The details of my Big Bet against Krispy Kreme

[DesertCat]

Even big companies can go bankrupt. It might even be easier for big companies because they are too large to have personal relationships with all their debt holders. Either way, KKD is far from a big company.

In this case the hedge fund that has owned their debt could have taken them into bankruptcy at any time they wanted, because KKD repeatedly violated loan covenants and needed waivers. But I think the debtholders did not want to go through a bankruptcy proceeding, because it opened the risk of other claiments (specifically the shareholder and franchise suits) laying claim to assets the debtholders have control of (all of the properties).

The debtholders have been more than willing to work with KKD to get through short term issues and it's worked out great for them. They've eliminated most of the lawsuits. The business appears to be roughly breaking even, even with big interest payments. If KKD's financials improve, it may even be able to refinance that debt at a much cheaper rate, and then the hedge fund walks away their money back plus two years of very high interest (around 12% per year).

If KKD was larger, it would be more likely to have a group of debt holders that would be more difficult to work with on waivers of it's covenants. Bankruptcy might have been more likely.

[NajdorfDefense]

Yes, of course they can, and sometimes do, just that it is very, very hard, much harder than you think if their stakeholders don't want them to do so.

[Off Duty]

The shareholders never want a BK. Never.

Their equity goes out the window upon filing.

[NajdorfDefense]

I didn't say 'shareholders,' read again.

[Off Duty]

I misread it, but it's confusing. What I think you ment was "debt holders".

There are lots of stakeholders. Franchisees, employees, debt holders, stock owners, vendors.......

[DesertCat]

I took a quick gander through the up to date filings KKD just released. I'm estimating current EV around $850M ($80M in net debt, 66M shares with shareholder suit settlement, $11.80 per share).

Charitably I put their EBITDA at an annualized run rate of $32M. I take the nine months operating loss of -5M, add back 16M in D&A, add back 6.5M in lease termination costs, then add back 7M for restructuring overhead (Cooper) that should go away.

You end up with an EV/EBITDA of around 27. As far as I can tell, this is the real cash flow from the business as it exists going forward, with all the one time bad stuff removed. That's an absurd ratio, unless the company is growing at a very high rate. KKD is actually shrinking. They closed 20 stores last quarter alone, and only offset that with 10 openings.

The bull case, as far as I can tell, is that KKD will be an "asset lite" franchiser, that spreads their brand throughout the world and generates huge franchise fees from it.

Right now they are only generating about $20M per year in franchise fees, less than 30 cents per share. Their number of franchise stores has declined from 195 to 184 in the first 9 months of 2006, almost all of it in the last quarter.

While I think the strategy of further international franchising is a good one, the ratio of it's potential benefits to the actual valuation is ridiculous. If they doubled their franchise store count (which will take years, if not decades), that would increase franchise fees to only about $40M per year, and while most of that is profit, G&A costs are close to $50M per year (assuming Cooper goes away). So while franchising can increase cash flow, it's not a silver bullet, requires that company stores and equipment mfg make substantial contributions and will take a long time to happen. And Intl. franchisors have to do better than U.S. franchisors, i.e. not go out of business after 3 years.

Unfortunately KKD ain't going bankrupt. And Howard Penney, the analyst over at Prudential, just upped his price target to $17 (just 37x EV/EBITDA). So I'm thinking of buying some more $10 2008 puts to bet on a price decline. Once a sucker, always a sucker I guess.

[NajdorfDefense]

Yeah, with E and Revs only down 7-12% or so, I don't see them going busto anytime soon. They may be due for a comeback, although I doubt that as well.

[The Don]

Random funny anecdote:

You're betting against a man (Brewster) whose daughter my friend had sex with.

[DesertCat]

Krispy Kreme update: They just announced a bad quarter and the stock dropped below $5 today. Essentially revenues continue to decline, more franchisees have shut down, and they are shutting down a distribution center. A few weeks ago one of the big hires they made in the upper management turnaround team left.

The most concerning part is that they are required to prepay $5M of their debt each quarter. Cash is back down to $25M. Everything that I wrote about is (slowly) coming true. Eventually I think this POS breaks their covenants and files for bankruptcy. Even if I'm wrong KKD has certainly proven it's not a growth story (and even at $5 it's trading at over 4x book value).

But the lesson is these things can take a long time. My timing was very poor and my use of shorter duration options killed me. Most expired worthless, and the ones I sold only recovered about 25% of what I put in them. I still own some jan 08 $5 and $2.50 puts, the $5 puts are now suddenly worth some money, but still much less than I paid for them. My guess is it's unlikely events will occur rapidly enough for me to make much more out of the remainder.

I learned how difficult it is to make money from short ideas. I used options instead of short sales to cap my downside risk but if I had shorted the common and just held it until now I would be up around 35% or so. But it doesn't matter, cause it's not something I'll likely do again. Making money on the long side is infinitely easier and less frustrating than going short.

[DcifrThs]

[ QUOTE ]
Krispy Kreme update: They just announced a bad quarter and the stock dropped below $5 today. Essentially revenues continue to decline, more franchisees have shut down, and they are shutting down a distribution center. A few weeks ago one of the big hires they made in the upper management turnaround team left.

The most concerning part is that they are required to prepay $5M of their debt each quarter. Cash is back down to $25M. Everything that I wrote about is (slowly) coming true. Eventually I think this POS breaks their covenants and files for bankruptcy. Even if I'm wrong KKD has certainly proven it's not a growth story (and even at $5 it's trading at over 4x book value).

But the lesson is these things can take a long time. My timing was very poor and my use of shorter duration options killed me. Most expired worthless, and the ones I sold only recovered about 25% of what I put in them. I still own some jan 08 $5 and $2.50 puts, the $5 puts are now suddenly worth some money, but still much less than I paid for them. My guess is it's unlikely events will occur rapidly enough for me to make much more out of the remainder.

I learned how difficult it is to make money from short ideas. I used options instead of short sales to cap my downside risk but if I had shorted the common and just held it until now I would be up around 35% or so. But it doesn't matter, cause it's not something I'll likely do again. Making money on the long side is infinitely easier and less frustrating than going short.

[/ QUOTE ]

given the money you spent on options, why not just short the stock outright and buy a call at a stike you're comfortable with (i.e. one where (K-S0)*your investment is your maximum comfortable loss or something like that...you'd earn money on the call though as St approached K so you could probably go a bit higher than you would if it was a non traded european option)

Barron