2023-06-26 17:26:59 ET
Summary
- Krispy Kreme is expected to experience revenue growth due to price increases, global Point Of Access expansion, and a strong e-commerce channel.
- The company is likely to benefit from improved margins through price increases, an optimized business mix, moderating inflation, and operating leverage.
- However, the stock's expensive valuation at a P/E of 42.46x FY23 consensus EPS estimates does not present an attractive entry point, leading to a neutral rating.
Investment Thesis
Krispy Kreme, Inc. ( DNUT ) is expected to experience revenue growth due to the carryover impact of recent price increases, as well as planned incremental price increases in the coming quarters. The company's strong global brand awareness and the expansion of new Point Of Access (POA) both domestically and internationally should help attract new customers and increase purchase frequency per customer. Additionally, the growing strength of the e-commerce channel is expected to contribute to the company's sales growth.
On the margin front, Krispy Kreme should benefit from price increases, an improved business mix achieved through optimization of the U.S. hub and spoke network, moderating inflation, and operating leverage. However, my main problem with the company is its expensive valuation. At a P/E of 42.46x FY23 consensus EPS estimates, it seems like these prospects for revenue and margin growth are already factored into the company's stock price. Therefore, the current higher valuation does not present an attractive entry point, and I have a neutral rating on the stock.
Revenue Analysis and Outlook
In my previous article , I discussed Krispy Kreme's strong sales growth prospects, primarily driven by its robust POA expansion. However, due to the company's expensive valuation, I chose to remain on the sidelines. Since then the company has reported better-than-expected Q1 earnings but the stock has remained flattish to slightly down because of valuation concerns.
During the first quarter of 2023, Krispy Kreme benefited from price increases and the expansion of its POA. Additionally, the company experienced strong demand on e-commerce platforms, contributing to a 12.5% year-over-year growth in sales, totaling $419 million. Excluding a 1.5 percentage point headwind from foreign currency and a 0.5 percentage point benefit from acquisitions, sales grew by 14.4% year-over-year on an organic basis.
DNUT's Historical Sales (Company Data, GS Analytics Research)
Looking ahead, I am optimistic about the company's ability to achieve revenue growth. Krispy Kreme is well-positioned to capitalize on several factors, including price increases, global POA expansion, and the strength of the e-commerce channel.
To offset cost inflation, the company has successfully implemented price increases. This strategy began in the second half of 2022 and continued into the first quarter. Furthermore, Krispy Kreme plans to pursue additional pricing actions in its international markets. These price adjustments, coupled with the carryover impact from previous increases, are expected to continue driving sales growth throughout the year.
In addition to the positive effects of pricing, the company anticipates sales growth through volume expansion. This is attributable to the increasing number of POAs both domestically and internationally, which enables Krispy Kreme to attract new customers and drive higher sales volumes. Since Q4 2019, the company has achieved an impressive 104% increase in its total POA count, reaching 12,410. Notably, the opening of Delivery Fresh Doors (DFD) has experienced a remarkable 136% growth within the same period, totaling 10,390. Krispy Kreme is actively expanding its DFDs in new channels such as QSR, drug stores, and clubs. For example, the company has successfully rolled out 160 DFDs at McDonald's ( MCD ) restaurants in Kentucky, and accelerated its POA expansion by introducing DFDs in drug stores through Walgreens ( WBA ) in the U.S., and in clubs through Costco ( COST ) in the U.K., Canada, and Australia. Furthermore, last quarter, Krispy Kreme established more than 350 DFDs with existing customers like Walmart ( WMT ) and Publix, as well as emerging customers like Target ( TGT ) and Albertsons ( ACI ). This ongoing expansion of DFDs supports the company's acquisition of new customers and drives increased sales per hub.
DNUT's Historical Total Point of Access Count (Company Data, GS Analytics Research)
To enhance sales per hub, Krispy Kreme is implementing larger DFD display cabinets, which have shown a remarkable 70% increase in sales per door. In the first quarter, the company installed three of these premium cabinets in grocery stores, including Kroger ( KR ), and a test with Target is anticipated in the coming months. The company is also focusing on improving the donut shop experience by upgrading equipment in drive-thrus, which accounts for approximately 60% of retail sales in the United States. Additionally, digital kiosks have been introduced in select locations across the U.S., receiving positive feedback from customers and enhancing overall satisfaction.
Furthermore, the POA expansion extends beyond the U.S. to international markets. In the first quarter, Krispy Kreme opened its first store in Chile, and plans are underway to open three more in the second quarter, including locations in Switzerland, Costa Rica, and Jamaica. The company is on track to expand into up to seven new countries this year, with expectations to sign three to five new development agreements for additional countries to open in 2024. This includes expanding into Western Europe and South America. The company's pipeline of new hubs and stores from franchise partners now exceeds 1,000 stores over the next five years, which will further expand its points of access in these markets. The global POA expansion is expected to continue driving sales growth as the company targets an annual POA growth rate of 10-15% and aims to reach a total of 75,000 POAs in the long run.
