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?