Description

I’m recommending that investors take a close look at Krispy Kreme Doughnuts, Inc. (KKD) as a short sale candidate. I will offer the caveat that my short sale ideas on VIC have been lousy. Fortunately, my long ideas have been a lot better.

I’m willing to venture into the short side again because KKD disclosed some sales data last week that could have very significant implications for the future of the company and that may not be well understood by the market. If certain assumptions prove accurate, KKD may have to disclose that its store-level operating income is approaching zero. Furthermore, it may become clear that the bulk of its franchise stores are losing money. Under such circumstances, KKD may be forced to begin a major reduction in operations that could leave little residual value for shareholders.

Before delving into the details, I want to acknowledge that this is far from a new idea for most shorts and that the short interest is already high. Interestingly, though, KKD has never been written up on VIC as a short, only as a well-reviewed long in January 2001. I believe the new data make it worth a fresh look, even for those who may know the story reasonably well. Also, while shorting is difficult, numerous option strategies are available. My firm currently owns puts.

KKD is, of course, a popular doughnut manufacturer and retailer that expanded very rapidly in recent years. Its operations are reported in three segments:

Company Stores – including wholly owned operations and consolidated joint ventures

Franchise Operations – franchise fees and royalties from unconsolidated franchises

Krispy Kreme Manufacturing and Distribution (KKM&D) – sales of dough, supplies,and equipment to franchisees

Operating income from these segments must cover unallocated G&A expenses, interest expense, and other miscellaneous expenses before profit drops to the bottom line.

The main focus of this analysis will be the Company Store segment which, as recently as recently as a year ago, was generating more than $20 million of quarterly operating income while corporate G&A was only $10 million. As the following analysis will show, Company Store operating income may be approaching zero, even while corporate G&A has ballooned to $13 million. While visibility into the two franchise-related segments is much lower, information regarding the Company Store segment may also have important implications for the Franchise and KKM&D segments.

Finally – to the heart of the matter. The health of the Company Store segment can be tracked by following average weekly sales and profits. These metrics are highly correlated and both have deteriorated significantly over the past six quarters. KKD reports average weekly sales per store for the Company Store segment and the results for the last eight quarters (beginning with Q4 2003) are as follows:

($ thousands)
75.9, 77.4, 74.4, 73.0, 69.1, 67.9, 63.1, 58.4

Reported operating income for this segment for the same quarters is as follows:

($ millions)
18.6, 21.6, 20.1, 20.3, 21.8, 19.3, 12.9, 9.6

The number of store-weeks reported for this segment each quarter are as follows:

1205, 1336, 1396, 1536, 1735, 1847, 1988, 2088

The last two series yield an average weekly operating profit per store as follows:

($ thousands)
15.4, 16.2, 14.4, 13.2, 12.6, 10.4, 6.5, 4.6

A statistical comparison of weekly sales and weekly profits shows a correlation of 98%. Given the relatively low marginal cost of a product like doughnuts and the relatively high fixed cost of KKD’s “factory stores,” this makes sense. The trendline for these data suggests that operating income for the Company Store segment would drop to zero when average weekly sales are $51,300 per store.

Now – to the new data. In announcing the retirement of its chairman and the hiring of two restructuring experts last week, KKD also disclosed that “company average weekly sales per factory store have decreased approximately… 25%” in the first eight weeks of the fourth fiscal quarter vs. a year ago. These are obviously incomplete data. However, if the trend holds true for the Company Store segment for the full quarter, then average weekly sales would equal the fourth quarter fiscal 2004 average of $69,100 x 0.75 = $51,800. Given the strong correlation between weekly sales and profit, there’s a high probability that operating income for this segment would be negligible.

Clearly, deterioration of the Company Store segment of this magnitude would be a major negative development for KKD and would help explain the decision to bring in restructuring experts with experience at companies such as Enron. Also, given the limited nature of last week’s disclosure, I’m not sure the market fully understands the potential implications.

To add just a little more color to these trends, a fourth quarter decline in weekly sales and profits would be the seventh straight quarterly decline in these metrics for the Company Store segment and there’s no obvious reason to believe there won’t be an eighth. Same-store sales have also turned from a +10.7% in the fourth quarter of fiscal 2004 to a –6.2% in the third quarter of fiscal 2005. The data above suggest that Company Store same-store sales may be negative in the high single digits or even low double digits in the fourth quarter. Same-store sales differ from weekly average sales because the latter is influenced by all store openings, closings, and reclassifications.

