Krispy Kreme Doughnuts

“It ain’t just the doughnuts that are glazed!”

Matt Gnau
Leslie Lee
Yves de Parseval
Bharat Poddar

Accounting 712, Section 3

April 15, 2003

1. Business Strategy
Krispy Kreme is a branded premium quality doughnut retailer. It has three sources of revenue.
• On- and off-premise sales from 99 company owned and operated doughnut stores. Off-premise
sales constitute doughnut sales to supermarkets, gas stations, etc.
• Royalties from franchisees (3% royalty, 57 stores) and area developers (4.5% royalty, 120 stores)
• Sales of doughnut mixes and doughnut-making equipment to franchisees and area developers
through Krispy Kreme Manufacturing and Distribution (KKM&D) commissaries

Industry and Competition: Krispy Kreme serves primarily in the doughnut industry (a subset of SIC Code
5812). It’s a highly fragmented industry characterized by low-volume outlets with undifferentiated
product quality. Krispy Kreme competes primarily on its quality, brand and unique way of manufacturing
and selling doughnuts on-premise. Its competitors include nation-wide companies, like Dunkin’ Donuts
and AFC Enterprises [AFCE] (Cinnabon, Seattle’s Best Coffee, Popeye’s), and many regional companies.
A secondary market is the packaged doughnut market (a subset of SIC Code 2051). Krispy Kreme’s
secondary market is a result of its off-premise sales, which are used to extend its brand equity and sales in
supermarkets. Competitors include Interstate Bakeries [IBC] (Hostess, Dolly Madison, Drake), McKee
Foods (Little Debbie), and Tasty Baking (Dutch Mill, Tastykake).

Growth strategy: Primarily plans to grow through new store expansion by area developers (particularly in
markets over 100,000 households) and by acquiring equity positions in selected franchisee businesses.
Area developers’ have contractual obligation to open 200 stores between the years 2003 and 2006. Krispy
Kreme also plans to increase sales through complementary products such as coffee and bread offerings.
The company is following an acquisition strategy to enter these product categories and leverage its core
competence in branding and innovatively selling hot products on-premise. Furthermore, Krispy Kreme is
introducing modular Hot Doughnut Machine, which will allow it to open small satellite retail outlets with
low capital expenditure. Finally, it plans to go international in Australia, Japan, South Korea, and the UK.

Key Success Factor: Success will be very much driven based on whether these new stores continue to
generate the crowds that recent Krispy Kreme grand openings have drawn along with their ability to
retain those crowds into the future.

Main Risks: Krispy Kreme doughnut “fad” and corresponding “premium” may reduce through time as the
brand becomes ubiquitous through channel flooding. Competition may arise from unforeseen other brand
leaders, like Starbucks, once Krispy Kreme tries to enter coffee and bread product categories. Modular
doughnut making machine still being tested and may not succeed.

2. Accounting Analysis
Upon analysis, we find no unusual accounting measures being taken by Krispy Kreme.

Of note, there is a different behavior between Cash Flow from Operations (CFO) and Net Income NI) as
shown on the graph in Exhibit 1. CFO flattens out between 2001 and 2002, whereas NI continues on a
straight line upwards. eVal 2 also notices this decreasing earnings quality.
Two reasons explain this phenomenon. First, the average number of days to pay payables went from 21
days in 1999 down to 12 days in 2002. On the other hand, the average days to collect receivables went
from 25 to 22 days in the same period. It seems that the company pays a lot more quickly than it collects,
which is not sustainable, unless KKD is able to collect much more each time than it pays out to its
creditors or finances it using debt or other external financing.

Second, the sales mix has been evolving such that it was more difficult to decrease the average number of
days to collect receivables:

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 • Off-premise sales from company owned stores have increased a lot more than on-premise sales.
(Off-premise sales include longer and more variable receivables recovery durations.)
• Franchise revenues have seen the same phenomenon (off-premise vs. on-premise sales).
• Franchise payments also include longer terms of payment (30-35 days) and have increased
slightly in relative terms.
• KKM&D sales, which include the largest number of days to collect receivables (30 to 54 days),
have increased significantly in relative proportion to total sales as shown in Exhibit 2.

