KRISPY KREME DOUGHNUT

KRISPY KREME DOUGHNUT Krispy Kreme Doughnut (KKD) is a retailer and wholesaler of high-quality doughnuts, complementary beverages, treats and packaged sweets and competes within the GICS consumer discretionary sector in addition to the QSR (quick service restaurant) segment of the restaurant industry. The company began in 1937 and its core business model includes the ownership and franchising of Krispy Kreme stores that offers a wide variety of doughnuts and complementary products such as coffee and other beverages. A series of accounting missteps and shortcomings with the corporate governance coupled with changing trends in American diet has troubled the company. Some current challenges the company face are the rising health concerns regarding its doughnuts and subpar past corporate governance. Some of the strategic issues the company currently faces are responding to the threats of mom-and-pop shops across the nation and improving franchise relations. The objective of strategic management is to achieve better alignment of corporate policies and strategic priorities. Some key strategic issues that plagued the company was the miss alignment between corporate and franchise interests since its expansion plan in 1995 but more specifically between the years 2004 and 2009. Overexpansion, accounting inaccuracies, and issues with corporate governance has shaken its stakeholder's confidence in the company. Although the company has bounce back from record losses and it s on a new path to profitability, Krispy Kreme must be careful to avoid its past mistakes and must carefully examine each site on an individual basis to make sure that it s profitable. Krispy Kreme core competency is based on a delivering a better doughnut experience. KKD delivers on that experience by creating and distributing its own secret recipe dough, giving its consumers a consistent high quality product. Since the company recognized the experience that comes with eating one of its doughnuts, it implemented the red sign. The sign is just a KKD store sign but lights up when there are fresh and hot doughnuts available to purchase. This is one idea that competitors have had a hard time imitating. KKD also recognizes that their employees are a key resource to creating a core competency. Rather than assuming employees know how to do their job, they take the time to train employees not only with customer service skills, but they also with marketing skills. Due to the capital requirements of a local store, the threat of new entrants is one major threat to Krispy Kreme. Local mom-and-pop shops have proven to be formidable competitors, creating a difficult environment for KKD to operate in. A limitation of breakfast products offered makes the threat of mom-and-pop shops much higher. Krispy Kreme specializes in doughnuts, which does not vary much if consumers tastes change but in order to maintain their ground and possibly come out ahead in the industry KKD needs to diversify it breakfast products. Rather than only offering this breakfast dessert as some refer to it, it needs to also offer breakfast sandwiches or bagels. As consumers tastes change, it is important to be able to deliver products that reflect those changes. The company generates revenues from four business segments: company stores (97), domestic franchises (142), international franchises (509) and the KKD supply chain which 1

produces and sells doughnut mixes and doughnut-making equipment along with other ingredients, packaging and supplies to KKD stores. The company has a total of 748 stores and segment revenue respectively represented 66.7%, 2.6%, 5.6% and 25.2% in fiscal year 2014 with total revenues of $460 million. Over the past 3 years KKD has effectuated a 63.41% growth in earnings per share, rising from $.11 per share in 2011 to $.48 per share in 2014. Over the past 10 years though, the company has delivered weak and erratic earnings that were negative from 2005 to 2009. (See Appendix Table 1 Earnings Per Share). The 10 year average ROE for KKD is negative 15.13% although the company has improved greatly in the last 5 years delivering a 26.92% ROE. (See Appendix Table 2) Over the last 5 years, revenue has risen from $347 million to $460 million in FY 2014, a growth rate 32.6%. (For additional key performance metrics, see Appendix Table 3). Fiscal Year 2014 Highlights are as follows: Domestic franchise same store sales growth of 7.9% increase in revenue year over year 9.9%. Total operating income increase of 28% to $46.6 Same store sales increase of 6.7% mill. Adjusted net income increase of 31% to $43.2 Company store operating income increase of mill. i 37%. According to the 2013 KKD 10-K, the QSR segment is the largest segment of the restaurant industry and has exhibited steady growth over a long period of time. ii The identified competitors of KKD within the QSR segment includes Dunkin Donuts (DNKN), Starbucks (SBUX) and McDonald s (MCD). Both Starbucks and McDonald s have exhibited strong earnings per share growth over the last 10 years of 18.79% and 13.4% respectively with 10 year return on equity averages of 21.04% and 28.2% respectively. The three-year EPS growth rate for each company is included in the appendix, table 1, and as detailed, over the last 3 years, KKD has dominated with a growth rate of 63.41% but over a longer term track of 10 years, we see that the company pales in comparison to SBUX and MCD. Industry profitability for the 2013 net profit margin sits at 7.73%. The reasons for the numbers observed above can the attributed to improper expansion plans and corporate mishandling. As a result franchises have underperformed for a long time and now the company has to play catch up with the rest of the industry. Compared to the industry net profit margin for 2013, Krispy Kreme Doughnuts does not appear to have a competitive advantage (4.77% versus 7.73%). Additional key industry metric comparisons echo this conclusion: KKD Hotel/Restaurant Industry Average Gross Margin (TTM) 18.56% 35.13% Operating Margin (TTM) 10.23% 18.31% Return on Sales (TTM) 7.88% 12.14% Return on Investment (TTM) 13.95% 14.63% Return on Equity (TTM) 14.11% 14.17% 2

