Krispy Kreme Doughnuts Teaching Note Background Krispy Kreme (KKD) has achieved spectacular growth in the last

few years using an area developer model to expand geographically. This case examines the factors that have driven its growth and their sustainability in the coming two years. Students are provided with forecasts made by financial analysts at CIBC. They are then asked to identify and evaluate the assumptions underlying these earnings forecasts. Since the CIBC report does not provide a forecasted balance sheet for KKD, the case can be used to let students learn how to build a forecasted balance sheet. Finally, the case can be used to discuss potential conflicts of interest between analysts and investors that might lead analysts to over-sell a growth firm such as KKD. Questions: 1. 2. Analysts are predicting that Krispy Kreme will be able to perform highly effectively and continue to grow rapidly in the coming two years. Do you agree with their analysis? If so, why? If not, why not? What factors did the CIBC analysts examine to forecast sales growth for KKD in the years ended January 2003 and 2004? What assumptions did they implicitly make about number of new stores and weekly sales per store (for both company and franchise stores)? What are their implicit assumptions about revenue growth from franchise operations and KKM&D? Do you agree with these forecasts? What are the NOPAT margins that the CIBC analysts have forecasted for KKD for the years ended January 2003 and 2004? What assumptions were made about specific expense items (e.g. margins, G&A, D&A, taxes)? Do you agree with these forecasts? The CIBC analysts do not forecast KKDs balance sheet for the following year (ended January 2003). Make your own balance sheet forecasts. In general, do you expect analysts forecasts for a company like KKD to be optimistic, pessimistic or unbiased? Why?

3.

4. 5.

Question 1: Analysts are predicting that Krispy Kreme will be able to perform highly effectively and continue to grow rapidly in the coming two years. Do you agree with their analysis? If so, why? If not, why not? Key factors underlying growth: 1. Brand based on high quality product.

2. 3. 4.

Fragmented (regional) competition with less brand recognition Strong opportunities to extend network of stores geographically. Area developer model seems to be working. Company store data suggests that model probably works for area developers. eg. Revenues ($70 per week *52) Gross profit at company rate (18%) Royalties (5.5%) Mark up on KKM&D (8.2*royalties*17%) Capital charge (10%*$1.4m cost of a store) Net $3,640 655 (200) (280)1 (140) 35

Further, if area developer models go broke, KKD seems to be able to operate them profitably. 5. Small store growth with new technology, and international growth hold promise, although untested. Beginning to compete with Starbucks. Will donuts appeal to non-US market?.

Potential Concerns 1. 2. Is this a fad? Will consumers tire of donut craze? But donuts have been popular for many years. Competition likely in long-term.

Question 2: What factors did the CIBC analysts examine to forecast sales growth for KKD in the years ended January 2003 and 2004? What assumptions did they implicitly make about number of new stores and weekly sales per store (for both company and franchise stores)? What are their implicit assumptions about revenue growth from franchise operations and KKM&D? Do you agree with these forecasts? Revenue Forecasts The CIBC analysts forecasts were constructed using per store information.
1

Company plans to add 62 new stores in 2003, mostly through area developers.

This estimate likely overstates the profit markup impact on the franchisees earnings, since it assumes that all of the KKM&D sales are reflected as an expense during the the current year. In reality some of the mix sales will be held as inventory, and new machines sales will be depreciated over time, reducing the impact on current earnings. .

What are revenues 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 year. We may be able to sustain 4%, Franchise store revenue growth is still high, as the number of area developers increase, with store revenue patterns comparable to company stores. This is likely to persist for several years until revenues per store are similar for company and franchise stores. Royalty revenues have been increasing over time since area developers pay higher royalty rates than old associates (5.5% versus 3%). These have averaged 4% for last 2 years. Use 4% going forward. 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 franchise sales. FEB. 3, 2002 FEB. 3, 2003 FEB. 3, 2004

Number of stores at end of period: Company Franchised Systemwide Average # company stores Average # franchise stores Average weekly sales per store: Company Franchised System Sales (avge stores * weekly sales*52) Company sales Franchise sales System sales Company Revenues Company stores Franchise operations (4% of franchise sales) KKM&D (32% of franchise sales) Revenues

75 143 218 69 127

80 200 280 77.5 171.5

87 273 360 83.5 236.5

$72 53

$75 60

$77 65

$258,336 350,012 $608,348

$302,250 $332,163 535,080 799,370 $837,330 $1,131,533

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

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

Revenue growth rate

25%

25%

Question 3: What are the NOPAT margins that the CIBC analysts have forecasted for KKD for the years ended January 2003 and 2004? What assumptions were made about specific expense items (e.g. margins, G&A, D&A, taxes)? Do you agree with these forecasts? 1. Forecast Gross Profits per Store

These vary greatly by business. For company stores they have increased to 18%. Royalty income has a 65% margin, and KKM&D is 17%. The CIBC analysts have forecasted that margins increase to 19% for company stores, 70% for franchise operations, and 18-19% for KKM&D. Using these values we get the following costs: FEB. 3, 2003 Gross Profit Company stores (18%) Franchise operations (65%) KKM&D (17%) $ FEB. 3, 2004

54,405 $ 59,789 13,912 20,784 29,108 43,486 97,425 $ 124,059

2.