3. Financial Analysis
Growth Rate: KKD’s growth rate has ranged from 22-37% during the same period that its sustainable
growth rate grew from 9% to 17%, implying that KKD would require outside financing in order to
continue its targeted 30% growth rate. Being only slightly levered, it may be able to finance its growth
through issuance of debt. Cash flows are positive and increasing year over year, though cash flows to
investors remain negative, not an unusual occurrence for a growing company.

Peer Comparison: We chose to compare KKD’s performance against those of Interstate Bakeries Corp
(IBC) and AFC Enterprises (AFCE). Both of these companies operate in restaurant industry and sell
baked- and pre-made goods. We were unable to consider Allied Domecq (AED), operator of Dunkin
Donuts, because usable data was not available. In any case, AED’s product lines include liquor and spirits
in addition to donuts and would not have served as a better comparison than IBC or AFCE.

Dupont Analysis: A decomposition of three-year Dupont averages based on actual 1999-2001 results
reveals the following:
• KKD has the highest asset turnover ratio but the lowest RNOA of the three companies.
• As confirmed by the gross margin analysis, KKD has much lower margins than either AFCE or
IBC, implying it is positioned more as a high-turnover, low-margin player than a premium one.
• Both IBC and AFCE are much more highly levered than KKD, which also has the lowest NBC.
During the three-year period, IBC increased leverage while AFCE decreased its debt.
• As a result, IBC’s and AFCE’s ROEs better than twice that of KKD. If KKD is able to sustain its
growth through leverage, it may also be able to reach its stated target ROE of 20%.

Charts in Exhibit 3 show the three-year averages of key ratios for the three companies in detail.

P/E and P/B Ratio Analysis: KKD’s P/E and P/B and 58 and 7.1 respectively are much higher than the
peer group (8.8 and 1.9), implying that the market views KKD not only as a growth company, but also as
a profitable one. However, our analysis does not support this outlook. While we agree it is going to
grow, we do not believe it is going to be a hugely profitable growth.

Default Analysis: A low debt to capital ratio of 14%, EBIT Interest Coverage of 38, and EBITDA
Interest Coverage of 45 implies a low default probability for Krispy Kreme, making it an investment
grade stock.

4. Forecasting:
Our forecasts are based heavily on Krispy Kreme’s 10K, Annual Reports, and press releases. We
considered other industry comparables, however, the highly fragmented industry does not have a good
public equivalent to KKD. Therefore, we created two sales forecast models in order to gauge the
accuracy of each and determine the sensitivity of our forecasts. Our February 2003 forecast is based on
three quarters of released data plus a Q4 conference call held in March 2003. This data is pro-forma and
no GAAP reports have yet been filed for the year. February 2003 serves as our anchor for our forecasts.

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Income Statement: (Exhibit 4)
Sales Growth and COGS/Sales:
Our primary sales model starts at this anchor point in 2003 and ramps sales growth down linearly to 4%
in the terminal year. We then forecasted COGS by analyzing the COGS trend over the past three years in
each of KKD’s three business units and forecasted operating expenses to reduce, but taper off, over the
course of the next ten years in each business unit. The overall company COGS is the weighted average of
the COGS of all business units. Weights are based on the proportion of total sales dollars for each
business unit. This forecast can be seen in Exhibit 5. In this scenario, sales growth is 24.6% in 2003,
sales may peek at $1.8 billion and COGS may ebb at 77.4% in 2013.

In an effort to gauge the accuracy of our primary sales model, we built a second model that was based on
our expectations of future store openings and future store sales growth. We based our analysis on
information from the 10K, Annual Report, and press releases. Some of the key information points were:
• Overall market potential is over 650 stores in the United States reached by 2013.
• Area franchisees are contractually obligated to build 200 more stores in the next four years.
• Worldwide expansion will be much less (33 stores).

Therefore, our first assumption was forecasting new stores over the course of the next ten years. The
other assumption made in this model was the percent increase in revenue per store. The problem that
quickly appeared with this model was that in order to make the 2003 figures match reported pro forma
numbers, we had to assume –9% growth in company owned revenue in 2003. This made it difficult to
forecast a growth trend going forward. We believe that company-store growth will rebound but see small
growth. Franchise revenue will continue to experience moderate growth, especially over the next four
years during construction of new stores. Yet, KKM&D will experience a reduction in its revenue growth
rate as franchisees’ contracts with KKM&D will expire at the end of fiscal 2003 and franchisees will be
given the opportunity to reconsider who it chooses to use as a supplier. This revenue growth rate forecast
and number of new stores opened allows us to forecast sales for each business line. We can determine the
percentage of sales in each business line relative to total sales. Furthermore, we forecast COGS to
continue to decrease slightly. The forecasts can be seen in Exhibit 6. In this case, sales may peek at $1.4
billion in 2013 and COGS may ebb to 75% in 2011.

