Description

INVESTMENT THESIS & CATALYSTS         

Krispy Kreme, Inc. (“DNUT” or the “Company”) went public in July after five years of being held privately by JAB Holding Company. JAB are solid operators but with DNUT they acquired a struggling asset facing troubles beyond their control nor ability to rectify. After mixed performance of its strategy, JAB reduced its stake to 37% following June dividend recap/ July IPO. Krispy Kreme is a stagnant business limited by regional appeal that is only growing at a 1-3% organic growth rate despite increasing the number of points of sale by +50% over the same time period. This fact has been obscured by re-franchising, acquisitions and IPO marketing materials that focus on its +19% total revenue growth. These acquisitions have left the Company saddled with nearly four turns of debt and limited capacity for further inorganic growth. Future performance is predicated on international expansion, increasing the number of wholesale outlets, and raising repeat purchase rates, all of which present significant structural and competitive challenges.

Meanwhile, its shift away from freshly-baked doughnuts served hot with its push into gas stations and wholesale over the last four years (now accounting for 90% of US doors) has created QC issues and has severely tarnished the brand—now just selling common glazed doughnuts. The concept is in a no-man's-land between made-to-order/ fresh and coffee chains that sell pre-made doughnuts. To further obscure performance at the IPO, DNUT curiously chose not to report SSS or any relevant KPIs. In its roadshow it instead focused on irrelevant metrics like "media impression" growth. Expectations are off-base and we believe performance shortfalls over the coming quarters will lead to 50% downside to the stock. DNUT is presently GC.

BACKGROUND

Krispy Kreme originally went public in 2000 (former ticker: KKD) and was primarily a franchise model with a strong presence in the Southeast. At the time the majority of its locations baked doughnuts on-site in Hot Light Theater Shops and served them “fresh and hot.” This made the SE market particularly well suited for Krispy Kreme given the lack of local bakeries and fact that up until recently far fewer grocery stores in the region baked fresh in-house (that is still in-part the case). The concept offered a unique customer experience (watching your doughnut get made) and delicious product. Growth and performance expectations, however, began to fall short, leading to a tumultuous tenure as a public company. International expansion faltered and problems in domestic expansion arose due to the fact that these locations cost $1M-4M to build out with new locations producing low ROIs, significantly limiting the potential franchisee base. As a solution, the Company created smaller format “Fresh Shops” that serve the same products but lacked the capacity to bake fresh. This set a lower buy-in for franchises with $150k-$1.5M buildout cost but lost was the experience and ability to serve the product “Hot Now.” Once the item cools, it is undifferentiated from any other glazed doughnut (64% of 2020 sales).

JAB

The Company continued to struggle, failing to resonate and generate brand awareness outside its core SE region. Then in 2016, Krispy Kreme was acquired by JAB for $1.3B (18.3x EV/ forward EBITDA). Part of DNUT’s appeal to JAB was predicated on its belief that they could turnaround the business by implementing operational improvements (digitization, online and delivery expansion, bolster supply chain, etc.) and enhance and expand DNUT’s coffee offering (to attract daily repeat customers). This playbook has been working well with its subsequent acquisition of Panera Bread and Pret but faltered with Krispy Kreme.

Following the acquisition, JAB brought in new management who expanded into smaller markets and the wholesale channel with pre-packaged doughnuts distributed to grocery and c-store locations through partnerships with Walmart, Kroger, Albertsons, etc. This led to growth in doors but a loss of freshness (products were often +5 days old on the shelf and obviously not hot). Facing quality control issues and even less fresh products, the Company launched a program it calls its “Hub & Spoke Strategy” whereby it bakes its doughnuts through its network of manufacturing facilities and in Theater Shops and distributes them to all its points of access on a daily basis. Even if DNUT is able to reach these locations with fresher doughnuts, the channel and concept itself faces some major challenges:

• Almost all supermarkets sell freshly made glazed donuts of comparable or better quality than Krispy Kreme’s which are sold in a box on a shelf versus the grocery store offering which often are displayed on a baking sheet.

