Krispy Kreme (short) KKD S
January 11, 2008 - 2:22am EST by
2008 2009
Price: 2.94 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 193 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV (in $M): 0 TEV/EBIT
Borrow Cost: NA

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After 3 months away from KKD I’m back in for the Short To Zero stage. During 2009 (and maybe 2008 alone) this puppy will be put to sleep. What brings me back? The risk/reward seems way more compelling following the appointment of their talent-less Chairman as CEO for the “foreseeable future”, as well as the shockingly disappointing sale price of the Effingham manufacturing facility. This isn’t yet a full position for me and I might add if circumstances make this even more attractive.

My previous write-up from 2 years ago is under the symbol YDRMA, which is the longest-term $5 LEAP. This write-up is filed under KKD; this time the reader shall choose how to play it. Also worth revisiting is max685’s write-up from 2005. Notwithstanding how detailed those legacy threads were, this new version was composed such that one doesn’t need them as prerequisites, just references. This is also more concise than the previous one. The outline: (1) Summary of past 3 years (2) What options do management/creditors have? (3) Franchisees’ role in all of this (4) Cash flow, Debt, Leverage ratios (5) Real Estate Liquidation Scenario
(1)  Summary of past 3 years
2004 (background): Krispy Kreme, a scale-less doughnut wholesaler, manufactures its food in expensive retail locations and tries to sell ship as fresh as possible, at any cost. It also sells doughnuts retail but very little coffee. Company revealed to have unsustainable cash flow based on a fad, an accounting scandal, and a massive related-party scandal. SEC/DOJ investigate and creditors panic, stock slides to $12 from a high of $50.
H1 2005: CEO Livengood kicked out, KZC hired for cost-cutting and secures high-interest loan [no SEC filings] to replace old cheap loan plus to provide extra cushion. Promises of turnaround abound yet alarming negative FCF + franchisee guarantee calls burn the cash cushion. Franchisee balance sheets look ridiculous. Not many store closures on either franchisee or company side, except for the KremeKo bk in Canada.
H2 2005: three franchisees, outraged at KZC’s behavior, sue KKD. Still no evidence of turnaround, three other franchisees go bankrupt, yet others close stores, company closes 35 of its own stores. It is now understood that MOST newer 4000sq.ft. stores are uneconomic. KKD violates covenants, interest on loan upped to LIBOR+725. Jervik hired as COO, has *some* retail background but no power.
H1 2006: 2-3 more franchisees essentially bankrupt. Thanks to the 35 closures KKD’s FCF becomes break-even and even slightly positive. Some of the JV franchisee relationships are undone, Daryl Brewster hired as CEO. The man has wholesale background, no retail background, yet KKD still confident about retail. Brewster’s team is expected to expand retail by building satellite spokes around existing factory stores. KZC role gradually decreases; KZC has burned a lot of cash. SG&A begins to decline.
H2 2006: KZC retreats almost fully. Only 2 of its consultants are left over. Couple of franchisees go bankrupt and all other franchisees start closing many stores. Company-owned stores start showing signs of strain (both retail and wholesale, both top-line and margins). Brewster is revealed to have no talent. He plays around with wholesale a bit. Steady reports of good employees exiting the company. Plans to open up international franchisees, which were on ice for legal reasons, are now free to be implemented. KKD expands right away into 6 Asian markets. Class-action settlement executed and a couple of legacy directors replaced by new ones. KKD starts filing overdue financial statements.
H1 2007: Financial statements up-to-date: turns out even old Southeast franchisees with unencumbered real estate had had sales declines of ~20% over past 2 years. Term loan balance refinanced with 110mm loan @ LIBOR+300 with more liberal covenants. Two annual meetings take place, some legacy directors resign and are replaced with 2 food veterans that are, to this day, very quiet. CFO + GC resign. A dispute with KZC leads to bad break-up. One of the KZC consultants, betrayed by KZC, joins KKD for a pretty important day-to-day role. But Brewster still bossing him (and others) around, with BOD blessing. Performance of company-owned segment deteriorates very significantly, so KKD closes some more of its stores. Evidence of strain among largest franchisees.
