Description

Investment Thesis: Krispy Kreme shares are a short. At 16.3x fwd. EV / EBITDA the Market does not appear to appreciate near term refinancing risk is set to nearly triple the Company’s cost of capital and complicate a longer-term turnaround story. DNUT has $750mn of bank debt going current in June 2023 necessitating a capital markets event that should catalyze a valuation re-rate; this is only a $30mn unlevered FCF/year business, and an equity raise may be required because cash flows cannot support a full refinancing at market rates, which could be 11%+. Downside could be 100% at QSR peer valuation levels and bankruptcy is a probability. This mispricing likely exists because 1) DNUT’s most recent capital markets event was a July 2021 IPO at ~18x EBITDA, six months before the market peak, and 2) cash flows have been insulated from rising rates as the Company’s current bank debt is underpriced at L+225 with rate risk hedged at 4%. The Company’s credit is not guaranteed by JAB, but as the largest shareholder their decision to backstop value is an important catalyst.

Krispy Kreme is an 85-year-old glazed donut brand which has grown into an omni-channel business with nearly 12,000 global points of access across its Hot Light Theater Shops, DFD Doors, Fresh Shops, and Cookie Shops concepts with LSD historical organic growth. About 67% of sales are derived from US & Canada, 24% International, and the balance from Market Developments. The Company IPO’d in July 2021 after being privately held by JAB Holding Company as a turnaround investment, the effectiveness of which is subject to debate. Today, Krispy Kreme has largely completed a refranchising strategy with 2% of revenues derived from royalties and now executes a hub and spoke model whereby the Company leverages existing donut shop manufacturing capacity to produce daily fresh product for DFD Doors at regional convenience and grocery stores. Historical demand at standalone donut shops had been constrained by low repeat customer visits per year, so hub & spoke incremental margins should be higher as greater product volumes can be spread across each hub’s fixed cost base. Although JAB initially acquired the Company in 2016, it is difficult to see progress flowing through to the P&L despite strong top-line growth as EBITDA margins have deteriorated and FCF conversion has been low as a result of the business becoming more capital intensive relative to franchise QSR peers.   

The Company’s capital structure consists of $781mn total debt, $750mn of which are amounts drawn under its 2019 Facility and include 1) a $595mn Term Loan and 2) $155mn drawn under a Revolving Credit Facility. Amounts under the 2019 Facility mature in June 2024 and will become current liabilities when the Company publishes its 2Q23 balance sheet. Interest is subject to leverage-based grid pricing, currently L+225 as of 3Q22, the maximum permitted spread. Management has hedged 70% of their debt’s interest rate risk resulting in a 4% weighted average cost of debt that has kept cash flows elevated. With $183mn LTM Adj. EBITDA, gross and net leverage is 4.3x and 4.1x, respectively, and inclusive of capital expenditures, Debt / EBITDA – Capex is 10.9x. Despite the rate hedge benefit, levered free cash flows are currently insufficient to materially de-leverage the balance sheet, and long-term net leverage guidance of 2.0x may be aggressive given future cash flows will be impacted by the Company’s cost of debt nearly tripling in a refinancing. While JAB does not guarantee the Company’s 2019 Facility, the Market may believe informal credit support exists. As will be discussed, we believe JAB’s incentive to backstop the Company in a refinancing is diminishing due to cash distributions.

The Company must remain compliant with a 5.25x maximum net leverage maintenance covenant under the 2019 Facility which is set to step-down to 5.0x in April 2023. The Term Loan requires quarterly amortization payments of 1.25% on the original $700mn loan size, about $35mn per year. Amounts drawn under the RCF have increased to $155mn from $70mn in 3Q21 driven in-part to fund Term Loan amortization payments due to insufficient cash flow generation.

Krispy Kreme also maintains $123mn in structured payables, separate from $188mn in other reported accounts payable. Structured payables are a form of supply chain financing whereby a counterparty bank pays the supplier directly, with DNUT reimbursing the bank at a later date. Neither the Company’s annual report nor IPO prospectus provide terms or other payment details for these payables. The Company may have some discretion as to whether to consider structured payables as funded debt or working capital; the IPO prospectus considered increases in structured payables as an operating cash flow activity in 2018 while more recent filings categorize increases / decreases as financing cash flow activities. Structured payables are not counted towards the Company’s net leverage ratio covenant, the inclusion of which would increase the ratio to 4.8x. These payables could be at risk as continued credit deterioration may lead to less favorable financing terms for the Company; a full refinancing of structured payables with funded debt would bring the balance sheet close to covenant non-compliance with the 5.0x step-down. At 4.1x net leverage, liquidity is $188mn and includes $28mn cash and $159mn incremental debt capacity under the 2019 Facility; including structured payables total liquidity would shrink to $64mn. Structured payables reclassification / restructuring is non-core to the thesis but provides additional downside optionality.

