Description

Recommendation: 

We recommend a standalone long position in Krispy Kreme (DNUT) with a DCF calculated price target of $21.71 per share, as we believe the company’s new hub and spoke distribution model will significantly improve the company’s ROIC (from 2.63% in FY2020 to 11.69% by FY2025) and LT EBITDA margins (from 12.96% in FY2020 to 17.77% in FY2025) by better monetizing and utilizing legacy infrastructure. This increased profitability is a result of a successful turnaround by JAB following DNUT (previously being traded as KKD) being taken private in 2016. However, the market still remembers DNUT’s previous poor operating performance as a public company and have placed a significant discount on the newly IPO’d Krispy Kreme (went public 7/1/21), viewing it as a “show me stock”. The company currently trades at ~17x LTM EBITDA, a ~1 turn discount to KKD’s previously public historic multiple range of ~18x LTM EBITDA. However, we view this discount as unwarranted as – while private – DNUT acquired both Insomnia Cookies and a new CPG product line, both of which are higher margin growth assets (we project revenues growing 17.9% and 23.4% for the two businesses respectively and with gross margins of 36% and 30% respectively). Additionally, most sell-side coverage does not properly incorporate a view on Insomnia Cookies, with only JP Morgan including it in its revenue build. Most sell-side commentary is completely focused on DNUT’s legacy HLT performance, but we believe Insomnia is not a negligible segment. On an LTM basis, the segment contributed 10.94% of company revenues. And finally, we believe the market and sell-side have misanalysed DNUTs turnaround story coming off its IPO, commenting on perceived margin compression (KKD FY2016 EBITDA Margin was 14% versus DNUT FY2021 EBITDA Margin of 8%). However, when adjusting for various one-time expenses from the defranchising of the Company’s US/CAN legacy locations, EBITDA Margins were ~15.26% in FY2020 and 12.96% in FY2021, significantly closer to KKD’s previous margin profile.

Thesis Points:

1. New Defranchising and H&S Strategy Will Significantly Improve ROIC and EBITDA Margin in Still Many Underpenetrated US/CAN Markets

2. Recent Artificially Low EBITDA Margins Weighing on Valuation are Transitory

3. Insomnia Cookies and New CPG Product Line are Hidden Gems

Business Description:

Krispy Kreme is an American donut company chain originally founded in 1937 in North Carolina, which has since grown into an iconic American consumer brand with ~400 store location in US and Canada and 35 locations internationally. The company recently re-IPOd in July 2021 after previously being taken private by JAB in 2016. Since being taken private, the company has significantly changed their operating model by defranchising their store locations in both the US and International markets (respectively +65% and 100% of US/CAN and International locations are now company owned) and converting their distribution model to that of a Hub and Spoke strategy. Under this new model, the Company uses their legacy store infrastructure as miniature factories and distributes their donuts daily to nearby company owned and branded cabinets in convenience and grocery stores. As of Q3’21, DNUT has 238 of these hubs (referred to as Hot Light Theatres / ‘HLTs’) and 5,220 spokes (referred to as DFD cabinets) in the US/CAN market (and 30 hubs and 2,415 spokes in the international market). The company’s segments are grouped as US/CAN Market Revenues (reflecting company owned store revenues in the US/CAN market), International Market Revenues (reflecting company owned store revenues primarily in the EMEA market), and Market Development Revenues (reflecting the royalties collected from all global franchisees). In FY2020, 70%, 21%, and 9% of total revenues came from these three segments respectively. Additionally, in the US market the Company owns the growthy Insomnia Cookies brand (with 206 shops primarily on US college campuses as of Q3’21), which generated ~10.5% of total company revenues in FY2020.

