2023-04-17 16:16:15 ET
Summary
- Krispy Kreme is one of the world's most renowned fresh doughnut and sweet treats producers.
- Their huge geographic spread, iconic brand and tasty products drive a relatively wide economic moat for the firm.
- A poor start since their IPO has left significant uncertainty clouding the future for the company, despite positive turnaround results.
- Current valuations combined with growth estimates leave little for value-oriented investors to latch on to.
- Krispy remains a Hold unless earnings estimates increase or share prices drop.
Investment Thesis
Krispy Kreme ( DNUT ) is one of the world's most iconic doughnut manufacturers. Their wide range of donuts, specialty products, and other sweet treats combined with a truly global presence means the company can harness the spending power of multiple different demographics.
A consumer-oriented business model has seen popularity and revenues grow significantly over the last four years. However, the company's turnaround project involving a transition to a new operational structure has led to net losses and poor profitability.
Therefore, a fundamental company analysis combined with an intrinsic and absolute valuation is required to assess any real opportunity that may lie in Krispy Kreme for value-oriented investors.
Company Background
Krispy Kreme is an American-based fresh doughnut, sweet treats, and coffee chain. With over 11,800 points of access spread across over 30 countries, the company has a market-leading distribution network. Krispy has been in operation for over 85 years and has one of the most loyal consumer bases of any sweet treats brand in existence.
The company still produces their original, 1937 recipe Glazed Doughnut with it being a solid best-seller for the firm. While Krispy has continued to sell the very same doughnuts they started with, the company has rapidly innovated their supply chains and distribution networks to create one of the most comprehensive omni-channel businesses operating within the fresh-treats industry.
While their doughnuts remain popular, the relatively recent IPO of the company to investors across the globe means evaluating the business as a potential investment opportunity is difficult and more uncertain than desired.
Therefore, a fundamental company analysis and intrinsic value calculation must be completed to fully understand whether or not any potential investment opportunity in Krispy Kreme is as sweet of a deal as their doughnuts.
Economic Moat - In-Depth Analysis
Krispy Kreme has a relatively wide economic moat, especially compared to some of its competitors. The primary drivers for moatiness in their business are their established and popular brand image as well as their innovative and comprehensive supply-chains and omni-channel distribution network.
Their core business model of delivering high quality, daily premium quality fresh doughnuts to consumers through a variety of different points of access has proved incredibly profitable for the company. Their focus on producing doughnuts through a "Hub and Spoke" model (where most doughnuts are made at a central production facility and then distributed to retailers daily) has proven to be a very capital-efficient operational strategy.
DNUT Investor Day Presentation 2022
This has allowed Krispy to maintain a streamlined operations structure and one which reduces the number of possible failure points which could lead to a compromised customer experience. The company is also able to tailor the number of doughnuts produced more effectively using this method which allows for food waste and lost revenue to be minimized.
Krispy has also focused their product offerings to catering for changing consumer tastes and preferences by creating many limited time offerings in the form of special edition treats and drinks. The company has also expanded their business model to offering a wider portfolio of products such as ice cream, cookie-wiches, and other specialty LTO items.
When Krispy's high-quality operational strategy is combined with their customer-oriented product range, the result is a highly popular brand with a strong and loyal customer base. In turn, these factors drive return visits for the company along with ensuring a positive word-of-mouth review is being passed on to prospective future customers.
I believe this is one of Krispy's key drivers for their economic moat as replicating such a devoted and loyal consumer base is difficult for new entrants. Such a reputation takes decades to foster, especially on the international scale upon which Krispy Kreme has achieved this status. Krispy Kreme has 99% global brand awareness which proves their brand is a household name.
DNUT Investor Day Presentation 2022
It is also important to note that since 2016, Krispy Kreme has increased the percentage of consumers who purchase Krispy Kreme for an event or party from just 10% to 36% at the end of 2022. This supports the hypothesis that their operational strategy focused around significant market penetration is working very effectively for the company.
