[DNUT stock] Krispy Kreme Q2 2021 Earnings Call (8/17/21)

Thanks, Mike, and hello everyone. As Mike said, we are pleased to report an excellent Q2 with net revenue growth of 43%, organic revenue growth of 23%, and adjusted EBITDA growth of 78%. Although our operations in several markets were impacted by COVID last year, our strong performance this quarter also reflects the underlying strength of our omnichannel business, with revenue growth of 50% and adjusted EBITDA growth of 64.5% when compared to Q2 2019. The difference between the quarter's 43% revenue growth and 23% organic sales growth is explained mostly by franchisee acquisitions made in the last 12 months. These include Japan, which we successfully integrated in December 2020, as well as franchisees in 12 U.S. cities including San Francisco and Miami, which we acquired in Q1. We made no franchisee acquisitions in Q2. All our business segments saw positive organic growth in the quarter, with the international segment, comprised of our fully owned and operated businesses in the UK and Ireland, Australia, New Zealand, and Mexico, leading the way with 126% growth. At the height of COVID restrictions last year, approximately 30% of our shops around the world closed. However, demand for our sweet treats remained strong, and we were able to quickly reopen in the back half of 2020. While lapping the effects of COVID explains much of the international segment's Q2 growth, we are very pleased to see that these businesses, where our signature hub and spoke operating model is most mature, have come back stronger than ever. For example, the UK and Ireland market, which makes the majority of its sales outside the brick and mortar donut shops, delivered Q2 net revenue growth of 37% versus 2019. Points of access to fresh doughnuts have increased by over 40% in the last 12 months in the UK and Ireland, driven mostly by additional delivered fresh daily doors at leading national supermarkets Tesco, Sainsbury's, and Asda. UK and Ireland spokes per hub are now 74, and sales per hub are $7.6 million, explaining why the UK achieved EBITDA margin in excess of 30% in Q2. The international segment helped drive overall consolidated adjusted EBITDA margin up 300 basis points versus last year to 14.7% year-to-date, higher than we expected at this point in the year. Looking to the consolidated P&L, product and distribution costs declined 380 basis points, mostly due to the international segment's rebound and also lapping start-up expenses incurred in launching the U.S. branded sweet treats business last year. We do see significant commodity cost pressure, particularly from edible oils. However, in Q2 we continue to benefit from forward contracts insulating us from this effect. Moving forward, we will use pricing to compensate for this headwind. Operating expenses rose basis points, largely due to the acquisition and conversion of franchisees, which add their operating costs to our P&L. Our existing controlled businesses saw some increased costs, with occupancy and lease expenses rising on the expiration of temporary savings arrangements negotiated with landlords during the height of COVID. We also saw U.S. costs rise as we invest in deploying the hub and spoke system there. SG&A rose 50 basis points, inflated by IPO-related expenses of $6.7 million. Excluding these, we have seen a 140 basis point reduction in SG&A, reflecting the benefits of scale from our revenue growth. On the bottom line, we saw a $15 million GAAP net loss, driven by multiple one-time items, including interest related to our short-term dividend recap loan and related party interests, one-time income tax adjustments such as non-deductible public company executive compensation, and the announced corporate tax rate increase in the UK. Without these one-time items, GAAP net income would be positive. Adjusted net income, which also adds back stock-based compensation, acquisition amortization, and other non-recurring expenses, was up to $20.5 million. Before reviewing the performance of our business segments individually, I wanted to update you on our consolidated net debt and leverage position as we've made a few significant cash and debt movements early in Q3. These include the proceeds from our IPO and the repayment of a $500 million loan. As of August 8th, we have $118.7 million of cash and net debt of $646 million. Now with all IPO-related transactions complete, our total net leverage stands at 3.6 times, using our Q2 trailing adjusted EBITDA, which is in line with our expectation going into the IPO process. Turning to our results at the segment level, in the US and Canada, where our deployment of the hub and spoke model is ongoing, we delivered our eighth consecutive quarter of positive organic sales growth. Net revenue grew in line with expectations, rising 25% to $231 million from $184 million the previous year, on a combination of franchisee acquisitions and organic growth of 3.9%, in turn driven by delivered fresh daily doughnuts sold in grocery and convenience stores, our new branded sweet treats line, and Insomnia Cookies. Notably, the segment's two-year organic growth stack is now 14.3%, with sales proving resilient last year despite COVID. DFD doors now exceed 5,000, compared to just 2,000 in Q2 2020. We've also seen average weekly sales per door increase more than 30% over this time, reflecting the success of our transition to only fresh donuts at a price consistent with menus at our donut shops. Excluding the impact of exiting our legacy wholesale business, the US and Canada segment would have recognized organic sales growth of nearly 19%, highlighting the underlying performance of the business and bolstering our confidence in organic growth acceleration for the segment going forward. Looking to profitability, US and Canada adjusted EBITDA grew to $28 million from $27.6 million the previous year, with DFD efficiencies, improved New York traffic, and Insomnia Cookies all contributing to the bottom line. US and Canada EBITDA margin this quarter was 12.2%, in line with the prior quarter's 12.4%. This result reflects both efficiencies from implementing our hub and spoke model and the fact that we are still early in its deployment in the segment. We continue to invest in the new operating model. We hired more Krispy Kremers than ever before this past quarter as we integrated newly acquired shops, added hub and spoke routes, and made the transition to DFD in major markets including Dallas, Houston, and San Francisco. A temporary increase in training costs and associated overtime, plus increased wage inflation pressures, are impacting short-term margin growth. However, we expect to mitigate these increases as well as commodity inflation with a price increase in September. We are aware that compared to Q2 2020, EBITDA margin has declined from that quarter's 15.0%. That was the highest the company had seen in recent years