The Tycoon Report

Time to Buy Krispy Kreme?

IT WASN'T SUPPOSED TO END LIKE THIS. 

No way. Scott Livengood - the ousted CEO of Krispy Kreme (SYM: KKD) - had other dreams.

In one of them, he's holding hands with Howard Schultz - the brassy Chairman of Starbucks (SYM: SBUX) - as they skip wildly into the retail hall of fame. After a lunch packed with caffeine and carbs, Schultz whispers into Livengood's ear that he - Scott Livengood - was the true king of $2 food retailing. Livengood chuckles wildly as he licks the glazing off his doughnut. 

In another recurring dream, the CEO of Dunkin’ Donuts (Allied Domecq SYM: AED) is on his knees begging Livengood to stop making his doughnuts so darn fresh. Laying sideways in his toga, Livengood pops a couple of grapes and decides the fate of the lowly Dunkin’ Donuts CEO. Five minutes later the Dunkin’ Donuts guy is tossed out of his chair "Dr. Evil" style. Why?

Because Livengood can. 

But none of that will ever happen. Not now. So that begs the following question: Were shareholders of Krispy Kreme just dreaming about rolling in all that dough? Not at all. As a matter of fact they had a decent shot. But their best shot is past.

And the sad part is that what happened to Krispy Kreme has happened to many a growth company before it. And No - it wasn't that silly low-carb craze that disappeared as soon Richard Simmons started dealin’ meals again. Nor was it the SEC/accounting issues at the company.

Sure, that's A PROBLEM. But we all know that in this day and age a $25 million dollar restatement isn't going to kill anybody. So the accounting "irregularities," while definitely a problem, weren’t THE PROBLEM.

No, the right kind of CEO could have survived that stuff easily. The kind of CEO who understands what skill set is needed to take a company from the hyper-growth phase of its business plan to the more mature-growth phase of its business plan. The kind who knows how to manage one of the most precious gifts a CEO could ever manage - a strong brand name.

No, Scott Livengood - and by extension, the shareholders of Krispy Kreme - were taken down by that all to familiar condition that has plagued many a growth manager: Inexperience (with a hubris frosting.) Not inexperience in the sense that Scott didn't know how to open new stores with plenty of fanfare. He proved he could do that. Inexperience in the sense that once the stores were open, Scott didn't know how to protect the brand.

Let me explain. 

Every company has a natural life cycle. The kind that takes a business through the four phases of its corporate existence: 

Phase 1: Start-up

Phase 2: Growth

Phase 3: Maturity

Phase 4: Decline

When Scott Livengood started working at Krispy Kreme in the 1970's, the company was at a relatively early point in its life cycle. Let's call it the early growth phase. And then they watched in awe as Starbucks began to conquer the western world. That was the turning point. Knowing that he could sell frosting as easily as Schultz sold whipped milk, Livengood began plotting. 

Plotting to go "Dr. Evil" on Dunkin’ Donuts. Plotting to bring Krispy Kreme into the retail hall of fame with Starbucks. But a funny thing happened on the way through the doughnut hole. The strategy changed. It went from "super-exclusive" to "all-inclusive." 

From lines around the block to blocks around the lines. And that, in a nut-shell, was Livengood's strategic mistake:Instead of keeping people waiting, he flooded the market with doughnuts. He diluted the brand. Wiped off the frosting. Doughnuts at Starbucks. Doughnuts at the local drugstore. Heck, even doughnuts while you shopped at the supermarket. This hurt for three reasons.

First, by distributing his doughnuts to every outlet available, his product became less exclusive. In other words, people didn't need to wait on lines when the new store opened - all they had to do is walk into a local Walgreens. That killed the buzz. 

Which led to his second problem: When you sell mass quantity through the mass merchants, not only do you sell it for less, but you have to take a smaller cut. And that hurts. But you know what's even worse? In a rush to expand, he took out a lot of debt. 

So much so that the company went from $0 to $130 million in debt in four years. That's 20% of their entire capital structure since 2000. All of these factors created a situation - not altogether uncommon in situations like this - where a company begins to dilute the value of its brand. It's happened before, folks. First, you expand too much - making the product almost ubiquitous (and taking on too much debt.) Then people lose interest in the product. Then prices go lower. And finally, returns on capital decline.

Just look at the facts: In 2000, Krispy Kreme had a return on capital of 11.7%. This year, they'll be lucky to break 5%.  That’s because brand power = pricing power.  And pricing power = high returns on capital.  And high returns on capital = high stock price.

But Livengood was just focused on sales, sales, sales.  And that's an admirable thing - for Phase I of a business plan. But not for Phase II.

Phase II needs a different kind of skill set. The kind of skill set that knows a thing or two about expanding a brand at the right time and at the right price. The kind of skill set that could save this company from its over-ambitious plans.

So, will investors be rolling in the dough if they buy shares of Krispy Kreme at current prices? That depends on whether management can actually run the business correctly. And that, my dear friends, remains to be seen. Don't worry, I'll keep watching it for you, and I'll let you know when you should get involved.

Until then, find out the four stocks we think have the biggest upside potential right now!

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