I'm shorting Krispy Kreme today

[DesertCat]

I can seldom talk about my picks here due to volume concerns, usually I still want to buy more and my stocks tend to be illiquid due to my focus on microcaps. But this one is different, and as I wrote to PokerHorse in the "insurance as investing" thread, it's critical to listen to and understand opposing viewpoints of your investment decisions (though PokerHorse of course didn't get it).

First, I'm actually not shorting, I don't believe in shorting due to the poor risk-reward profile (infinite loss potential vs. capped 100% upside), as well as dealing with the costs and difficulty of finding borrowable shares.

Instead I am attempting to conduct my first ever options transaction (hopefully I'm doing this right). I'm trying to buy 20 LEAP contracts for January 2008 at an exercise price of $5 (+YRDMA is the symbol). Right now the ask has run up to $1.25, so I haven't actually gotten any yet. I expect to pay around $2500 for the contracts, and for them to be worth $10k when Krispy Kreme files for bankruptcy (i.e. the contract gives me the right to sell 2000 shares of KKD at $5, presumably when it's trading near zero).

Why do I expect KKD to file for Bankruptcy? There are two good writeups on ValueInvestorsClub.com covering the (unbelievable) problems KKD faces and making the short/put case. One is about a year old, the other from January, and both should be accessible to guests. But I will try to summarize here.

This also a case of trying to take advantage of "good news" that is really meaningless. KKD just hired a real CEO, which has caused the stock to almost double. The problem is, that the company is doomed and the CEO won't be able to do anything about it.

The reason the CEO will fail that same stores at Krispy Kreme have been in a death spiral, and are below $50k per week. This means company owned stores probably can no longer cover their own costs, let alone contribute to company overhead. KKD stores are very expensive to operate and require a large volume of sales to cover their expenses. In fact, it's not clear if this model ever worked, new stores typically started as high as $500k per week in sales, and fell rapidly to the $50k level within two years. The company tried to supplement their sale by wholesaling through grocery stores, but the largest franchisee just threw in the towel on that, claiming that wholesale sales were unprofitable and worse, cannabilized retail sales.

To compound this, franchises are failing and being shut down at a rapid rate, drying up two important streams of net cash for KKD corporate, the first being franchise fees.

The second is sales of supplies and equipment to franchisees. KKD relied on forcing franchisees to buy all supplies (ingrediants) and donut making equipment from corporate at a healthy markup. Now with franchises shutting down, no more equipment is needed, and obviously, less supplies. And corporate overhead is significant, esp.since the "turnaround" specialists "running" the company charge close to $1M a month for their "services".

So the new CEO will have to continue to shut down stores to try to create a smaller core that can possibly be profitable, and restructure to create a healthy business both for itself and it's franchisees. For example, they have not yet shown they can do lower cost "satellite" stores successfully. But the problem with this is that even if the CEO can accomplish these daunting tasks there are some huge potential liabilities.

First, there are allegations that KKD was a fraudulent enterprise that management milked for hundreds of millions if not billions in illegal stock sales. Essentially that it manufactured profits and growth by forcing franchisees to buy overpriced supplies, equipment and to rapidly open stores, and used misleading or fraudulent accounting to hide losses from dying franchisees. If true, this would lead to SEC and civil suits, expensive, and hugely distracting.

They are also facing multiple lawsuits by franchisees claiming they were defrauded via the mechanisms listed above. KKD appears to be settling these suits rather than allow public disclosures of internal corporate documents. Some have speculated that this is to protect board members and others from future shareholder suits.

It appears that KKD may have run out of credit availability with their lenders as well. So the natural course (which is the standard operating procedure for the "turnaround experts" running KKD) is a chapter 11 filing that will basically hand the company over to the lenders and consolidate the messy mass of lawsuits they are facing. And presumably leaving the common stock worthless.

My possible concern is that I can't necessarily pin down some of this. I'm still doing more research and may up my purchases as long as everything turns up well. KKD may have other assets that can keep them afloat, real estate for example. Since they haven't filed real financials in a year and a half it's difficult to pin down their real cash burn rate and what they have left. Their 12/13 8k has some good info but I'm still trying to model it better. Essentially my rule of thumb is that if they are able to create a profitable $300m business out of the wreckage it should be worth around $450m, while current enterprise value is $740m, so my worst case scenario is that if they succeed ait's still overvalued by almost double.

Also my other concern is that I've never bought options before, so I don't want to overlook some big possible mistake. For example, I think with these puts I only have $2500 at risk, and I have almost two years for my thesis to prove true. I picked the $5 strike price instead of the $2.50 to give me more downside protection for example but if KKD really goes to zero the $2.50s will produce a higher return.