Additionally, Krispy Kreme Doughnut falls short regarding EPS stability and average return on equity in comparison to major competitors such as Starbucks and McDonald s, (see Appendix Tables 1 and 2) indicating that the company does not have a competitive advantage. In recent years though, the company has drastically improved its performance. With recent corporate performance paving the way to profitability one can see that profitability is not the only goal of KKD as it was in the past. An over-emphasis on corporate profits with a corollary cancer of overexpansion led to past growth sales but caused many of its franchised outlets to struggle. iii The firm now focuses on sustainable growth and effective corporate leadership. A goal conflict always exists within franchisor/franchisee relationships: franchisors try to maximize sales made to franchisees while franchisees try to minimize expenses. iv The misalignment is still a major concern for Krispy Kreme but the firm is adding a Vice President of Franchise Development to alleviate the conflict and maintain strong relationships with its franchisees.v The supply chain segment for KKD generates revenue by selling doughnut mix and equipment to franchisees. Krispy Kreme demands a small royalty from franchisees but makes up revenue with the mix and equipment which has led to misaligned incentives where maximizing overall corporate profits through increased KK supply chain revenue came at the expense of the individual franchisee. vi A recommendation for the company would be to increase its franchisee royalty payment similar to the DNKN royalty model while decreasing the mark-up on mix and equipment or perhaps allowing franchisees to purchase equipment from other vendors. This move would shift the revenue earned by the supply chain to the sales of the franchisee thus creating alignment. In order for the recommendations above to work, Krispy Kreme would need to set some criteria that 3rd party equipment will need to meet in order to not jeopardize quality. Currently Krispy Kreme Doughnuts continues to expand in the United States as well as abroad. From their peak of almost 400 stores in 2005 and the subsequent closure of nearly half of those by 2009, Krispy Kreme had somewhat rebounded as of February 2013. At that time, they had 239 domestic stores and 748 total worldwide (Reuters). Krispy Kreme has always been known for their doughnuts and that is what they continue to be known for today. According to their website, in 2011 they launched their signature coffee blends to attempt to compete with Dunkin Donuts. While it wasn t a complete bust, they are still not known for their coffee even though they recently launched their coffee in K-cups for retail stores (Krispy Kreme). Since hitting rock bottom on February 11, 2009 with a stock price of $1.29, their stock price has increased steadily over the last five years as is shown in the graph in the Appendix. After the spike a year ago when they closed at $25.83, they most recently closed on October 31, 2014 at $18.52 per share (Yahoo! Finance). While the price hasn't reached the highest they have ever seen, topping off just over $49 per share, this is a very good increase over the lowest and still doubles their IPO price of $9. And finally, Krispy Kreme is keeping up with technology as well as attempting to differentiate themselves with their Hot Light App for smartphones to allow customers to know exactly when their doughnuts are at their hottest (Krispy Kreme). 3