DNUT FY22 10-K
Krispy's aforementioned hub & spoke operations strategy combined with their omnichannel distribution network is another key driver for the company's economic moat. By manufacturing doughnuts in so-called "Hot Light Theater Shops", Krispy is able to create a complex network of doughnut-producing facilities which not only act as shops themselves but also serve as local production facilities from which produce can be transported to their "fresh shops".
Krispy has also managed to create an incredibly efficient franchising network where setup costs for their facilities are some of the lowest within the industry. A "Hot Light Theater Shop" costs between just $2-4M in capital investments while a "Fresh Shop" can range from anywhere between only $0.1M-$1M.
Significant investment into high traffic convenience locations known as "Delivered Fresh Daily" ((DFD)) locations such as small kiosks within supermarkets, shopping malls, and other retail locations is one of the primary factors which has allowed the company to increase their wide-spread brand penetration drastically.
These DFD stalls are very low maintenance and cost just a couple thousand dollars to setup. Krispy operates over 9,800 of these locations.
Finally, Krispy Kreme has diversified their operations structure to include Ecommerce and fresh doughnut delivery services which was particularly pursued during the COVID-19 pandemic. The opportunity for customers to order Krispy Kreme products directly from their branded e-commerce platform as well as through third-party digital channels has made it easier than ever before for consumers to enjoy the company's treats.
Fundamentally, this comprehensive network of distribution and manufacturing solutions acts to significantly drive the company's economic moatiness. Replication of such a network even by an established competitor such as Dunkin' would be a difficult and capital-intensive endeavor.
Overall, I believe Krispy Kreme has a strong brand image which is bolstered by a comprehensive product portfolio and an outstandingly efficiency operational strategy. While Krispy's economic moat may not be the widest in absolute terms, on an industry-wide scale their business model is truly remarkable.
Financial Situation
Krispy Kreme has had a difficult start with regards to profitability since the IPO of shares in their company back in 2021. Their net margins for the last four years have hovered around -1.5% with ROIC for the same period averaging 0%. While these metrics do seem incredibly poor, there are a few other crucial factors which have colluded to create these lackluster fiscal results.
Most notably, Krispy Kreme's gross margins are very healthy with their four-year average being 72%. This suggests the issue in their operations structure lies in operational cost control rather than their core product or business proposition.
By examining Krispy's 10-K forms for the past two years, it is clear that their episode of producing a net loss seems to be coming to an end. Since FY20 , Krispy has decreased their net loss from over $60.9M to just $8M at the end of FY22.
This has primarily been accomplished by decreasing the firms spending on strategic initiatives, acquisitions and mergers as well as the opening of a new New York flagship Hot Light Theater Shop.
The huge strategic initiatives spending in FY20 was primarily on consulting and advisory fees associated with the set-up costs of evolving their legacy U.S. wholesale business. This spending should not be replicated in the future and coincided unfortunately with the company's IPO.
The limited $2B spent on strategic initiatives in FY22 were associated with the transfer of their Branded Sweet Treat Line manufacturing facility from Burlington, Iowa to Winston-Salem, North Carolina.
The main hurdle holding Krispy back from achieving substantial profits in FY22 was due to the costs related with shop closures. Krispy spent a huge $19.7M on this in FY22 with most of this sum being due to lease termination costs, impairment charges, and loss on disposal of property, plant and equipment.
This spending was absolutely necessary for Krispy Kreme as they transition away from their legacy supply-chain network and move towards an operation entirely centered around the Hub and Spoke model. Importantly, Krispy Kreme has increased their sales per hub with spokes from just $487M in FY21 to over $587M in FY22.
The company also saw net revenues grow 10.5% from just $1.4B in FY21 to over $1.53B in FY22.
This suggests that Krispy Kreme is rapidly accelerating their revenue generation abilities, mainly thanks to increased efforts to target underserved markets in developing countries. Undoubtedly, when combined with the focus management has devoted to efficiency through increased adoption of their hub and spoke model, the company should begin to produce sizeable profits in the coming year.
Within the same period, Krispy saw operating expenses increase by 0.5% proportionally as a percentage of net revenues. While, initially, this may seem distressing, it is important to recall the huge non-recurring expenses Krispy endured in FY22 as a result of their transition away from their legacy distribution and supply network.
