Krispy Kreme Case Study: Exploring the Decline in Market Value

Factors Contributing to the Decline

Task:

You can easily see what happened to Krispy Kreme after the events of this case study. Please don’t do that, and follow the history of Krispy Kreme using just the information within the Case Study…  In other words, answer the question as if just after this Case Study was printed (do not use any subsequent information or events).

This company isn’t fancy, complicated, or in a new disruptive technology like Uber, WeWork or Tesla. We are talking about a company that sells doughnuts (and the equipment/supplies to make them). You can read the background and see the facts easily.  It isn’t complicated. To simplify and summarize the situation:

A high price-earnings stock, that is a “growth story”, falls to earth. When a stock is at a high multiple of earnings (or cash flow), it falls faster than normal when the perception of that earnings or cash flow changes;

There appear to be “Agency” problems since management used accounting that was irregular (some would say “deceptive), had some nice jets, and tried to hide issues with re-acquired franchises. Montana Mills was just one of the several problems;

They really depended upon growth of new units (locations) since they got a portion of their sales from the one-time equipment sales when new locations opened.  It was very important to keep up the belief that new locations were profitable for the franchisees and new people would want to continue to open new locations;

There were many analysts – all acting with “herd instinct” on both the way up, and the way down for the stock;

A good balance sheet and better cash and liquidity than many in its industry… and not a lot of debt.  We are told that the bank may claim they violated their debt covenants, but this is not a company in danger of going bankrupt (ignoring any risk of lawsuits from investors)… Its basic business operations were not as good as what analysts and “bulls” on the stock believed through the end of 2013, but it is not a WeWork risking running out of cash.

You know that the market is a discounting mechanism, discounting what people think they will receive as future cash flows either in the form of dividends or in an even higher stock price at a future point in time. Page 12 (Exhibit 6) shows a graph of the stock price. Exhibit 1 (page 7, at the bottom) shows the number of shares of stock outstanding.  So, you can figure out the approximate decline in Market Capitalization and when it occurred (you are told on Page 6 that about $2.5 billion of market value was blown away by the radical decline in stock price).

Investors should have been following cash flows all along – not just accounting numbers that were not based upon hard cash flows that could be realized on a recurring basis. You are not given the WACC or any form of a discount rate that investors were using.  You don’t even know the exact cash flows that were being discounted.  Like would any real “security analyst” you need to guess or estimate these numbers from the data you have.  The company obviously became riskier in the eyes of investors.  Please assume that the “WACC” or Discount rate increased from 9% to 16% during the end of 2003 and early 2004… The company was perceived as higher risk for all the reasons mentioned (including faith in management’s accounting and leadership and the failure at the Board level).  

Question:

Dig into the dataset and find “chunks of the decline in cash flow” that could explain the $2.5 billion decline in market value. Remember that if no dividends (or small dividends), then the stock price basically becomes almost a “growing perpetuity formula” on the firm’s cash flow. We discussed this concept twice in class, with the Terminal Value for Nike in the first Case Study.   Show me some calculations (or give me some reasons) why, when built into an NPV model for investors, these “abrupt changes” in perceived cash flows being generated by the firm can have huge impacts on its market capitalization.  1-1/2 to 2 pages, with some supporting Calculations (if desired) should be more than enough to make your point. Nobody will get this 100% correct – you can’t.  Not you, not I, not any of the security analysists (who are the so-called pro’s).  I want to see that you understand the impact of changes in operating cash flows on the valuation of a firm when perceptions of risks (the WACC) changes.