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  Krispy Kreme: Shorting, not Shortening

BENJ GALLANDER and BEN STADELMANN

Friday, September 3, 2004

One of our "works in progress" is to figure out how shorting stocks might complement the Contra portfolio, which currently comprises long positions only. As we analyze companies, looking for ones that fit the Contra mould, it is inevitable that some will not only miss the grade but be cast in a diametrically opposite light. Could these be candidates for shorting?

When testing a new strategy, it is helpful to make some "paper trades" and gain experience before playing with live ammo. For us, one such test was a short position taken on Krispy Kreme Doughnuts in April 2002 at $37.51.

Did we have some inkling that Dr. Atkins' weird diet was about to enter the cultural mainstream? Hardly. The very idea that bread and rice, touchstones of the emergence of human civilization 6,000 years ago, would in our time be labelled "evil carbohydrates" is a bizarre quirk of fashion that could never be anticipated like, say, whalebone corsets or foot binding.

No, as far as we were concerned Krispy Kreme was simply the antithesis of a contrarian value play: a wildly popular company that appeared to have precious little content once past the sugary icing.

When we applied the Contra methodology, alarm bells were set off by massive insider selling, rising debt levels, low book value, and a price/earnings ratio of over 100. These signals appeared in the context of a business model that was clearly based on a perceived novelty.

Of course, as Canadians, we have a propensity to know something about the doughnut. Like French bread, it's a pleasant experience when fresh, but stale, its best us is as pigeon fodder. Krispy Kreme capitalized on freshness, but this is a daunting feature on which to base a large, far-flung commercial operation. To keep the product yummy means being able to match production to the number of customers at any time of day.

Though Krispy Kreme was founded in 1937, it only went public in April 2000. That's a difficult transition for any company, but all the more for one with such optimistic hopes for sales growth.

Unlike most IPOs, which flounder in the months after their issue, Krispy rocketed to over $40 in 2001 from $5.25 (prices are split-adjusted). That kind of success carries a heavy burden, for once Wall Street's lofty expectations are set, enterprises must jump through hoops to satisfy them.

In Krispy Kreme's case, this meant that when sales growth in their retail channel flattened, they attempted to reenergize by selling wholesale to local grocery stores. That tossed freshness out the window, and with it, the point of product differentiation that brought Krispy Kreme to fame. Though management has seized on the diet craze to explain all of its ills, this was only the catalyst that forced its deep-seated problems to the surface.

With the stock now trading at $12.96 and its popularity in a steep decline, could Krispy change spots and become a value play? That's possible, but the company will have to improve their business model. Until then, pass the croissants and jam. Mmmmmm, carbs.


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