Therefore, while the huge costs are regrettable and their impact on net income was substantial, the process was a necessary evil for the company to tackle.
DNUT ICR Conference 2023
Labor costs also grew around 11% in FY22 compared to the previous year due to rising labor cost inflation. However, Krispy Kreme is beginning a move towards significant levels of automation within their supply network to reduce the number of employees the company needs to operate.
This move towards a more automated doughnut production process will undoubtedly help reduce labor costs, increase operational efficiency, and bring the company in line with what the current industry is capable of achieving with regards to the technology available.
Strong growth in product sales by 10.7% in FY22 compared to FY21 further supports the thesis that Krispy Kreme is expanding their reach and popularity within the market thanks to their comprehensive omnichannel approach.
Geographically, Krispy Kreme continues to see its domestic U.S. and Canadian markets producing the greatest EBITDA earning the company $118M in FY22, up 10.1% from FY21. This was achieved as a result of the efficiency increases thanks to the increased adoption of their hub and spoke model along with organic growth in sales of around 12%.
While international markets continue to play an important role in Krispy Kreme's earnings landscape, overall EBITDA from the market segment reduced 7.3% in FY22. This was mainly due to rapidly rising commodity and labor costs along with significant FX losses.
Developing markets continue to grow rapidly at around 8.8% per annum which suggests management's desire to cater more to these emerging markets could prove lucrative in the long run. Krispy Kreme could find themselves becoming key players in these markets by essentially being the sole player in these market environments. When combined with the prospects of most emerging markets seeing a rapidly growing middle class with more disposable income, I believe Krispy Kreme's developing market earnings will grow significantly over the next 10 years.
Seeking Alpha's quant assigns Krispy Kreme with a " C- " profitability rating. I believe that while this is a representative snapshot of Krispy's historic profitability, it fails to capture what the future has to offer for the company.
Krispy's balance sheet looks to be in relatively healthy shape. The company currently has $178.3M in Total Current Assets while Current Liabilities only total $516.5M.
The company has a debt/equity ratio of just 1.03 which is fantastic to see from an investor perspective. Their quick ratio (current assets minus inventory divided by current liabilities) is just 0.20.
Krispy Kreme has around $713.8M in long-term debts with a majority of senior notes maturing in 2024. Luckily, Krispy has just completed a refinancing of its existing term loan A and revolving credit facilities so that the maturity of these debentures is extended until March 2028.
This is excellent news for investors and solidifies the firm's finances moving further into the future. Their net debt remains unchanged as a result of this refinancing.
Overall, Krispy Kreme clearly has the tools it requires to transform their operation into a highly profitable entity. While it is difficult to assign an exact timescale on this turnaround, I believe 2023 could be a highly successful year for the doughnut maker, provided a huge recessionary episode for global economies can be avoided.
Valuation
Seeking Alpha's Quant system has assigned Krispy Kreme with an "F" Valuation rating. I find this valuation relatively representative of the Doughnut maker's current value proposition.
The firm is currently trading at a whopping P/E GAAP FWD ratio of 201.68 and a P/CF TTM ratio of 17.89. Furthermore, when considered against an FWD EV/EBITDA ratio of 18.02, the evidence clearly points towards a real overvaluation in the company.
From an absolute perspective, Krispy shares are also quite pricey. Compared to lows of around $10/share, the current almost $15/share is incredibly expensive, and unfortunately, much of this current valuation is built around hype instead of tangible results in my view.
The company's partnership with McDonald's (MCD) to offer their products through the burger chain's access points spurred a rally in Krispy, although material evidence that this partnership has resulted in increased profitability remains sparse.
While it is possible that Krispy could grow revenues significantly, the fact remains that at the current time, shares look expensive.
Seeking Alpha | DNUT | Earnings
By accomplishing a simple financial valuation based on the calculation below and using the estimated 2024EPS of $0.43 a realistic r value of 0.09 (9%) and the current Moody's Seasoned AAA Corporate Bond Yield, we can derive a base-case IV for Krispy Kreme of $10.9.
