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Krispy Kreme's Failings Tough To Glaze Over

In that conference call with analysts last week, Krispy Kreme chief executive Scott A. Livengood said the company's problem was that it was growing too fast. In fact, Krispy Kreme couldn't grow fast enough to justify the price its stock had reached. Investors pay 50 times earnings for companies they expect to grow so rapidly that the stock will look cheap in a year or two.

Cutting growth is not likely to make the stock go back up, but that is what Krispy Kreme is doing. "There's no point in opening stores if we aren't able to achieve the full measure of their potential," Livengood said. With 390 stores now, Krispy Kreme once was planning to add as many as 120 this year, but cut that to 100 and then scaled it back to 75 on Thursday.

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That's about an 18 percent expansion rate. But sales are not keeping pace, growing only 11.5 percent last quarter. One rule of thumb is that the price/earnings ratio of a company is roughly equivalent to its growth rate. A P/E of 50 does not compute for a company growing less than 12 percent a year, which helps explain why the shares (NYSE: KKD) are now trading for around 16 times this year's projected earnings.

A Krispy Kreme spokeswoman said Friday that the company had been hit by a "perfect storm" of higher gas prices, low carbs, competition from Wal-Mart and overheated growth. "Any one of them individually, we could have dealt with," she said.

Krispy Kreme closed some stores because it couldn't sell enough doughnuts to keep up with the company's automated doughnut machines, which churn out 270 dozen an hour. (You don't slow down a doughnut production machine.) New machinery that makes 65 dozen an hour will make it possible to open smaller, lower-volume units that can operate profitably without excess capacity, the spokeswoman said.

Besides opening new doughnut-making shops, Krispy Kreme, based in Winston-Salem, N.C., hoped to increase sales by selling its doughnuts in supermarkets and in satellite retail shops like the one at Dupont Circle, which do not actually fry the doughnuts.

The famous Hot Doughnuts Now sign may be in the window of the Connecticut Avenue shop, but the doughnuts are made out on Highway 1 in Alexandria. They truck them in, heat them up and then drizzle on the hot glaze that ups the calorie count from obviously-bad-for-you to obesity-inducing.

Take it from a doughnut junkie -- a Krispy Kreme fresh out of the fryer tastes better than a batch imported from Virginia, despite the assurance that it is as close to the original experience as you're going to get.

And a Krispy Kreme in a box at the supermarket might as well have been made in Minnesota. Hot doughnuts have the half-life of a sub-atomic particle. Hostess cupcakes hold up better over time. Cartoned up in cardboard, Krispy Kremes taste as fresh as an Amtrak sandwich.

Yet boxed doughnuts were supposed to allow Krispy Kreme to leverage its growth, keeping the fryers bubbling with wholesale orders. That business is off more than over-the-counter sales, the company acknowledged last week. More worrisome: The Kroger supermarket chain has pulled Krispy Kreme out of a batch of its stores. Supermarket computers track the sales of every item every day. You can bet that if Kroger decided Krispy Kremes weren't moving fast enough to keep, Giant and Safeway and every other outlet are scanning their register records, too.

Thursday's earnings report brought a second downgrade of the stock from analyst John S. Glass of CIBC World Markets, which instead of the "Buy, Sell, Hold" system rates stocks to outperform, match or underperform others in its sector. Glass downgraded Krispy Kreme to "sector performer," or hold, in November and dropped the stock to "sector underperformer" last week.

Only one analyst still rates Krispy Kreme a buy -- Glenn M. Guard of Baltimore's Legg Mason. Acknowledging all the ugly developments, he said, "We believe most of the bad news is already in the stock and now that growth is more deliberate and rationalized, the market will gradually warm back up to the story."

Even Krispy Kreme's surprise announcement that it closed several stores last quarter means "management is unwilling to let underperforming assets linger -- a good sign," he argued, and the depressed stock price now means Krispy Kreme has been transformed from a high flyer to an undervalued stock.

Even the Legg Mason analyst, however, radically reduced his estimate of how much money investors might make buying Krispy Kreme stock. Until Friday morning, when he reduced his target, the Legg Mason analyst was predicting that within a year, Krispy Kreme could hit $30. Now he's estimating the price could go to $17 -- which is still a long way from the $10 a share estimate of CIBC World Markets.

A year from now, one of those analysts -- and his clients -- will be able to sip champagne with their Krispy Kremes.

The other will either be swallowing dried-up, days-old doughnut stocks or lamenting why he didn't grab one while the glaze was hot.

I'm not making any bets, but I'm having a doughnut for breakfast this morning.

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