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.

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Questions:

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1. Analysts are predicting that Krispy Kreme will be able to perform highly

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effectively and continue to grow rapidly in the coming two years. Do you
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agree with their analysis? If so, why? If not, why not?
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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
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both company and franchise stores)? What are their implicit assumptions
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about revenue growth from franchise operations and KKM&D? Do you agree
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with these forecasts?

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
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agree with these forecasts?

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4. The CIBC analysts do not forecast KKD’s balance sheet for the following
year (ended January 2003). Make your own balance sheet forecasts.
5. In general, do you expect analysts’ forecasts for a company like KKD to be
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optimistic, pessimistic or unbiased? Why?

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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?
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Key factors underlying growth:

1. Brand based on high quality product.

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 2. Fragmented (regional) competition with less brand recognition

3. Strong opportunities to extend network of stores geographically.

4. Area developer model seems to be working. Company store data suggests that
model probably works for area developers. eg.

Revenues ($70 per week *52) $3,640

Gross profit at company rate (18%) 655
Royalties (5.5%) (200)
Mark up on KKM&D (8.2*royalties*17%) (280)1
Capital charge (10%*$1.4m cost of a store) (140)

Net 35

Further, if area developer models go broke, KKD seems to be able to operate

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them profitably.

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5. Small store growth with new technology, and international growth hold
promise, although untested. Beginning to compete with Starbucks. Will

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donuts appeal to non-US market?.
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Potential Concerns
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1. Is this a fad? Will consumers tire of donut craze? But donuts have been
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popular for many years.

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2. Competition likely in long-term.

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Question 2: What factors did the CIBC analysts examine to forecast sales growth for
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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
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franchise operations and KKM&D? Do you agree with these forecasts?

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Revenue Forecasts

The CIBC analysts’ forecasts were constructed using per store information.
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 Company plans to add 62 new stores in 2003, mostly through area developers.
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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. .

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  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 (table C dropping from 28% to
4%) in last year. We may be able to sustain 4%, Franchise store revenue
growth is still high (13.2% in 2000, 23.2% in 2001) 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%*4.5% ? page 244 versus 3%).
These have averaged 4% for last 2 years. Use 4% going forward.

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 KKM&D revenues are driven by franchisee revenues, since sales are to

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franchisees and will vary with their volume. They have averaged 33% of

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franchise sales in last two years. Use 32% of franchise sales.

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2002 2003 2004

Number of stores at end of period:

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Company 75 80 87
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Franchised 143 200 273

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Systemwide 218 280 360

Average # company stores 69 77.5 83.5

Average # franchise stores 127 171.5 236.5
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Average weekly sales per store:

Company $72 $75 $77
Franchised 53 60 65
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System Sales (avge stores * weekly sales*52)

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Company sales $258,336 $302,250 $332,163

Franchise sales 350,012 535,080 799,370
System sales $608,348 $837,330 $1,131,533
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Company Revenues
Company stores $302,250 $332,163
Franchise operations (4% of franchise sales) 21,403 31,975
KKM&D (32% of franchise sales) 171,226 255,798
Revenues $494,879 $619,936

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 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, FEB. 3,
2003 2004

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Gross Profit

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Company stores (18%) $ 54,405 $ 59,789

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Franchise operations (65%) 13,912 20,784
KKM&D (17%) 29,108 43,486

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rs e $ 97,425 $ 124,059
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2. Forecast Other Costs

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G&A and Depreciation costs have averaged 9% of sales for the last three years. The
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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.
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FEB. 3, FEB. 3,
2003 2004
Other expenses (9% of sales) $ 44,539 $ 55,794
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Minority Interest (0.3% of franchise sales) 1,605 2,398

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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.
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3. Forecast Interest Expense

This requires assumptions to be made about the firm’s capital structure. The beginning
capital structure is given, and shows that the company has negative net debt of $20
million. This arises from the prior year’s decision to raise new equity to meet future

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 growth plans. As a result, if the interest rate on these short term cash resources is 3%, the
company’s 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 year’s time, leaving no interest income or expense.

4. Forecast Tax Rate

Rate has been around 38%.

Summary of full effect:

FEB. 3, FEB. 3,

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2003 2004

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Company Revenues
Company stores $302,250 $332,163

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Franchise operations (4% of franchise sales) 21,403 31,975
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KKM&D (32% of franchise sales) 171,226 255,798
Revenues $494,879 $619,936
Gross Profit
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Company stores (18%) $ 54,405 $ 59,789

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Franchise operations (65%) 13,912 20,784

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KKM&D (17%) 29,108 43,486

97,425 124,059
Other expenses (9% of sales) 44,539 55,794
Minority Interest (0.3% of franchise sales) 1,605 2,398
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Earnings before interest 51,281 65,867

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Interest Income 600 0

Earnings before tax 51,881 65,867
Tax Expense (38%) 19,715 25,029
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Net Income $32,166 $40,837

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This implies that the company’s 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
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8.1%.

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 Question 4: The CIBC analysts do not forecast KKD’s 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 year’s 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, FEB. 3,
2002 2003

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Beginning net working capital (4% of sales) 21,142 24,805

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Beginning long-term assets have increased as a percentage of sales from 20% to 25% in

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year 2001 and 2002. For 2003, based on forecasted sales growth of 25% and actual long-
term asset growth in 2002, the beginning long-term assets to sales ratio becomes 30%. If
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we assume that this rate is relatively stable at 20%, long-term assets will be as follows:

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

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2. Forecast Capital Structure

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As noted above, we have assumed that KKD’s 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
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unlikely to persist, since the company will probably have positive net leverage over the
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long term.
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 The condensed balance will therefore be as follows:

FEB. 3, FEB. 3,
2002 2003
Operating Assets
Beginning net working capital 21,142 24,805
Beginning long-term assets 146,950 186,038
168,092 210,843

Net Capital
Net debt -19,575 0
Common equity 187,667 210,843
168,092 210,843

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Question 5: In general, do you expect analysts’ forecasts for a company like KKD to be

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optimistic, pessimistic or unbiased? Why?

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Most of the incentives faced by financial analysts are likely to lead to optimistic research.

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Factors affecting analyst incentives include:
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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.
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This makes it unlikely that analysts will be very critical of a company,

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since they want to encourage its management to use the firm for any
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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.
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ii. Brokerage services. Analysts at many banks are rewarded based on

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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
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by producing research that encourages investors to purchase a stock.

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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
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research reports from other analysts, making it easier to rate an

analyst’s research relative to other analysts covering the same
company.

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