Description

I recommend buying January 2008 puts on KKD (Market Cap: $350mm) or shorting it down to zero. Equity holders will either be wiped out in chapter 11 or left holding an empty shell company burdened by lawsuits. KKD is tough to borrow (some have paid around 25% interest) so my official recommendation is 2008 $5 puts, which at around $1.70 can return 200%. Borrowing at 25% interest and shorting to 0 would give you a 75% return on the short price. We currently own puts.

Max685 wrote up KKD last year and the stock's down 30% and the situation has evolved. Some of the comments he and others made on that thread were very good and I recommend checking it out. Max focused on operating profit of company-owned stores as well as the most essential KKD statistic: average unit volume. My focus is on franchisee health, capital structure, lender incentives and management strategy.

Summary:

- KKD did a U-turn 3 months ago and has begun liquidation. The CEO recently declared that KKD will become a "smaller regional company". They've been quietly mass-closing stores (around 20% of the 'factory' stores closed in the past 3 months) and the stock market has no clue what that implies.

- Senior debt outstanding was recently $185mm and there are big future unsecured liabilities to deal with it (due to past fraud). The liquidation value or ongoing concern value are likely $100-$200mm and the secured lenders are eager to sell out. If they choose to wait for an unlikely turnaround I estimate they'll get $250-$405mm worth of value for $240-650mm – not a very appealing option.

- Multiple catalysts are just around the corner. Midwest franchisee Glazed Investments is probably weeks away from either bankruptcy or a costly out-of-court settlement between their creditors and KKD (like New England Dough a few days ago). Freedom Rings, the Philadelphia franchisee, has filed ch.11 and liquidated. KremeKo, the Canadian franchisee, has filed for bankruptcy, closed 12 of 18 stores and has been acquired by KKD, who had to do a DIP & pay dearly to KremeKo lenders. 6 months later, KremeKo is still not cash flow positive and this year it exits the "honeymoon period" of sales. The condition of other franchisees is catastrophic, with sales down 20-30-40% from last year. Most are in violation of covenants with their creditors and have begun liquidating stores. KKD's #1 source of cash, by far, was sales of custom equipment to new franchisee stores. This business no longer exists. In some cases communication with franchisees has ceased altogether. KKD is involved in legal battles with 3 of them as result of trying to drive them to bankruptcy on purpose. Past and allegedly CURRENT fraud are also being litigated. Details of individual franchisee relationships are too long for this write-up but I can provide them in subsequent posts. It suffices to say that almost every franchisee is cash-flow negative (after royalties and interest) and highly levered operationally and financially.

- The stock is scheduled to be delisted mid-April if restatements aren't ready – almost for sure

- KKD is bleeding cash. They've angered 5-10 big banks. Shareholders have been out of the picture and the BOD is assuming the "zone of insolvency".

As of October 30th:

Cash burn: $2-$3mm per month. This number may temporarily decline as the company continues to close unprofitable stores, but it excludes one-time franchisee debt repayments, which is likely to be at least the $42mm in guarantee payments (should occur mostly in Q1&Q2). Asset sales of 1mm+ must be used to repay debt and this process has begun post-October 30th. Without further funding the company had $59mm of liquidity left ($25mm cash + $34mm from two credit lines).

:::Sources of liquidity:::
$25mm Cash
$27mm (1st lien $27mm credit line – untapped but at risk of being revoked)
$7mm (2nd lien tranche A $30mm credit line)

:::Debt and maturities:::
$23mm (2nd lien tranche A $30mm credit line – already in default & being repaid)
$120mm (2nd lien tranche B $120mm term loan – already in default & being repaid)
$100mm (estimate) Lease obligations from unprofitable stores
$42mm Off-BS franchisee debt guarantees (mostly to be repaid/untied this year)
unknown Off-BS future fines & judgments related to fraud (1-2-3 years out)


- KKD is a battleground between the company's main secured lenders and the many franchisees' creditors. While it's been a ceasefire up until now, it seems the franchisee side is gaining the upper hand: 2 weeks ago, New England Dough's guarantees were paid at face value. This may become a feeding frenzy and bring the day of chapter 11 closer. It appears the company's plan is to restructure its franchisee relationships as much as possible and then sell out. This consists roughly of:

a) Liquidating some stakes in JV franchisees by transferring the equity + associated debt guarantees to the partner. That scenario is viable where the partner's credit quality is superior to KKD's

b) Liquidating other JV stakes by buying out creditors and partners and selling most of the acquired assets. This was done with 3/4 Consolidated JV's (where KKD was a majority owner and therefore exposed to potentially explosive liabilities). This method gives KKD the rights for the territories in question. Since the current business model is disastrous, the value to a potential buyer is proportional to the population covered by owned territories

c) For another group of JV's, paying off the portion of JV debt that it had guaranteed, but not paying the balance (and therefore, not acquire the rights)

d) Forcing regular (non-JV) franchisees into bankruptcy and acquire their rights either by influencing their creditors.

