What group of investors banded together to buy KKD (took it private) from the food conglomerate Beatrice?
The (associate) franchisees.
Is this important? Very.
In the normal franchisor-franchisee relationship, each entity strives to maximize its wealth. The relationship must strike a balance or it will not be very succesful.
1) If the franchisor's terms (to the franchisees) are onerous, few franchisees will be recruited and the franchisor will not grow (=> low stock price).
2) If the franchisor's terms are too generous, the franchisor will not be profitable (=> low stock price). Thus an appropriate balance of interests will allow both the franchisor and franchisees to get a slice of the pie and for the pie to grow.
This "mutual dependence" model does not apply to KKD, because the franchisor and the franchisees, to a large degree, are one and the same. KKD points out this conflict of interest in the recent S-3:
"A number of our directors own, and some officers have a financial interest in,
some of our franchises. The interests of these individuals, therefore, may be
potentially in conflict with our interests.
Some of our directors own and some officers have a financial interest in
some of our franchises. As directors and officers of Krispy Kreme, these
individuals influence the way our business is managed and the formulation of
business strategies. The interests of these individuals may, therefore,
potentially be in conflict with our interests. In addition, we have made
guaranties, entered into collateral repurchase agreements and provided other
financial assistance to some directors and two officers. "
1) entities attempt to maximize wealth
2) franchisee wealth is made up of two components - KKD stock holdings + value of franchises
The KKD stock holdings (at current valuations) likely represent a sizable portion of each franchisee's wealth. For example,
1) Charleston franchisee sold or holds $50 million in stock (sold Charleston franchise for $4 million)
2) Augusta - Athens - Orlando franchisee has had past operational problems at Athens store; he holds around $40 million in stock, franchises are worth $1-$4 million (my estimate)
The franchisees, therefore, have a strong interest in a high stock valuation (that's where most of their wealth is). So, what specific behaviors would promote a high stock price? To answer that, one must look at factors in KKD's valuation. Based upon analyst and discussion board comments, I would guess that the following are factors:
1) strong same store sales
2) rapid franchise expansion
3) strong profitability growth
Can the (associate) franchisees influence these factors. Absolutely. Would they be willing to sacrifice profitability of their own local franchises in order for the company to post better numbers? Microeconomic theory (and common sense) says that they would, at least in the short run.
So, how exactly could the (associate) franchisees exert control over the critical KKD factors
STRONG SAME STORE SALES
The same store sales calculation has little analytical value due to its ambiguity and exclusions:
It wouldn't take much effort for KKD to breakout same store sales by "associate" franchise and "area developer" franchises (not to mention the information is quite important), but they haven't done it.
There is some evidence that the same-store sales numbers are being boosted by large increases in low-margin off-site sales (from the company stores and associate franchisee stores). From the most recent 10-Q:
"We believe continued increased brand awareness and increased off-premises sales contributed significantly to the 12.3% increase in our systemwide comparable store sales."
The royalty rate for the associate franchisees on off-premises sales is 0% (private label) or 1% (versus 4.5% for area developer franchisees), so such an increase in sales (from the associates) is hardly helpful to KKD's bottom line.
KKD warns that the current same store sales are not sustainable. From the recent S-3:
"You should not rely on our comparable store sales as an indication of our future
results of operations because they may fluctuate significantly.
It is not reasonable to expect our comparable store sales to increase at
rates achieved over the past several years. Changes in our comparable store
sales results could cause the price of our common stock to fluctuate
My question: Are these incremental sales profitable? We have no way of knowing, but they do boost the reported same store sales.
RAPID FRANCHISE EXPANSION
A significant portion of the "area developer" franchises are being financed internally
Others are being bought back (Savannah, Charleston, Baltimore).
Some of the new "area developers" are actually KKD officers or existing franchisees (see SEC filings). It is not clear (save for Jimmy Buffett in West Palm Beach) that deep-pocketed outsiders are actually being courted as franchisees. Why not? Are the franchises not profitable?
STRONG PROFITABILITY GROWTH
Much of the profitability growth has come from
1) 1999 restructuring
2) $130,000 profit (my estimate) realized for every "area developer" new store opening ($30,000 franchisee fee + $100,000 profit on equipment sales)
3) Failure to recognize some costs (Effingham facility, quirky depreciation rules, growing prepaid expenses) as they are incurred
4) Sales of supplies to franchisees
5) IOU's from Affiliates (franchisees)
So, if my model of KKD is correct, why does the market obviously disagree (evidenced by a relatively high valuation)?
My best guess: asymmetric information. The market believes that the individual franchisees are (wildly?) profitable. Because the franchisees are privately held, we have no way of verifying this. Only the franchisees know. The existing evidence (from joint ventures contained in the financial statements) is to the contrary.
From the SEC filings:
1) Northern California joint venture has had declining profitability over last several quarters
2) Equity method joint ventures have not achieved profitability