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Behind Krispy Kreme's Pain

The Atkins craze is a factor, but other issues are also hurting the doughnut purveyor. Shares tumble.

Updated from 8:08 a.m. EDT

Krispy Kreme

(KKD)

has discovered a hole in its business model. And it's blaming the Atkins diet.

Shares in the North Carolina-based doughnut maker plunged Friday after it lowered earnings guidance for the first quarter and full-year 2005, saying the low-carbohydrate craze has hurt demand for its products. Recently, the stock was down $7.90, or 24.8%, to $23.91.

Certainly, Krispy Kreme is being affected by the Atkins, South Beach and other low-carb diets. But just like a company that blames the weather on poor sales, some companies are better than others at weathering a storm.

One source who is short Krispy Kreme cited some company-specific issues working against Krispy Kreme, which go beyond the low-carb craze. First, the company's wholesale business is expensive to operate, requiring trucks and distribution channels (and the costs associated with that). Second, the wholesale business is cannibalizing the company's retail operations, and perhaps undermining them as well.

Krispy Kreme doughnuts bought at the wholesale level are often inferior to the doughnuts that customers can get at a company store. A consumer who is trying a Krispy Kreme doughnut may be underwhelmed by the ones that sell at a grocery store, which may prevent that consumer from ever going to a retail Krispy Kreme store, where doughnuts have higher margins.

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Third, those retail stores -- under pressure from both the company's wholesale business and the low-carb craze -- are expensive and uneconomical in smaller markets.

"Each Krispy Kreme store costs about $3 million to open. It's not economical in every location," said the short-seller, who requested anonymity. These stores tend to hit their peak in about 12 to 18 months, and if you don't have a fresh supply of consumers to snap up every doughnut that comes off the conveyor belt, you end up having problems, he continued.

So, the company won't be closing stores in places like Los Angeles or New York, where millions of people live, but it makes little economic sense to continue operating less profitable stores in smaller markets.

It'll be interesting to find out if there is more bad "weather" on the way for Krispy Kreme or if this is an isolated thunderstorm that will eventually move on. Our short-selling source thinks there are more storms on the horizon.

Friday's storm began when the company lowered its earnings forecast by about 10%, saying it expects EPS of 23 cents in the first quarter and $1.04 to $1.06 for fiscal 2005, based on continuing operations.

That compares with analysts' consensus forecasts of 27 cents a share and $1.17 a share, respectively, according to Thomson First Call.

Including charges, the company forecast EPS of 16 cents for the first quarter and between 93 cents and 95 cents for fiscal 2005.

The company said: "There has been increasing consumer interest in low-carbohydrate diets, which has adversely impacted several flour-based food categories, including bread, cereal and pasta. This trend had little discernable effect on our business last year. However, recent market data suggests consumer interest in reduced carbohydrate consumption has heightened significantly following the beginning of the year and has accelerated in the last two to three months. This phenome-non has affected us most heavily in our off-premises sales channels, in particular sales of packaged doughnuts to grocery store customers."