Q3 2007: Two and a half large franchisees blow up (Great Circle, Sweet Traditions, the LBO’d half of Westward Dough). This time the mainstream media catches the chapter 11 filings. Stock downgraded, Cramer + Greenberg turn against it, large shareholders start selling. In early September KKD reports its Q2, which is seasonally weakest. It explicitly discusses franchisee bk’s & covenant violations, and predicts future problems in its own stores too. Language becomes liquidation-oriented and stock tanks. More downgrades follow, large shareholders completely exit. Wall Street swears off the stock, which ends up declining 60% in a week. The COO Jervik is pushed out. Incompetent new COO and CFO are appointed from within.
Q4 2007: In early December KKD reports Q3. Smaller-store format is STILL more talk than action, and unaffordable. KKD says it’ll liquidate one of its two big manufacturing facilities (Effingham, IL). The company declares that the Gillette razor-blade model of ripping off franchisees on equipment & fixtures is finished. Months-long anecdotal evidence suggests franchisees go for supplies elsewhere, Overall, “supply-chain” segment clearly under pressure. International franchising appears to be successful in Japan and less successful elsewhere; donut too sweet. Koreans, Indonesians have competitors. In Middle East traditional desserts taste better. UK & Australia franchisees still opening lots of new kiosks/satellites despite negative FCF, both clearly still looking for a flip. Franchisee KKSF revealed as still being a guarantee problem (5-10mm may be called soon). Sweet Traditions, in chapter 11, reveals horrendous numbers, fails to liquidate stores and is set to be taken over by its secured creditor Allied Capital. In each of Q1, Q2, Q3 KKD makes 5mm prepayment to stay in compliance. Effingham building sold for 11.8mm vs. originally expected 20mm+. Proceeds used to prepay debt. All assets, except stores, are now required to run business. SG&A scaled back significantly.
January 2008: KKD shares have been trading mostly in the 2.50 – 3.50 range since the September shock. Brewster kicked out, Chairman Jim Morgan who has neither good judgment nor retail/wholesale/food talent, is declared CEO “for the foreseeable future”. In the past few months commercial real estate market + retail environment have deteriorated. U.S. Banks, worried about recession and liquidity issues, stretch for deposits and scale back lending. Also, persistent input cost inflation is hurting KKD.
(2) So…. what now?
The brand’s been hurt for many reasons: (i) fad reversal (ii) diet trends (iii) Dunkin Donuts shamelessly going into KKD’s southeast (iv) Tim Horton’s expanding in United States (v) closures and financial troubles. Cash flow is decreasing because: (i) less supplies sales to franchisees (ii) less franchisee stores and therefore less royalty (iii) less scale (iv) decline in company-owned segment’s margins. This is partially offset by: (i) SG&A reductions - I don’t think there’s much more to cut (ii) Asian franchise royalty growth.
So overall cash flow is declining and if you’re a creditor, why would you believe that international franchisees are NOT a fad? I mean yes they are doing a hub-and-spoke system but there is no proof that it works, the leases there are rather expensive and the marketing is still such that they’re dependant, mostly, on the unsustainable fad aspect.
So if long-term cash flow is unreliable and the brand is destroyed, real estate is the only significant collateral.
Over the years I’ve browsed Krispy locations listings, spoken to brokers and looked into specific cases. It is clear that KKD is UNABLE to find new tenants quickly, whether we’re talking about flipping owned land, leased land or structuring a sublease. Krispy Kremes sit dark for long, they often stay on listings for 12+ months. Same thing for franchisees who have tried hard (because their money was on the line). Fixtures in these buildings are annoying to potential suitors. Often the properties end up being sold to banks who spend a lot to convert into branches. Chick-Fil-A is the only company that likes the format/locations. Creditors, obviously, don’t really want the keys either.
