Fat Prophets take profits

Since our last review in FAT168, Krispy Kreme's (NYSE, KKD) recovery has continued. Recent full year results have provided valuable insight on the progress. While profits remain elusive, cash flows have strengthened, losses are narrowing and the hefty debt burden has eased slightly.

Despite this, on the charts there has been a clear deterioration in the outlook for Krispy Kreme since January's two and a half year high of US$13.93. Prices have retreated to a low of US$9.15 today and with such soft near term momentum, we cannot rule out a deeper correction in the weeks ahead.

Turning back to the latest result, the company recorded a net loss of US$42 million for the full year to 28 January 2007 - a marked improvement on last year's US$136 million loss.

A major reason there is less red ink is down to a reduction in professional fees related to resolving the company's legal and accounting issues (see previous reports for details). While significant sums are still being absorbed in this area, 2007's US$9 million expenditure represents vast progress on the US$32 million incurred in fiscal 2006.

This receding reliance on external consultants is a tangible indicator in our opinion of the advances management have made towards a full operational recovery. Indeed, the company lodged its last overdue financial statement with the SEC in January.

Investors can also take some comfort from the improvement in operating cash flows, which were over US$22 million for the year compared to less than US$2 million in 2006.

This has enabled management to pay off around US$15 million of the company's outstanding debt. Even so, gearing (net debt to equity) remains uncomfortably high at 90 percent and we would expect to see further debt reductions over the course of the year.

In light of the high level of gearing, the continued slide in revenue does present a concern though. During the course of the year, total revenue fell to US$461 million, compared to US$543 million in 2006.

However, falling sales are largely due to the continued restructuring of the company's network of stores. New outlets are opening to replace the closure of underperforming locations and these are taking some time to get up to speed.

Furthermore, the rate of sales decline is slowing. To illustrate, first quarter sales fell 22 percent on the same period one year prior, however the latest fourth quarter rate of decline was only 8 percent.

Management are also attempting to reverse the declining sales trend with the recent launch of a 100 percent whole wheat doughnut for the 'health conscious' consumer. With the product containing only 20 fewer calories than the original version though, we will reserve judgment on its likely success!

Elsewhere from the executive suite, Krispy Kreme announced the resignation of CFO Mike Phalen, who has decided to return to his former Investment Banking career. Given Krispy Kreme's past accounting irregularities, one could be forgiven for viewing this with suspicion. However, there doesn't appear to be any evidence to support such concern at this stage.

Replacing Mike will be the more than capable Chief Accounting Officer, Doug Muir.

In summary, we continue to have faith in management's ability to capitalise on the company's exceptional brand strength and turn the business around in the long term. Having said that, considerable risks remain and the continued weakness of the US dollar is likely to prove a strong headwind for UK based investors.

This is particularly the case for Krispy Kreme whose product, unlike gold and oil stocks, does not provide a natural hedge against currency weakness.

Since our initial entry price of US$8.35 in June 2005, Krispy Kreme Doughnuts has gained around 10 percent. With a number of better opportunities arising in the UK market, we are taking the opportunity to realise our position and deploy funds more profitably elsewhere.

Accordingly, Fat Prophets recommends selling Krispy Kreme Doughnuts around US$9.17.