Exhibit 7 shows a comparison of the gross profit forecasts from our two sales models, which are very
close particularly over the next first five years. Because the firm is supposedly overvalued, we opted to
use the more optimistic model in order to identify the most optimistic possible price per share.

The remainder of our Income Statement is forecasted as follows. We expect SG&A to increase relative to
sales as the company continues to grow larger. Depreciation and Amortization is 6.1% in 2003 based on
the Q4 conference call and we expect it to increase over time back up towards KKD’s previous years’
Depreciation & Amortization. Interest Expense/Average Debt is 4.5% in 2003 and scaled down to 2.6%
over the course of 10 years, bringing it back on par with pre-2003 numbers. Non-Operating Income/Sales
is –2.5% in 2003 due to an arbitration settlement and 0.3% for the remainder of the years (similar to pre-
2003 figures). We expect the effective tax rate to remain approximately 38% although it increased to
38.9% in 2003.

We compared our forecasts with analysts’ forecasts. Even using our most optimistic forecast, we remain
on or below par as compared with other forecasts. This comparison can be seen in Exhibit 9.

Balance Sheet: (Exhibit 8)

We kept Ending Operating Cash/Sales around 10% based on KKD’s current cash position. We expect
growth in receivables, particularly from off-premise sales from accounts such as Kroger’s. With the new

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store growth, we expect more Kroger’s and other grocers will buy Krispy Kreme doughnuts for resale.
Although inventories have risen in 2003, we see no reason for this to sustain. We scaled it back off to
5%, similar to pre-2003 figures. Other Current Assets are forecasted to remain between 6.1% and 5%.
Accounts Payable/COGS remained fairly constant in 2003 at 3.9% and were maintained across the 10-
year horizon. Other Current Liabilities/Sales were 6.8% in 2003 and forecasted to steadily decrease to
4.5%, closer to pre-2003 figures. Net PP&E/Sales were 41.2% in 2003. This is a result of Krispy
Kreme’s new factory, which will depreciate with other PP&E and decrease over time to a forecasted
28.5%. We predict Investments/Sales to remain fairly constant between 3.3% and 5%. Intangibles
increased substantially as a result of Krispy Kreme’s recent purchase of Montana Mills. We expect
intangibles to continue to decrease over the 10-year horizon. Long-term Debt/Total Assets increased to
10.5% in 2003 as a result of taking on debt for the purchase of Montana Mills and the new KKM&D
factory. Long-term debt levels are forecasted to remain high for the next few years before dropping off
over the remainder of the 10 years. Finally, we expect the dividend payout ratio to continue to increase
upwards toward 50% as a result of the enormous growth KKD will experience in the upcoming years.
This is based on a reasonable ROE, examining Interstate Bakery as a comparable because no true industry
comparable exists, and past performance in 1998 before KKD went IPO and began its growth campaign.

5. Valuation
Our valuation using the forecast described above resulted in a valuation of $21.39, according to eVal 2’s
residual income model. Krispy Kreme’s recent market price has hovered around $34, and analysts’
twelve-month price targets have ranged from $37 to $50 with a median value of $40 (Yahoo! Financials).

We attribute the discrepancy between our valuation and that of the analysts to two main things: First,
even though we attempted to provide a best-case scenario in our forecasts of KKD’s financial statements,
we found that we were still much more conservative in our forecasts than analysts. For example, Thomas
Wiesel has forecasted COGS to decrease to 65% of sales in 2004, a scenario we think is unlikely for
KKD to achieve based on its business unit breakdown. Second, some analysts have worked closely with
KKD on recent stock issuances, which KKD has used for acquisitions, and thus they have a strong
incentive to project optimistic price targets.

We attribute the difference in our valuation and KKD’s current stock price to similar reasons, mainly, an
over-optimistic outlook on KKD’s growth prospects. Additionally, the presence of a 25% short interest
since the stock’s IPO has been forced to cover as KKD’s, stock price has remained level or increased.