Moving beyond the Company Store segment, it’s worth noting that average weekly sales for “Area Developer” franchise stores in the third quarter was $49,900, down from $60,300 a year before. To the best of my knowledge, the stores run by Area Developers are similar in character to those run by KKD and may therefore have similar economics. If so, many of the 164 stores run by Area Developers may also be operating at breakeven or worse. Further, these stores are handicapped by franchisee fees and by supply agreements with KKD. I roughly estimate that each of these stores transfers $4,000 per week of economic value to KKD. Because of this, the breakeven sales level for the Area Developer stores may be materially higher than it is for Company Stores.

KKD also has 54 “Associate” franchise stores. These are older franchises whose franchise terms are more favorable than are those of the Area Developers. The economics of these franchises are even more opaque, but have clearly deteriorated as average weekly sales declined from a peak of $52,400 in the first quarter of fiscal 2004 to $41,700 in the most recent quarter.

If the economic picture is anywhere near as bleak as the above figures suggest, KKD is in a great deal of trouble. The Company Store segment could shrink significantly through store closures, a possibility suggested by KKD’s comment that the new managers “will work with the Company to review whether it should take certain operational actions, which could include the consolidation of store locations.” Franchise stores could also close, default on their obligations to KKD, or renegotiate their agreements. In any of these cases, operating income from the Franchise and KKM&D segments is likely to deteriorate further. Already, combined operating income from these two segments declined to $10.4 million in the third quarter of fiscal 2005 from $16.2 million a year ago.

For what it’s worth – which may not be a lot – I’m estimating that fourth quarter revenues could be as low as $164 million and total segment operating income might be $11-12 million. Corporate G&A is likely to be at least $13 million as KKD continues to cope with business challenges and an SEC investigation. I believe the net result from these estimates would be materially worse than the current Wall Street consensus.

One question that arises is whether recent results might represent a nadir from which KKD can rebound. Certainly, the Krispy Kreme brand is strong and has value. I’m skeptical about the prospects for a dramatic turnaround, however, mostly because I have seen that “hot concepts” such as Planet Hollywood and Boston Market have a very difficult time rebounding once the initial excitement has worn off.

This write-up has gotten quite lengthy, but I would feel negligent if I didn’t pay some attention to the balance sheet and to valuation. As troubled companies go, KKD isn’t horribly leveraged, but its balance sheet has deteriorated. As of October 31, 2004 and prior to any restatements, KKD’s total liabilities were $238 million and its tangible net worth was approximately $240 million ($3.90 per share). Funded debt less cash on hand was $116 million.

For a company with $717 million of trailing 12-month revenue, the funded debt level isn’t extreme. However, KKD’s liabilities could grow rapidly. In addition to the funded debt, KKD has approximately $9 million of letters of credit outstanding, $24 million of franchisee debt and lease guarantees, and $135 million of long term lease obligations. If the KKD system experiences a significant amount of consolidation, many of these contingent liabilities could be added to KKD’s balance sheet.

Reviewing the asset side of the balance sheet, KKD has substantial tangible assets, including outright ownership of more than 60 stores, 424,000 square feet of warehouse-type facilities, plus other real estate assets. However, at least $130 million of KKD’s tangible assets are equipment and leasehold improvements and approximately $35 million are receivables, notes and investments related to franchisees and related parties. Realizations from this $165 million of tangible assets ($2.70 per share) could be low in a consolidation scenario.

Considering all of the above, it’s certainly possible that KKD will be able to shrink its operations, sell assets to pay down debt, and preserve at least some value for shareholders. However, it seems to me that KKD’s enterprise value is likely to decline meaningfully from the current level of about $650 million. This enterprise value equals 1.0 times my estimate of run-rate revenues. This is in the same ballpark as companies like California Pizza Kitchen (CPKI), Denny’s (DNYY), and Landry’s (LNY). It’s quite easy to imagine the valuation falling to roughly 70% of revenues, comparable to companies such as Papa John’s Pizza (PZZA) and Lone Star Steakhouse (STAR). At that level, the stock might be around $5.50 per share.

If the store-level operations are deteriorating anywhere nearly as much as it appears, KKD is likely to shrink its operations, revenues will fall further, and KKD could lose money for an extended period of time. In that case, the enterprise value might be more comparable to companies such as BUCA, Inc. (BUCA), Quality Dining (QDIN), and Worldwide Restaurant Concepts (SZ) that are valued at 35-60% of revenue. To illustrate, one hypothetical scenario is that KKD’s revenues fall to $600 million, debt rises to $150 million, and the market values the enterprise at 50% of revenue. In that case, the equity value would be roughly $2.40 per share. Of course, there are even more negative scenarios, but there are too many moving parts to be definitive at this point.

Catalyst

Additional news of deteriorating operating results, store closures, asset writedowns, financial restatements, and results of internal and SEC investigations.