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Krispy Kreme Analysis

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Krispy Kreme Doughnuts Inc.

The Doughnut Industry

The U.S. doughnut industry was a $5 to $6 billion market in 2003 – 2004 with a robust growth rate of 13%. Doughnut specialty stores were the fastest growing dining category in 2002 – 2003 with sales increases of 9% to approximately $3.6 billion. Opportunity for expansion in North America and globally is desirable. Doughnuts appeal to many people across all ages and demographics. The increasing rate of obesity and the concern about healthy living triggers a change in buyer demand toward a more health conscious diet.
The doughnut industry consists of few major competitors which are Dunkin' Donuts ($2.7 billion ), Tim Hortons ($651 million ), Krispy Kreme Doughnuts Inc. (KKD) ($665 million ), Winchell's Donut House and a large number of smaller, independent doughnut shops, including neighborhood bakeries/doughnut shops and bakery departments in supermarkets. (See Figure 1)
Major players in this industry rely heavily on franchising and royalties' fees paid to the parent companies. Most companies are retailers selling directly to end-users. Some i.e. KKD also use other channels for distribution of their product.
Price competition among rivals is close to nil, industry participants are very competitive when it comes to product differentiation. Product offerings to satisfy consumer demands include a variety of coffee, juices, muffins, bagels, cookies, cream cheese sandwiches, soups and other miscellaneous items.

The Competitive Environment – Competitive Success

Rivalry among competing sellers can be classified as strong. Competing sellers are constantly offering a broader product selection to dissuade competition for example Dunkin' Donuts' introduction of bagels and cream cheese sandwiches to protect against the pressure of Starbucks, Tim Hortons' expansion of the lunch menu, and KKD's acquisition of Digital Java to be able to compete in the coffee segment.
The threat of new entrants is moderately strong. Incumbents do not strongly contest entry of newcomers, but existing industry members are consistently looking to expand their geographic reach and offer a broad product assortment. Brand awareness and customer loyalty are high and greatly important i this industry.
Substitute products for doughnuts are readily available including other baked items i.e. bagels, muffins, healthier food alternatives such as sandwiches, yoghurt, fruit and other comfort food for example ice cream and chocolates. The cost for consumers to switch is low.
The bargaining power of suppliers is very low. Major players are vertically integrated for example KKD is producing their own equipment while others are partnering up with suppliers. It's an industry where volume purchases implicated success and supplies are commodities which are readily available.
The bargaining power of buyers is moderately strong. Buyers purchase doughnuts infrequently and in comparatively small quantities. Consumers have low switching costs to competing brands or substitute products.
In consideration of all the factors within the competitive environment the overall industry attractiveness is moderately high.

With an increasingly health conscious population, it is an absolute must to adapt to consumer demand through diversification. This required offering a broad variety of quick-to-eat healthy alternatives to doughnuts such as a sandwich, salad, or bagel. To analyze the aspect of the retail business, selecting excellent retail locations is the utmost importance. Typical doughnut patrons will not travel more than one or two miles to get doughnuts. The high loyalty rates in this industry make it very important to have a well-respected brand name which is established and supported by consistent quality product offerings, customer service and clever advertising. As in any other industry with relatively low margins, operational efficiency and efficient distribution capabilities are imperative. (See Figure 2)