Company History (pre-2016):

• Aggressive Growth Strategy: Krispy Kreme first went public under the ticker KKD in 2000, riding the wave of the dot-com bubble for its early success. At the time, the Company primarily viewed itself as a QSR business, and sought to expand extremely quickly by heavily rely on new franchised locations (~80%+ of locations were franchised). The advantage of such a strategy was to grow top-line revenues quickly while increasing EBITDA margins due to the strategy’s asset light approach. The franchisee contracts were structured such that Krispy Kreme Inc. would collect 4.5% of on-premise sales and 1.5% of off-premise CPG sales as royalties. The Company grew mostly in the Southern California market, as well as the US South-East region to much fanfare. 

• Disappointing ROIC and Organic Growth: However, after quickly growing following their first IPO, the Company began to run into significant headwinds. Firstly, the actual store locations were (and still are) very costly to build, making it very unattractive to new franchisees. An average location costs ~$1.5M to build, with 1/3 of the cost coming from just the industrial grade donut machine on each location (~$500K). This high startup cost heavily reduced each location’s ROIC to <20%, implying a repayment period of 5.5 – 6.5 years. Secondly, while the total number of stores grew quickly across the country, the demand for donuts appeared flat – at least to the market at the time. So, while it was true that during the first 3-6 months of a new Krispy Kreme Store opening, demand and fanfare would be high (with each location generating ~$100K in sales per week) sales would shortly thereafter fall off by ~60%+.

• Acquired by JAB in 2016: The result of this obviously disappointing performance caused the public market valuation of the Company to plummet from ~$50 per share in 2003 to ~$10 in 2004, with the valuation only slightly recovering to ~$17 per share in 2016, at which point JAB Holding Company stepped in buy it out at $21 per share (reflecting a ~$1.35B Enterprise Valuation). The timing of this acquisition coincided with JAB’s recent involvement in the US Coffee Market. Around the same time as their KKD acquisition, JAB acquired Peets Coffee, Caribou Coffee, Keurig, Panera, and many other coffee brands, seemingly in an attempt to corner the coffee market.

Investment Thesis:

1. New Defranchising and H&S Strategy Will Significantly Improve ROIC and EBITDA Margin in Still Many Underpenetrated US/CAN Markets

• The company has reacquired and continued operating ~65% of their US/CAN HLT locations in order to implement a new Hub and Spoke (H&S) business model.

• Under this model, DNUT’s HLTs would use their industrial grade donut machines to act as essentially “miniature factories”, producing donuts to be shipped out daily to DFD Cabinets (“Delivered Fresh Daily Cabinets”) or Fresh Shops. 

• DFD cabinets are freestanding cabinets owned by DNUT, but whose inventory are paid for by the grocery/convenience store (i.e., the inventory risk is born by the retailer). Fresh shops are more Dunkin’ Donut-esc locations, getting a certain number of donut delivered each morning, but with no donut machine/specialized equipment on premise

• In the US/CAN market, DNUT will be significantly using the DFD cabinet format more than the Fresh Shops to increase # of POA (Points of Access)

• This H&S strategy allows DNUT’s locations to spread the high fixed cost per donut machine across a greater number of donuts. At maturity, we project each DNUT hub with spokes in the US/CAN market to support ~80 of these DFD Cabinets (in-line with more attractive EMEA comps)

• The model is to eventually have around 3-5 Hot Light Theatres in a city, then to have ~20 fresh shops, followed by 250-400 cabinets

• The long-term ROIC and EBITDA margin under this new strategy are significantly higher than the legacy franchise model. We project LT EBITDA margins in the corporate owned US/CAN market expanding from ~12.96% in FY2020 to ~19.15% by FY2025.

• As per DNUT’s CFO & COO, Josh Charlesworth, each cabinet only requires an initial outlay of ~$5K before including additional costs from the trucks and labor required for daily delivery (with these factors considered we estimate each cabinet will cost ~$7.5K in our model).

• Overall, this strategy can best be understood as better monetization of legacy infrastructure that has already been built out.

• A bearish analyst on DNUT might disagree at this point, arguing that this new H&S business model does not address one of the major weaknesses of legacy Krispy Kreme, being that demand was flat/declining for the company’s product – as evidenced by the 60% sales “fall-off” referenced earlier.

