It's safe to say most people don't need a background on the business of Krispy Kreme Doughnuts, Inc. (KKD). However, for the benefit of those of you have been living under a rock, are compulsively healthy, or live on the West Coast, I'll provide a bit of background for your edification. Obviously, Krispy Kreme is in the business of selling doughnuts, are they any good you ask, I'll let Chris Rock answer that for you:
"Krispy Kreme Donuts are so good, if I told you it had crack in it, you would be like, 'I knew it was something in there. These donuts are too good."-Chris Rock, 2004
As they say, it's funny because it's true. The company uses two methods of distribution for these delectable delights, retail and wholesale. On the retail side they operate around 230+ stores in 38 states. Internationally there are 460 stores in 20 countries around the world. The company separates these roughly 700 stores into about 300 factory stores and 400 satellite stores. The distinction between the two is that the factory stores double as wholesale distribution centers in addition to their retail capacity, while the satellite stores focus on retailing the doughnuts. All of these stores are run through either direct company ownership or a franchise model.
To have a great business model, you don't necessarily have to have a great product, just look at Herbalife (HLF) for you doubters. However, it obviously helps and after doing some due diligence to refresh my memory, I can confirm that Krispy Kreme still makes a delicious product. While Krispy Kreme has a great product, it historically did not have a great business, which is where our investment opportunity derives from.
Throughout the early 2000's through the credit crunch of 2008, Krispy Kreme expanded its store footprint far too rapidly and funded it with expensive debt with liabilities increasing at a rate of 94% Vs. a 37% decline in equity over the same period. It found itself far too levered to make a profit on a great product. Since 2008, the company has restructured its business model and battened down the hatches. It has aggressively paid down debt and finally has substantial free cash flow to grow the business organically. The best part is, the company turned the corner in fiscal 2011 and turned its first annual profit since fiscal 2004 and have been making consistent quarterly profits ever since.
Earnings turned positive in Fiscal 2011:
The company's near-term plans are to continue expanding both domestically and internationally through the small shop format. In fact it has recently sold the franchise rights to the South Korean market. The difference this time around is that the management of Krispy Kreme is focused on growing the business primarily through organic cash flow and franchising rather than borrowing gobs of money it could barely pay back, and using it to buy-out existing franchises at huge premiums.
"The last decade of the 20th century and the early years of the 21st was a period of rapid growth in the number of stores and domestic geographic reach of Krispy Kreme, particularly following the April 2000 initial public offering. In many instances, the Company took minority ownership positions in new franchisees, both domestic and international. Enthusiasm for the brand generated very high average unit sales volumes as Krispy Kreme stores expanded into new geographic territories, and the Company generated significant earnings driven by the domestic store expansion. The initial success of a number of franchisees led the Company to reacquire several franchise markets in the United States in 2003 and early 2004, often at substantial premiums. By late 2003, average unit volumes began to fall as initial sales levels in many new stores proved to be unsustainable, which adversely affected earnings at both the Company and franchisees, leading to a period of retrenchment characterized by over 240 domestic store closings from 2004 through 2009. The Company's revenues fell significantly during this period, principally as a result of store closings by the Company and by franchisees, and the Company incurred significant losses, including almost $300 million in impairment charges and lease termination costs over the past six years related principally to store closings and to the write-off of goodwill from the franchise acquisitions." 2010 Annual Report
Ultimately, the investment thesis with Krispy Kreme is very simple. It makes a great product, and is finally recovering from terrible management decisions from the first decade of its existence as a publicly traded company that knocked its stock from almost $50 per share in 2003 to around $15 a share today. The next steps before investing are to look at the ROE, the current valuation, and the potential risks.
As you can see, in the above chart, operating margins (green line left axis) have been strongly expanding q/q from a low of 1.4% to 8.3% in Fiscal Q3 2013. While this is very promising, the measures of the drag debt can put onto ROE are even more positive. The leverage ratio (blue line, right axis) has been steadily decreasing from 3.4 Assets to Equity to a much more stable 1.4x A/E. Confirming the reduced burden of debt is the Interest burden (EBT/EBIT) (red line, right axis). Interpretation of the number indicates that the company keeps 95% of operating earnings after paying interest on debt payments Vs. the loss the interest payments caused in 2009.
Krispy Kreme lists its top competitors as Dunkin' Brands (DNKN) and Tim Hortons (THI). This makes the most sense from a business perspective although interestingly Krispy Kreme has the lowest correlation with them among the Quick Service Restaurant Sub-Group. I certainly wouldn't take this to mean that Bob Evans has more in common with Krispy Kreme than Dunkin' does, but rather the market is viewing Krispy Kreme separate from its competitors due to its current resurgence.
By Correlation, the primary competitors are: Bob Evans Farms (BOBE), AFC Enterprises (AFCE), BJ's Restaurants Inc. (BJRI), Starbucks (SBUX), Panera Bread (PNRA), Biglari Holdings (BH), Denny's (DENN), McDonald's (MCD), Buffalo Wild Wings (BWLD), then finally Dunkin' Brands, and Tim Hortons.
The peer comparison is not as clear cut as the case can be in many deep value situations. In recovery and growth investments, it is much more common to run into situations where there can be conflicting measurements. The table below summarizes the relative value to the peer group across multiple metrics.
The first thing that jumps out in this table is the P/E ttm of Krispy Kreme versus the average and versus Dunkin' and Tim Hortons. Looking at this value alone would indicate that based on ttm earnings, Krispy Kreme is trading between 22% and 33% of the value of its peers. This is misleading. There are many issues here but the primary ones are the differing degrees of earnings growth, the different capital structure (leverage), and the size difference between Krispy Kreme and its peers. Accounting for growth, the PEG ratio using the estimate of 1 year forward earnings still shows Krispy Kreme as undervalued compared to its doughnut selling peers, but slightly overvalued to the rest of the industry. Another way of considering the company value would be to look at the Enterprise Value to Book Value. Enterprise value eliminates the effects of capital structure and cash from a company making comparisons across companies more accurate than P/E. This measurement once again shows mixed signals. It points to slight undervaluation relative to all peers and much greater undervaluation relative to Dunkin'.
The way I interpret the valuation data, is that based on trailing earnings, Krispy Kreme is slightly undervalued. However, the potential for earnings growth is much higher than its peers as the recovery story plays out. Therefore, if you value the company on a forward earnings basis, Krispy Kreme appears much more attractively valued.
- Failure to continue execution of controlled store growth
- Litigation or legislation against snack-food companies
- Stalling recovery at the earnings release (3/14/2013) could prompt a sharp drop in the shares.
- General exposure to consumer spending and tastes.
Price Action for Consideration
Krispy Kreme sells a great product that is finally developing a great business to support it. The shares have recovered dramatically over the last twelve months as the company has broken back into consistent profitability. The company is very attractive from a forward earnings perspective as its recovery continues. This article (not published) was originally written when the stock was trading in the mid $12 range and has since begun trading in the low $15 in anticipation of the quarterly earnings release. Ultimately Krispy Kreme is a Buy, although I would recommend investors wait patiently for a dip in price before entering their full position as this is a volatile name and the stock has essentially gone straight up and is due for a correction.