Krispy Kreme Bankrupt?

While I haven’t been short Krispy Kreme (KKD) stock over the last year, I wish I had been. The shares have fallen from $40 each to $7 today, an all-time low. Having ignored this stock since the IPO due to a terribly high valuation and a personal preference for the product at Dunkin Donuts, I finally decided to do some due diligence this week after hearing whispers of the company’s ultimate demise.

As a contrarian, whenever I hear rumors of possible bankruptcy, I take notice. Often times people spread bankruptcy rumors when they are short a particular stock, regardless of whether the risk is really there or not. One of my best trades in recent years was picking up shares of then-troubled Nextel (NXTL) in 2002 when the stock was pricing in tremendous bankruptcy risk due to a mountain of debt.

After carefully examining the company’s finances, investors would have realized that although debt levels were too high, the company’s wireless business was so strong that cash flow from operations would be able to cover the firm’s interest expense. The Nextel story is about to be closed, as Sprint (FON) has agreed to buy the company for about $30 per share. Not bad for a stock that bottomed out at $2 per share less than three years ago.

Back to Krispy Kreme. As you may have read in recent months, KKD has had poor accounting practices in the past, resulting in a CEO resignation recently. Evidently, the company has used the repurchase of stores from franchise owners to boost financial results. In the midst of a full accounting review, the company missed its deadline to file financial statements for the last quarter, due in late January.

Normally this wouldn’t be that big of a deal. The company’s new management is on track to clean up the books, file financial statements, and move on to turnaround the company’s business. However, KKD has a $150 million credit facility that freezes should the company miss a regulatory filing deadline, which it did. Given the internal accounting probes, numerous legal issues, and restructuring going on right now, KKD needs some additional cash to weather the storm and continue to fund operations. But since their credit facility is frozen, they can’t borrow any money until they file.

As a result, newly appointed CEO Steven Cooper is scrambling to cut costs in order to ensure they don’t run out of money before they can tap their credit. KKD’s creditors have extended a deadline for the financials until late March, so current cash must last for six more weeks, assuming the March deadline can be made. To help, the company has sold its corporate jet (why did they have one to begin with?) for $30 million and announced plans to lay off 25% of its workforce at the company’s corporate headquarters.

The interesting thing about this whole story is the talk of possible bankruptcy. KKD is hardly overly leveraged. They have about $120 million in total debt, but the interest rate is less than 3 percent. Operations generate positive free cash flow and the company’s tangible net assets are more than $250 million. Sales at KKD’s 435 stores nationwide are $700 million annually. Interest expense ran $1.4 million last quarter, hardly dramatic.

While I still have some DD to do today on KKD shares, it appears that the largest issue with the company is not its debt load, but rather the ability of their accountants to file accurate financial statements. The company’s operations can adequately fund the debt after these legal and regulatory issues have been resolved. Of course, there is always a chance that things could get worse and they would not hit their deadlines. However, it seems unlikely that the creditors would choose to force KKD into default when the operations seem not only salvageable, but also potentially extremely valuable.

As for trading this situation, it depends on which side of the fence you fall on. I haven’t made a conclusion yet, and don’t know if I will opt to put on a trade or not, but you really have two choices that make sense. If you think bankruptcy is a real option, then short the common stock and buy some calls to hedge your position. If you think they’ll survive, buy the common along with some puts to protect you, should they happen to file Chapter 11.