Krispy Kreme Soars On A Tasty Initiative (NASDAQ:DNUT)

March 26th ended up being a really fantastic day for shareholders of Krispy Kreme (NASDAQ:DNUT). This is because, after announcing a major expansion of a partnership that the company has with restaurant giant McDonald’s (MCD), shares spiked, closing up 39.4%. It’s unclear the exact impact this will have on the company moving forward. However, it likely will help the company to significantly increase its revenue over the next several years. As for what this means for existing investors, is a bit more complicated. The fact of the matter is that the stock is not particularly attractively priced at this time. This is especially true after factoring in the surge in price that shares experienced. This could mean underperformance for investors for some time. But for those with a very long term horizon, it’s likely that additional upside could be on the table.

A big deal

On March 26th of 2024, shares of Krispy Kreme shot up 39.4%. This came in response to a press release issued by the company. In it, the company made clear that, starting in the second-half of this year, it will begin offering three of its doughnuts for sale in select McDonald’s restaurants throughout the US. This follows a pilot program that involved 160 McDonald’s locations in Lexington and Louisville, Kentucky that obviously showed positive results for both it and its partner in the venture. It’s unclear exactly how many McDonald’s locations this will be rolled out to by the end of the year. But by the end of 2026, the company plans to have these doughnuts for sale throughout all of the restaurant’s locations nationwide.

To be clear, this is not a maneuver that Krispy Kreme is being forced to make. The company clearly has a handle on how to grow. In the chart above, for instance, you can see revenue, profits, and cash flows over the last three fiscal years. Revenue has risen nicely, climbing from $1.38 billion to $1.69 billion. It is true that the firm has generated a consistent net loss over this five-year window. But adjusted operating cash flow and EBITDA have been fairly robust during this window of time.

While price increases have certainly played a role in some of its expansion, a big part of the growth of the firm has come from a rise in the number of locations it has in operation. They have grown from having 10,427 locations at the end of 2021 to having 14,147 by the end of the 2023 fiscal year. It is worth noting, however, that not every location is the same. Instead of classifying these locations as restaurants or stores, the company classifies them as ‘Global Points of Access’.

Examples include Hot Light Theater Shops and other Hubs, which the company describes as immersive and interactive experiential shops that also serve as local production facilities for its vast network. The typical shop here costs between $2 million and $5 million to establish. Given this high cost, the company has also experimented with other formats. It has smaller shops and kiosks that do not have any manufacturing capabilities that it operates. These are called Fresh Shops and they instead receive fresh doughnuts delivered each day from Hub locations. The typical investment here is between $0.1 million and $1 million per location.

Management has rolled out ecommerce and delivery options for customers that you utilize third party digital channels, as well as its own. But on top of this, it has also developed what it calls its DFD Doors, or Delivered Fresh Daily locations. In these instances, the company arranges to place a doughnut cabinet in high traffic grocery and convenience locations, quick service restaurants, club membership facilities, drug stores, and other similar facilities. These are often the cheapest setups, costing the company only between $2,000 and $10,000 per location.

Given the low cost of setting up DFD Doors, management has invested heavily in the expansion of the initiative. 11,924 of the firm’s 14,147 locations occur through DFD Doors. That includes 6,808 of the 7,372 of the firm’s locations in the US. Of course, these locations bring with them lower revenue. Despite accounting for 92.3% of all of the company’s locations throughout the US, DFD Doors are responsible for only about 19% of the sales generated from the domestic market. The reason why I bring up so much detail about these particular locations is because this is the grouping that the 160 McDonald’s locations fall under.

When it comes to the domestic market, this makes it possible to run some interesting numbers. We have no idea how much revenue Krispy Kreme will generate from its partnership with McDonald’s. A case could be made that McDonald’s has a special deal with the company that results in a disproportionate share of revenue going to it as opposed to Krispy Kreme. But of course, this is speculative and we will not have any idea of what the picture looks like until additional data comes out over time. But assuming that each McDonald’s location has the same kind of economics that Krispy Kreme’s existing DFD Doors locations have, then we can anticipate $30,836 worth of revenue per year per store.

