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?

I was able to identify five key factors underlying growth as shown below.

• Brand based on high quality product.
• Fragmented regional competition with less brand recognition.
• Strong opportunities to extend network of stores geographically.
• Area developer model seems to be working. Company store data suggests that model probably works for area developers.

Further, if area developer models go broke, Krispy Kreme seems to be able to operate them profitably.

• Small store growth with new technology and international growth hold promise, although untested. Beginning to compete with Starbucks. Will donuts appeal to non Unites States markets?

There are two potential concerns I thought of.  First being the chance this is a fad and that consumers will get tired of donuts however they have been popular for many years.  Second is the threat of competition in the future.

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?

The CIBC analysts' forecasts were constructed using per store information.  The company plans to add 62 new stores in 2003, mostly through area developers.  What are the revenues per new store?  Take into consideration the initial boom, followed by the leveling off.  Also, not all the new stores were open for an entire year.

Revenue growth per new store has been impressive.  Company store growth is stabilizing, dropping from 28% to 4% in last year.  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 many 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%.  These have averaged 4% for the last two years.  KKM&D revenues are driven by franchisee revenues, since sales are to franchisees and will vary with their volume.  They have averaged 33% of franchise sales in the last two years.

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?

• 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.  With that in mind, we get the following costs:

• 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 in 2004 to 8.74%.  In addition, minority interest has been around 0.3% of the franchise revenues for the last two years.

• Forecast Interest Expense

This requires some assumptions to be made about the firm's capital structure.  The beginning capital structure is given, and shows that the company has negative debt of $20 million.  This arises from the prior year's decision to raise new equity to meet future growth plans.  As a result, if the interest rate on these short term cash resources is 3%, the company's interest income will be about $600,000.

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 a year's time, leaving no interest income or expense.

• Forecast Tax Rate

The following is considering a rate which has been around 38%.

This implies that the company's NOPAT margin is 6.4% in 2003 and 6.6% in 2004, versus 6.3% in 2002.  In contrast, the CIBC forecasts show a NOPAT margin of 7.4% and 8.1%.

4. The CIBC analysts do not forecast KKD's balance sheet for the following year (ended January 2003).  Make your own balance sheet forecasts.

• Forecast operating assets

KKD has shown a large increase in working capital this year, mostly 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%.  For next year's balance sheet, I will assume this increase will likely continue.  Therefore, working capital will be as follows given the former sales growth rates:

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%.  I will assume that this rate is stable at 20% and the long-term assets will be as follows:

• Forecast Capital Structure

I 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.  This is not likely to continue since the company will probably have positive net leverage over the long term.

The condensed balance sheet will be as follows:

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

Most of the incentives faced by financial analysts are likely to lead to optimistic research.  There are two factors I could think of affecting analyst incentives. 

First is 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.

Second are 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 very strong for analysts that cater to retail investors.  Institutional investors also reward 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 analysts research relative to other analysts covering the same company.