• We disagree with this conclusion however as we believe that the issue was not flat demand but rather it was a mobility issue. People enjoy and are willing to buy Krispy Kreme’s product, but they just aren’t willing to go out of their way for them (i.e., going into the legacy HLTs)

• For evidence of this, we look to the following:

• Over 50% of a Krispy Kreme location’s revenues are attributable to CPG markets (i.e., where they ship the donuts to other local stores)

• And in the other half, over 80% of donuts that are purchased from the actual Krispy Kreme store are consumed off premise

• When a drive through is added to a location, weekly revenues per week jump by ~11% almost immediately as per Tegus Expert calls

• Donation drives, corporate events, and other bulk purchases show that consumers want the product away from the store

• Additionally, since DNUT sees very low customer repeat purchases in a year on average (just 2.5x a year), a cabinet near the checkout aisle causing a customer to buy just one more box of donuts a year, would be a 40% increase in customer sales. This is a very low hurdle rate the DFDs need to meet.

• Another fear by investors fueling the recent bearish sentiment on DNUT post it’s 2021 IPO was the company’s heavy debt burden and high historical CAPEX figures.

• However, again, the H&S business model is using already built out Krispy Kreme infrastructure, meaning the incremental Debt and CAPEX required for growth are extremely low versus historical measures

• As such, we project that Net Debt/LTM EBITDA will decline from the 9.00x in FY2020 to 1.18x in FY2024

• Now, the optimistic growth we are underwriting for Krispy Kreme’s transition to H&S are not purely hypothetical, as there are numerous case studies showing these improvements in other targeted dense urban areas.

• The EBITDA margins in these key markets have improved from the legacy ~14% to 30% by implementing these changes

• UK – Peterborough, Los Angeles, Tampa, Atlanta, Denver

• Below are the performance figures for two of the markets showing the high incremental ROIC seen (ROIIC)

• Additionally, while the model is set-up to work in denser urban areas – as one hub can ship to more cabinets each day without needing to travel as far – DNUT is still heavily underpenetrated in the 10 largest US cities.

• The reason for this massive underpenetration in what we consider “tier-1 cities” has to do with KKD’s old franchising strategy, where franchisees predominantly opened HLTs in smaller 2nd tier cities such as Tampa, Denver, etc.

• To offset this whitespace, in FY2020 Krispy Kreme opened their first – and currently only – HLT in NYC in Times Square, which is meant to service the city’s 5 boroughs.

• This will be the first major tier-1 US market in which DNUT will be building out their H&S model since going public, and – as such – will be important to monitor, since the market seems to view DNUT and its new strategy as a “show-me stock”.

• A successful DNUT NYC expansion would likely break this line of the bear narrative.

• We will admit that the LT EBITDA margins of the US H&S model will never be as high as the LT 30% EBITDA margins seen in “newer” markets such as the UK, as – unlike in new markets – DNUT’s legacy US locations are not always in the best location to distribute to DFD outlets, creating a higher cost structure.

• However, the mobility factor improving does not all need to come from the Company’s own investments in DFD infrastructure. 3rd party order aggregators and delivery apps offload both mobility constraints and costs from DNUT’s perspective, and these 3rd party apps’ contribution to Krispy Kreme (and the Company’s subsidiary Insomnia Cookies) are growing.

• E-commerce and delivery apps made up 20% of FY2020 revenues.

• Bears would argue that this will not be sustainable, as that 20% figure is likely from COVID’s impact boosting delivery volumes.  We admit that we cannot be certain of the sustainability of these volumes, but it is just another possible way for DNUT to “win” POA without substantial further investments

• Incorporating the above points into our valuation we have projected the following:

• DNUT will continue adding spokes to hubs, increasing the number of hubs with spokes from 121 in Q3’21A to 167 by FY2025

• On these grown hubs we project the # of spokes per hub growing to a LT count of 80 per hub in our base case. Resulting in a total of ~9,700 spokes by FY2025E (a CAGR of +18.62% from FY2020 # of spokes of 4,137)

• We also project revenues per spoke in the US/CAN market to be $40K a year, in-line with historical sales figures, underwriting a modest 4.74% CAGR from FY2020 sales per spoke

• We also project that as DNUT sales increasingly come from DFD cabinets, their SG&A within the US/CAN market will not grow at the same rate with revenues, allowing EBITDA margins to expand for the segment from 11.79% in FY2020 to 19.15% by FY2025. 

