Text of fool.com
to be followed by some comments.
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A Ghoulish Trick
Krispy Kreme
By Bill Mann (TMF Otter)
October 24, 2000
Trading at $88 1/2 as of October 23, 2000
It gives me no joy to write this. I love Krispy Kreme Doughnuts (Nasdaq:
KREM). I grew up on a steady North Carolina diet of the four essential food
groups: barbecue, Cheerwine, MoonPies, and Krispy Kreme doughnuts.
In fact, we didn't call the Krispy Kreme doughnut shop in our town by
name. We called it "The Promised Land." I mean, people everywhere have a
story about the best local shops for doughnuts, but I was sure growing up
that my doughnut shop made the best, most delectable ones in the world.
Now that they've gone national, everyone else knows it too.
In fact, you want a test of Pavlovian response theories? Just watch
someone initiated in the wares of Krispy Kreme when they drive past an
outlet with the "Hot Doughnuts Now" sign lit up.
Krispy Kreme seemed to gain momentum when Rosie O'Donnell raved
about its wares. Next thing you know, our little Southern institution (born in
Winston-Salem, N.C.) is opening shops in New York, California, Nevada,
and other "international" locales. Then, this year, Krispy Kreme hit the big
time -- choosing, after 68 years of running as a private company, to offer
its shares to the public.
This is where the trouble began. The company's shares closed that day at
$37 per share, and have gone as high as $103 per share from there. It has
dropped somewhat, but still remains high. Too high.
I'm not going to regale you with stories of sudden acts of greed on the part
of the company or its management. I'm not going to say that the employees,
to whom the company holds famous loyalty, have suddenly taken their
stock options and bolted. And I'm certainly not going to make a statement
that would in any way denigrate the wonderful addictiveness of Krispy
Kreme doughnuts.
"Is there nothing doughnuts can't do?" -- Homer J. Simpson
As a matter of fact, Homer, there is. Doughnuts, even Krispy Kreme ones,
cannot justify a P/E ratio of 90-plus. This chain of stores has grown
suddenly to span 28 states (30 by year's end), and I think it is fair to say
that the other 20 states are the poorer for it.
But this is a food services business. Food services is an asset- and labor-intensive, notoriously
thin-margined business to be in. It doesn't scale that well (particularly for Krispy Kreme, which I'll
explain), and there are significant up-front investment costs for each new location.
Krispy Kreme share appreciation has a lot to do with the laws of supply and demand. Company insiders
still hold more than 77% of the outstanding shares, with institutions holding another 15%. That leaves less
than 7% of the total float available for individual investors, which is very thin. This is not a weakness, nor
is it necessarily a bad thing, but when a company's shares are in demand, it lends itself to market
inefficiency.
The company is run very well -- it has increased its operating margins by some 40% over the last year.
Still, even with the new store openings, earnings from the first six months of the year only crossed $6
million, and net margins still were less than 4%. That is a very, very difficult point to increase. The
company can deploy more capital for stores. It can grow by leaps and bounds, and still not have much in
the way of free cash flow to show for it. Because, though Krispy Kreme has the best doughnuts around,
they still do not have a huge amount of pricing power -- their incremental gains in margin will have to
come from operating expenses. Given that this company still has traditions like having its central depot in
Winston-Salem quality control each batch of flour for every store (which, as a customer, I believe is a
GOOD thing), its choices may be limited.
Gosh, I hate this. I feel like I'm criticizing my mother's milk. I think this is a wonderful company, with a
wonderful product, wonderful traditions, and a great future in front of it. But Krispy Kreme's growth will
come with considerable capital costs, and continued thin margins due to a lack of real pricing power.
Be very, very careful with this stock. The company is a performer and a solid grower, so the chance of an
investor losing everything is slight. But, it does not generate the free cash flow at a rate nearly sufficient to
make this a good buy at this price or anything near it.
When I think of Krispy Kreme, I think of something light, fluffy, and airy. I just want to be talking about
its products, not its stock. |