Bibliography "Krispy Kreme Doughnuts." Krispy Kreme. N.p., n.d. Web. 30 Oct. 2014. "Krispy Kreme Doughnuts Inc (KKD.N) Company Profile Reuters.com." Reuters. Thomson Reuters, n.d. Web. 30 Oct. 2014. "Krispy Kreme Doughnuts, Inc." Yahoo! Finance. N.p., n.d. Web. 30 Oct. 2014. Appendix Table 1 Earnings Per Share EPS Trend and Growth Rate KKD DNKN SBUX MCD 2004 $ 0.93 $ 0.48 $ 1.79 2005 $ (3.22) $ 0.61 $ 2.04 2006 $ (2.20) $ 0.71 $ 2.83 2007 $ (0.68) $ 0.87 $ 1.98 2008 $ (1.05) $ 0.43 $ 3.76 2009 $ (0.06) $ 0.36 $ 0.52 $ 4.11 2010 $ 1.24 $ 4.58 2011 $ 0.11 $ 0.32 $ 1.62 $ 5.27 2012 $ 2.33 $ 0.93 $ 1.79 $ 5.36 2013 $ 0.30 $ 1.36 $ 2.26 $ 5.55 2014 $ 0.48 P/Y 1 1 1 1 PV $ (0.11) $ 0.00 $ (1.24) $ (4.58) FV $ 0.48 $ 1.36 $ 2.26 $ 5.55 N 3 3 3 3 CPT I/Y 63.41% > 100% 22.15% 6.61% Table 2 Return on Equity KKD DNKN SBUX MCD 2004 17.15% 17.40% 2005-57.23% 21.60% 17.73% 2006-77.66% 26.13% 23.16% 2007-45.02% 29.81% 15.58% 2008-98.91% 13.21% 30.01% 2009-7.10% 14.12% 33.20% 2010-0.26% 28.14% 34.51% 4

2011 10.92% 32.55% 30.91% 37.92% 2012 102.15% 19.83% 29.15% 36.82% 2013 8.39% 38.97% 0.17% 35.69% 2014 13.39% 10 yr Average ROE* 15.13% 30.45% 21.04% 28.20% 5 yr Average ROE* 26.92% 30.45% 20.50% 35.63% Table 3 KKD Key Metrics 2009 to 2011 Table 4 2013 Net Margin Ranking by Industry Rank Industry Name Net Margin 1 Thrift 164.70% 2 R.E.I.T. 73.16% 3 Broadcasting 29.55% 4 Bank 27.21% 5 Tobacco 24.69% 6 Banks (Regional) 23.05% 7 Beverage (Alcoholic) 22.63% 8 Financial Svcs. 21.77% 9 Computer Software 20.47% 10 Pharma & Drugs 20.31% 11 Railroad 17.62% 12 Investment Co. 16.63% 13 Financial Svcs. (Non bank & Insurance) 15.55% 14 Information Services 15.50% 15 Telecom. Equipment 14.98% 16 Utility (Water) 14.20% 17 Internet software and services 14.18% 5

