stock had suffered from an over ambitious expansion plan, deteriorating demand and declining earnings.

It also transpired that management had been manipulating earnings and the board was forced to purge those concerned with the accounting shenanigans from the company. The subsequent requirement by the SEC (Securities and Exchange Commission) for restated financial statements placed further downward pressure on the stock price.

Having assessed the actions of new management and considered their plans for a revival of the company, we felt that the stock represented an excellent turnaround candidate at the time.

And in our last review (FAT 63) we had begun to see tangible evidence that the stock's recovery was becoming established. The company had lodged its final overdue statement with the SEC in January and operating cashflows had improved significantly.

Management were also making headway in reducing the company's substantial debt mountain and the rate of sales decline had slowed. While challenges remained, we felt our original investment case still held.

The latest quarterly report for the three months to July 29 however, shows that a recovery may now be a far more long-term proposition than we originally thought. Sales are continuing to decline, many franchisees are in financial distress and rising commodity costs are further hampering profitability.

In addition, the market's renewed focus on risk will undoubtedly make life tougher for the heavily geared company. In fact, debt covenants are already forcing accelerated repayments, with $5 million due in the three months to October 31.

The company's cash balance of $25 million is more than sufficient to meet the required repayment this quarter. However, Krispy Kreme is continuing to burn cash at an uncomfortable rate and we believe the risk of stress in the months ahead has increased substantially.

In order to address the company's challenges, the management team have announced various actions revolving around the closure of under-performing stores and other cost-cutting measures. Even so, we don't see that these plans contain anything different to the strategy of the last couple of years and therefore question their likely effectiveness.

From a technical perspective, since breaking below trendline support in May, the overall chart structure of Krispy Kreme has deteriorated sharply. Over the past month, there has been acceleration in downward momentum with the stock falling to an all time low of $2.91.

Without any clear indication of an imminent reversal in trend, we believe the best course of action at this time is to cut our losses and move on. The risk reward characteristics of the stock have deteriorated significantly and we feel investors would be better off allocating capital elsewhere. As such, Krispy Kreme will be removed from the Fat Prophets Portfolio.