- KKD's lost all employees who knew anything about the business and is now headed by bankruptcy experts Kroll Zolfo Cooper (KZC), led by Steve Cooper of Enron fame. He has no public record of a non-chapter-11 restructuring job. KZC in turn are hiring expensive counsel and consultants for PR, IR, BOD protection, franchisee bankruptcies, financial restatements and litigation. This is a result of the company's well known past of massive fraud. Over the past 11 months Cooper has been ruthless in his treatment of franchisees and his strategy of liquidating the business. Multiple flip-flops have exposed his incompetence and carelessness. His main goals are to protect management and maximize creditor value (check out his work at Enron, Laidlaw and Polaroid). To give the company credit, KKD recently hired a food industry executive (albeit an inadequately inexperienced one) to assist the COO.

- On April 1st, KKD pledged all of its assets as collateral to a very restrictive senior secured loan made by Silver Point Capital, a distressed debt hedge fund that specializes in "taking control of corporations in chapter 11". It doesn’t look like they'll get further funding. Multiple covenants have been violated and the interest rate has been hiked to LIBOR+7.25%. Silver Point doesn't want long-term ownership - they want to flip. The legal 'hair' on KKD is mostly tied up in the asset-less publicly traded shell company, KKDI. The shares of the wholly-owned business-conducting subsidiary, KKDC, have been pledged as collateral to the loan. So it appears likely that the KKDC will be completely liquidated/sold with the proceeds sent to Silver Point and an empty KKDI will eventually file chapter 11.

- The potential unsecured liabilities arising from leases, franchisee debt guarantees and various lawsuits would point to a chapter 11. However, KKD's payment of some of these at face value indicates they're in such bad legal shape that they're afraid of ch.11 so long as JV's still exist. KKD shareholders are in a catch-22 situation (not file and pay / file and not pay).

- On October 16th, 2 hours before the new bankruptcy law came into effect, Krispy Kreme filed the chapter 11 for Freedom Rings, a "subsidiary". The real story: this was a JV acquired by KKD and placed into a case of chapter 11 to which future cases could be joined. This strategy allows KKD to use the old law, which is friendlier towards entities with corporate governance issues.


To make things easier I have divided my write-up into 3 parts:

A) KKD's current situation and how they got here
B) The value of KKD's assets and operations assuming an ideal turnaround
C) Why KKD will not be able to get from (A) to (B) without transferring shareholder's assets to creditors (i.e. discussion of liquidity situation and lender incentives)



PART A - THE PAST AND PRESENT OF KKD


The most common misperception about KKD's business is that it was an amazing retail business that expanded into a cannibalizing wholesale channel (gas stations, grocery stores, kiosks). The truth is the exact opposite: KKD was an "ok" manufacturing wholesale business ruined by a fraud-driven expansion with a retail cost-structure.

Here's the short history:

- Founder Vernon Rudolph rented a building and began selling doughnuts to grocery stores in 1937. People started asking if they could buy hot doughnuts, so he cut a hole in a wall and sold them directly to customers.

- In the 50's 60's and 70's, expansion of franchise base geographically, franchisees bought custom doughnut-making equipment from KKD. They had a wholesale model and were run by hard working families (i.e. thin margins).

- In 1976, due to Rudolph's passing, the company was sold to Beatrice Foods, who ruined the brand.

- In 1982, franchisee associates led by the McAleer family organized an LBO 'coup' and took KKD from Beatrice. Then they started pumping the retail side of the business.

- Scott Livengood rose through the ranks during the 80's and 90's and the McAleers endorsed him. He was the leader of massive fraud, the "hot doughnuts now" campaigns, the long lineups etc. He convinced everyone that KKD is a retail company and this translated to demanding 5.5-7% royalties as opposed to 4-5%. He forced franchisees to expand their retail base at the risk of losing their license, thus ruining them. In the late 90's KKD aggressively pumped the business model to even more franchisees and then to the stock market. This wholesaler was awarded retail-like valuations. Despite this hoopla, competing local mom-and-pop doughnut businesses didn't feel much pain other than during the first few weeks post-opening. KKD franchisees had to get expensive real estate, buy equipment at huge markups and allegedly buy the doughnut mix at an illegal markup and pay up to 6% royalties + 1% brand fund contribution (money that was spent on perks). Many of them got highly levered. Some of these were structured as JV's with KKD, where guaranteed an amount of debt proportional to their equity ownership. BOA, BB&T and GE are particularity exposed.

