Yesterday, The Motley Fool ran an article asking a not-so-rhetorical question: Is Krispy Kreme (NYSE:KKD) at a price that makes it an attractive investment?
The author concluded that since the company is going through some cost-cutting and has new management and a new strategy, it "looks like an excellent value pick." In fairness, the author also noted that Krispy Kreme was nowhere near the point of being out of the woods, so the ride is going to be volatile.
To which I reply, "Yeah, volatile like a bullet train to hell."
In other words, I come to a slightly divergent conclusion. I thought last year that Krispy Kreme's fair value was, if the worst would come to pass, zero. Well, we haven't hit the worst case, but we're pretty close. And one thing I hadn't counted on at the time would be that Krispy Kreme would fall out of covenant with its lenders, or that its company stores (the ones owned by the company instead of by franchisees) would do so poorly.
If Krispy Kreme stock were a doughnut variety, I think it would be something like "powdered mutton-filled," or "sweat-glazed." Not attractive. Purge-worthy. This is a company in big trouble. And while it has new management to take over for the (insert your negative adjective here) former CEO Scott Livengood, the group headed by Scott Cooper has been dealt such a raw hand that my own analysis tells me that it's going to be able to restructure the company mainly in the friendly confines of Chapter 11 bankruptcy protection. Krispy Kreme the brand will be fine. The company may eventually succeed in a scaled-back fashion. The common stock? Check for spoilage.
Let's get to the heart of why I believe nearly any price -- much less a $9 level that puts its equity at a value of $550 million -- is too much to pay for Krispy Kreme stock. I hate to disparage the analysis of a colleague in the process, but I'm afraid that I can't let some of these assumptions go unaddressed. What we have in Krispy Kreme is a company that, as of this moment, produces close to zero earnings on a company-store level, needs hundreds of millions in financing to remain afloat, and is not in covenant with the Securities and Exchange Commission.
For whatever reasons, two recent rumors have caused Krispy Kreme shares to spike. The first was a tale traders began circulating that Warren Buffett was buying equity. The second rumor was that Krispy Kreme was close to securing $225 million in financing from Credit Suisse First Boston (NYSE:CSR). Hold this particular thought, as it's important.
Reduction of debt? How?
One of the big memes in the thesis that Krispy Kreme can get back onto its feet, providing a good risk/reward from here, is that the company can lower its debt levels by letting some franchises wither on the vine. I think this is a pipe dream. First and foremost, if we're talking about bringing a company back to health, and it is a franchisor, we have to talk about bringing the entire Krispy Kreme ecosystem back to health. What happens if we let a few of the franchises fail? My calculations show that Krispy Kreme the mother ship has guarantees on about $24 million in franchise obligations and another $135 million in long-term lease obligations. By putting some of these franchises out to pasture, Krispy Kreme will have some of these contingent liabilities added to its own balance sheet.
And we also need to look at the quality of the financing and the cash flows. At present, Krispy Kreme's debt is made up entirely of bank loans that come due in 2007; the company hasn't issued any debt securities. Bank debt is callable pending the debtor's failure to meet certain covenants. By failing to file its financials with the SEC, Krispy Kreme is currently operating solely at the mercy of these banks, including Wachovia (NYSE:WB) and BB&T (NYSE:BBT), which have granted the company waivers on its deadline to comply with the covenants of the loan.
Given the amount of exposure these two banks have to Krispy Kreme, would it not make sense that they'd be first in line to change the company's financing terms if they felt that the company's condition was anything less than dire? They could attach Krispy Kreme assets, but in a liquidation, what do you suppose the market value for used doughnut-making equipment would be? I'm guessing that the book value of these assets ($130 million in equipment and leasehold improvements) far overstates what they would be worth should the company close stores and attempt to liquidate them.
As for the cash flows, remember that Krispy Kreme's economic condition will change as a function of its cutting back on opening franchises. Krispy Kreme sells its doughnut-making equipment to new franchises and also pockets a fee for selling the franchise. These revenue streams will both disappear, and that will leave the company's cash flows dependent on ongoing operations. With store-level sales for franchises (i.e., most of the newer stores) dropping like a stone, the two entities must be in conflict. Franchises pay Krispy Kreme between 4.5% and 5.5% of sales as a royalty, plus they pay marked-up prices for the doughnut mix. Krispy Kreme could cut costs by shutting down its own company stores, but if franchises continue to struggle, the parent company will be faced with a Hobson's choice of either buying out the stores (with cash the parent company doesn't have) or assuming responsibility for loan guarantees. Ouch.
And even if the CSFB debt comes through, it will replace some of the existing debt and also be used to fund operations. All of this tells me the same thing: It's not a good bet to suggest that Krispy Kreme debt will decrease anytime soon. And it's REALLY not a good bet to assume that any debt abeyance that does come down the pike wouldn't come at a real, dilutive cost to existing equity.
Where's the cake?
The end result here is that the company is dependent on a dramatic improvement at the store level. Such an improvement would be quite a leap of faith given current trends at Krispy Kreme's outlets, particularly in off-premises sales. This is where comparisons between Krispy Kreme and Starbucks (NASDAQ:SBUX) have always broken down. Krispy Kreme stores make economic sense only when they have healthy off-premises demand -- the in-store sales come nowhere close to justifying the cost of such expensive equipment. But as we see in the most recent results, per-store sales continue to drop at double-digit percentages. At what point does the pressure on the franchisees mean that they come back to the parent company and demand a change in their deals, including a reduction in royalty rates?
This to me is a huge issue. Krispy Kreme needs cash, but its stores are selling less and less. There isn't exactly a long line of franchise candidates lined up to pay the fees and buy the equipment for new outlets, and Krispy Kreme has to worry about what's going to happen to the ones that exist right now, if sales trends do not stabilize and in fact tick upward. What the economics will look like for the company, given the poor health of its franchise and company store network, is nearly impossible to determine.
That's why a stock valuation of nearly $500 million makes no sense whatsoever. (The price has declined sharply since our story yesterday.) It assumes way too much optimism, where I see cause for very, very little. If anything, I think that the worst of the franchise woes for Krispy Kreme are still ahead of us, and that tells me that the thought of jumping in and hoping for the best with no real visibility into the condition of the franchises makes little sense. While the CSFB cash would certainly help, it isn't likely to be cheap, and it isn't likely to be pari passu with the common stock.
I don't think Krispy Kreme the brand and the company are going anywhere -- they have too much value. But the outcome for a company and the outcome of its common stock are sometimes very different things, and I think we may have a good chance of getting an object lesson in this with Krispy Kreme. To me, the common stock right now screams all pain, no gain.
Bill Mann has no financial interest in any company mentioned in this article.