18 Homebuilding 14.11% 19 Entertainment 13.75% 20 Computers/Peripherals 13.17% 21 Beverage 12.77% 22 Semiconductor 11.43% 23 Chemical (Specialty) 11.19% 24 Diversified 10.46% 25 Insurance (Prop/Cas.) 10.33% 26 Brokerage & Investment Banking 9.72% 27 Oil/Gas (Integrated) 9.72% 28 Household Products 9.63% 29 Shoe 9.47% 30 Healthcare Equipment 9.41% 31 Electronics (Consumer & Office) 9.36% 32 Cable TV 8.93% 33 Chemical (Diversified) 7.74% 34 Restaurant 7.73% 35 Machinery 7.72% 36 Oil/Gas (Production and Exploration) 7.68% 37 Heathcare Information and Technology 7.52% 38 Recreation 7.29% 39 Power 7.26% 40 Biotechnology 6.88% 41 Computer Services 6.85% 42 Apparel 6.72% 43 Aerospace/Defense 6.64% 44 Electrical Equipment 6.36% 45 Utility (General) 6.28% 46 Food Processing 6.22% 47 Electronics 5.67% 48 Heavy Construction 5.61% 49 Retail (Building Supply) 5.56% 50 Reinsurance 5.37% 51 Insurance (General) 5.02% 52 Metals & Mining 4.86% 53 Insurance (Life) 4.85% 54 Real Estate (General/Diversified) 4.80% 55 Environmental & Waste Services 4.40% 56 Business & Consumer Services 4.34% 57 Chemical (Basic) 4.28% 58 Healthcare Products 4.26% 6

59 Furn/Home Furnishings 4.16% 60 Oil/Gas Distribution 4.14% 61 Paper/Forest Products 4.05% 62 Auto Parts 4.00% 63 Real Estate (Operations & Services) 3.96% 64 Advertising 3.90% 65 Retail (Special Lines) 3.88% 66 Auto & Truck 3.82% 67 Packaging & Container 3.73% 68 Retail (Distributors) 3.53% 69 Oilfield Svcs/Equip. 3.52% 70 Retail (Internet) 3.37% 71 Transportation 3.36% 72 Telecom. Services 3.32% 73 Trucking 3.17% 74 Publshing & Newspapers 3.10% 75 Construction 3.02% 76 Retail (Automotive) 2.94% 77 Retail (General) 2.90% 78 Hotel/Gaming 2.87% 79 Air Transport 2.82% 80 Office Equipment & Services 2.68% 81 Rubber& Tires 2.68% 82 Healthcare Facilities 2.54% 83 Healthcare Services 2.42% 84 Engineering 2.15% 85 Food Wholesalers 2.02% 86 Building Materials 1.91% 87 Farming/Agriculture 1.05% 88 Retail (Grocery and Food) 0.75% 89 Shipbuilding & Marine 0.27% 90 Educational Services 0.07% 91 Semiconductor Equip 1.25% 92 Steel 2.44% 93 Telecom (Wireless) 6.30% 94 Coal & Related Energy 10.81% 95 Real Estate (Development) 12.88% 96 Precious Metals 18.86% Total Market 8.06% Source: Aswath Damodaran http://pages.stern.nyu.edu/~adamodar/new_home_page/datafile/margin.html 7

i KKD 2014 Annual Report. ii KKD 10 K filing 2013 http://investor.krispykreme.com/phoenix.zhtml?c=120929&p=irol SECText&TEXT=aHR0cDovL2FwaS50ZW5rd2l6YXJkLmNvbS9maWxpbmcueG1sP2lwYWdlPTg4NjcwNjkmRFNFUT0xJl NFUT03JlNRREVTQz1TRUNUSU9OX1BBR0UmZXhwPSZzdWJzaWQ9NTc%3d iii Hitt, Michael A., R. Duane Ireland and Robert E. Hoskisson. Strategic Management: Competitiveness and Globalization, 11 th ed. Mason: South Western Cengage Learning, 2014. Krispy Kreme Doughnuts Case Analysis iv Hitt, Michael A., R. Duane Ireland and Robert E. Hoskisson. Strategic Management: Competitiveness and Globalization, 11 th ed. Mason: South Western Cengage Learning, 2014. Krispy Kreme Doughnuts Case Analysis v Hitt, Michael A., R. Duane Ireland and Robert E. Hoskisson. Strategic Management: Competitiveness and Globalization, 11 th ed. Mason: South Western Cengage Learning, 2014. Krispy Kreme Doughnuts Case Analysis vi Hitt, Michael A., R. Duane Ireland and Robert E. Hoskisson. Strategic Management: Competitiveness and Globalization, 11 th ed. Mason: South Western Cengage Learning, 2014. Krispy Kreme Doughnuts Case Analysis 8