FCF right now is slightly above break-even but declining. All along, KKD should have liquidated stores, lowered interest costs, and used the newly grown FCF for further amortization. But they’ve never done that with any urgency and as franchisees go bk, FCF disappears and it’s harder to get into a healthy amortization spiral. Plus now they have the additional burden of retail property bear market. Well…. it’s better late than never and now that KKD has entered the land of persistent covenant violation it appears the BOD will have to do that because creditors are demanding it. The most likely scenario is that *they* asked for Brewster’s head and Morgan’s appointment as liquidator. Morgan might even try to sell the whole thing (won’t get anything close to current EV….). Sale/liquidation is the only thing to do because the company lost too much HR and cannot hire now.
(3) Franchisees’ point of view  
Two years ago KKD was arrogant and had a cash cushion. They’ve been very slow to realize that long-term events and incentive structures take them into an age where they desperately need franchisee talent and royalties. KKD finally seems to have opened up. Though over half of the franchisees lost their battle vs. KKD and are fading memories, those that somehow survived have almost won the war and can help restructure KKD, and ask for board seats in return. If they do that, they’ll give themselves discounts or otherwise channel resources from the franchisor towards themselves. They’ve gotten a break on supply-chain items but they need more. The newer AD franchisees still pay wholesale royalty of 5.5% vs. 1% for their southeastern peers, and 5.5% also on retail vs. 4% in the southeast. This ensures unprofitable wholesale and messes up their business model, plus it’s not fair. Not to mention that the southeastern guys own real estate outright. Another important idea I’ve raised in the past is that pre-IPO KKD had near-zero profit because franchisees were its shareholders, its BOD members etc’. I don’t see a reason why it can’t go back to being that way, especially in an environment where everyone faces headwinds. And besides, the lack of HR, lack of FCF, and SOX costs, all point in the direction of franchisor privatization. In sum, the point of this paragraph is that equity is in competition not just with debt but also with franchisees.
 (4) Cash flow, Debt, Leverage ratios
From this point forward, to avoid confusion, please note FY2008 is roughly calendar 2007. FY2009 will start at the beginning of February.
Let’s look at the business briefly:
-     The franchisor-owned store segment is barely breaking even when seen the way KKD reports it – that is: company-owned stores pay the same mark-ups on doughnut mix that the franchisees do and these mark ups are allocated as profits in the supply chain segment. This metric shows that KKD’s stores are just as bad as franchisee stores on an apples-to-apples basis. This is pre-interest-expense.
-     Another important fact is that the expensive expansion markets are precisely those that are most uneconomic. So if segment is break-even, that’s essentially composed of southeast profits minus expansion market losses.
-     Off-premises sales are continuing to crater. In Q2, the year over year drop was 1.6% in number of doors and 6.1% in sales per door. In Q3 these numbers are 5.7% and 7.4%. Retail seems more stable but that’s after negative comps for a long time.
-     Now, the franchise segment (i.e. royalties) - margins have been in the 70-85% range historically. Obviously this cannot be a money-losing segment, but its profits are going down and corporate SG&A + interest are pressing.
-    The supply chain segment is really changing as I mentioned. Sales and margins are both declining hard now.

Operating profits over the past year:
-         Q1 operating profit was down from 22.3mm to 13.9mm YoY
-         Q2 operating profit was down from 15.5mm to 8.8mm YoY
-         Q3 operating profit was down from 20.9mm to 12.5mm YoY
-         Q4 (and FY2008) will end in 3 weeks
Run rate FCF is probably 6-9mm, which I estimate to be composed of 20mm EBITDA minus 3-6mm cap-ex, minus 8mm interest (LIBOR+300 on roughly 100mm). For covenants lenders use TTM EBITDA. Here’s that figure for FY2008 thus far:
Q1 FY2008:  32.2mm
Q2 FY2008:  29.2mm
Q3 FY2008:  28.6mm
Now let’s look at the debt outstanding:
+Ongoing letter-of-credit balance (varies a bit but we assume 20mm) = $20mm
+Original term loan balance (originated about a year ago) = $110mm
-Q1 prepayments = 5mm Voluntary + 4.3mm asset sales = 9.3mm
-Q2 prepayments = 5mm Voluntary + 0mm asset sales = 5mm
-Q3 prepayments = 5mm Voluntary + 2.6mm asset sales = 7.6mm
-Q4 prepayments = 0mm Voluntary + 11.8mm Effingham sale = 11.8mm
=Current debt leftover at the end of Q4 = $96.3mm
Here are the quarter-end required leverage ratios + comments, assuming 96.3mm debt:
Q4 FY2008: 4.0x
At current debt load KKD would need TTM EBITDA > 24.1mm. This quarter the calculation drops the prior year’s Q4 EBITDA (6mm) and adds this Q4’s, which, therefore, needs to be = 24.1 - (28.6 – 6) = 1.5mm. Not too difficult, they’ll probably make it.