So am I overlooking anything?

[plj8624]

You highlighted the risks of using put options. I also have no actual experience with options. There's the time risk. A lot could happen in two years.

How confident are you in your assessment of the company? You can never be 100% certain what will happen. Could they get bought out and rescued by another chain? Could they languish and continue to use dubious accounting to stick around for another 5 years? What about the chance they turn it around?

Not saying it isn't a worthwhile idea just that I would be cautious. At the very least you are making a somewhat high risk/high reward speculation, but you are being smart and making a small enough bet that it won't hurt you too badly.

[DesertCat]

[ QUOTE ]

How confident are you in your assessment of the company? You can never be 100% certain what will happen. Could they get bought out and rescued by another chain? Could they languish and continue to use dubious accounting to stick around for another 5 years? What about the chance they turn it around?


[/ QUOTE ]


Thanks for your comments. I am planning to keep this to less than 5% of my portfolio, where I can take a total loss without sobbing uncontrollably.

I calculate that if I am only right 50% of the time (that KKD goes bankrupt before my options expire), it works out to a very substantial return. The math is $2.5k cost, $5k average gross ($10k half the time, zero half the time), for an average 100% return in 2 years.

I'm still trying to pin down their cash uses, but on Oct. 30 they only had $61M in total cash and credit available. I'm guessing they are burning at least $2M a month but that doesn't count cash needed for legal settlments, and franchise buy backs (they are on the hook for a lot of franchisee debt). It's all difficult to model though, so it's possible they have two years of cash.

But their real problems are the lawsuits. I doubt anyone will buy them without the suits being resolved, which I don't think they can do very easily outside of bankruptcy. I think it's much more likely the lenders panic, force a pre-pack Ch 11, and sell the stores to a competitor to make sure they get paid. Then they'll leave the rest of the problems to the bankruptcy judge. I may be wrong, it may be they sell the stores first, then seek bankruptcy, but I think the end result is still the same for the commons stock.

And I think it unlikely they turn it around on their own. Read the company report filed last summer (and the ValueInvestorsClub writeups). Krispy Kreme's business never added up, the new "factory" stores never made money other than in the first year after opening. It's possible that a smaller number of stores can be profitable, i.e. in the five years before the IPO they had 100 stores and averaged $3M in profit a year total. That doesn't support a $500M in enterprise value (where my strike price is at).

[Mr. Now]

First of all the time value decay in LEAPS is nil until about 1.5 years out. Even then it's minimal until about 9 months out. Therefore, you can roll them forward about 10 months out, for example rolling the Jan08 to Jan09 in the same strike.

Second, it's do or die technically for the stock price right now. It has to break out over 9 and will need serious buying power to do it. This level has been a near-term historical high in March and June of last year. Price remembers, and many miserable owners of this stock will be happy to get out at 9 in the coming days. There was alot of volume in March/April. That's positive for a short entry here and will tend to cap any movement higher.

I notice the volume has declined substantially in the past 3 days and is very low today. That is not a recipe for a big honking breakout from here. Add to this the fact that price is pushing outside the upper Bollinger band, a volatility-based measure of price based on recent price ranges.

Lastly we have the entire market at a recent all-time high, literally laughing in the face of 15 consecutive rate hikes and a 5-year high in the cost of money.

Your fundamental analysis looks very comprehensive. The chart is displaying an opportune time to short this.

The near-term reward to risk looks like this:

Enter short at around 9 stop 10, Risk = 1/9 or 11% for $1 a share. $10 proves you likely very wrong and provides a logical place to jump ship on this trade.

Previous low was 4, so target 4 based on your fundamental analysis. Reward = 5 points or 5/9, 55%

So what we have here is a 5:1 reward to risk ratio.

You can be right WAY less than 1/2 of the time to make money on this kind of deal. The convergence of $9-based resistance, sharply declining volume after a runup in price, other technical measures supporting favorable short entry, the recent high in the indexes (and sharp break today) as an overall supporting backdrop and your detailed fundamental analysis all point to a good place to enter short.

Thanks for bringing this to my attention.

[AvivaSimplex]

Very interesting. I knew there was some reason I kept reading this forum.

I was able to find the Jan 05 post on valueinvestorsclub. Is there a more recent one? Specifically, I'm looking for the source that individual store sales are below 50k/week.

I'll do some more research, but KKD certainly seems like a bad business. They haven't filed financial documents in more than a year. Leading up to that point, we see diminishing same-store-sales. Recently they've closed 22 of their 343 stores. I certainly wouldn't bet on them.

