Krispy Kreme Doughnuts

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, highly differentiated products, high-volume
production
2. Fragmented (regional) competition with less brand recognition
3. Strong opportunities to extend network of stores geographically.
4. Great steps to insure customer satisfaction from the use of their proprietary flour recipe to
their automated doughnut making machines.

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

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.

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.

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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 growth plans. 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,
2003 2004

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
Gross Profit
Company stores (18%) $ 54,405 $ 59,789
Franchise operations (65%) 13,912 20,784
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
Earnings before interest 51,281 65,867
Interest Income 600 0
Earnings before tax 51,881 65,867
Tax Expense (38%) 19,715 25,029
Net Income $32,166 $40,837

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%.

FEB. 3, FEB. 3,
2002 2003

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 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 we assume that this rate is relatively
stable at 20%, long-term assets will be as follows:
FEB. 3, FEB. 3,
2002 2003

Beginning long-term assets (30% of sales) 146,950 186,038

2. Forecast Capital Structure

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 unlikely to persist, since the company will
probably have positive net leverage over the long term.

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

Question 5: In general, do you expect analysts’ forecasts for a company like KKD to be optimistic,
pessimistic or unbiased? Why?

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