Krispy Kreme
...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. 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 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 an...