• Note that this is still below international markets/cities ~30% EBITDA margin due to the less attractive HLT hub locations. There is also contribution to EBITDA margin expansion due to the growth of DNUT’s other two businesses (insomnia cookies and their CPG Sweet Treats product line) which we will discuss more in Thesis #3

2. Recent Artificially Low EBITDA Margins Weighing on Valuation are Transitory

• Following DNUT’s re-IPO in July 2021, the market was initially very pessimistic on the Company’s new strategy and reorganization. Even though revenues had nearly doubled since the last time investors saw Krispy Kreme in 2016 (growing from $518M in 2016 to $1,122M in 2020), EBITDA margins had instead nearly halved (falling from 14.1% in 2016 to 8.1% in 2020)

• Reading sell-side initiations from this period reveals the bearish conclusion that not only had JAB failed in its efforts to turnaround this subpar QSR brand, but it had also managed to make it even worse. 

• The analysts (and one tegus expert call with the former head of Krispy Kreme franchising) argued that JAB had brought in a bloated, overpaid management team. 

• They argued that Krispy Kreme was still a relatively small company, with only ~350 US/CAN locations. Yet, despite this, JAB had still given the Company two separate highly paid CFOs.

• They also concluded that JAB and DNUT’s management team’s decision to defranchise Krispy Kreme locations was flawed. 

• They argued that DNUT’s management did not have experience or a real plan for operating these locations once they were defranchised and were stuck holding the bag on lower-margin company operated HLTs. After all, collecting franchise royalty fees is simpler, more stable, and higher margin, so the IPO margin compression makes sense.

• Though we cannot be certain, this bearish diagnosis may have been the reason why DNUT was unable to gain enough interested institutional buyers when it re-IPOd, forcing it to price itself at $17/share at the opening, well below it’s expected range of $21-24/share

• We strongly disagree with this conclusion. Firstly, many of these “wasteful” operating expenses bearish sell-side analysts write about, no longer appear to be seen. In fact, gone are the two highly paid CFOs. At the time of their IPO, DNUT had greatly consolidated their c-suite, even to the point where the office of both the CFO and COO were under one executive, Josh Charlesworth.

• Additionally, we disagree with the idea that DNUT’s operations and margin profile are less attractive as a H&S than they were as a franchise business. While we admit there is significantly more operating risk under the new strategy, it is also apparent that Krispy Kreme’s business is not well suited to work as a franchise either. After all, KKD was not a very successful QSR. 

• As mentioned before, the costs to open a new HLT are very high for potential franchisees. Secondly, franchises are not suited to address the mobility constraint issues, as franchise owners may neither be willing to open a 2nd HLT location in an urban area nor allow a competing franchise to enter. However, by limiting the # of Hubs – and thereby spokes – the overall Krispy Kreme system sales will be hampered. 

• Additionally, the old franchise structure did not properly reward Krispy Kreme at a corporate level for sales generated outside of the HLT. Under the franchise agreements, franchise owners were to pay 4.5% royalties from on-premise sales (i.e., donuts bought at the HLT) but only 1.5% from off-premise sales (many franchises at the time had their own independent contracts with retailers in the local areas to deliver donuts). However, the real growth and value of DNUT would be seen in these off-premise sales.

