After reporting substantial losses between fiscal years 2005 and 2009, Krispy Kreme Doughnuts (KKD) is now profitable again. The stock is currently selling at multiples that may seem attractive compared to the industry, but in reality it is not.
The real P/E ratio of KKD is quite high
The reported P/E ratio for Krispy Kreme is abnormally low since in Q4 2012 the company reversed a tax valuation allowance in the amount of $139.6 million. Adjusting out the $1.96/share boost this “non operating” entry provided to the EPS, the adjusted P/E ratio of KKD stock on a ttm basis is 47.63. The company currently projects $0.44 to $0.47/share in eps for FY 2013, which will put its 2013 P/E ratio at (today’s price of $13.08/share) 28 – 30, which is not any cheaper than the competition.
Good Business Does Not Always Mean Good Stock
The fact that the company is able to reverse this valuation allowance, reflects the company’s confidence that the business will continue to be profitable in the near future. The company continues to grow its same store sales and add new stores and franchises both domestically and internationally. The company does have some competitive advantage in the industry. This can be seen when a company is able to charge higher prices than its competition, resulting in a greater gross margins. Gross margins for Krispy Kreme is at 35%. Restaurants as an industry averages gross margins of 30% while a company like Starbucks that has tremendous competitive advantage enjoys gross margins of 57%.
Key is to note that Starbucks mainly has company operated stores. Krispy Kreme operates a mix of company operated stores as well as franchised stores and margins differ across the concepts. The following is a reconstruction of the gross margins across Krispy Kreme’s segments in Q3 2013
KKD Gross Margins across Segments
- Company Stores (67.7% of Revenues): 30%
- Domestic Franchises (2.3% of Revenues): 100%
- International Franchises (5.6% of Revenues): 100%
- KK Supply Chain (24.3% of Revenues): 28%
- Consolidated: 35%
Please note that Krispy Kreme Supply Chain segment is in the business of selling products to both company owned stores as well as the franchisees. The numbers here only include external sales, which means inter-company sales have been netted off. Cost of Sales from the franchises segments are 0 since the company primarily collects royalties. Other product sales are handled through the KK Supply Chain segment.
Overall the effect of Franchising the shops have resulted in an improvement in the margins.
Regardless of a good business with healthy growth rates, the stock itself is not particularly attractive today at a P/E ratio > 25. It trades at a relative parity to Starbucks with a smaller franchise value. (It can also be argued that Starbucks may be overvalued but that is for another day).
The stock will start to become reasonably attractive at 50% below the current prices or about $6.5/share or under.
A Word About Growth
A good counter argument is that with a projected 25% a year growth estimates, KKD stock today is at a PEG of about 1. For growing companies, investors should expect to pay higher multiples, right?
The problem with this argument is that future growth is never certain while the price you pay today is etched in stone. Anytime you decide to pay heed to growth estimates, you are hitching your wagon to a target that is bound to be wrong. Besides, a company may indeed grow but not be able to protect its margins, in which case the growth is worthless to the current shareholders.
When looking at growth, it is important to consider if the company has the ability to maintain or enhance its competitive advantage. Krispy Kreme does not yet present me with an overwhelming evidence that it can.