Sensitivity Analysis:
Our $21.39 stock price was based upon a rather arbitrary (but optimistic) 10% cost of equity capital. Yet,
a 1% change in either direction changes the stock price dramatically, as shown below. We calculated
another value for KKD’s cost of equity capital by using the size model, assuming a risk-free rate of 4.5%,
and conservatively using KKD’s current market capitalization of $1.9B, which ranked KKD in the fourth
decile and resulted in a cost of equity capital of 13.88%. We also calculated the cost of equity based on
the CAPM model. The sensitivity analysis is shown in Exhibit 10.

Based on our model, which gives a terminal ROE value of about 17%, any cost of equity capital below
this amount presupposes that KKD will be able to build up Krispy Kreme’s brand such that it will
continue to be a source of competitive advantage. Our main intent in doing the sensitivity analysis is to
show that it would be difficult to justify KKD’s $34 stock price without being generous and optimistic
about its sustainable sales growth, magnitude of cost reduction, or cost of equity. Within reason, we have
used the most optimistic sales forecast, COGS forecast, cost of capital, and growth rates. Therefore, we
stand by our price valuation of $21.39 and conclusion that KKD is overpriced.

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Exhibit 1: Cash Flow from Operations (CFO) vs. Net Income (NI)

CFO and NI Difference between CFO and NI (CFO minus NI)

30,000
10,000
Exhibit 2:
20,000 Net Income
5,000
$'000

10,000 $
Cash From '00
Operations 0 CFO - NI
0 0
1999 2000 2001 2002
-5,000
00

01

02
99

-10,000
20
19

20

20

Ye ar
-10,000
Year

Exhibit 2: Business Line Portion of Total Sales

% of total sales in 2001 % of total sales in 2002

Company owned stores 71.1 67.5
Franchise 3.1 3.6
KKM&D 25.8 28.9

Exhibit 3: Advanced and Basic Dupont Models

Key Ratios: Three-Year Historical Averages from 1999-2001

KKD AFCE IBC
ROE 0.074 0.192 0.163
Net Profit Margin 0.020 0.036 0.027
Dupont Dupont
Advanced Basic

Total Asset Turnover 2.157 1.290 2.122

Total Leverage 1.988 4.572 2.960
RNOA 0.071 0.106 0.116
NBC 0.037 0.064 0.048
Spread 0.034 0.042 0.069
Leverage 0.397 2.355 0.757
Gross Profit Margin 0.140 0.316 0.525
Valuation

Current P/E * 58 8.8 8.8

Current P/B * 7.1 1.9 1.3

* as of April 10, 2003

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6
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Exhibit 9: Analyst Forecast Comparisons

Revenues
Analyst 2003 2004 2005
Merrill Lynch 491.5 618 756.6
Brean Murray 491.5 622.9 790.3
RBC 491.5 633.5 779.9
Michigan Team 491.5 603.9 731.1

We are more conservative on the revenue side. As we ramped sales growth figures from the average of
the past three years down to 4% for the terminal year. In the short to mid term, we are concerned that
comparable store sales may not remain as strong and that the gap between the first week of sales and the
steady state widens, to the disadvantage of the steady state level.

COGS
Analyst 2003 2004 2005
Merrill Lynch 381.5 468.5 567.5
Brean Murray 381.5 474.9 599.7
RBC 392.2 500.1 609.5
Michigan Team 392.2 476.4 568.6

Our COGS forecasts remain within the analysts' range.

Net Income
Analyst 2003 2004 2005
Merrill Lynch 33.5 53 67.7
Brean Murray 39.1 53.1 73.5
RBC 39.1 53.8 72.2
Michigan Team 33.5 49.3 60.3

The overall result is a more conservative net income. As our forecasts keep a lower profile, the difference
between our forecasts and the analysts' widens.

Exhibit 10: Sensitivity Analysis

Sensitivity Analysis Cost of capital

eVal default 10.00% +1% -1%
KKD stock price $21.39 $16.56 $28.74
r(e) based on company sizea 14.58% +1% -1%
KKD stock price $7.79 $6.46 $9.46
r(e) based on CAPMb 14.03% +1% -1%
KKD stock price $8.66 $7.16 $10.57
(a)
based on market cap of $1.9B (4th decile ranking), and r(f) = 3.9%
(b)
based on r(f) = 3.9%, market premium = 7.5%, beta = 1.35