• The strategy requires a high population density given the low frequency of purchase (average customer only purchases Krispy Kreme doughnuts just over twice a year) thus limiting the model and its economic viability outside urban and suburban markets. Daily delivery also requires a capital intensive fleet of vehicles.

• The packaging and presentation are the same so unclear if customers will even notice the change.

• One industry expert said he was hearing that DNUT “started shipping frozen donuts and glazing hot in new markets.” He noted that, “cannibalization in specific markets was high given low frequency of purchase” (ie. market cannot support more than a couple locations).

• Also noted, “have tapped out the attractive markets and opening in low volume/ low population density areas. Legacy stores look dingy and need overhaul. Opening in highway track stops doesn’t make any sense. Even in the core Southeast region, nostalgia of the freshness was diminished by expansion.”

Over the course of 2018-2019, the Company acquired its perpetually struggling franchises in Australia (territory rights with 29 locations for $123M), Mexico (231 locations for $76.8M), Japan and US (22 stores for $26.6M) as well as specialty cookie company Insomnia Cookies ($139.5M for 75% interest with 136 locations). This transitioned the business from 90% franchise/ 10% company-owned to nearly the inverse, 86% 14%. DNUT touts that this elevated number of company-owned stores affords it a high level of control over product quality. This may be the case with its stand-alone retail locations but clearly is not the case with its in-store kiosks and displays where it has a natural reliance on its retail partners to drive traffic growth at its DFD locations. The reality is that refranchising was a means to bailout struggling franchisees and optically boost revenue growth as part of its repackaging into the IPO.

Prior to being acquired, the Company made multiple attempts to increase coffee sales. As the owner of a portfolio of coffee chains (Peets, Caribou, DE, Espresso House), JAB should have been better suited than anyone to leverage those assets to grow DNUT’s coffee sales. These efforts did not gain traction and an attempt to develop a Krispy Kreme branded coffee failed as well. Coffee currently accounts for ~5% of revenue, approximately the same level as 2016.

Here are the most noteworthy insights about the turnaround that we learned (these are direct quotes):

• Restructuring the company was unsuccessful. Reducing 30% of its employees, without planning/foresight, had a massive backlash. The company not only lost control over its franchisees and thereby sales and quality, they also have not opened any new markets in the last 4-5 years. Buying out international franchisees, without understanding the markets or their business model, has led to massive debt.

• The brand has been driven into the ground to a point of no return.

• Absolutely no focus on a coffee program. They don't believe in it, despite the great coffee chains JAB owns. Each of the international markets has their own coffee program, coffee beans, coffee machines - no consistency in quality or branding. Top management has always taken the stand that KK is a doughnut concept.

• JAB strength is great at delivery and online ordering and when they bought Insomnia Cookies they brought in an exec from Panera who pushed the needle.

UNIT GROWTH & INTERNATIONAL EXPANSION

Following its July IPO, the Company had 9,575 outlets--1,527 retail shops (378 larger footprint theater-style, 1,149 smaller stores, 199 Insomnia cookie locations) and 7,849 DFD doors (kiosks and wholesale shelves) in 30 countries. The International growth leg of the bull story is limited by the fact that in every new market it enters, it needs to establish its brand from scratch. One of DNUT’s competitors told us that they abandoned their expansion into Europe given QC and ingredient procurement challenges, the need for a local team (higher overhead per region) and most significantly cultures that consume less sugary snacks and prefer local bakeries when they do. They also noted they never pursued entering the Canadian market given Tim Horton’s dominance. The international markets where Krispy Kreme already has a presence have underperformed and struggled.   

COMPETITION

The domestic doughnut market is mature and saturated. Brick and mortar competitors include large national chains like Dunkin’ Brands (DNKN), Tim Horton’s (privately held by 3G), Cinnabon (privately held by Roark Capital), to a lesser degree Starbucks (SBUX) and emerging franchise concepts like Duck Donuts. At the local level DNUT competes with independent coffee shops, bakeries, cafes, local gourmet markets and grocery store bakeries. At the wholesale level, its product is nearly indistinguishable from doughnuts baked in-house at grocery stores.  