- So KKD was a capital-recycling business. Cash inflows: equity and debt financing, upfront franchise fees, royalties and equipment profits, mass-sales of doughnuts upon new openings. Cash outflows: buying out franchisees from related-parties before those entities collapse, marketing, free doughnuts, new store construction and management perks. All in all, KKD burned about $300mm in 2000-2004. In order to keep SSS rising, franchisees had to open more stores and expand existing stores into wholesale (tying up capital in low-margin business). Eventually the franchisees ran out of capital to do that, the growth rate became negative and the rest is history.

- Insiders made $1.5B (more than Enron insiders). KKD insiders were connected with BB&T and Wachovia and especially PWC, the auditors. At the heart of the accounting fraud was the fact that KKD was manufacturing its own PP&E and selling it both to itself and franchisees. Upon request, I can write-up another 2-3 pages on the details of the fraud

- In the 6 years prior to the IPO, KKD made an average net income of $2mm with around 100 stores in operation. Older than MCD but only 100 stores - that's some retail business!!


---- The present situation ----

Primer on BOD protection: The main culprits at KKD were Scott Livengood and John Tate. There are also 'secondary' culprits, including board members who profited handsomely from stock options while forgetting their duties. Normally, new shareholders would raise their voices and force directors to quit and disgorge funds.
Cooper has a reputation for circumventing that scenario. How? The most obvious way is to give power to creditors, with whom Cooper has a good reputation as well. So creditors bring him in and he tells the BOD to hire consultants who assess the company's value. These consultants, wanting to be hired in the future, tell the BOD that they're in the "zone of insolvency" and owe fiduciary duty to creditors. The BOD gives Cooper the power to act on that recommendation and he takes it from there. Normally Cooper follows with a chapter 11 filing where a low-ball valuation promptly delivers the assets to creditors - sometimes they even get more than they deserve. Lawsuits are settled; BOD members testify against the primary culprits and get slapped on the wrist without admission of guilt. Cooper's CV gets bigger.
In the case of KKD, however, chapter 11 is being delayed because the company wants to restructure franchisee relationships out of court. In chapter 11 KKD would have less power to do that and franchisees and their creditors could come forward with more fraud claims. The appointment of a trustee would spell great trouble for Cooper/BOD. The pace of the out-ofcourt restructuring has accelerated tremendously over the past 3 months and is likely to accelerate further.

December 2004: KKD's lenders (Wachovia syndicate unsecured credit line with $90mm/$150mm outstanding) got impatient and forced KKD to hire a restructuring expert (which ended up being Cooper's KZC). Cooper got a secured loan and used some of its proceeds to repay the Wachovia group in full and the rest for operations. Since KZC's arrival, KKD's been burning about $6mm per month vs. $1mm before. The rate is now down to $2-3mm due to the total halt of cap-ex.

These 'normalized' burn rate figures are based on the PR's issued on August 10th and December 13th. They exclude franchisee debt repayments and other 1-time items, which are now more important than the burn rate itself:

- Some Franchisees or their creditors decided to stop royalty payments. Most franchisees are still paying for the mix. Many new receivables will likely never be recovered.
- $1mm per month to KZC - hourly billing for Steve Cooper, his assistant Steve Panagos, and various accountants and others consultants
- No more cash flow from selling equipment (more closings than openings – equipment will suffice for years to come)
- Driving franchisees into bankruptcy: Negotiation and litigation vs. franchisees who sued KKD (brand fund fraud, guarantees, new business models, royalty and mix payments…)
- The Special Committee (SC) investigating KKD, counsel to the SC, consultants to the SC
- Counsel and consultants to the BOD (Weil, Gotshal & Manges - D&O liability issues, decisions in the 'zone of insolvency')
- Continuing deterioration in sales with a relatively fixed cost structure, higher oil prices (delivery of doughnuts)
- Company store closing costs and various other legal and professional items
- preparing restatements all of all financials back to the 2000 IPO (more accountants, lawyers…)
- cost of restructuring of franchisees (in or out of court)

Some of these items, like SC-related expenses, may shrink. Others, like lack of royalty payments, are a growing problem.

Following are the 1-time cash flow items since the new lenders came in (April 1st).

