Description

I think Krispy Kreme could be a short.  While the most egregious issues from ‘04/’05 (providing balance sheet to financially troubled franchisees who were pushing a faddish food concept) have been resolved, the international growth concept doesn’t seem to be working; if true, this could have deleterious consequences on their supply chain segment; and they could be facing increasing competition in their core domestic markets.  20x LTM EBITDA seems too expensive given these concerns.  Otherwise, I love their doughnuts and they seem like nice guys.  Let me know what you think.  I'm having some trouble getting the exhibits to paste, but I am referencing a June 2012 KKD Investor Presentation in this write-up. First, a brief overview:

A brief overview

Branded retailer and wholesaler of doughnuts (mostly) that operates through four business segments:

Company-owned stores (97 stores; 68% of rev / 13% of operating profits / 29% of system-wide sales): 76 “factory” stores with doughnut-making production capability that sell doughnuts on-premises and wholesale to grocery stores and convenience stores, and 21 smaller, satellite shops that have doughnuts delivered to them from the factory stores and sell doughnuts on-premise

Domestic Franchise (142 stores; 2% of rev / 9% of operating profits / 28% of system-wide sales): 99 factory stores and 43 satellite stores that operate similarly to company-owned stores

International Franchise (509 stores; 6% of rev / 27% of operating profits / 42% of system-wide sales): 389 satellite shops and 120 factory stores that sell almost exclusively on-premise

KK Supply Chain (24% of rev / 51% of operating profits): makes doughnut mix and doughnut-making equipment that all stores, Company owned and franchised, are required to purchase

KKD trades at 17x LTM EBITDA (vs.18/19x for Dunkin Donuts) despite having a more vulnerable income stream vs. its more established peer

Here are some points to consider if you decide to do more work on this:

(1) A significant part of KKD’s growth strategy involves increasing its international franchise presence; however, the KKD concept does not seem to be working overseas

a) International franchisees have reported negative same store sales growth every quarter since at least 1Q08, attributable to a “honeymoon” effect on new stores and cannibalization

Poor same-store-sales performance in established markets (countries where the first store opened 6 or more years ago) suggests that the honeymoon effect is only partially to blame – the concept, itself, might be broken:

From FY2012 (ending January) 10-K:

“Constant dollar same store sales in established markets fell 1.9% in fiscal 2012 and fell 18.4% in new markets.”

From FY2013 (ending January) 10-K:

“Constant dollar same store sales in established markets fell 0.8% in fiscal 2013 and fell 14.0% in new markets.”

b) I suspect that the average international franchisee may struggle to generate acceptable returns

Of the 509 stores that overseas franchisees operate, 389 are satellite stores.  What kind of sales must a satellite store generate to be economically viable? 

(see Page 25 of the presentation)

According to this exhibit from the Company, a satellite must generate average sales of ~$18k / week to be profitable.  (Surprisingly, the above exhibit shows that half of the company-owned satellite stores are unprofitable and the half that are profitable earn a paltry 10.5% return on investment)

International franchisees appear to generate AUVs well below the $18k threshold ($11.3k in 2012).  While there are obviously costs differences between domestic and international markets, the volume discrepancy still seems vast.  Furthermore, strong honeymooning effects from rapid store openings may exaggerate the international franchise store volumes figure.

c) KKD’s franchisee for the Middle East, once the largest owner of KKD stock, holding 13% of the Company’s shares, sold all his shares

(2) If the KKD concept proves unsuccessful internationally, profits from its supply chain segments could be in jeopardy

 Upon first glance, the Company’s international expansion strategy appears modest.  The number of stores has increased by around 20% over the last 2 years, from 417 stores as of January 2011 to 509 stores as of February 2013.

 However, the net store growth of 92 units has come from opening 269 stores and closing 118.  The pace of store openings and closings make us suspect that: 1) the failure rate is higher, 2) KKD and its franchisees are simply capitalizing on short-lived honeymoon effects and 3) the expansion path may be shorter than advertised as franchisees have clearly thrown spaghetti all over the map and are unlikely to “re-capture” honeymoon volume on plots they have exited.

 The rapid pace of store openings makes perfect sense when you consider that over half of KKD’s operating profits comes from its “supply chain” segment.  This segment sells doughnut mix and equipment to franchisees and books profit from those sales.

 (3) Economic returns on the domestic store base seem questionable

a) While KKD claims that the typical, large-format factory store generates ~$32k in average weekly sales (generating a reasonable ROI), there is large variance around that number, with nearly half of these stores generating flat to negative returns

(see page 25 of the presentation....figures above are pro-forma for 4.5% franchisee royalty)

This exhibit (by the Company) shows that the 2^nd quartile of stores that generates $34k in average weekly volumes yields positive operating profits and a strong 41% ROI.  Yet, Kremeworks, LLC, a franchisee in which KKD has an equity interest, generated $35k in average weekly volume in FY13, but still posted operating losses, calling into question the profitability metrics presented or suggesting that there is large variance even within the above quartiles

The Company’s share of losses from the 3 franchisees in which it has equity interests deepened from $122k in FY2012 to $202k in FY2013.  While these are small numbers, they give us a peek into the profitability of North American franchise operations.  2 out of 3 of those franchisees are technically insolvent (have negative equity) while the third has posted operating losses over the last three years

b) KKD faces impending competition in its core Southeast market from Dunkin Donuts: despite having strong brand awareness in the Southeast, Dunkin Donuts is underpenetrated and has made overtures about increasing its penetration here.  This may obstruct KKD’s plans to increase the proportion of sales that come from higher-margin beverages

Risk

Beyond the obvious risk of this concept really taking off internationally, the Company might prove successful in increasing its coffee mix as a percent of sales (from 4% now to a target of 12%).  However, it seems to me that in order for this to happen, people need to start incorporating a trip to Krispy Kreme as part of their regular routine (as lots of people do with DNKN, which gets nearly 60% of its sales from beverages).  However, the average KKD customer visits only once a month, suggesting that it is still a place that people visit on special occasions to buy doughnuts by the dozens for an office birthday party, etc.  I also think it’s interesting that when management talks about coffee sales, they only disclose same-store-sales by units, suggesting that much of the growth is coming from promos.

Catalyst