When using this realistic CAGR value for r, Krispy Kreme appears to be overvalued by a large 36.5%. By using Krispy Kreme's growth estimate CAGR value of 0.17 (17%), shares are valued at around the $17.5 mark, only 15% more than its current valuations.
The Value Corner
Therefore, I believe Krispy Kreme is currently sitting somewhere between fairly valued and overvalued. Both its absolute comparison to historic share prices combined with an intrinsic value calculation suggests the company's shares are trading at roughly the right price point if not a little too dearly.
In the short term (3-10 months) it is difficult to say exactly what the stock will do. Much depends on the prevailing macroeconomic conditions and the ability of global economies to skirt a recession in 2023. Given that most fundamental market metrics are forecasting a recession, significant uncertainty exists for such a consumer discretionary stock moving forwards.
In the long term (2-4 years) I expect their position in the fresh sweet treats industry to become stronger. Their reliable brand reputation, great selection of products to choose from combined with significant market presence means any arising threat from a competitor should be relatively predictable.
Nonetheless, the key for Krispy will remain in how quickly the company can start making money again. Without substantial increases in profitability (which I realistically do expect thanks to their efficiency-focused turnaround), the stock will remain volatile and unpredictable.
The current share price leaves little for value-oriented investors to latch-on to. Shares would have to drop another $5-$8 for any real deep-value opportunity to exist. Alternatively, a significantly improved estimate of earnings for the coming years could also increase the value proposition of Krispy Kreme.
Risks Facing Krispy Kreme
Krispy Kreme faces risk from a few different perspectives with the most notable threat arising from a recessionary environment leading to a decrease in consumer discretionary spending along with the threat of increased competition.
A recessionary period in global economies would undoubtedly lead to Krispy Kreme's revenues taking a hit from decreased consumer discretionary spending.
When consumers are more tightly pressed for cash, spending usually ceases on non-essential items. Whether or not Doughnuts are viewed as an essential item differs from individual to individual, but on average it is difficult to argue their necessity in day-to-day life bar to satisfy a habitual preference.
Without the projected increases in revenues, EBITDA, and EPS, Krispy Kreme shares will almost definitely plummet from their current $15 high.
Krispy also faces significant competitive threats from companies such as Dunkin', Tim Hortons or even Starbucks (SBUX). Given the equally huge scale of its competition , Krispy Kreme could find it difficult to compete within the market, especially given the rapidly increasing trend of quickly opening local doughnut shops which may begin to decrease Krispy's market popularity.
Changing consumer tastes and preferences could also mean potential doughnut enjoyers could be swayed to purchase other sweet treats instead of Krispy Kreme's traditional selection. While the company has a varied product portfolio designed to harness the popularity of these emerging foods, Krispy could find themselves unable to compete fully in these markets.
From an ESG perspective, Krispy Kreme faces little threat. Their commitment to sustainable business operations along with a relatively small global environmental footprint means the probability for a scandal or disruptive event remains quite small.
Their devotion to ensuring Krispy Kreme as a business contributes beneficially to both the environment and society is admirable making Krispy a suitable pick for most ESG-conscious investors.
Summary
Krispy Kreme has had an unimpressive fiscal story since its IPO. Their inability to return a profit from their otherwise rapidly growing business has left many investors doubting the abilities of this doughnut maker.
While I am not as pessimistic given their clear growth-oriented strategy and ongoing efforts to transition to a more streamlined operational structure, the truth is that at present there is very little value-oriented material to promote building a position in the company.
The lack of clarity on how global economies will react to the still inflationary and high interest rate environment moving forwards into 2023 also decreases the doughnut maker's appeal. The firm's reliance on continued consumer discretionary spending to achieve their lofty - but not unattainable - growth and earnings targets means a recession in 2023 could seriously harm the company's march towards profitability.
To begin building a position, shares would have to fall another $5-8$ at a minimum to present any value opportunity accompanied by a sufficient margin of safety. Equally, any significant increase in EPS, EBITDA or net income could also promote the building of a position from a value perspective should prices remain around their current levels.
Therefore, I rate Krispy Kreme as a Hold given current valuations and earnings potential.
For further details see:
Krispy Kreme: Tasty Treats But A Sour Valuation