I would suggest you give a little more consideration to shorting. If you don't have a timeframe for when you expect the stock to tank, there's a good chance you'll overpay for time value, or buy options that expire too soon (right now obviously you're leaning towards the former). If you couple a short with a stop-loss order, you don't necessarily face the 100% gain/infinite loss problem.

[AvivaSimplex]

[ QUOTE ]
Enter short at around 9 stop 10, Risk = 1/9 or 11% for $1 a share. $10 proves you likely very wrong and provides a logical place to jump ship on this trade.

[/ QUOTE ] Why would the stock reaching $10 prove him wrong? He's making a prediction that this is a money-losing company that will go under in the next 2 years. Short-term price movements, unless they're accompanied by real news, have no bearing on that prediction.

[Mr. Now]

An adverse move of 11% is not a typical short term movement in this stock.

The average range for the past 15 days is 43 cents. The daily range is typically about 5% of the opening price.

Even if price crept up slowly to $10, that's a very real alarm bell.

Reaching $10 (adverse 11% move) would be non-trivial. It breaches the expected $9 top and invalidates my thesis for entry, which is based in part on historical price peaks in the recent past as stated in my post.

If price can close over $10 that would provide 70 to 90 percent certainty the timing on the short sale and the underlying thesis was "less than optimal".

As for substantial price movements of 08% or more, short term or otherwise: in my experience, it's the price that often moves well before the actual news. Google before last earnings is a nice example of this. The price tipped the news to perceptive observers well in advance.

We might very well see that pattern here in KKD. Price may move suddenly lower while pronouncements from management remain quite rosy.

Then the bad news a few weeks later.


As soon as you enter, you are a member of a crowd and lose objectivity. That being the case, having a plan for every possible price event, in advance of entry, is required.

Where you jump ship (your risk-defining stop) is a major aspect of that overall plan.

Don't you agree?

[AvivaSimplex]

[ QUOTE ]
Reaching $10 (adverse 11% move) would be non-trivial. It breaches the expected $9 top and invalidates my thesis for entry, which is based in part on historical price peaks in the recent past as stated in my post.

[/ QUOTE ]
Well, yeah, it invalidates your thesis, because yours is based on technical analysis. Price movement is obviously important for that. DesertCat's thesis is based on the fundamental idea that this is a company that can't function profitably at this size. Price movement without news doesn't have much impact.

I agree price movements can sometimes telegraph news events. I haven't seen that happening for this stock over the past 6 months at least. The two major events, hiring the new CEO and getting a filing extension from the NYSE, did not have anticipatory bumps in front of them. Also, there are several moves of 11% or greater without major news items.

Cat, had you considered buying May 06 puts? KKD will file their first financial statements between now and then. The new CEO has every incentive to make their position look as bad as possible. He doesn't want to go to prison for covering up someone else's mess, and the deeper the hole when he starts, the more credit he gets if he pulls them out. The only reason he might want to make them look good would be if he's afraid creditors will cut off support if they're obviously doomed.

[schnoodleC]

I've been reading these forums for some time. This is my first post. This is a great idea. Unfortunately, KKD shares are not eligible for short sales. I haven't investigated an options play. Has anybody actually made an options play yet?

As for why it is a great idea:
Book value as last stated in Sept 2004 was only $8, of which $4.00 was tangible. Since then, they have lost mountains of $$, which they have not be able to report. My guess is their legal liabilities from franchisees is monstrous. The company is worthless--at best.

[DesertCat]

[ QUOTE ]
Cat, had you considered buying May 06 puts? KKD will file their first financial statements between now and then. The new CEO has every incentive to make their position look as bad as possible. He doesn't want to go to prison for covering up someone else's mess, and the deeper the hole when he starts, the more credit he gets if he pulls them out. The only reason he might want to make them look good would be if he's afraid creditors will cut off support if they're obviously doomed.

[/ QUOTE ]

Also he may not be willing to sign off on the financials and they'll miss the April deadline and get delisted. Good idea on the May puts, I'm pondering it now.

[ QUOTE ]

Has anybody actually made an options play yet?


[/ QUOTE ]

So far I've learned options have big spreads and are restricted to increments of a nickel. Case in point, yesterday the 2008 $5 puts sold at 95 cents early, but when I put my order in, the spread was $1.10/$1.20, so I bid $1.15. No fill. Today some sold early for 90 cents, but I overslept. When I got to my computer spread was 90 cents/$1.20! I bid 95 cents, no fill. Some 2007 $2.50s were .05/.15 bid ask (imagine a stock being asked at 3x it's bid!). I put in an order at .10, no fill.

So my answer is, no play yet. But I have orders out for various puts from 2008 to 2007 between $2.50 and $5. And looking to put some in May as well. So hopefully I'll get some tomorrow without overpaying.