Q1 FY2009: 3.75x
At current debt load KKD would need TTM EBITDA > 25.6mm. At the rate that EBITDA has been declining (about 2mm per quarter YoY), it’s very possible the calculation goes below 25.6mm. I think we’re going to have 23-25mm at that point. Problems include the ST/ALD situation, the liquidation of which would cost KKD about 3mm in annualized EBITDA and therefore perhaps 0.5mm during Q1. Also, KKD could be hurt by potential pain at other franchisees, inflation pressures as well as wholesale customers increasingly asking for consignment arrangements. But they might make it.
Q2 FY2009: 3.5x
At current debt load KKD would need TTM EBITDA > 27.5mm, this is not doable at all. In other words KKD must prepay debt during H1. How much? Assuming EBITDA deterioration of 2mm per quarter, the end of Q2 finds KKD at 22.6mm TTM EBITDA, Multiplying by 3.5x = 79.1mm required debt balance, i.e. $17mm worth of prepayments.
Where do they get that? Cash & FCF isn’t the answer. With my FCF estimates above, even if they bring cap-ex to zero, they won’t generate more than 4mm in H1 due to Q2 seasonality. This plus any cash on hand are likely be needed to run the business, cushion against franchisee receivable non-payments, franchisee bk’s, and potential KKSF guarantee calls of $5-10mm. In order to generate that 17mm KKD needs to hire property-flipping consultants; such consultants, by the way, will further ensure that any excess cash is soaked up. Then they need nice discounting plus good execution. Successful store liquidation on that scale has never been done by KKD or its franchisees, even in cases of emergency. But of course this isn’t such a big deal – after all we’re only talking about $17mm here! But discount is the key word. What happened with Effingham in Q4 will have to happen with company stores in Q1 and Q2.

(5) Real Estate Liquidation Scenario

We only have the owned/leased breakdown as of January 28th 2007 so I’m going to value that and then subtract the value of properties sold during 2007. KKD owns land under 47 stores, owns building on leased land at 52 stores, and leased everything at 9 stores. There is also a potentially free Winston-Salem industrial facility.
Of the 47 owned outright, 32 existed in 1999 (old, small, southeast); their value = $500k land + $100k building for a total of $19.2mm. The other 15 are fancy 4000 sq.ft. stores. Average value = $2mm at most. The 52 owned buildings on leased land have negligible worth due to customized design. Land leases have sometimes been abandoned and sometimes sold for over 1mm. It depends of course on individual circumstances. Based on everything I know I take all 61 at $300k average. We also have a 100,000 sq.ft equipment manufacturing and training facility which I think is no longer needed. At $60 per sq.ft we add another $6mm. All together that’s 54.3mm. Subtracting the 16.9mm of stores sold this year leaves us with $37.4mm of real estate value.
In a fire-sale environment this could fetch 30mm, give or take. As we said, this figure assumes the shut down of 32 old stores which are profit-generating. The company doesn’t break out southeast profits but I think we could be looking at 5mm in EBITDA. If KKD wanted to maintain ~20mm EBITDA, only 18mm worth of hard assets are available for sale. In other words, if they keep the southeast stores and liquidate the newer stores + the unneeded plant in a very successful fire sale, it will suffice to prepay the 17mm at the end of Q2.
