The KREMEY Warning for Krispy Kreme

The tumble of our index of Net stocks from its bubble days suggests investors should approach the doughnutmaker's lofty shares with care

By David Shook

Since much-loved Krispy Kreme Doughnuts went public in April, 2000, analysts have often declared the stock overvalued. Yet even though the share price has suffered its dips, for the most part, it has recovered and kept on rising, just like the dough. Based on its IPO price, Krispy Kreme is up 463%, to a split-adjusted $37.

The decidedly low-tech doughnutmaker's lofty returns are in marked contrast to the tech-heavy Nasdaq, which has lost 66% of its value since KKD shares began trading. For an even more striking contrast, we've taken a look back at BusinessWeek Online's Krispy Kreme Euphoria Yardstick, aka The KREMEY. It's an index of Internet stocks we created just as the bubble was bursting to track Krispy Kreme's rise (See BW Online, 5/10/00, "How Far Have Net Stocks Fallen? The KREMEY Knows"). Since April 2000, the KREMEY has fallen a punishing 78%, vs. Krispy Kreme's 463% gain.


  For anyone tempted to snack on a few dozen Krispy Kreme shares right about now, that divergence in returns should serve as more of a warning than an endorsement. Even though investors who bought in at the IPO have made a killing, persistent concerns about the stock's high valuation shouldn't be ignored. And now that earnings growth is slowing, Krispy Kreme may be especially vulnerable to a setback, especially since much of future sales growth is predicated on an untested strategy for taking its sticky, sweet treats overseas.

Krispy Kreme's basic business is quite simple. It boasts 165 franchises and 93 company-owned stores and is opening new outlets in both large and small U.S. cities. The doughnut mix, baking equipment, and roasted coffee beans are sold to store owners, who increasingly distribute their wares to restaurants and coffee shops. Krispy Kreme just built a doughnut-mixing facility in Effingham, Ill., doubling its North American production capacity.

As for long-term future growth, execs say they are confident foreign palates will acquire a craving for the sugary snacks when the outfit expands into Australia, New Zealand, Britain, Spain, Japan, and South Korea. Krispy Kreme has taken its time finding the right corporate partner in each of those markets, and CEO Scott Livengood says it hasn't done any product-specific market research to test foreign appetites. Says Livengood: "We decided to target those countries based on the popularity of American products in those markets -- as well as the ease of doing business." (For more of Livengood, see BW Online Q&A, 12/09/02, "I Love Every Store. They're My Children".)


  For some analysts, that isn't quite convincing. "Krispy Kreme talks a lot about its international ambitions," says Greg Schroeder of Fulcrum Global Partners, (which has no banking ties to Krispy Kreme). "But I haven't seen any evidence that people outside the U.S. and Canada will eat doughnuts."

Nonetheless, it's probably wise for Krispy Kreme to begin exploring overseas markets, since its remarkable profit growth -- now based entirely on sales in the U.S. and Canada -- may be tapering off. Earnings growth has decelerated from a remarkable 64.5% in fiscal 2002 (which ended last January) to the roughly 45% projected for the current fiscal year. In fiscal 2004, analysts expect earnings growth to come in at 33%. While that remains a robust figure, it's a good deal lower than the forward price-to-earnings (p-e) valuation of 42 -- and analysts traditionally consider a growth stock overvalued if the p-e far exceeds its growth rate. Analysts also point out that Krispy Kreme commands the richest valuation in the restaurant sector -- far above even Starbucks (SBUX ) at 30. Says Schroeder: "We think it's a great company, but the stock is overvalued."

For this reason, many stock-pickers are proceeding with caution: "It probably would be a little bit safer to buy Krispy Kreme if the price declined and provided a decent entry point," says investment manager Robert Burgoyne, of Burgoyne Investment Services. Likewise, critics and shortsellers are again declaring the stock full of hot air. The skeptics quieted after seeing Krispy Kreme fall to a temporary low point of $27.40 this past summer. But short interest, a measure of how many traders are betting that the stock will decline, remains high.


  While the KREMEY yardstick may not be the most financially sophisticated indicator of Krispy Kreme's prospects, it does serve as an additional sign that the stock is fully valued and, in all likelihood, sensitive to early signs that the amazing earnings growth cannot be sustained. Now, of all places, Internet stocks might even be a better bet to put your money. (The KREMEY is comprised of 10 -- now 9 -- former high-flyers: America Online [now AOL Time Warner], Ebay, Priceline, Amazon,, Yahoo!, E*Trade, CNET, IVillage, and the now-defunct eToys.)

"Krispy Kreme is soggy from too much time soaking in tepid coffee," quips noted stock-picker Peter Cohan, founder of venture-capital and management-consulting firm Peter S. Cohan & Associates. He would opt for a "crunchy blend" of e-commerce stocks over Krispy Kreme -- if he had to make the choice at all, that is.

Krispy Kreme's Livengood says the outfit can continue to deliver robust growth, even if international markets take time to develop. Of the overseas strategy, he says: "We are proceeding very methodically and with the proper due diligence overseas, with the belief that, over time, the international markets can be as large, or larger, than the domestic business."


  Livengood also points to Krispy Kreme's history of exceeding Wall Street's earnings estimates. Each of the last four quarters has seen Krispy Kreme beat expectations by a penny a share. On Nov. 22, it reported that third-quarter net income had increased 56.3%, to $10.1 million, vs. $6.5 million in the third quarter of fiscal 2002. Diluted earnings per share rose to $0.17, vs. $0.11 a year ago. Revenues climbed 9.4%, to $129.1 million. "Our guidance has always been conservative," says Livengood. "And I don't know many companies out there that have sustained the kind of earnings' growth that we have."

That's certainly been true for the past two years. But as Internet investors learned so painfully in 2000, hot stocks can fall even faster than they rise. Perhaps, in the current environment, that's the real wisdom to be gained by comparing Krispy Kreme with the KREMEY.

Shook is a writer for BusinessWeek Online in New York

Edited by Amey Stone

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