• Overall, we agree with DNUT’s management team that the best way (and really the only way) forward was to defranchise locations and implement a H&S model from the corporate level

• Overall, when further analyzing DNUT’s lower GAAP reported EBITDA margins, we see that it was largely driven by one-time expenses largely attributed to IPO expenses and de-franchising costs. In fact, the margin compression argument (i.e., that JAB sacrificed profitability for growth) is not seen.

• The main lines that investors flagged at IPO are highlighted in red text below but note that most of these have disappeared in the YTD financials. Suggesting that they were truly in-fact one-time expenses.

• The others we highlighted in blue are those related to the de-franchising strategy, which are not truly indicative of the underlying business’ performance

• Now, even if we add back SBC – as you can argue whether it should/shouldn’t be added back – the adjusted EBITDA doesn’t show margin degradation

• However, these figures obviously are controlled and can be massaged by management, so we clearly shouldn’t put too much confidence in them. However, the temporary nature of some of these add-backs does suggest that bear’s arguments that JAB sacrificed profitability is misplaced

3. Insomnia Cookies and New CPG Product Line are Hidden Gems

• We believe that the market is missing or heavily underestimating the value of Insomnia Cookies and Sweet Treats, two new businesses DNUT has acquired and built-out since it was last public in 2016.

• Insomnia Cookies is a cookie company largely operating on or near US college campuses, where they sell fresh cookies for $2-3 each late into the night. 

• The locations are very small, often staffed by one to two employees with only a few ovens to bake cookies throughout the day. As such, the cost for such locations are very low. 

• The product is very popular among college students (for late night munchies), with it commonly being ordered online for delivery. 54% of their volumes in FY2020 were through digital orders.

• Krispy Kreme acquired a majority stake in the Insomnia Cookies brand in 2018, valuing the company at ~$500M. 

• We believe that Insomnia Cookies is a very high-quality growth asset for DNUT, with high EBITDA margins, ROIC, and unit economics.

• An average Insomnia Cookies store cost <$200K to build, with a contribution margin of 27%, and an AUV of $650K. The payback periods on such locations are

• The runway for growth is also very high. Currently there are only 206 Insomnia Cookies locations across 100 college campuses, but there are +4,000 college campuses alone in just the US.

• The store count growth for Insomnia over the past 3 years has been extraordinarily high. With the company growing locations at a 25% CAGR (from 106 in FY2019 to 206 in FY2021)

• Additionally, the brand is not just a small/insignificant part of DNUT’s operations. In FY2020 the brand made up 10.49% of the company’s revenues and an estimated 10.93% of gross profits. 

• We consider this to be a large enough portion of DNUT’s operations to warrant coverage and investor attention, especially considering it is a high growth and high margin segment.

• Yet, despite this, sell-side coverage primarily focuses on legacy HLTs and Krispy Kreme Donuts, with JPMorgan being the only sell-side firm (that we are aware of at the time of writing this initiation) to model out Insomnia Cookies separately from the rest of the business.

• The other business which we don’t believe the Market is paying enough attention to – but we admit is significantly smaller at this stage – is the recently launched Sweet Treats CPG Product line.

• Following JAB’s acquisition of KKD, new management decided that all Krispy Kreme donuts would be made fresh daily, and as such they shut down their wholesale donut factories. 

• Previously under KKD, one of the company’s revenue streams came from producing wholesale amounts of donuts to be shipped to various retailers across the country. The consequence of this industrial process was that – more often than not according to past customers – the donuts were old, stale, and were overall of low quality.

• However, rather than just shut down and sell the wholesale factories, DNUT’s new management team decided to convert them to make a new packaged CPG line, Sweet Treats.

• The products can be bought at various retailers, including Walmart. 

• The new Sweet Treats factories only required an additional $2 million in CAPEX to convert them, making it an essentially free vertical that DNUT got by using their legacy infrastructure.

• There is not too much currently known about the segment, but CFO/COO Josh Charlesworth did confirm that they expect the segment to be profitable by EOY FY2021.

• The new segment was only launched in Q1’21, making it a very small portion of DNUT revenues.