Moreover, the company is well-positioned to benefit from the strength of the e-commerce channel. The acquisition of Insomnia Cookies in 2018 has played a significant role in driving e-commerce growth. Insomnia Cookies operates under the late-night bakery concept and generates the majority of its sales through online platforms. The strong demand for Insomnia Cookies resulted in a 23% increase in e-commerce revenue in the first quarter compared to the previous year, and contributed to a 220 basis point increase in the sales mix of e-commerce, accounting for 19.6% of retail sales during the quarter. Krispy Kreme plans to expand Insomnia Cookies internationally by opening stores in the U.K. and Canada later this year, further supporting the growth of the e-commerce channel and overall sales. The company is also investing in upgrading its webpage and app to enhance the customer experience when ordering online. Additionally, the launch of a loyalty program in the U.S. early next year is expected to increase customer engagement. Krispy Kreme already has over 11 million loyalty members in the U.S., and this program aims to further strengthen customer relationships. These initiatives should continue to support overall sales growth in the future.
During the Investor Day held in December 2022, management acknowledged that the biggest challenge for the brand is consumers' inability to access donuts whenever they crave them. To address this, Krispy Kreme is focused on expanding its footprint by robustly opening POAs in every locality and improving its e-commerce platform. This global POA expansion, along with the growing strength of the e-commerce channel and strong brand awareness, is expected to increase purchase frequency per customer from the current 2-3 times and support sales growth in the years to come. Therefore, I maintain an optimistic outlook regarding Krispy Kreme's sales growth prospects over the coming years.
Margin Analysis and Outlook
Inflationary pressures have emerged as a significant challenge for companies in various sectors, and Krispy Kreme has not been immune to its impact. During the first quarter of 2023, the company encountered headwinds arising from inflationary pressures on raw material and labor costs, along with unfavorable foreign exchange movements. However, Krispy Kreme effectively mitigated these challenges through strategic price increases, optimizing hub-and-spoke operations, streamlining labor utilization, and leveraging volume advantages. As a result, the company managed to maintain a steady year-over-year adjusted EBITDA margin of 13.1%.
DNUT's Historical Adjusted EBITDA Margin (Company Data, GS Analytics Research)
Looking ahead, I anticipate that Krispy Kreme will be able to expand its margins. The company is currently experiencing a softening in prices for key commodities such as wheat and edible oils , and it expects inflationary pressures to further moderate in the second half of 2023. This should alleviate some of the inflationary impacts on margins. Additionally, Krispy Kreme has plans to implement additional pricing measures, particularly in Australia (where inflation is currently a significant challenge) in the second quarter of 2023, as well as for Insomnia Cookies. These additional price increases, along with the carryover effect from previous pricing actions, should assist the company in offsetting high commodity and labor costs. Furthermore, the company anticipates a favorable shift in foreign exchange conditions starting in the fourth quarter of 2023, as it faced adverse FX effects in the fourth quarter of 2022. This favorable FX environment is expected to contribute to margin improvement towards the end of the current year and into the next year. Additionally, the company's robust top-line performance should enable it to benefit from operating leverage, further supporting margin growth.
Furthermore, as mentioned in my previous article , Krispy Kreme is enhancing its business mix by exiting lower-performing hubs without spokes, which do not benefit from the DFD expansion. In the first quarter, the company closed 29 shops and transformed them into different shop formats. This resulted in a 180 basis point margin improvement year-over-year in hubs without spokes. The company expects an additional five to ten shops to undergo this transformation process by the end of 2023. These efforts will further enhance the business mix and contribute to margin growth. Additionally, the rollout of larger DFD display cabinets is expected to contribute to margin improvement by generating favorable volume leverage. Therefore, I anticipate that the company should experience margin growth in the coming years.
Valuation and Analysis
There is little not to like about Krispy Kreme's business as of now. However, my biggest problem with the company is its valuation. I am a big believer in Warren Buffett's investment philosophy that "It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price."
DNUT is currently trading at a P/E of 42.46x the FY23 consensus EPS estimate of $0.34 which is much higher than other growth companies like Starbucks ( SBUX ) which trades at a P/E of 28.69x FY23 consensus EPS estimates.
Recently, the stock has been in the news as billionaire investor Ron Baron, well known for his Tesla ( TSLA ) investment, commented that he has bought the stock at current levels. While I admire Ron Baron's success with his Tesla investment, unlike Tesla, DNUT doesn't have any sustainable competitive advantage in my opinion, and at some point, it will start getting impacted by competitive threats. Also, Krispy Kreme's exposure to sugary products isn't something I am a big fan of, as health issues stemming from sugary products may start impacting its sales growth in the long term.
So, while the company's prospects look good, I am not comfortable buying the stock at a significantly high valuation. Hence, I have a neutral rating on the stock.
For further details see:
Krispy Kreme: Expensive Valuations Keep Me On The Sidelines