Broad Differentiation Strategy

Capitalizing on its strong brand name, beginning in 1996, KKD began to reposition itself by focusing less on the wholesale bakery strategy and putting more emphasis on implementing a specialty retail strategy for the purpose of boosting stagnant sales of $110 to $120 million. This decision was partially financed by taking the company public in April 2001. Retail stores were designed as a "doughnut theater", where customers could watch the doughnut-making process, and be a part of the "hot doughnut experience". The anticipation for the "Hot Doughnuts Now" sign would turn on consumers. The "buzz" around the brand, created by both the media and word-of-mouth advertising, resulted in numerous new store openings and tremendous sales increases. (See Figures 3 & 4) KKD created a multimedia training curriculum in 1999 to ensure a well trained management team and consistent customer service. These are clearly a few of the differentiating factors of the company.
KKD has three revenue generating business segments: 1) sales at company-owned stores, 2) franchise and royalty fees from franchise stores, and (3) Krispy Kreme Manufacturing and Distribution (KKM&D) unit producing and selling proprietary doughnut-making equipment and doughnut mixes to franchisees. (See Figure 5)
In early 2001 Digital Java Inc. was acquired as another vertical integration step that improved the caliber and appeal of the company's on-premise coffee and beverage products allowing KKD to be more competitive in the coffee segment.
In early 2004 it became clear that KKD was spiraling out of control. The increasing health consciousness of consumers definitely played a part in the predicament of KKD, but it certainly isn't the major cause of the issues. It is very difficult to grow a business that is solely based upon one single product, doughnuts. Even though coffee and other beverages are offered this limited product mix puts KKD at a competitive disadvantage. An attempt was made to broaden KK product offerings by acquiring The Montana Mills Bread Company which failed. The growth strategy around the single product was clearly unsustainable. As the number of stores grew, revenues per store decreased, partially because of existing stores were cannibalized, operational inefficiencies (See Exhibit 1) and poor choice of locations. Krispy Kreme relies heavily on wholesale channel sales, the packaged doughnuts to grocery stores account for 50% to 60% of sales. The proliferation of bakeries in supermarkets and the availability of substitute products weaken this multi-channel market penetration strategy.
The contribution of the KKM&D business segment to operating income is a substantial amount (38%-45%). The slowdown in new store openings resulted in a 4.1% drop in revenues. In addition, the practice of forcing franchisees to exclusively buy KKM&D equipment at costs of $770,000 per doughnut-making equipment package put a great deal of financial pressure on many franchisees. And ultimately KKD's dealings with their franchisees resulted in an inquiry by the US SEC.
KKD spent very little on advertising and relied almost exclusively on media publicity and

Word-of-mouth advertising. One percent of revenues from franchise stores were used for company administered advertising and PR funds, compared to 4% of monthly gross sales at Tim Hortons. (See Exhibit 2 for SWOT analysis)

Recommendations

The new business strategy includes: First and foremost, KKD must start to capitalize on its strengths - a major competitive advantage is its brand name associated with a quality product. Since roughly 50% of all purchases at other major competitors include coffee without a doughnut it is imperative that KKD starts to compete much more fiercely in the existing coffee-segment of the business by benchmarking competitors and increasing awareness through additional advertising. The sole reliance on word-of-mouth advertising will not be enough.
Secondly, the reliance on wholesale channels selling Krispy Kreme doughnuts defeated the strength of a fresh hot doughnut. It is necessary to reduce focus on the multi-channel penetration strategy. The savings from the distribution to supermarkets can be used in other areas. As seen in Figure 2, the company is severely lagging behind competitors in key areas. The introduction of a sugar-free doughnut, whole-wheat cookies, and other healthier baked substitutes to doughnuts will help improve at least one of the main issues in the short-term because the production capabilities already exist. KKD must definitely build the size of their non-baked product assortment to better compete in the marketplace by entering into strategic partnerships and/or new acquisitions. Since this can be a very capital intensive proposition and KKD's long-term debt position (long-term debt/equity ratio 38.97% in 2004) is not very promising, building such a product assortment must be undertaken in the long-run.
Thirdly, the decreasing profitability of existing stores warrants a severe reduction in growth and focusing on leaner more cost efficient means of operations in fewer locations. It has been shown that low populated areas, with 100,000 households or less, can provide an area for significant revenue boost. By offering smaller Krispy Kreme locations in these smaller urban areas KKD can capitalize on the effective plan used by Tim Hortons and compete with the coffee giant. Tim Hortons uses this strategy and has been incredibly successful in their implementation with thousands of stores thriving in unattractive markets such as Northern Ontario.
Fourthly, the highly profitable KKM&D business segment presents an attractive opportunity for growth by selling equipment to other companies. This is contingent upon one main issue: how much of the distinct taste, texture, look of a Krispy Kreme doughnut can be attributed to this equipment and how much can be attributed solely to the recipe i.e. doughnut mixes? If there is no or little relationship between doughnut making equipment and the end product, this machinery can be promoted to other organizations. If on the other hand the equipment is essential in the manufacturing of a Krispy Kreme doughnut, this strategy is nullified. To take some financial pressure off franchisees and to induce more franchise investments, we recommend lowering the margins on doughnut-making equipment and selling it at lower prices to franchisees as well as reducing the initial franchise fee for opening new stores by 25%. To make up for this reduction in sales will be to implement a different royalty payment structure – increase royalty fees from 4.5% to 5%-6% on all sales and increase fees to fund advertising and promotional activities from 1% to 3%-4%. The increased funds for advertising and public relations must be used to institute loyalty programs to keep customers engaged once the "buzz" of a new KKD store has worn off.
If the main issues are addressed as recommended, we are confident, that Krispy Kreme Doughnuts Inc. will regain momentum in the marketplace and rebuild shareholder confidence

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