Case Study

Krispy Kreme Doughnut

Introduction
Vernon Rudolph started Krispy Kreme Doughnut in

1937 in Winston-Salem, North California by selling doughnuts to local grocery stores.

Thereafter it added new stores and in mid-1990 using

area developer franchise model to pursue its ambition of geographical expansion.

In 2002 with 222 stores under its network in 34 states,

it is producing 2 billions of doughnut yearly.

Milestones

1996
2000 2001 2002

First store in New York City to capture market in metropolitan region through area developer franchise model.

Issued IPO at $5.50 which soared to $9.25 on the first day of trading.

Opened first international store in Toronto, Canada.

Krispy Kremes network comprised 222 factory in 34 states.

Revenue generation model

From self owned and operated doughnut stores Royalties from franchise and area developers From sale of doughnuts mixes and doughnut making equipment

Store under network at the end of 2002

Number of Stores in %
23.87 42.34 33.78

Franchise Associates Self owned

Type of Franchise
Associate

Royalty Scheme
3% for on-premise sales + 1% on other items except private label items. Contract for 15 yrs 4.5% of all sales + 1% for advertisements. One time franchise fee of $20,000 to $40,000.

Area developer

Competitors in 2002
Dunkin donuts: 4,736 franchise stores in 43 states

and 20 countries with $1.6 billion sales a year

Winchells: 200 stores in West Cost region. Donut Connection : 140 stores in 13 states of mid-

Atlantic region
Honeydew Donuts: 100 stores in New England Few hundred regional bakery shops.

Growth Plans of Krispy Kreme

Plans to open 62 new stores in 2003, mostly franchise stores,

in addition to the 200 new stores that the area developers are contractually obliged to open from 2003 to 2006. Exploring opportunities in Japan ,South Korea, Australia, Spain, and the United Kingdom. Plans to increase the sales of complementary products through existing stores, like in February 2001 it acquired Digital Java, a small Chicago-based coffee company for addition of enhanced espresso and coffee offerings at Krispy Kreme stores. Use of smaller hot doughnut machine, producing the same quality doughnuts as existing larger machines. It will allow them to expand into smaller markets and into dense urban areas that were more costly to reach under the larger factory store model.

Growth plans (continued)

As per their plans of increasing franchise operations, it

require the company to invest heavily in plants, property and equipment. In February 2002, the company spent $37 million to construct and equip new company-owned factory stores, to upgrade manufacturing facilities, to install coffeeroasting operations in stores, and to construct doughnuts and coffee shops. It planned to invest aggressively in both long-term assets and working capital to achieve growth targets.

Financials for growth target

In 2002, Krispy Kreme raised funds through a $17.2

million stock offering (for 10.4 million shares) Increased its revolving credit facility from $28 million to $40 million. Agreed to a $35 million bank loan to fund the construction of a new mix and distribution facility. In 2002, Company planned to fund its next 24 months capital needs through IPO completed in April 2000, follow-on public offering completed in Feb 2001, cash flow generated from operations and borrowing capacity through credit. It had other plans like to raise additional capital through public or private equity or debt financing in case of capital offshoot.

Analysts forecasts:
Feb 3,2002 Number of stores at the end of the period: Company Franchised Average # company stores Average # franchise stores Average weekly sales per store: Company Franchised System sales (avg stores*weekly sales*52) Company sales Franchise sales System sales Company revenues: Company stores Franchise operations (4% of the franchise sales) KKM&D (32% of franchise sales) Net Revenue Revenue Growth rate $302,250 21,403 171,226 $494,879 25% $332,163 31,975 255,798 $619,936 25% $258,336 350,012 608,348 $302,250 535,080 837,330 $332,163 799,370 1,131,533 $72 53 $75 60 $77 65 218 75 143 69 127 Feb 3,2003 280 80 200 77.5 171.5 Feb 3,2004 360 87 273 83.5 236.5

Analyst forecasts (continued)

Mainly predicted that KrispeKreme would report

earnings per share of $0.64 for the year ended January 2003 and $0.83 for the January 2004 year. The forecasts projected earnings growth of 42 percent and 33 percent for the next two years All analysts covering Krispy Kreme predicted the same trend.

Stock Price Performance

(April 2000 to May 2002)

Will Krispy Kreme grow?

Key Factors underlying growth:
Brand based on high quality product. Fragmented(regional) competition with less brand

recognition. Strong opportunities to extend network of stores geographically. Small stores growth with new technology and international growth hold promise, although untested. Beginning to compete with Starbucks. Will donuts appeal to non-US market?

Will Krispy Kreme grow? (contd.)

Area developer model seems to be working. Company store data suggests: Revenues($70 per week *52) $3640 Gross profit at company rate(18%) $655 Royalties(5.5%) (200) Mark up on KKM&D(8.2*Royalties*17%) (280) Capital Charge(10%*$1.4m cost of a store) (140)

Net 35 If area developer models went broke,KKMD seems to be able to operate them profitably.

Political Concerns:
Is this a fad? Will consumers tire of donut craze?

But donuts have been popular for many years.

Competition likely in long-term.

Revenue forecasts.
The CIBC analysts were constructed using per store

information. Company plans to add 62 new stores in 2003, mostly through area developers. What are revenue per new store? Initial boom, followed by leveling off. Also, not all new stores are open for full year. Revenue growth per new store has been impressive. What do we forecast for these? Company store growth is stabilizing(dropping from 28 % to 4%) in last years. (continued..)