DNUT has questionable quality of earnings and actual cash flows are insufficient to support the leverage profile. We see little evidence of the Company’s turnaround strategy flowing through to Segment EBITDA margins, which have declined from 19.6% in 2018 to 15.5% in the LTM; Adj. EBITDA margins have similarly declined due to growing corporate overhead expenses. We also see about $34mn in “cash” add-backs to Adj. EBITDA per year further pressuring margins to about 9-12%. Although we appreciate that turnarounds take time and there are several maturing concepts within the Company’s operating model, we are hesitant to give much benefit of doubt as these execution initiatives are now several years into plan. In any case, Management will need to defend a declining margin profile to investors in a refinancing process. We note Consensus estimates see DNUT returning to 15%+ EBITDA margins by 2026.

The Company’s business model has become more capital intensive due to refranchising; with royalties only constituting 2% of sales, DONUT lacks the recurring, high margin, franchise cash flows of other QSRs and cannot shift operating / capital expenditures onto franchise partners. Capital expenditures are currently 7.4% of total sales, down from 8.0%+ in 2019 – 2021, but above the pre-2019 average of 4.5%. Management has guided to long-term capex as a % of sales of ~6%, but with little indication of plans to reduce the rate of hub / access point growth capital expenditures are likely to remain elevated in the near-to-medium term. Given the low quality of Adj. EBITDA, FCF conversion is also likely to remain pressured compared to 80%+ conversion rates seen by other QSRs such as WEN, JACK, QSR, YUM, SBUX, and DNKN. Despite generating nearly $590mn in cumulative Cash EBITDA since 2018, DNUT has burned more than $50mn in free cash flow. This business does generate ~$30mn in unlevered free cash flow per year, likely insufficient to support $780mn of debt at market rates. Further evidence of this is seen by the Company’s 1.4x “zombie ratio” which we define as Cash EBITDA - Capex / Interest. We think interest coverage will become severely impaired upon a balance sheet refinancing and require curtailment of capital expenditures, thus hampering the Company’s ability to reinvest and progress towards long-term EBITDA margins.

Although their debt matures June 2024, we think its realistic for the CFO to start working on a refinancing prior to or soon after the debt goes current, in which case DNUT will be at 3.5x – 4.0x net leverage with artificially high cash flows, likely a B/CCC credit profile.  Single Bs currently yield 9% and CCCs 14%; based on recent new issue activity we don’t think improbable for the market to price new DNUT risk at 11%. Assuming current outstanding debt and some incremental RCF draw, we think the Company’s annual interest expense could grow to $85mn relative to ~$35mn today and result in ~$30mn per year FCF burn, likely triggering a need for additional liquidity. The balance sheet would be much more financeable if pro forma cash flows allowed for some organic de-leveraging.

We think new capital may be required to assist in refinancing this balance sheet. The Company could cut capex to 4% of total sales, in-line with franchise QSR peers, but still only generate a MSD % of debt in cash flows; trading growth capital for modest at best organic de-leveraging is likely unsustainable. A sizable equity raise to de-leverage may be necessary as current cash flows are probably only strong enough to support $300-400mn debt at market rates implying a ~$400mn capital need. Dilution could be quite severe to current shareholders; for example, an equity raise of this size at a 50% discount to current share price would be about 25% dilutive but still create the Company at 10x EBITDA and a 1% LFCF yield; with franchise-heavy, free cash generative peers trading at 4% LFCF yields, downside could be substantially lower. Restructuring risk is a probability here as well, in which case shares could have 100% downside in a bankruptcy. On an absolute basis, it is difficult to see why the enterprise is worth more than $350mn - $500mn at a HSD / low-teens UFCF yield; such a level may imply marginal operational but high brand IP value.

The upside case is that DNUT does $0.30 - $0.50 levered FCF per share by 2025 / 2026 in which case shares are worth about $18.50 when valued at the Company’s historical 2.5% LFCF yield. A more bullish view would be that at 21x EBITDA, DNKN’s take-out multiple, there is 50% upside to current share price with potential for 100%+ if long-term EBITDA estimates pan out. The risk / reward here is rather asymmetric and favors the downside given the Company’s execution risk, negligible FCF profile, and near-term maturity wall that should serve as a catalyst.

The primary risk to this thesis is a more accommodative refinancing process than we anticipate, which could take the form of JAB extending short-term bridge financing hoping for a potentially cheaper capital market environment. As mentioned, JAB is not a guarantor under the 2019 Facility and no formal form of credit support exists. Although we don’t know their starting basis, JAB and controlling stakeholders have taken at least $500mn capital off the table through distributions / dividend recaps since 2019 and may not have much incentive to backstop the Company. JAB’s decision to assist the Company’s refinancing may be a more important catalyst for the short than the refinancing itself. The Company’s Term Loan is Citibank agented and syndicated among several banks with no secondary market, so while the banks may agree to a short-term maturity extension this is credit risk they’d prefer off their balance sheet.

DNUT will hold their Investor Day on December 15 and plans to provide an initial 2023 – 2026 outlook. As Management has already provided a detailed growth algorithm through 2025, we don’t think there is much the Company could reveal to meaningfully change the business setup heading into a balance sheet refinancing. In fact, given the lack of attention we believe the balance sheet has received from investors, we would not be surprised to see leverage as a more prominent point of discussion. 

Catalyst

Debt Refinancing