Krispy Kreme Stock: Too Rich For My Taste (NASDAQ:DNUT)

A few months ago, I wrote a cautious article on Krispy Kreme Inc. (NASDAQ:DNUT), arguing the risk reward in the stock was not attractive, given it was trading at 38x Fwd P/E.

To be fair, my article was not well timed, as DNUT’s share price began to recover almost immediately after my article was published (Figure 1). The move looked very odd, as the company was coming off a very large Q2/2022 earnings miss and there were no catalysts to cause the stock to recover.

McDonald’s Partnership Spur Massive Rally

However, by mid-October, the investing public finally found out why the stock had been going up when Krispy Kreme announced a partnership deal with McDonald’s (MCD), in which nine restaurants in the Louisville and surrounding areas would trial serve a limited selection of Krispy Kreme doughnuts.

The stock’s recovery from the Q2 earnings miss made sense in hindsight, as an important partnership of this nature would probably take months of negotiations and back and forth, during which the news could have been discovered by investors with superior tools and access.

In any event, the McDonald’s news sent DNUT shares soaring, rallying from a September low of $11 to a peak of $16 in late November.

McDonald’s Trials Are Double-Edged Swords

Partnership trials with McDonald’s are a double-edged sword. Just ask Beyond Meat Inc. (BYND), which announced a McDonald’s trial in September 2019. Initially, the trial resulted in a lot of positive press exposure for Beyond Meat, as it was a ‘validation’ of the company’s products. However, Beyond Meat’s stock price plunged in June 2020 when CNBC reported that the trial had ended quietly by April 2020 with little fanfare. Ultimately, the Beyond Meat PLT (“Plant Lettuce Tomato”) sandwich was not picked up by McDonald’s for its everyday menu.

While Krispy Kreme may fare better than Beyond Meat, it is still early days in the trial period, so investors should not get their hopes up just yet. History is filled with McDonald’s trial items that were ultimately discontinued.

Q3 Review

The McDonald’s hype conveniently overshadowed a mixed Q3/2022 earnings report from Krispy Kreme, with the company reporting a revenues beat of $378 million (+10% YoY) vs. $363 million consensus, but an earnings miss of $0.03 non-GAAP EPS vs. $0.04 consensus estimates.

Importantly, although DNUT’s revenues climbed 10% YoY in Q3/2022, growth was much more muted sequentially, with top line revenues rising only 1% QoQ. Furthermore, despite strong revenue growth, Krispy Kreme continued to operate at an operating loss of -$1.0 million in Q3/2022, marginally better than the -$2.9 million operating loss in Q3/2021.

For a company generating $1.1 billion in top line revenue in the first 3 quarters of 2022, Krispy Kreme’s operating profit of $24 million (2.1% operating margin) remains pitifully low (Figure 2).

Investor Day Was A Disappointment

Consistent with the surprise run up in the share price in September ahead of the positive McDonald’s news, Krispy Kreme shares began to sell off hard in late November on no known catalysts. The actual catalyst was revealed at the 2022 Investor Day on December 15, when the company announced modest long-term growth plans that disappointed investors (Figure 3).

Importantly, the company’s long-term growth model forecasts revenues of $2.15 billion by 2026 (9.4% CAGR from 2022 levels) and ~$0.53 in adjusted EPS by 2026. Since Wall Street analysts were already expecting $0.42 in adj. EPS for 2023, that implies DNUT is much less profitable than analyst had assumed.

Since the investor day, we have seen Wall Street analysts rapidly reduced their earnings estimates for DNUT, with the most drastic cut being to 2025 EPS estimates (Figure 4).

Valuation

In fact, on the topic of valuation, Krispy Kreme remains one of the richest valued companies in the restaurant space, currently trading at 43.6x Fwd non-GAAP P/E (Figure 5).

In fact, even if we give management the benefit of the doubt and believe their long term growth plans, with 2026 EPS guidance of ~$0.52, the shares are trading at an eye-watering 22.2x 2026 EPS, a full four years in the future.

Risk

The biggest risk to DNUT remains the discretionary nature of its products. With inflation hurting consumers in their wallets, we could see consumers pull back on discretionary spending on items like doughnuts when times are tough.

Another risk with DNUT is the erratic nature of its share price movements. As a fund manager, whenever I see stocks move without any obvious catalysts, my first reaction is that someone else has better information than me. For DNUT, that appears to have been the case, first with the September rally ahead of the McDonald’s partnership, and then subsequently with the November/December decline ahead of the negative Investor Day guidance. While there is no proof of any nefarious insider trading, the optics certainly does not look good.

Conclusion

I continue to believe investors should avoid Krispy Kreme stock, as it trades at an elevated 22x 2026 EPS. Although management has done a good job increasing revenues, there does not appear to be any corresponding jump in profitability and earnings.