Revenue forecasts(continued..)
We may be able to sustain 4%. Franchise store revenue

growth is still high, as the number of area developers increase, with the store revenue patterns comparable to company stores. This is likely to persist for several years before revenue per store are similar for company and franchise stores. Royalty revenue has been increasing over time since area developers pay higher royalty rates than old associates (5.5 % versus 3%). These have averaged 4% for the last 2 years. KKM&D revenues are driven by franchisee revenues, since sales are to franchisees and will vary with their volume. They have averaged 33% of franchise sales in last two years. Use 32% of the franchise sales.

Factors examined to forecast sales growth in 2003 & 2004 (Contd.)

Feb 3,2002 Number of stores at the end of the period: Company Franchised Average # company stores Average # franchise stores Average weekly sales per store: Company Franchised System sales (avg stores*weekly sales*52) Company sales $258,336 $302,250 $332,163 $72 53 $75 60 $77 65 218 75 143 69 127 Feb 3,2003 280 80 200 77.5 171.5 Feb 3,2004 360 87 273 83.5 236.5

Franchise sales
System sales Company revenues: Company stores Franchise operations (4% of the franchise sales) KKM&D (32% of franchise sales) Net Revenue Revenue Growth rate

350,012
608,348

535,080
837,330

799,370
1,131,533

$302,250 21,403 171,226 $494,879 25%

$332,163 31,975 255,798 $619,936 25%

NOPAT margins forecast

1.

Forecast Gross profits per store:

These vary greatly by business. For company stores they have increased to 18%. Royalty income has 65% margin and KKM&D is 17%. The CIBC analysts have forecasted that margins increase 19% of the company stores, 70% of franchise operations, and 18-19% for KKM&D. Using these value, the costs are:

Feb3, 2003 Gross Profit Company Stores (18%) Franchise operations (65%) KKM&D (17%) $54,504 13,912 29,108 $97,425

Feb 3, 2004 $59,789 20,784 43,486 $124,059

NOPAT margins forecast (Contd.)

2. Forecast other costs: G&A and Depreciation costs have averaged 9% of sales for the past three years. The CIBC analysts show this declining marginally in 2004 to 8.74%. In addition, minority interest (presumably in franchisees) has been around 0.3% of the franchise revenues for the last three years.
Feb. 3, 2003 Feb. 3, 2004

Other expenses (9% of sales)

$ 44,539

$ 55,794
2,398

Minority Interest (0.3% of franchise 1,605 sales)

NOPAT margins forecast (Contd.)

3. Forecast Interest debt Expense:
Assumptions about the firms capital structure: If the interest rate on these short term cash resources is 3%, the companys interest income will be around $ 600,000. This means that it will draw down cash for the It seems reasonable to assume that the company expects to draw down its cash ($ 37 million in Feb 2002) almost completely to finance its growth. This means that the net debt would be close to zero in one years time, leaving no interest income or expense.

The prior years decision to raise new equity to meet future growth plans

In the beginning the company has negative net debt $ 20 million.

Forecast tax rate: The rate has been around 38%.

Company revenues Company stores Franchise operations (4% of franchise sales) KKM&D (32% of franchise sales) Revenues Gross Profit Company Stores (18%) Franchise operations (65%) KKM&D (17%)

Feb. 3, 2003
$302,250 21,403 171, 226 $494,879

Feb. 3, 2004
$332,163 31,975 255,798 $ 619,936

$ 54,405 13,912 29,108 97,425

$ 59,789 20,784 43,486 124,059 55,794

Other expenses (9% of sales)

44,539

Minority Interest (0.3% of franchise sales)

Earnings before interest Interest income Earnings before tax

1,605
51,281 600 51,881 $19,715 $32,166

2,398
65,867 0 65,867 $25,029 $40,837

Tax expense (38%) Net income

Forecast operating assets.

KKD has shown a large increase in working capital(mostly

receivables from franchise).

FEB 3,2002 Beginning net working capital(4% of sales 21,142 FEB 3,2003 24,805

Working capital/sales rate increases from 2.3% to 4.3%.

If the increase persists then Working Capital will be :

FEB 3,2002 Beginning net working capital(4% of sales 21,142 FEB 3,2003 24,805

Forecast operating assets(contd.)

Long term assets as a percentage of sales have

increased from 20% to 25% in 2001 and 2002.

For 2003, long term assets to sales ratio becomes

30%.

Assuming rate is stable at 20%, long term assets will be:

Feb 3,2002 Beginning Long-term assets(30% of sales) 146,950 FEB 3,2003 186,038

Forecast capital structure.

Assuming KKDs negative debt position will be

eliminated by the beginning of 2004, (excess cash will finance growth); KKD will be an all equity firm.
But, it is likely to change, since KKD will probably

have positive net leverage over the long term.

Condensed balance will be:

FEB. 3,2002 Opening Assets Beginning networking Capital Beginning Long Term Assets 21,142 24,805 FEB 3,2003

146,950 168,092

186,038 210,843

Net Capital Net Debt Common Equity -19,575 187,667 168,092 0 210,843 210,843

Optimistic, pessimistic or unbiased!

OPTIMISTIC. Factors affecting are :
o o

Investment banking opportunities. Brokerage services.

Investment banking opportunities

Analysts receive significant bonuses If : o they play a role in attracting a company as an

investment banking client, o If they participate in selling a new issue to investors. It makes it unlikely that analysts will be very critical of company so as to encourage management to use firm for new equity placements

Brokerage services
Analysts rewarded based on commissions generated

for the companies they follow Produces incentives to producing research that encourages investors to trade. Given costs of short selling and identifying customers, it is easier for analyst to increase trading volume. Incentives particularly strong for analysts catering to retail investors.