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Maria Pereira, center, and Susan Jackson, right, load up a dozen glazed donuts for customers at the Krispy Kreme doughnut shop in the Dupont Circle neighborhood of Washington. (LAWRENCE JACKSON/AP/LAWRENCE JACKSON/AP)
Maria Pereira, center, and Susan Jackson, right, load up a dozen glazed donuts for customers at the Krispy Kreme doughnut shop in the Dupont Circle neighborhood of Washington. (LAWRENCE JACKSON/AP/LAWRENCE JACKSON/AP)

Food

Krispy Kreme beckons sweetly to investors again Add to ...

Krispy Kreme went from an obscure regional brand to the hot growth stock of 2003 to a scandal-ridden mess. Now, the doughnut maker is writing a new chapter, largely out of Wall Street's eye: a profitable and growing restaurant company.

In its most recent quarter, the company posted its biggest profit in six years and is on track to report positive full-year net income this year for the first time since 2004. After years of closing locations, Krispy Kreme will actually expand its store base in 2010. At one point earlier this year, the stock was up 75 per cent from 2009-end levels; a retreat has left it up just 27 per cent.

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It's a pleasant batch of news for a company that has toiled in profitless obscurity since it was knocked off its perch as a Wall Street high flier.

Charmed by the cult-like queues at brand-new Krispy Kreme locations, investors bid up the stock eightfold in the first two years after its 2000 IPO. In a Fortune magazine cover story called "How Krispy Kreme became America's hottest brand," writer Andy Serwer said, "No, it's not as recognizable as Coke or McDonald's - yet."

Part of the appeal seemed to be that after the vapour-like earnings at companies such as Enron and WorldCom, investors wanted to bite into something more tangible. Unfortunately for shareholders, Krispy Kreme became yet another example of a company whose earnings were too good to be true, and a restatement followed.



The hemorrhaging has been halted … This significant improvement in operating trends and financial condition has not yet been reflected in improved stock price performance, with the stock price still more than 90 per cent below peak levels. Anton Brenner, Roth Capital Partners


At the company's annual meeting in June, CEO Jim Morgan summarized the last several years Krispy Kreme spent in the wilderness: "We had too much debt, and we were encumbered by the restrictions that went with it. We also had a rapidly declining revenue base, a legacy of lawsuits and government investigations, and our franchisee relations certainly were not the best. We had had four CEOs in less than three years, and we were having trouble getting traction in improving the business."

By closing unprofitable locations, Krispy Kreme boosted cash flow, which it then used to cut debt, from $123-million (U.S.) to $77-million to the current $43-million. With about $20-million in cash on the balance sheet, net debt is roughly $23-million.

The company's first-quarter profit of $4.5-million more than doubled the net of $1.9-million in the prior-year quarter. While revenue declined 1.2 per cent to $92.1-million, thanks to the re-franchising effort, the widely watched same-store sales metric rose 3.4 per cent, the sixth-consecutive quarterly increase.

Unfortunately for the company, no one on Wall Street is watching. The company has just two analysts following it, neither from major firms. One of them, Anton Brenner of Roth Capital Partners, initiated coverage in June with a "buy" and a 12-month target price of $6, which would represent a gain of more than 50 per cent.

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"Management not only is articulating a turnaround strategy, but is aggressively implementing that strategy. The hemorrhaging has been halted … This significant improvement in operating trends and financial condition has not yet been reflected in improved stock price performance, with the stock price still more than 90 per cent below peak levels," Mr. Brenner said.

Alas, the previous peak levels may never be attained again, as the company faces significant challenges in growing revenue.

Strategy

The lesson of Krispy Kreme's past crash was that the excitement of new locations wanes, and the company's strategy of building only a few large, destination-location "factory stores," where people could watch the whole doughnut-making process, dampened traffic. There's only so far people will drive for doughnuts, after all.

The company is trying to fix that problem with a "hub-and-spoke" strategy where new, smaller locations receive the cooked doughnuts and apply the chain's "waterfall of glaze" on site. Some new locations will be too small even for the waterfall, and will receive their doughnuts pre-made.

Krispy Kreme has also decided to limit new company-owned stores to its native Southeast, letting franchisees take the risk if they want to compete in markets with a strong presence from giant Dunkin' Donuts or other chains. Interestingly, Krispy Kreme now has more locations outside the United States than in, with a strong presence in the Middle East.

Unlike Canada's clear favourite Tim Hortons, Krispy Kreme has been unable to broaden its menu, with 88 per cent of revenue coming from doughnuts. (What kind of doughnut shop fails to sell a lot of coffee? Try one that originated in the American South, where it's so hot at breakfast time people drink Coca-Cola instead.) The chain is trying to diversify by adding soft-serve ice cream and baked goods such as muffins, bagels and pecan rolls.

At the same time, it's trying to manage expectations, not letting investors get too excited about what the near-term holds. Chief financial officer Doug Muir told attendees at the annual meeting that this year's profit "is not going to be breathtaking, but it should be another step in the right direction.

"I think we've reached an inflection point at which things are starting to get better instead of getting worse," he added.



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