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Krispy Kreme Doughnuts, Inc. (KKD), started in 1937 in Winston-Salem, NC, has become a globally recognized brand name as a specialty retailer of premium quality doughnuts. The company first went public in 2000, after which it expanded aggressively. However, the rapid expansion led to market saturation and failing franchises, and by 2004, the company itself was reeling with losses and debt. Having returned to profitability in 2010, and with a good core product and brand name, the company once again sees expansion potential, but it will need a more sustainable model this time around. The staggering success of Krispy Kreme’s main competitor, Dunkin Brands (DNKN), presents some intriguing possibilities.

While Krispy Kreme and Dunkin Brands may appear similar to a consumer, their business models are quite different. Whereas the vast majority of Krispy Kreme’s revenues come from doughnuts, a majority of Dunkin’s revenues come from beverages. As early as the 1950s, Dunkin advertised itself as “The place for donuts and coffee”. Noticing that Americans like to drink coffee with their doughnuts was a fortuitous beginning for Dunkin, as it would later become clear that while doughnuts are a good business, coffee is a great business.

The profit margins on Dunkin’s coffee have traditionally been far higher than those on its doughnuts, but perhaps just as importantly, repeat customers of coffee have a much higher visit-frequency, with many coffee drinkers returning to their favorite stores multiple times a day.

Indeed, beverage sales proved to be a strong elixir for Dunkin’s business and expansion opportunities, and the company now considers coffee its core product offering. It is currently gaining momentum with its K-cup business, further expanding Dunkin’s association with coffee.

Dunkin’s greater visit-frequency is largely attributable to the fact that it has become a go-to breakfast staple, as in recent years Dunkin has expanded into breakfast sandwiches, another high margined business. Currently, the company is working to expand its sandwich product offerings to give guests a reason to come to Dunkin throughout the day, not just for breakfast.

The expansion into these high-margined businesses has led to drastically different business metrics. Dunkin Brands’ 2011 operating margin amounted to 51.4%, while Krispy Kreme’s came in at only 8.6%. It should be noted, however, that due in part to its heavy debt burden of over $1.4 billion and the resulting high interest expenses, Dunkin’s net profit margin came in at a far more modest 16.2%.

Another competitor, Tim Hortons (THI), came surprisingly close to that, with a net profit margin of 13.4% in 2011. While that company’s operating margin was only 23.5%, its long-term debt burden was far lower than Dunkin’s, which may be attractive to investors seeking to avoid Dunkin’s leverage while liking its business model.

Krispy Kreme, realizing that it bet on the wrong horse by focusing exclusively on the traditional factory-store doughnut business, has taken a page from Dunkin’s book in its new strategy. The plan entails creating smaller shops, lowering operating costs, increasing visit frequency, and focusing on beverage sales. In order to drive same-store sales growth and improve margins, last year the company launched Krispy Kreme’s Signature Coffee Blend in cups, Brew Boxes, and retail bags for home brewing in its domestic stores with the slogan “worthy of our doughnuts”. In the first quarter of 2012, the company increased its coffee unit sales at a decent rate. The company seeks to increase coffee as a proportion of its sales from 4% today to 12% by the end of fiscal 2015.

What Krispy Kreme would most like to emulate is Dunkin’s visit-frequency, which makes its move into the coffee business all the more important. To expand its geographic scope, Krispy Kreme is focused on building smaller factory stores with full doughnut-making capabilities, which management hopes will allow it to establish a presence in smaller markets. Krispy Kreme’s company stores are still focused in the southeastern United States, but it is seeking to expand its franchise system, and international growth is picking up, as well.

This year, Krispy Kreme announced new international franchise agreements in Russia and India. The Russian development agreement is expected to add 40 Krispy Kreme shops in Moscow over the next five years. The company currently has a total of 458 international franchise stores, with a goal of at least 900 by the end of fiscal 2017. Interestingly, the company’s international stores are heavily based in the Persian Gulf region, with 143 stores in total, and Saudi Arabia as its top country for store concentration, at 87 stores. However, most of these locations are “fresh stores” and kiosks rather than full factory stores, and revenues are still overwhelmingly U.S. based.

With Dunkin Donuts providing an example of how a doughnut chain can improve its business by broadening its offerings, and Tim Hortons presenting an example of how a company hesitant to over-invest in expansion can grow earnings organically, Krispy Kreme has some great examples to emulate. In order to grow in a sustainable way, an expansion of its product offerings seems like the right strategy. Investors should keep an eye on the progress of the company’s transition, as success could mean big returns for investors, but failure could leave the company marginalized by its competitors.

At the time of this article’s writing, the author did not have positions in any of the companies mentioned.