Operationally speaking, McDonald’s is a behemoth. Globally, the company has 41,822 locations. 13,457 of these are located in the US. Of the US ones, 685 are owned and operated by McDonald’s corporate. There rest fall under franchise or licensing agreements. Globally, the number of locations that McDonald’s corporate owns is about 2,142. Seeing as how the revenue that McDonald’s brings in from the locations it does not own is largely restricted to franchise fees, marketing fees, and more, most of the revenue it generates will probably be associated with the stores that it owns. But so long as this arrangement boosts sales overall, both it and Krispy Kreme stand to benefit.

Taking the same aforementioned economics, and assuming that the number of McDonald’s restaurants remains unchanged between now and the end of 2026, this could translate to an extra $415 million in revenue for Krispy Kreme on an annualized basis. Assuming the same margins as with the company currently gets, this should translate to an extra $11.4 million of adjusted net profits each year. It should also work out too about $30.1 million in additional adjusted operating cash flow and an extra $52.8 million annually in EBITDA for the business. This is on top of any additional growth that the company might experience outside of this initiative over the next few years. Even if we add these potential profits/cash flows onto the business and assume that management achieves the same kind of profit growth in 2025 and 2026 that it expects to achieve this year, the stock isn’t exactly cheap as can be seen in the chart below.

This is not the first time that a major chain has partnered up with another sizable chain. Earlier this year, for instance, The Wendy’s Company (WEN) released a new product called the Pull-Apart that is currently made by Cinnabon. I am sure that there are other examples as well if you dig deep enough. The advantage for the small chain is that it gets additional revenue and profits, while being able to optimize its supply chain to minimize production costs across the board. And the advantage for the large chain is that it gets incremental revenue and profits for almost no additional work. This is a classic win-win situation that is unlikely to go bad. As for the long term, I have to wonder if an acquisition might be on the table. There’s no evidence that McDonald’s is considering such a maneuver. And investors would not be wise to speculate that a move like this will ultimately come to pass. But there are other signs that show that McDonald’s is intensely interested in this space.

For starters, back in 1993, McDonald’s began its McCafe initiatives. In an article published in 2022, it was stated that the brand is now present in over 50 different markets and, that by the end of 2023, there would be at least 3,500 McCafe locations in China alone. More recently, McDonald’s has also dabbled with another concept called CosMc’s. It opened one location back in 2023 and is expected to grow the location count to 10 by the end of this year. If all goes according to plan, the business will expand the location account starting next year. Although these initiatives have largely centered around beverages, management at McDonald’s admits that the McCafe initiative is part of the company’s strategy to capture a sizable chunk of the $100 billion a year afternoon ‘pick-me-up occasion’ market.

I would argue that very little would go better with these kinds of initiatives than doughnuts and other similar offerings. What’s more, this is not just a US based opportunity. This is a global one. I say this because, in 2022, the global market for doughnuts was $12.6 billion. That number is expected to grow by about 3.5% per annum, eventually hitting $17.8 billion in 2032. Add on the ability to get some synergies involving beverages, and the benefit that would come from having thousands of additional locations, and I can see why a purchase of a firm like Krispy Kreme, should this rollout go according to plan, might make sense at some point.

Takeaway

At this point in time, Krispy Kreme is not exactly the cheapest company on the market. Its revenue growth in recent years has been encouraging and adjusted cash flow numbers make the stock look more attractive from a pricing perspective. But it’s most certainly not a deep value play. It does seem to offer some attractive growth prospects, not only because of how well it has grown in recent years, but also because of the expanded partnership it has with McDonald’s. For those who don’t mind a little bit of risk associated with growth, I would say that this makes a decent ‘buy’ candidate.