"Grab the Doughnuts"

08/19/2005 12:00 am EST

Focus:

Jamie Dlugosch

Editor, The Rational Investor

"Grab the doughnuts before they get cold," says Jamie Dlugosch. The top-notch value and growth investor explains, "'Mr. Irrational Market' has given us the chance to buy a quality business at a discount. This bargain price won't last for long."

"After reaching a post-IPO high of nearly $45, Krispy Kreme Doughnuts (KKD NYSE) has made a number of missteps and seen its stock decline 85%. Accounting problems and an ineffective management team were the main contributors. Investors panicked over the spiraling problems and reacted irrationally to the troubles. While the luster is off the brand, the underlying opportunity has not changed. Traders are not adequately valuing the intangibles and future potential cash flow that can be generated as a result of a successful turnaround. Indeed it is truly shocking to see the extent of its demise given the bright future it once had.

"As businesses mature, 'founding fathers' often outgrow their abilities. It takes professional management to operate a big company with numerous retail outlets. Overexpansion and a reliance on off-site sales led to its collapse. How could a management team so absolutely ruin itself? It’s no wonder shareholders and employees are upset and inclined to litigate. Of course, we care less about the past and more about the future. In this case we have a brand with significant cache and staying power.

"Meanwhile, Kroll Zolfo Cooper, the consulting firm that was instrumental in the turnaround with Boston Market, is ready to perform similar wonders at Krispy Kreme. Should they reinvigorate KKD, we will be more than adequately compensated. And with warrants to buy shares at a price near current levels, the company is highly motivated to succeed. This is our opportunity to buy one of the most well-known brands at a discount. As investors turn their attention to the future, we think the potential here is startling. 

"The stock trades for 0.61 times sales and one times book value. Because profits have been falling, it sports a fairly healthy multiple of earnings. But we think any shortcomings in earnings will be temporary. The troubles that led to the fall in share value are real and will be difficult to overcome, but we are convinced that new management will be able to right the ship. Clearly, prior management was overwhelmed with the opportunity and lost control of growth. With a new management team and plenty of growth opportunities, we view KKD as a value stock with tremendous potential.

"There are sure to be bumps along the road. Many of our purchases can decrease in value in the early stages of a turnaround. I would advise rational investors to ignore the chatter and focus on the underlying issue at hand. KKD has a fantastic brand, a solid management team, and a valuation that is compelling. We think $1.00 a share in earnings is possible in a three-five year period. Put a 20 multiple on that number and we get our rational price of $20 per share, making KKD a potential doubler. We would be buyers up to $10."

Related Articles on