So let’s assume they execute well: 17mm in asset sales by Q2 and KKD stays alive with 20mm EBITDA; the debt balance is now at the 79.1mm required to satisfy the 3.5x leverage ratio (59.1mm term loan + 20mm letters-of-credit). Even if all this happens, they’re still in trouble because they’ll violate covenants again in Q3! And even if we assume an extra free cash flow of 10mm (or maybe fire-sale proceeds of 10mm above projections) they would still violate the Q3 leverage ratio and have 49.1mm outstanding under the term loan, which should scare lenders anyway. For example, at a forward run-rate FCF of 12mm (20mm – 5.5mm interest – 2.5mm cap-ex) , the cash-on-cash payback time on that 49.1mm is 4 years. Would lenders stick around for 4 years as franchisees go bankrupt and macro pressures build? Probably not; with Krispy getting into a scenario of perpetual leverage ratio violation, in an environment where it is unlikely to find conventional refinancing, I think the lenders are in full control and have an incentive not only to set up prepayments & rate hikes but also to force strategic alternatives.
So what will KKD do when it violates covenants again in Q3? One option is to continue: liquidate the old southeast stores; then we’re looking perhaps at 35-40mm in term loan balance left over, and therefore FCF = (15mm EBITDA – 4.5mm interest – 0 cap-ex) = 10mm. That’s a cash payback time of 3.5 to 4 years, not much better. A southeast fire-sale isn’t really worth it considering the effects: reduced future potential, reduced scale, substantial brand damage. The “strategic alternatives” option is better.
Time might be given for a normal buyout but that’s fantasy. Beyond this, creditors are better off in a situation where KKD’s equity is valued low enough to attract potential saviors. Hiking interest and/or declaring default is the best way to cause such pressure. If the market cap violates the NYSE’s 75mm threshold, KKD goes to the pink sheets and someone like middle-east franchisee & shareholder Nasser Al-Kharafi can come in for a deal that’s attractive to him as well. Al-Kharafi is probably concerned about the Brewster-Morgan switchover. At less than 75mm market cap and 70mm in total debt he can easily pull an equity/convert deal that gives him 50%+ ownership and make the creditors whole. Then, since we’re talking pink sheets, it’s really not hard or him follow up with a takeunder Oh, and give himself a zero royalty policy; or maybe even use KKD’s FCF the good old Livengood/McAleer way. I’m just thinking through scenarios here, this is not a firm prediction. A 50%+ owner might also use the occasion to foster confidence in a new debt-less KKD, bring in fellow franchisees to revamp the business model and instill confidence for a re-accelerated expansion of Asian markets and maybe even, one day, put together a satellite model in the U.S. If he wants to make back the money he lost on this thing, this is the way to do it. ALD could also do something like this if they want to but I suspect they’re now sick of Krispy Kreme.
The key is this: ALL big shareholders except Al-Kharafi are gone. Other franchisees and their potential sponsors are competing with equity holders. No one in management owns enough shares to care. KKD management barely even exists. All AD franchisees are psychologically fatigued. All Asian franchisees are wealthy/big enough to not care one way or another. All southeast associate franchisees are too small to do anything and they own the real estate outright so they can just liquidate it and move on. KKD’s term loan was originated less than a year ago with 3:1 oversubscription. Creditors have gradually started feeling more queasy almost as soon as the ink dried. In my view KKD common is about to be short-changed. Short-changed to zero.
** Risks **
-    Stupid white knight.
-    International expansion explodes upward way faster than expected while domestic closures abate.
-    One of the franchisees musters up ambition to join BOD, make peace, work hard, perhaps with the ambition of becoming CEO, convinces creditors to wait while he partners with a coffee chain, uses day-parts and sells new products.


(1) Franchisee closures, bankruptcies or guarantee calls (2) franchisee politics (3) creditors become more nervous (4) credit markets and retail property markets deteriorate (5) more input cost inflation (6) SEC/DOJ investigation ends (7) franchises find alternate source for mix (8) supply chain segment loses scale (9) company southeast stores forced to shut down (10) corporate SG&A’s operating leverage works in reverse (11) equity bear market (12) NYSE delisting (13) equity/convert deal (14) infighting of any kind (15) analyst downgrades (16) every 10-Q (17) more top-level resignations
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