CATEGORY DECLINE

The domestic “indulgent food” category (which includes baked goods, confectionery, and ice cream/frozen desserts) is mature and stagnating. Overall sugary snacks sales volumes have been on the decline in the US due to improved health awareness/ diet and a movement away from highly-processed sugar snacks like doughnuts. According to Euromonitor the category declined from 2017-19, experienced a boost from pantry loading during the pandemic and is now expected to grow at an annualized rate of just 20bps from 2020-2025.

The average American may lack health awareness but it is pretty universally understood that doughnuts are very unhealthy, particularly ones with 32 ingredients like DNUT’s glazed. They are essentially a cliché of what not to eat. According to our research, unlike candy bars, ice cream or other sugary snacks which many people eat on a weekly basis, consumer purchasing trends of doughnuts are such that they are typically bought on special occasions such as birthdays, when on vacation, etc. The average customer only purchases Krispy Kreme doughnuts 2.5x a year, making it a very low average customer repeat concept. Part of management’s plan to reaccelerate revenue growth is to increase purchase rates to three to four times per year. Our conversations with former employees and competitors indicate this is unattainable. Competitor Duck Donuts has been growing units fairly rapidly and developing a bit of a cult following. A former executive from that chain said that having a customer return even three times per year is very aspirational.

FINANCIAL PROFILE & VALUATION 

Management claims that having 73% of its locations company-owned affords it a high level of control over product quality when in reality it is not only highly-reliant on its retail channel but is now an asset intensive business that only derives less than 3% of its revenue from royalties. Management blames its poor 2020 performance on the pandemic impact yet its grocery and channel partners never closed and there were only limited closures of its locations (most of which have a drive-through offering). In some regards, DNUT should have benefited from aspects of the pandemic where people temporarily reduced their eating standards. Regardless, the expectation of 10% annual revenue growth while maintaining margins is unrealistic given the shift towards healthier eating habits/lifestyles, various other elements outlined and model’s sensitivity to inflation (in particular its asset intensive distribution network).

The Company has very low earnings quality with lots of addbacks—FY2020 net income was -$61M versus adjusted net income and EBITDA of $42M and $145M, respectively. It is also now a very capital intensive business, spending $98M on capex last year and $52M so far YTD. DNUT is currently trading just below its IPO price of $17 per share or 20x EV/ forward adjusted EBITDA. On an absolute basis this is a very rich multiples for a challenged business. DNUT is even trading at a premium to where JAB acquired the business (18.3x EV/ forward EBITDA). Based on its franchise mix and growth profile, the stock should trade in-line with Bloomin’ Brands (BLMN, 21% franchise), Texas Roadhouse (TXRH, 15%), Brinker (EAT, 33%), Darden (DRI, 0%) and Cheesecake Factory (CAKE, 0%) or bakery good companies like Hostess (TWNK) at 8-14x EV/ forward EBITDA. This equates to $5-$11 per DNUT share, representing a 40%-70% return on the short. 

We could see a scenario where the stock really cracks once people look at the numbers more closely and gain a better understanding of the challenges the Company faces. Sell-side initiated last month and none of them could substantiate the current valuation (removing some sell-side promotion risk).

OTHER RED FLAGS & CONSIDERATIONS   

• The largest technical risk is that DNUT becomes a meme stock given its ticker and retail awareness of the brand. The beginning of options trading, which seems to be a big trading boon for IPOed meme stocks, has now passed. These trading spikes in names like HOOD seem to have become very short lived when they do occur but is indeed a risk in the event of a buy-in.

• In June, several weeks prior to IPO, JAB undertook a $500M dividend recap which ultimately reduced its ownership to 37% of S/O following the offering.    

Catalyst

Performance shortfalls

Awareness of the challenges facing the business

IPO unlock