The Hole in the Krispy Kreme Craze - TheStreet

The simple doughnut is on the ascendant in America, and by the time it reaches its apex our world will be a very different place. Doughnut shops will spread to every corner, making American towns look much like downtown Toronto. Barry Sears will publish a bestselling book suggesting that the key to shedding pounds is a doughnut-rich diet. In the halls of the great universities philosophers will debate whether the cruller should be classified in the genus

doughnutae

.

At least, this is apparently the world as envisioned by those investors who over the last two months caused the shares of

Krispy Kreme

(KKD)

to more than double.

To say that the shares of the doughnut maker are rich is an understatement. Even when one takes into account how quickly the company is growing -- earnings jumped 49% over the last year on a 34% revenue gain -- its price-to-earnings ratio of 107 seems steep. That said, the cult that has grown up around this Winston-Salem, N.C., food company makes it anything but a sure short play, market observers say.

Next Big Thing?

It's not hard to see Krispy Kreme as expensive. Consider

Tim Hortons

, the Canadian doughnut powerhouse owned by

Wendy's

(WEN) - Get Report

. Hortons is much bigger than Krispy Kreme, reporting revenue of $538 million for its latest year, against $318 million at Krispy Kreme. Yet while Hortons is just a part of a vast fast-food machine, accounting for less than a quarter of Wendy's total sales, Krispy Kreme's market capitalization, at $1.8 billion, is hardly dwarfed by Wendy's $2.8 billion.

Sweet
Krispy Kreme's rise

Admittedly, this is all something of an apple-fritter-to-orange-glazed comparison. About half of Hortons' sales come from coffee, compared to around 5% for Krispy Kreme. Hortons' base is the most doughnut-saturated country in the world -- there are seven times as many doughnut shops per capita in Canada than in the U.S. -- and that makes expansion difficult. And though they have begun cropping up in this country, the opening of a new Hortons can never approach the frenzy of what happens when Krispy Kreme comes to town: the long lines, the media coverage, the glazed look we get while watching doughnuts pass through the glaze fountain.

Heating Up
Starbucks over a decade

Investor expectations for Krispy Kreme also look grand in light of other food-business highfliers down through the years. While the company is growing rapidly, its revenue growth doesn't approach the 60%

Starbucks

(SBUX) - Get Report

showed at its valuation peak in November 1993, when its price-to-earnings ratio hit 111. Of course, now that we can sit in one Starbucks and watch what people in the Starbucks across the street are doing, the investors who were buying back in 1992 don't seem so dumb after all.

But that's hindsight, and though we may pretend that we knew what Starbucks would become back in 1992, we really don't possess such powers of forecasting. Starbucks executed extremely well. Wall Street is littered with the stories of equally promising companies that misstepped. Furthermore, investors are always seeing in some new company the heir-apparent to some present giant. Investors in technology stocks are always looking for "the next

Microsoft

." And

Merrill Lynch

restaurant analyst Peter Oakes has noted a similar clamoring for "the next Starbucks." Apparently, some think they've found it in Krispy Kreme.

Oakes doesn't buy it. He's had a sell rating on Krispy Kreme since initiating coverage on it in November -- one of four sell ratings Merrill analysts have on U.S. stocks. (Merrill has done no underwriting for Krispy Kreme.) Oakes believes that the company is solid, but that its valuation is extreme. The growth expectations built into the stock are optimistic, to say the least, ignoring the faddishness of the company and the considerable execution risk that management faces in trying to build something more enduring. Oakes reckons that there may be something of a

Peter Lynch

syndrome going on -- people go to the store, see the long lines, like the doughnuts and go home and buy the stock.

Shortbread?

The trading in Krispy Kreme bears this out. Although volume has lately been fairly heavy -- in excess of a million shares a day -- most of those trades are in small lots, suggesting that individual investors dominate this stock. Traders who have had to buy larger blocks of the stock for clients complain about how it has "run away" from them -- rising in price as they try to amass shares.

Given its extreme valuation and fad status, many investors have shorted Krispy Kreme, selling stock they have borrowed in hopes of buying it back at a lower price and keeping the difference. Although short interest had fallen to 5.9 million shares by mid-May from 6.4 million in mid-April, it is still very hard to borrow the stock, according to several traders. Even if you want to short this stock, you will have a difficult time doing it.

Not that shorting Krispy Kreme -- despite its cult status and its heady valuation -- is necessarily such a good idea.

"This is the quintessential example of a stock I would never short," says Bill Fleckenstein, president of

Fleckenstein Capital

and a noted short-seller. "I don't short stocks just because they're overvalued. I particularly stay away from stocks that are crowded

with shorts like this one. I've seen this movie too many times before." An overvalued and overloved stock can always get more overvalued, more overloved. As its shares run higher, anyone who has gone short has to worry about losing money. Some will cave in, rushing to buy back the stock they have borrowed, and in so doing sending the price ever higher. If short interest is high, a short-covering can send a stock appreciably higher.

That's something like what's already happened with Krispy Kreme. Much of its big jump has been the result of rolling short-covering -- some people throwing in the towel and buying back the shares they borrowed, others borrowing those shares as they come back on the market, and so on. "The amount of people that lost money trading this stock," says

Gruntal

director of equity trading Sam Ginzburg, "could fill Giants stadium."

His advice to those who would get involved with Krispy Kreme, on either the long or the short side: "Don't do it. Don't trade this stock. Leave it alone. Give your money to charity."