Text of that Washington Post piece on KKD.
The Hole in the Doughnut Strategy
By Jerry Knight
Monday, July 16, 2001; Page E01
Let's just bite right into it: Krispy Kreme Doughnuts Inc. has one of America's most hyped brands of sugar-coated, fat-fried flour. Not as hyped, however, as the company's stock.
As much a cult object as the doughnuts, Krispy Kreme stock is the last of the piping-hot IPOs. The stock is selling for almost seven times the price of the initial public offering just 15 months ago, adjusted for two splits.
At Friday's close of $36.19 a share, Krispy Kreme is valued at 119 times the company's profits last year -- a price-earnings ratio rarely seen since the Internet bubble burst.
That makes Krispy Kreme, which is expanding rapidly, including in the Washington area, the doughnuts.com of the post-Internet era.
The stock is as full of air as a Krispy Kreme cruller and just as certain to turn stale.
The only question is when.
Krispy Kreme insiders, who've been as phenomenally successful in promoting their doughnuts as their stock, are setting up the rest of the stockholders up for dunking. For months now, insiders have been selling shares as fast as fresh doughnuts, flooding the market with a supply of new stock that sooner or later will catch up with the demand that has driven up the price.
The massive insider selling ought to, by itself, be a warning to investors that loading up on Krispy Kreme is just asking for a Maalox moment. But insider selling is one of those old-fashioned red flags that are now dismissed as red herrings by too many investors.
In this case, the insider selling could alter the trading dynamics of the stock, which is one of the reasons Krispy Kreme shares are priced so high.
The stock has been driven up not only by the demand generated by Krispy Kreme's carefully cultivated fan club of investors, but also by the actions of short-sellers who consider the stock overpriced and ripe for a fall.
Short-sellers try to make money by betting on a stock to fall. They go to a brokerage firm and arrange to borrow some shares that are being held for other investors. Then they sell the borrowed shares. If the stock does go down, the shorts go back and buy shares on the open market. They use those cheaper shares to replace the ones they borrowed and pocket the difference.
When the stock doesn't go down right away, however, the short-sellers can get caught in what's called a squeeze. To cover their bets, they have to return the borrowed stock. That means they have to buy shares back -- even if it means paying a higher price. As soon as they start buying, of course, the new demand drives up the price of the stock, squeezing the shorts even tighter.
That's what's happened to Krispy Kreme stock, said Robin Rodriguez, president of Anglo-American Investor Services Corp., an investment firm based in Charlottesville.
"If it hadn't been for the short-sellers being forced out, you wouldn't have had the stock this high," he said. "A lot of the recent buying was from covering short positions."
Rodriguez said he's one of the people who's been betting on Krispy Kreme stock to fall and he recommended that strategy to his firm's clients at the end of May.
At that time, though, Rodriguez warned that short-selling Krispy Kreme stock was risky because there are relatively few shares available and there were already signs of a short squeeze.
Often when corporate executives see short-sellers betting against their stock they try to foil the effort. The typical reaction is to tighten the supply of stock even more, but Krispy Kreme executives are doing exactly the opposite. By selling more stock, they are playing into the hands of the shorts, Rodriguez said. They are increasing the supply of shares, thus increasing the prospect that the stock will fall.
The insider selling began in February, when Krispy Kreme floated a 5.2 million share secondary stock offering. More than 4.6 million of those shares were sold by various insiders, who pocketed $155 million.
Since then the selling has continued. Lock-up agreements that prohibit many early investors from selling their stock expired in April, allowing another 14.8 million shares to be sold over the coming months.
In April and May, insiders reported selling $57 million worth of stock, and in June they gave notice that they intended to sell almost $52 million more.
Krispy Kreme officials downplay the importance of the insider sales and say they don't expect them to have much effect on the stock price.
"These are really nominal amounts compared to the holdings of these individuals," said Michelle Parman, senior vice president for corporate development. Some of the people selling stock "are really not insiders" she said, explaining that they were not officers or board members. The Securities and Exchange Commission uses a different definition, however, requiring employees, venture capital investors, Krispy Kreme franchise owners and even relatives to file insider-trading reports.
"Unloading is not the proper term" to describe what Krispy Kreme executives have been doing, Parman said. Chief executive Scott Livengood, who recently sold 190,000 shares for $6.4 million, did so "primarily for debt reduction and for a small amount of liquidity," she said.
The traditional reason investors watch reports of insider stock sales is that insiders are assumed to know better then anyone else how a company's business is going and what its stock ought to be worth.
If insiders are buying, according to the theory, it means they think the stock is too cheap and are betting on it to go up. If insiders are selling, on the other hand, it's a signal they think the stock is as high as it's likely to get.
If that theory holds, Krispy Kreme's insiders would seem to share the view of the short-sellers that the stock is overpriced.
An analyst for Merrill Lynch made the same point recently in one of those rare Wall Street research studies that did not recommend buying the stock. The Merrill Lynch memo expressed "concerns about [Krispy Kreme's] ability to sustain . . . sales and earning momentum at levels that justify the stock's valuation."
Short-seller Rodriguez is more blunt: "It's just a ridiculous valuation."
The price-earnings ratio of 119 is the first number that scares off many investors. The stock of Starbucks Corp., the most successful new restaurant of the past decade, sells for only 50 times earnings. Shares of McDonald's Corp., the ultimate symbol of success in the food business, carry a price-earnings ratio of 19.
A couple of years ago lots of Internet stocks were selling for 100 times earnings. Try finding one today.
Rodriguez of Anglo-American Investors Services suggests another way to look at the value of Krispy Kreme, what you might call the "dollars-to-doughnuts" ratio.
Comparing the number of Krispy Kremes sold last year -- 1.3 billion -- to the total value of the company's stock -- $1.95 billion -- he comes up with a dollars-to-doughnuts ratio of 1.5.
In other words, stockholders are paying $1.50 for every doughnut Krispy Kreme sells.
A Hot Original Glazed sells for only 60 cents and generates less than two pennies in profit for Krispy Kreme.
Would you pay $1.50 for the right to sell something for 60 cents and make a couple of cents profit?
One guy who wouldn't is Benny Fischer, who just bought Montgomery Doughnuts, a large local wholesale bakery and a handful of doughnut shops that baked up $5 million in sales last year.
"People don't understand what they're paying for," said Fischer. "People don't understand what P/E really means. If you said to them it would take 100 years to get your money back, to break even on their investment, they might."
What Krispy Kreme stockholders are buying is not a doughnut stock but a dream -- a company so much a part of Americana that it's in the Smithsonian Institution, a name with enough nostalgic cachet that people will pay $48.95 for a Krispy Kreme sweat shirt, a doughnut so divine that love songs have been written about it.
"You can't knock success," Fischer admits. "These guys have created a product and a market behind it that obviously has taken over. You have to tip your hat to that."
But what about the doughnuts?
"I still think mine is better," said Fischer. "It's mine."
As a connoisseur of doughnuts, I'm with Benny. I'd take a bag of his "Black Beauties" -- chocolate doughnuts with chocolate frosting -- over Krispy Kreme anytime.
And as a connoisseur of stocks, I wouldn't buy Krispy Kreme even if the doughnuts were as good at they're cracked up to be.
© 2001 The Washington Post Company |