- $9mm paid to New England Dough creditors to make good on guaranteed debt
- $4mm paid to KremeKo creditors to make good on guaranteed debt
- $9mm paid for acquiring the non-guaranteed part of KremeKo debt (to buy KremeKo). This amount is an estimate based on lenders' refusal of a $8mm+ outside bid. Apparently, BNS correctly read KKD's willingness to pay. If KKD has to do this with every franchisee, they'll need a lot of cash: there has to be at least $200mm in face value of franchisee debt, possibly up to 400-500mm
- $6mm inflow from sale of stake in Australia franchisee: the 33% of this JV that was owned by KKD was sold back to the partners so that they could bundle it with another restaurant chain they own and flip the whole package in an IPO.


------- current state of the operations --------

The company has no statements, but we can pull out public info from the bankruptcies and franchisee lawsuits.

KKD has 3 segments:

1) KKM&D: production of equipment and ingredients for sale to franchisees. This subsidiary was the heart of the fraud. Since the number of factory stores is sharply dropping, this segment is generating very little FCF. It's not clear to what extent ingredients and supplies are still being marked up or if such markups violate agreements with franchisees.

2) FRANCHISE SEGMENT: this segment makes 5.5-7% royalty depending on the franchisee and some are not paying. The biggest franchisee, Great Circle Family Foods, was not paying until this week. Now they agreed to pay under threat of losing their license, but this will cause financial hardship. Most of the franchisees are hurting, many are no longer making payments to lenders, or are being forced (or deciding) to close stores. Every store closure reduces revenue to KKD. Leverage is high with Debt/EBITDA in some cases is over 10x.

3) COMPANY-OWNED STORES. Average unit volume, SSS and total revenue have all been down 20-30% in the past 3 quarters, but in order to guess what the margins are like, we can use common sense and franchisee filings on PACER as a proxy. Here's what we find:

i. Common sense: you have a 4,000 sq.ft. store in a small-medium town on the corner of Main & 1st or in a big city suburb prime location. You sell only doughnuts manufactured on-premise and branded coffee. 2/3 of the doughnuts are delivered wholesale, increasingly on a contingency basis. The rest are sold on-site. This is what's known as KKD's "factory stores". Once the KKD hype goes away, how the heck can you make enough sales to cover your fixed costs, especially given expansion by SBUX, Dunkin' Doughnuts, Tim Horton's and other coffee shops? Not to mention the local mom&pop doughnut businesses to whom locals are still being loyal! Cooper has recently declared that the factory stores make no sense.

ii. The "satellite stores", a newer concept that started over a year ago, will probably never take hold. The idea is to build 2,000 sq.ft. stores without equipment or take underperforming factory stores (due to over-capacity in a specific market) and convert them to satellite by retiring the equipment. Satellites keep heat impingers, which is the "final stage" machinery that heats up the doughnut and glazes it. They get an almost-ready doughnut from a nearby factory store (usually 5-20 miles away), heat it up and sell it. While this strategy gives more scale (centralized manufacturing) within the specific market, note that satellites are not selling wholesale, since they can't produce! So while gross margins increase, 2/3 of sales are gone and operational leverage hurts. There have been other similar small store concepts that were tried within the KKD system but it's all a big mess. Examples include: doughnuts not being re-heated, doughnuts being re-heated but not glazed, walk-in but no drive-thru. Many factory stores have been converting to satellites temporarily while waiting for someone to take over the lease or buy the building. Proposals for a new model are all over the place but none of them make sense.

iii. Franchisee evidence: Sweet Traditions - net loss of $1.2 million in 2003, $3.2 million in 2004 and $2.2 million in first half of 2005. Chicago same store sales fell 36% in 2003 plus 29% in 2004 and have continued to decline. Profit margin: -10%.

iv. Freedom Rings bankruptcy filings: In 2005 the franchisee's net margin was close to -20%. Before the liquidation, Q1's expected loss was -$1.5mm on sales of $2.3mm. Their revenue recently declined by 40%+ year over year, with average unit volume in line with the rest of the KKD system.

v. KremeKo had a net loss of -9% if we combine its 2003+2004 numbers and D&A expense was arguably understated.

vi. The 10-K from 2 years ago shows many JV's with negative net income. We can only imagine what they look like nowadays. My guess is that almost no franchisee is generating positive cash flow - certainly none of the Area Developers, who represent the vast majority of franchise stores, pay higher royalties, and don't have a multi-decade relationship with their communities.

With all these items in mind, we cannot expect KKD-owned stores to do much better. If KKD's HQ overhead is bigger than the 5.5%-7% franchisee royalty, KKD's margins are probably even worse.

--- please see part B in the thread ---

Catalyst

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