Starbucks and Krispy: A Soggy Combo

Disappointing news has stocks in both companies tumbling. The donut maker, however, may offer a buying opportunity for investors

By Amy Tsao

Aug. 26 was a bad day for coffee and donuts. Shares of Seattle-based Starbucks stock fell 6% when it announced July same-store sales rose just 8%. Meanwhile, shares of Winston-Salem (N.C.)-based Krispy Kreme slid 11% because its second-quarter earnings fell far more than Wall Street had anticipated.

What's going on? Both food powerhouses are entering a new phase of growth. Starbucks' (SBUX ) disappointment is less worrying, but it's certainly a wake-up call for investors who have come to expect the company to top its own sales estimates every month. That's going to be increasingly difficult as the 8,337-store chain becomes more ubiquitous domestically and extends its global presence.

"Starbucks stock was pushing the envelope," says Morningstar analyst Carl Sibilski. "They won't always be able to beat expectations." (Sibilski doesn't own either Starbucks or Krispy Kreme stock, and the firm doesn't perform banking services.)


  In Krispy Kreme's (KKD ) case, the earnings shortfall is the latest in a series of disappointments. In May, executives blamed the low-carb diet craze for a decline in earnings. Then shareholder lawsuits and a Securities & Exchange Commission accounting investigation surfaced. The company said net income in its fiscal second quarter, ended Aug. 1, fell 56%, to $5.8 million, or 9 cents a share, from year ago levels. That was well short of the consensus forecast of 22 cents. Management also ratcheted down plans for new store additions to focus on making existing stores more profitable.

"Krispy Kreme is transitioning from a rapid-growth company to growing and being profitable at the same time," Sibilski says. Indeed, the donut giant is facing more serious growing pains. As the novelty of its core product has faded, it must focus more on profitability. "Krispy Kreme has been very successful with marketing over the last several years, but now they have to become better operators," says Dennis Milton, an analyst at Standard & Poor's.

Profit margins in the latest quarter deteriorated as Krispy Kreme had a hard time predicting how many donuts it would sell through grocery stores. "Their distribution system is geared toward a higher level of sales. They have to correct that," says Milton. Sibilski expects the chain's efforts to improve its supply-chain and distribution systems could take up to 12 months. (Milton doesn't own either stock, but S&P has received non-investment banking fees from Krispy Kreme in the past year.)


  As for the stocks, Krispy Kreme, despite the uphill road ahead, could be the better bet. With so much negative news already known, now may be a good time to buy. The stock was trading around $13.70 as of Aug. 26, well off its 52-week high of $44.59. "It's a value name now," says Sibilski, who raised his rating on to five stars, Morningstar's highest, in the spring. The firm's estimates of future cash flow suggest the stock should rise.

Starbucks stock will likely be the more steady performer, but it's still no bargain at about 44 times 2004 earnings-per-share estimates. Milton rates Starbucks stock a hold, while Sibilski advises investors to consider buying only if it slides below $31. It was trading around $43 as of Aug. 26.

In the long run, neither company's products are going away. In fact, both should still grow at a respectable rate, though not at the pace of their early days. Over the long term, if Krispy Kreme can fix its supply and demand problems, investors in its stock could enjoy a sugar rush.

Tsao is a reporter for BusinessWeek Online in New York

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