The details of my Big Bet against Krispy Kreme

[Peter666]

Contrarians were picking Krispy Kreme with big turnaround potential early last year figuring the Atkins diet fad would die. Of course, Krispy Kreme had underlying financial problems that hit the stock hard after that.

Will it get worse or better from here? If they get their financial house in order, the contrarian prediction may come true. They have had a while to plan a way out of their considerable current troubles. Taking this factor into consideration, shorting the stock is more of a gamble than getting the best of it.

However, the rewards are potentially so great (a 10 bagger short) that if you have 10K to burn, it may very well be worth the gamble.

I think the soundness of your decision is based more on risk tolerance than technical analysis in this case.

[DesertCat]

They issued liquidity information this morning. Interestingly they didn't release available borrowing power, but indicated it's probably zero now due to declining cash flow reducing the amount lenders will lend them. Cash is $19M, so it looks like net liquidity has dropped from $52M in six months.

All is not as dire as I had hoped. Not only does cash burn look like it was zero for the quarter, but they received $3M in cash from KKD Australia post this filing, and announced they finally got a definitive agreement to sell KKD UK for $3M. They've closed enough stores that the remaining stores aren't cannibalizing each other, and company owned stores are rebounding a little. Franchisees on the other hand, are still failing.

They might be able to muddle through and avoid bankruptcy for a while if they can keep cash burn to a minimum. If that's the case we'll be dependant upon a significant event, probably one of their many lawsuits, to trigger a large liability that forces them under. That will take quite a while. I think they still need to find new capital to redevelop their stores and update their franchise concept so it actually works. And I can't see how they can do that when they've mortgaged everything to their lenders and don't have accurate financials.

Either way, at $460M a year in revenues, they certainly aren't generating enough true EBITDA to be worth $600M in EV, which is where we are today. Essentially EBITDA is probably $20M or so right now (just enough to pay interest costs), which gives an intrinsic value of around $1-$2 per share.

So bankruptcy probably not imminent, but still way over valued.

[DesertCat]

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Contrarians were picking Krispy Kreme with big turnaround potential early last year figuring the Atkins diet fad would die. Of course, Krispy Kreme had underlying financial problems that hit the stock hard after that.


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This is a myth. Krispy Kreme was unaffected by the Atkins diet (Dunkin Donuts sales were fine during the same periods). That was just an excuse that management used to disguise the fact they were cooking the books and had run out of accounting tricks.

[TimM]

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This is a myth. Krispy Kreme was unaffected by the Atkins diet (Dunkin Donuts sales were fine during the same periods).

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Yeah, and its not like the next diet craze was going to be heavy on donuts.

[Peter666]

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Contrarians were picking Krispy Kreme with big turnaround potential early last year figuring the Atkins diet fad would die. Of course, Krispy Kreme had underlying financial problems that hit the stock hard after that.


[/ QUOTE ]

This is a myth. Krispy Kreme was unaffected by the Atkins diet (Dunkin Donuts sales were fine during the same periods). That was just an excuse that management used to disguise the fact they were cooking the books and had run out of accounting tricks.

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Those bastards! For what its worth, people seem to be more health conscious on the whole than in previous times. I don't see a company with a drinkable donut being a long term winner.

[hawk59]

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So bankruptcy probably not imminent, but still way over valued.

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This is a pretty good sign that you shouldn't be short.

[DesertCat]

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So bankruptcy probably not imminent, but still way over valued.

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This is a pretty good sign that you shouldn't be short.

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Well, technically I'm not short, I own puts. But do you really believe it's a bad idea to own long dated puts against a stock trading at least 4x it's intrinsic value?

[LinusKS]

Hi DesertCat.

Thanks for posting your bet against KK, along with your analysis.

I have a question about intrinsic value, and efficient markets - which is basically this -

When people talk about efficient markets, what exactly do they mean?

In the real estate market a propety's value is more or less what people will pay for it. It's the price paid by a willing buyer to a willing seller.

In the stock market, some people - I guess what you'd call value investors - think that a stock has a "real" value, that's separate from what the market says it is. That real value - and correct me if I'm wrong - is basically the discounted value of the company's future earnings.

Obviously, if you think a stock's value is what someone will pay for it, the market is necessarily efficient (in fact, it's a tautology).

If you think stocks have a true value, that's represented by the value of the future earnings, the market is demonstrably ineffient - since the market has often and repeatedly over- and under- estimated the value of those earnings, simply as a matter of historical fact.

But I'm not sure EMT means either of these things, which makes me wonder what it does mean. More specifically, what does the EMT say about the ability of a particular investor - no matter how smart he is - to more accurately forecast the movements of a particular stock, than all the other investors in the market, combined?

[DesertCat]

If you haven't read "A random walk down wall street" you should. I can't really do justice to the arguments for an efficient market, esp. since I don't agree with many of them. There are actually flavors of EM, and the "strong" flavor says no one ever has an advantage or skill, it's all luck. I think the track records of Warren Buffett and some others clearly demonstrate skill.

Most value investors believe the market is usually pretty efficient, i.e. most stocks do trade for around their DCF valuation. But occasionally they don't trade near their intrinsic value, sometimes not remotely. That's when skill can make a big difference.

KKD is one example. I think it's DCF valuation has to be very low, yet the market believes it's around $600M. We'll certainly see what the outcome is and whether I have any "skill" here.

A better example is USG. It traded as high as $122 less than a month ago. Today it closed around $69. Has it's real value changed that much in one month? Part of the loss is because some investors were hoping that congress would pass legislation to help USG out of their asbestos mess. But even if congress did, the net value would only be worth a maximum of $30 per share due to a prenegotiated asbestos settlement. And that legislation was never even likely to pass, it's probability probably wavered between 10% and 30% at most, so the EV of legislation was max about $10.

So how can USG's value change by 40% (billions of dollars) in one month? Clearly it's value didn't, but it's price did. It's a clear example of the market being inefficient.

[hawk59]

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So bankruptcy probably not imminent, but still way over valued.

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This is a pretty good sign that you shouldn't be short.

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Well, technically I'm not short, I own puts. But do you really believe it's a bad idea to own long dated puts against a stock trading at least 4x it's intrinsic value?

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Is that a rhetorical question?