Krispy Kreme (DNUT) – Lock-up Expiration With a Twist – 20% Upside

Current Price: $15.96

Target Price: $12.50

Upside: 20%

Expiration Date: January 2022

IPO Prospectus

 

This is a light note on an interesting, but a bit speculative lock-up expiration opportunity. Short selling is very risky. Do your own due diligence before investing. Not an investment advice, just an overview of the situation.

Krispy Kreme is an international doughnuts brand, which completed the IPO on the 1st of July this year. Post-IPO, the previous PE owner JAB Holdings retained 74% ownership with a standard 180 days lock-up. The lock-up expires on the 27th of December (Monday). Nothing interesting so far. However, there is an unusual twist – right after the IPO JAB distributed about half of its stake to 100 of its minority partners. JAB is unlikely to be a seller after the lock-up, but there’s a good chance that a large part of minority partners will quickly head towards the exits – they have invested in JAB PE fund and are not likely to be interested in holding an individual stock in their portfolios. These limited partners own 63m shares – about 37% of all outstanding or 67% of post-lock up free float excluding JAB. Thus a heavy selling pressure could be expected at the end of the year or beginning of 2022 – some willing-sellers might hold off for a week in order to roll capital gain taxes.

The stock has been pretty volatile after the IPO and has reached $13/share price multiple times. Currently, DNUT trades close to its IPO price ($17/share) and is priced at 18x+ E2021 adj. EBITDA, so definitely not on the cheap side. Borrow is available but very expensive – has increased to 69% over the last few days. For more levered bets, January options or option spreads might also work in this situation – e.g. Jan $15-$12.5 put spreads at a cost of $0.6/share at the time of writing – limited risk (100% loss of the premium paid) and potential return of $2.5/share (or +300%) if shares drop below $12.5 level.

If anyone can recall any other lock-up expiry situations where a large part of ownership had been distributed to limited parts of PE fund, please share – would be nice to have a couple of precedents to see how similar cases have played out.

From IPO prospectus:

JAB has advised the Company that it is obligated to distribute, through its affiliate, approximately 62.7 million shares of the Company’s common stock, representing approximately 38.3% (or approximately, 37.3% if the underwriters excercise their over-allotment option in full) of common stock following this offering and the use of proceeds therefrom, to its approximately 100 minority partners in the Distribution, and that the Distribution will occur immediately following the consummation of this offering and the application of proceeds therefrom. Following the Distribution, JAB will beneficially own approximately 38.0% of our common stock through its affiliates (or approximately 37.0% if the underwriters exercise their option to purchase additional shares of common stock in full), prior to giving effect to any purchase by JAB of shares in this offering. The shares of common stock to be distributed in the Distribution will be subject to a lock up agreement in favor of the Underwriters for a period ending 180 days after the date of this prospectus.”

Plenty of background details can be found in this well-written short thesis on VIC. A quick summary:

• DNUT’s IPO was a failure and ended up priced at $17 instead of the initial expectations of $21-$24/share.
• DNUT used to be a public company once before (IPO’ed in 2000), however, at the time the business offered a different concept (baked on-site) and was franchise-based. Due to expansion and changing market conditions the company had to change the concept to “fresh shops” whereby DNUT baked doughnuts in their centralized facilities and supplied produce to their/franchisee stores.
• The concept failed to gain traction and in 2016 DNUT was acquired by JAB for $1.35bn EV or 18.3x EV/forward EBITDA.
• JAB is a German PE firm (5bn Eur AUM) with significant experience in similar industries. JAB thought they will be able to revitalize the brand through operational improvements and expanding the offerings (Coffee) and entering new markets. However, new market locations faced quality control issues, some of the new concepts proved to be not working or failed to gain the expected traction (coffee) and eventually, DNUT began rapidly buying out its franchises.
• Over time, the company became a struggling asset-heavy business (currently only 6% of revenues are from franchising).
• In the recent IPO process, DNUT masked the obscure performance and low organic growth (1-5%) by the total growth, including acquisitions, and did not report any important metrics like same-store sales.

