Summary

I’m following up on my coverage of Krispy Kreme (NASDAQ:DNUT), which I previously recommended a buy rating, as DNUT’s fundamentals remained strong on the back of strong execution. Given the growth runway ahead, DNUT should have no issues growing. This post is to provide an update on my thoughts on the business and stock. I am reiterating my buy rating for DNUT as I believe the expansion of its partnership with McDonald’s (MCD) will be a strong driver of revenue growth and EBITDA margin expansion.

Investment thesis

Splitting the 3Q23 results into US and International, US saw revenue growth of 5.45% to $260 million, with $216 million in fresh net sales and $53 million from Insomnia net sales. While growth decelerated from 2Q23’s 9.3% on a reported basis, organic growth only saw 250bps of decline sequentially, and 4Q23 should see an acceleration in organic growth as management mentioned that sales improved in October with low-double-digit organic sales growth. Regarding profits, US adj EBITDA came in at $22.3 million, or 8.6% margin. As for International, net revenue came in at $106 million, growing 15.4%. The strong growth was driven by Mexico, which saw double-digit growth that accelerated both sequentially and annually. Expansion into new international markets also helped with growth (such as Switzerland and Kazakhstan). DNUT is also on track to open in 7 new countries in 2023, with 3-5 more in 2024. The International segment reported 20.2% adj EBITDA margin, driven by incremental pricing actions and a higher number of DFD doors, which increased the number of points of access.

3Q23 growth performed in line with my model expectations for FY23 9% revenue growth, while the 9M23 adj EBITDA margin tracked slightly below my expectations for 12.7%. While the stock remains volatile, I believe there isn’t much to be concerned about as execution remains strong. I believe the partnership with McDonald’s is going to have a significant impact on DNUT’s financial performance if executed properly. For a brief background update, DNUT and MCD have been in a partnership for more than a year as MCD went deeper into its coffee strategy. I take this expansion plan as a major indication that MCD is seeing strong signs of demand and believe that it would work well across the nation. For reference, the partnership so far has reached a total of 160 restaurants in Kentucky, and DNUT is about 2% of MCD US sales per store (management did not outright deny this in the 1Q23 earnings call). Suppose the partnership expands to the entire base of MCD US restaurants (13,459 of them as of 3Q23), the financial impact on DNUT would be insanely huge. At 2% of MCD US sales per store (or US AUV of around $3.9 million as of MCD last 12 months average), it implies a total of $1 billion in potential revenue if it is scaled across all the 13,459 units. Assuming low-teens (i.e., 12%) EBITDA margins, this implies a total EBITDA potential of $120 million, which represents a 50% growth. I would note that my margin assumptions might be too low as these are wholesale products for MCD (although MCD would likely squeeze DNUT regarding margin as MCD has a lot more bargaining power).

Given the numbers you gave, the doubling the sales of those hubs in that market, it would imply something like $200 per day per McDonald’s in Krispy Kreme sales, which might be about 2% of the sales of the McDonald’s. Is that way off? 1Q23 earnings results call

To execute this, management US strategy is to increase capacity with a 10-15% increase in hubs, which is around 25-35 new hubs over the next few years, from $3 million to $6 million per hub. Assuming the rollout will take about 5 years, this would average out the 50% EBITDA growth to ~17% a year. With the appointment of the new CEO, Josh Charlesworth, I expect this to be executed flawlessly, as he has strong operating experience within the business (serving as the COO since 2017) and has decades of experience managing consumer brands.

Cycling back to EBITDA growth, I believe commodity price increases should not impact EBITDA performance that much. Management intends to conduct another round of price increases as the company takes advantage of the low price sensitivity of its brand (consider that 40% of their customers buy for special events; these customers are more willing to pay more since it is seen as a “one-off” event).

As I mentioned, we took pricing across all our markets. In the U.S. specifically, we took another low single-digit price increase in the quarter. That leaves us to the mid-teens on an annualized basis. 3Q23 earnings results call

Nearly, 40% of our customers buy our doughnuts for a party or a special event in their life, up from just 10% a few years ago. Our customers trust us to be part of their special moments. We don’t take that lightly. 1Q23 earnings results call

Valuation

My target price for DNUT based on my model has increased to ~$26.50. My revised model assumptions are that growth will accelerate in FY24 and FY25, as I expect the partnership with MCD to go through expansion and DNUT will start leveraging MCD distribution across the nation to sell more doughnuts. The acceleration in revenue growth will have a direct impact on EBITDA margin, as the sheer volume of sales that MCD can bring in will have high incremental margins (DNUT wholesales to MCD, so margins should be higher than DNUT’s own store margins). With the MCD partnership, I believe DNUT business has structurally improved and deserves to trade at a premium to its historical trading range. On average, DNUT trades at 15x forward EBITDA, and I am expecting the new normal to be the current +1 standard deviation, 16x.

Risk

I think the risk is that the demand seen in Kentucky may not be representative of the entire nation. The US is a very big country with a wide range of preferences and cultures. My concern is that after spending CAPEX and building out the H&S facilities, the demand may not be as good as I expected. This will weigh on EBITDA margin expansion and growth.

Conclusion

I continue to be positive about DNUT after the strong 3Q23 results and execution. I reiterate my buy rating as I expect the expansion of their partnership with MCD as a key driver for revenue growth and EBITDA margin expansion. The prospective expansion of the McDonald’s partnership presents significant potential for DNUT’s revenue, with an estimated $1 billion revenue possibility if scaled across all 13,459 US locations. To make this partnership work, operation execution is key, which I believe is the new CEO’s expertise.