2023-08-18 09:28:46 ET
Summary
- Domestic and international expansion prospects are cautiously optimistic.
- Increasing adoption of hub and spoke model in the U.S., international expansion driven by franchise stores, automation efforts, exit of lower-margin Branded Sweet Treats business could be margin positive.
- Risks include overexpansion and execution risks.
- Valuation is pricey.
Krispy Kreme's (DNUT) "doughnut logistics" strategy could deliver top line growth and margin expansion but valuation is pricey.
Company overview
Krispy Kreme is a fresh doughnut producer and retailer, operating in the U.S., as well as certain international markets including the UK., Australia, New Zealand and Japan. The company has traditionally relied on a wholesale distribution model which focused on franchised stores and capital-heavy company-owned stores ("Hot Light Theatre Shops" which have manufacturing facilities on-site and "Fresh Shops" which do not), however their new "doughnut logistics" strategy follows a "hub and spoke model" whereby fresh doughnuts, produced in "hubs", are delivered to "spokes" which are retail outlets comprising Krispy Kreme's shops or capital-light retail outlets ("Delivered Fresh Daily" or DFD doors) located in grocery stores, convenience stores, etc. The average capital investment for a Hot Light Theatre Shop is around $2 million - $4 million, Fresh Shop is around $0.1 million - $1 million, and a DFD door is around $2,000 - $10,000.
Background
Krispy Kreme continues to deliver decent top line growth partly due to the acquisition of franchise units and partly due to growth initiatives as well. Profitability, although still in the red, appears to show consistent (albeit very marginal) improvement over the past few years. The momentum this year is encouraging as well; for the first half of 2023, Krispy Kreme's net loss of $100 million is a slight improvement from the $200 million loss recorded the same period last year.
Several growth drivers including international expansion through capital-light franchise stores, and domestic DFD expansion
Looking ahead, Krispy Kreme's top-line could benefit from a number of growth drivers. There is still room for further expansion in the U.S. where Krispy Kreme doesn't have a presence (in cities such as Boston and Minneapolis according to their latest 10-K). Krispy Kreme currently has about 6,000 DFD Door (Delivered Fresh Daily) locations and has ambitions to more than double that to 15,000. Their McDonald's partnership could be the key to spearheading a nationwide DFD expansion over the coming years. McDonald's currently has about 13,500 locations.
Krispy Kreme is also exploring international expansion opportunities. The company's International segment accounts for around 24% of revenues, generated from the U.K., Ireland, Australia and New Zealand while their Market Development segment which includes revenues from markets like Japan as well as revenues from franchise operations internationally accounts for 9% of revenues. Krispy Kreme management has identified 75,000 potential new access points worldwide (deducting their targeted 15,000 in North America means a potential 60,000 access points around the world, representing a potential ten-fold increase from around 6,000 access points currently). In line with their strategy of entering five to seven countries this year, Krispy Kreme opened their first franchise shops in Chile, Costa Rica, and Jamaica last quarter.
Krispy Kreme 10-K, FY2022
Several avenues to increase margins
The Hub and Spoke model is still relatively un-developed in the U.S. with about a third of hubs having no spokes in contrast to international hubs all of which have spokes. Continued portfolio transformation could be margin accretive; U.S. cities that have changed from the legacy wholesale business to the hub and spoke model are reportedly seeing a 300-400 basis points benefit to margins.
Krispy Kreme 10-Q, Q2 2023
Additionally, a potential nationwide rollout in partnership with McDonald's could support further margin expansion due to scale economies; JP Morgan analysts estimate potential store margins as high as 40% .
Furthermore, the company's international expansion has so far been driven by franchise stores . Further global expansion through franchises could be positive on margins as franchise stores are substantially more profitable than company-owned shops.
A $6 million investment on automation is expected to deliver $2 million annual savings according to a report in December last year. With that investment covering just 18% of Krispy Kreme's donut production, further cost savings down the road could be margin accretive.
In addition, Krispy Kreme's exit of their Branded Sweet Treats business is a positive for profitability as the business was margin dilutive.
Risks
Inconsistent dividend history
Krispy Kreme has a checkered dividend payment history and last year's FCF just barely covered dividend payments (that too thanks to a 5% YoY dip in CAPEX). If revenue growth keeps up and margins improve, the company may be able to maintain their dividend (the company expects CAPEX of around $105 million - $115 million for the coming fiscal year) however if revenues and margins deteriorate more than anticipated, the dividend may be at risk which may have a negative impact on their stock price.
Dec 2018 | Dec 2019 | Jan 2021 | Jan 2022 | Jan 2023 | |
Operating cash flows | $148 million | $81 million | $29 million | $141 million | $140 million |
CAPEX | $43 million | $76 million | $98 million | $120 million | $112 million |
Free cash flows | $106 million | $4 million | -$69 million | $22 million | $28 million |
Dividend payment | $30 million | $2.6 million | 0 | $48 million | $23 million |
Overexpansion and execution risks
Krispy Kreme is no stranger to overexpansion, having been in that position two decades ago which resulted in ballooning losses and a steep drop in share price. Although some may argue that their expansion strategy is different this time since it is based on a theoretically capital-efficient "donut logistics" model, cost overruns and execution missteps could result in negative results, potentially worsening their currently fragile profitability metrics.
Conclusion
Krispy Kreme has a moderate buy analyst consensus rating, and a hold rating on Seeking Alpha's quant system.
Assuming a 9% revenue growth rate over the coming four years (based on 11% annual expansion of Global Access Points to meet their targeted 18,000 Global Access Points by 2026 ), net margins increasing a few percentage points to roughly 4% by 2026 (based on product and distribution costs dropping from 26.6% of revenues currently to 24.5% by 2026 to account for moderating inflation, scale economies, automation-driven cost savings, as well as improving store economies due to their U.S. transformation to a Hub and Spoke model, offset by costs incurred due to portfolio transformation efforts; operating expenses dropping from 46% of revenues currently to about 44.5% by 2026 and SG&A dropping from 14.6% of revenues currently to about 13% by 2026 to account for higher revenues being spread across their fixed cost base; and all other costs remain roughly the same as a proportion of revenues), a terminal growth rate of 2%, depreciation of around 7% of revenues, neutral working capital, CAPEX of around 7% of revenues, and a WACC of 10%, suggests Krispy Kreme is worth a little under $1 billion, considerably less than its current market value.
Author
A forward P/E of 41 (considerably higher than the sector median of 16 ) and a high short interest of over 10%, further suggests a pricey valuation.
Seeking Alpha
The stock may be a hold for investors willing to tolerate the risks.
For further details see:
Krispy Kreme: Cautiously Optimistic Prospects But Pricey Valuation