Currently, the company trades at 18.4x E2021 adj. EBITDA, similar levels to where JAB bought it in 2016 (IPO was priced at 20x adj. EBITDA). VIC author argued that based on its growth profile and franchise mix such valuation is too high, the stock should trade in line with other low-franchise restaurant operators like BLMN, TXRH, EAT, DRI, CAKE, etc. at 8-14x EV/forward EBITDA. Worth noting that since the thesis was published in September, most of these peers have traded down, probably in part due to renewed COVID fears, and some have dropped quite materially (BLMN now trades at 5x E2021 adj. EBITDA).

The only indicated minority partner is PE firm BDT Capital, with 14.3m shares (8.7%). Officers and employees own another 7.2m shares and seem to be under the same lock-up terms.

Again, I don’t expect JAB to be a seller as the group has been acquiring shares recently in the open market  (see the risk section below).

However, the 100 minority partners who now hold an odd DNUT share in their portfolios should be eager sellers after lock-up expiration:

• Minority partners are likely to be limited partners who invested in JAB’s fund in order to take DNUT private, transform the business, and then sell it more expensively. We are now at the last stage, the sale/exit part. There does not seem to be any reason for minority partners to continue holding these positions.
• By my count, these minority shareholders sit on gains of 50%, clearly not the most impressive return for private equity over 5.5 year period. If JAB could not squeeze more from the business while it was private, why should that change when the company is public to warrant a further holding period?
• Importantly, these shareholders might be not interested at all in holding individual stock in their portfolios – keep in mind their ownership is the result of investment in Private Equity and not selective stock picking.
• IPO was a failure, the share price declined subsequently and now is back almost to IPO levels – it might be viewed as a lucky opportunity to exit the position on which these shareholders no longer have any control (previously they trusted JAB to do the work for them).

 

Risks

• Short selling is inherently risky – do your own due diligence before investing.
• Due to the recent share price run-up and potentially, upcoming lock-up expiration borrow is becoming tight. Borrow fees used to be around 8% at the end of November and have recently spiked to 69%. On top of that, the current free float of DNUT is low – only about 23m shares (14% outstanding shares). Short interest is high with 4.8m of DNUT shares on short-sale, which is around 21% of free float. There is a risk of the potential squeeze, which could end up pretty badly. The lock-up expiration will dramatically ease up borrow availability (float increasing fourfold) and borrow fees should drop down at the end of the month.
• DNUT has recently issued pretty strong Q3 results – organic revenue +18% YoY due to success in the international and market development segments. Organic revenue in the US declined. Adj. EBITDA grew +10% YoY. The company has reiterated its 2021 guidance (24.5% EBITDA growth and 1% revenue growth) and long-term expectations of annual EBITDA growth of 12-14% and long-term annual revenue growth of 9-11%. However, this is a freshly baked public stock and at least some of the positive YoY change might have been impacted by a more difficult market environment last year due to higher COVID restrictions (Q2 results were also quite strong YoY).
• After the IPO JAB has been slowly increasing its stake in DNUT. During Aug and Sep the firm acquired an additional 2%. Then on the 29th of November, JAB issued a 13D showing that a further increase of 1.5% with purchases at $13.7-$15.65/share. Finally, on the 2nd of December, JAB announced a return swap deal with BNP Paribas for up to 6.5m (about 4% outs. shares) DNUT shares basically betting that in 3 years DNUT share price will increase. The announcement also stated that JAB “intends to be an anchor shareholder for many years to come” and a strong “confidence in the long-term potential of Krispy Kreme”. JAB currently owns 44.8% of DNUT. These announcements had a very positive effect on DNUT share price. It is hard to judge from the sidelines and JAB’s incremental investments might indeed be driven by the belief in DNUT long term prospects, however, at least the recent SWAP deal coupled with many bullish statements does look suspicious when released so close to the lock-up expiration date and smells a bit like an effort to provide share price support for the lock-up expiration. Overall, JAB’s purchases definitely challenge the short/sell-off thesis. If the PE firm continues to buy DNUT stock, there is a risk that together with the increasingly positive market response it could offset part of the expected post-lock-up expiration selling.