Forecast Other Costs

G&A and Depreciation costs have averaged 9% of sales for the last three years. The CIBC analysts show this 9% 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 two years. FEB. 3, FEB. 3, 2003 2004 $ 44,539 $ 55,794 1,605 2,398

Other expenses (9% of sales) Minority Interest (0.3% of franchise sales)

Note that there are other items that tend to cancel each other out (joint venture income, minority interest). The analysts forecast a lower MI item. 3. Forecast Interest Expense

This requires assumptions to be made about the firms capital structure. The beginning capital structure is given, and shows that the company has negative net debt of $20 4

million. This arises from the prior years decision to raise new equity to meet future growth plans. As a result, if the interest rate on these short term cash resources is 3%, the companys interest income will be around $600,000. This implies that it will probably draw down cash for the next year. 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 would imply that net debt would be close to zero in one years time, leaving no interest income or expense. 4. Forecast Tax Rate

Rate has been around 38%. Summary of full effect: FEB. 3, 2003 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%) Other expenses (9% of sales) Minority Interest (0.3% of franchise sales) Earnings before interest Interest Income Earnings before tax Tax Expense (38%) Net Income FEB. 3, 2004

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

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

54,405 $ 59,789 13,912 20,784 29,108 43,486 97,425 124,059 44,539 55,794 1,605 2,398 51,281 65,867 600 0 51,881 65,867 19,715 25,029 $32,166 $40,837

This implies that the companys NOPAT margin is 6.4% in 2003 and 6.6% in 2004, versus 6.3% in 2002. In contrast, the CIBC forecasts show a NOPAT margin of 7.4% and 8.1%.

Question 4: The CIBC analysts do not forecast KKDs balance sheet for the following year (ended January 2003). Make your own balance sheet forecasts. 1. Forecast operating assets KKD has shown a large increase in working capital this year, largely in the form of receivables for franchisees. Given the projected 25% growth in sales, the working capital/sales rate increases from 2.3% to 4.3%. For next years balance sheet, you need to ask whether this increase is likely to persist, or whether the old rate is applicable. If you assume that it continues, working capital will be as follows given the former sales growth rates: FEB. 3, 2002 Beginning net working capital (4% of sales) 21,142 FEB. 3, 2003 24,805

Beginning long-term assets have increased as a percentage of sales from 20% to 25% in year 2001 and 2002. For 2003, based on forecasted sales growth of 25% and actual longterm asset growth in 2002, the beginning long-term assets to sales ratio becomes 30%. If we assume that this rate is relatively stable at 20%, long-term assets will be as follows: FEB. 3, 2002 Beginning long-term assets (30% of sales) 2. Forecast Capital Structure As noted above, we have assumed that KKDs negative net debt position will be eliminated by the beginning of 2004, as the company uses its excess cash to finance growth. This implies that the company will be an all equity firm. Of course, this is unlikely to persist, since the company will probably have positive net leverage over the long term. 146,950 FEB. 3, 2003 186,038

The condensed balance will therefore be as follows: FEB. 3, 2002 Operating Assets Beginning net working capital Beginning long-term assets 21,142 146,950 168,092 FEB. 3, 2003 24,805 186,038 210,843

Net Capital Net debt Common equity

-19,575 187,667 168,092

0 210,843 210,843

Question 5: In general, do you expect analysts forecasts for a company like KKD to be optimistic, pessimistic or unbiased? Why? Most of the incentives faced by financial analysts are likely to lead to optimistic research. Factors affecting analyst incentives include: i. Investment banking opportunities. Analysts receive significant bonuses if they play a role in attracting a company as an investment banking client, or if they participate in selling a new issue to investors. This makes it unlikely that analysts will be very critical of a company, since they want to encourage its management to use the firm for any new equity placements. Note: following the April 2003 agreement between the ten leading underwriter firms and the SEC/NY State Attorney General, banks are required to separate the underwriting and research parts of their business. Brokerage services. Analysts at many banks are rewarded based on commissions generated for the companies they follow. This creates incentives to producing research that encourages investors to trade. Given the costs of short selling and the identifying investors that already own a stock, it is easier for analysts to increase trading volume by producing research that encourages investors to purchase a stock. This incentive is particularly strong for analysts that cater to retail investors. Institutional investors also reward analysts using commissions, but they are more explicit about providing feedback on which particular reports were valuable. They also have access to research reports from other analysts, making it easier to rate an analysts research relative to other analysts covering the same company.

ii.