Krispy Kreme Uncovers a Balance-Sheet Strength

What's the biggest item on Krispy Kreme Doughnuts' balance sheet besides shareholders' equity, and why should you care? At the end of its last fiscal year, on Jan. 29, the company recorded a $139.5 million deferred tax asset, which counted for more than 38% of total assets.That's important for two reasons: The company's future cash flows will benefit from the asset, and its appearance on the balance sheet gives investors a hint about where management thinks the company is headed.
 
What is a deferred tax asset?
Between 2005 and 2008, in what is probably a painful memory for long-term shareholders, the company was rocked by poor earnings as a result of overly aggressive expansion, poor performance from large franchisees, and an accounting scandal that ultimately led to an SEC investigation and the resignation of its then CEO, Scott Livengood. The company wrote down the value of its goodwill and took charges for store closures. The losses it suffered during those years created federal and state net operating loss carry-fowards, or "NOLs." In short, when a corporation loses money on a tax basis, it can in some instances "carry the loss forward" to apply against future tax liability. This ability to reduce future taxes becomes an asset on the corporation's books.
 
Krispy Kreme won't realize the benefit of the deferred tax asset in the form of higher earnings, though. Generally accepted accounting principles, or GAAP, requires that the company still record an income tax expense on its books every year against its profits. Its real boost will come from having to pay little or no cash for several years to the U.S. government and various states in which it would normally owe taxes. 
 
Take the first nine months of the current fiscal year, which began in February. Through Oct. 31, Krispy Kreme recorded $12.26 million in income tax expenses -- the amount under GAAP that the company projects it should owe in taxes for the period. But if you look at the cash-flow statement for the same period, you'll see the company spent $9.5 million on new property and equipment. Without the NOLs, Krispy Kreme would have been out of pocket almost $22 million in cash to pay for both taxes and the equipment. Some would say that because of the benefit, the company essentially picked up its capital investment for free this year. If you're newly invested in Krispy Kreme, you're benefiting from a value that's the result of prior mistakes.
 
When the original tax asset was calculated in 2005 and forward, the company had to book an allowance against the asset, essentially reducing it to zero. But if the losses occurred so long ago, why did it take the company so many years to show the tax benefit on its books? Well, GAAP requires that management devalue a deferred tax benefit if it can't be more certain than not that the benefit will be realized. In other words, management has to be solidly confident that the company will have significant future earnings to use the benefit. Until 2012, management hasn't been able to make that call. So in addition to the cash advantages that will accrue to Krispy Kreme, shareholders can infer an implicit endorsement of the company's prospects from CEO Jim Morgan, CFO Doug Muir, and other members of management. 
 
Implications for valuation
Let's look at Krispy Kreme's price/earnings-to-growth, or PEG, ratio over the past few quarters. As a rule of thumb, a PEG of less than 1 marks a company as being undervalued.

KKD PEG Ratio Chart

KKD PEG Ratio data by YCharts.

Krispy Kreme has been profitable since the second calendar quarter of 2008. It's also improved its operating income in its most recently reported fiscal quarter by 66% versus the prior year. Yet it has a PEG ratio of 0.005, far below the "less than 1" rule. On the surface, Krispy Kreme looks seriously undervalued. What should we make of this?
 
When the company went public in April 2000, it was a favorite of individual investors and attracted avid institutional interest as well. The company burned through most of that enthusiasm with its corporate mismanagement of the mid-2000s, and the market hasn't been convinced that its earnings are stable enough to risk a long-term investment. Basically, the opinion has been that it's been a great place to grab a couple of doughnuts, but you wouldn't want to park your money there.
 
But the signs that earnings stability has returned are numerous. Operating cash flow has strengthened for five consecutive years, and year-to-date, at $38 million, it outpaces the comparable period last year by 65%. In November management also increased operating income guidance, not only for the rest of this fiscal year, but for fiscal 2014 as well. 
 
A taste of things to come
Removing the valuation allowance from the company's deferred tax asset is a subtle but unmistakable sign that management believes earnings will be consistent and predictable. Given its relatively low valuation, those with an intermediate to long-term horizon may be rewarded by revisiting a stock that investors, along with customers, once happily queued up in line for.
 

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The article Krispy Kreme Uncovers a Balance-Sheet Strength originally appeared on Fool.com.

Fool contributor Asit Sharma and The Motley Fool have no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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