• So far, the segment has generated $18.6M in sales from Q1’21 to Q3’21. We project that it’s FY2021 revenues will be $21.6M. This is only ~1.57% of company level revenues.

• However, similar CPG product lines have a LT EBITDA margin of ~20%, making it accretive to DNUT overall.

• For Insomnia Cookies we project that the brand will grow locations at a 10.92% CAGR from FY2020 to FY2025 (from 184 to 309 stores). Over the same period we also project that revenues per store will grow at a modest 6.13% CAGR (from $669K per store to $900K). This all results in overall Insomnia Cookies revenues growing to $268.2M by FY2025, or a 17.91%. We assume CAPEX per location of $200K.

Risks/Bear Case:

1. JAB and Minority Partners Liquidation Risk: The primary risk in this investment comes from DNUT’s previous owners JAB, who may begin aggressively selling their shares following the lockup period ending in 2022. In fact, one of the main bear thesis points on DNUT is that JAB is using the recent IPO as a way to liquidate their position in the company following a “failed” turn-around story. While we agree that it is a fair point to consider, we are ok accepting this risk, as we don’t agree with the view that JAB is simply looking to exit the company as soon as the lockup period ends. Firstly, JAB has been recently IPO-ing their coffee portfolio (which they had acquired from 2012-2018), which can be seen by their decision to take Keurig (via the KDP merger) and Panera Bread (which recently filed an S-1 on Nov. 8th, 2021) public. Because of this we don’t think JAB is necessarily selling off DNUT because of a failed turnaround story (i.e., that the defranchising and H&S model are unattractive), but rather because they weren’t able to incorporate coffee into DNUT’s model (while private JAB had apparently tried to roll-out a “coffee corner” in Krispy Kreme locations. This hasn’t worked with coffee only being ~1% of sales). Secondly, JAB and other company insiders have been buying up shares at the current valuation. And third, in other sold coffee assets (namely KDP) JAB did not sell off their large stakes in the business and have remained as large shareholders in the business since it’s “re-IPO” in 2018.

2. Mostly Unproven Management in a High Operating Risk Strategy: While we believe the defranchising strategy and the rollout of the new H&S model for DNUT are attractive, we admit that it is one which bears high operating risk. Because of this, another primary risk we identify with the investment would be the largely unproved management team. The current CEO Mike Tattersfield was previously the CEO of Caribou Coffee (both before and after it was acquired by JAB in Jan. 2013) and does not necessarily have a lot of experience in operating the new H&S model. He has also largely built his career alongside JAB, meaning that he may not align himself as closely with the public equity shareholder if push came to shove between JAB. However, we would not necessarily consider him to be inexperienced or a bad manager, as he had a decent track record at Caribou Coffee, growing revenues faster than his predecessor while also turning the business EBIT positive. On the other hand, the current COO and CFO is Josh Charlesworth who – prior to DNUT – worked at Mars Inc. and does not have a “restaurant” business background. Because of this management risk we believe the market is treating – and valuing DNUT – as a “show me” stock, since we only have 2 quarters so far to go on. We believe that the market simply may need to see more quarters of a successful implementation of the new strategy, potentially providing us a good opportunity to get into the investment.

3. High Inflationary Pressures in the Short Term: A primary focus of sell-side equity research analysts and investors with a shorter-term horizon is the impact that higher input costs may have on the margin profile of the business. Since the new H&S model does require additional CAPEX spend (due to the installation of DFD cabinets) and the purchase of a fleet of delivery trucks, there is risk that higher labor input costs could compress EBITDA margins for the next several quarters. Again, while we believe this is a valid concern, we think the longer-term fundamentals of the business will continue to improve, regardless of the shorter-term transitory expenses they may incur.

Appendix:

Catalyst

• A successful roll-out of the H&S model in NYC
• More quarters to show outperformance of H&S model
• Company Investor Day to Better Explain H&S
• Further JAB Purchases of Stock
• Sell-Side inclusion of Insomnia Cookies in Valuation