and is partly explained by a reduction in labor costs at the time as sales shifted to pickup and drive-through while our shop lobbies were closed in the face of COVID safety measures. Turning to our CPG offering, our branded sweet treats line gained momentum in the quarter as we brought to market three new varieties: S'mores Bites, Key Lime Coolers, and Chocolate Coolers. The range is expanding, with our launch customer Walmart undertaking a shelf reset to give us more space, and Albertsons, one of the largest grocery chains in the US, becoming our second largest customer. Today the line is already available at approximately 6,300 locations across the US across 17 different retailers. To feed our branded sweet treats expansion, we undertook during Q2 an investment in three new production lines across our factory network, which will increase capacity by over 200%. By leveraging existing infrastructure, we will require less than $2 million in capital investments to do so. We expect branded sweet treats to be profitable by the end of 2021, and overall in the US and Canada, we expect branded sweet treats, the New York market, and the whole system at large to see margin improvements over time as we continue to deploy the hub and spoke model. Moving to the international segment, we grew net revenue 159% to $89 million from $34 million the prior year, with organic revenue growth of 126% year-over-year driven by increased foot traffic and in-shop dining following the lifting of COVID restrictions. We grew international points of access by 600 versus the same quarter last year, helping the segment to 28% organic growth versus Q2 2019 and demonstrating the strength of the omnichannel strategy. In addition, e-commerce is now well established in the segment, representing 15% of Q2 retail sales. Looking to profitability, international's Q2 adjusted EBITDA grew to $24 million from $1.6 million, driven by strong revenue growth and COVID recovery. Profitability continued to benefit from the robustness of our hub and spoke model, which is most mature in this segment. Overall, international's markets rebounded to match or exceed their performance prior to the pandemic, and we expect the segment to continue to contribute to strong EBITDA performance in the future. Now turning to the market development segment, net revenue grew to $29 million from $26 million year over year, with 17% organic growth driven by overseas franchise markets. Despite continued COVID restrictions in certain segment markets, we continue to see growth, with revenue exceeding pre-pandemic levels. Further, we saw the addition of 92 new points of access across the segment as well as strong e-commerce performance. In our newly acquired Japan business, e-commerce and our recently launched DFD program continue to drive growth even despite government-imposed state of emergency measures. Overall performance in the segment resulted in market development's adjusted EBITDA growing to $10 million from $8 million, representing 25% year-on-year growth. Looking forward, we expect the segment to continue to deliver strong organic growth as we add more points of access across the world, including our upcoming new market entry in Egypt. As Mike explained, our hub and spoke operating model is key to the execution of our omni-channel strategy. And as referred to earlier when discussing the UK and Ireland, we track three metrics to measure progress in the implementation of the hub and spoke model: points of access, spokes per hub, and sales per hub. As of the end of Q2, we have 9,575 points of access, a near 70% gain over this time last year. These points of access include 7,849 DFD doors, with 5,067 in the US and Canada, 2,264 in the international segment, and 518 in market development. This represents a global net increase of 1,261 doors from the end of 2020. Here today we have added 930 DFD doors in the US, with the largest gains in Dallas, Chicago, and Houston. In brick and mortar, we now have 1,726 Krispy Kreme and Insomnia Cookies branded shops, an increase of 39 since the beginning of the year. We see significant white space opportunity to continue to grow our points of access, with the potential to have more than 2,900 points of access within the US and Canada segment and an additional 2,800 points of access in the international segment. 1,700 of these rest in the top US markets which are New York, Los Angeles, Chicago, Philadelphia, Dallas, San Francisco, Houston, Washington DC, Atlanta, and Boston. As we expand into these white spaces, we are aiming for an annual global development goal of 800 to 1,000 new points of access. Looking to hubs, as of Q2 we have 413 production facilities around the world, an increase of five since this quarter last year. Our strategy is to selectively add around 10 new production hubs per year. Much of our focus is on leveraging capacity at our existing hubs by adding new points of access. To that end, we have increased the number of hubs with spokes in the US and Canada segment to 114 from 88 one year ago, mostly by converting legacy Hot Light Theater shops. With the additional points of access, we have increased average spokes per hub in the US and Canada segment to 45 from 37, and in the international segment to 71 from 65 since the end of 2020. International's higher average reflects the higher proportion of off-premise DFD sales in that segment. International's trailing 12-month sales per hub reached $8 million in Q2, up from $6.4 million in the full year 2020. In the US and Canada segment, average sales per hub reached $3.6 million, up from $3.5 million in the full year 2020 and up from $3.2 million at the beginning of our transformation in 2019. Turning to our expectations for the rest of the year and beyond, based on the great progress through the first half of the year, we are confident in our ability to continue our momentum and deliver strong growth in 2021. Reflecting this, we are issuing full year 2021 guidance of net revenue of $1.34 billion to $1.38 billion, or growth of 19.4% to 23%; organic revenue growth of 10% to 12%; adjusted EBITDA of $178 million to $185 million, or growth of 22.4% to 27.2%; adjusted net income of $62 million to $68 million, or growth of 46.4% to 60.6%. Q3, which is typically a seasonally softer quarter, is expected to see increased pressure from wage and commodities inflation, especially in the US. However, helped by our September price increase, we remain confident in our ability to deliver on this full year guidance. Further, looking beyond this year, we are also issuing a long-term outlook for organic revenue growth of 9% to 11%, adjusted EBITDA growth of 12% to 14%, and adjusted net income growth of 18% to 22% per year. Without the US legacy wholesale business to lap in 2022, the current momentum in our business means that we expect to exceed this long-term outlook next year. In addition, we expect total net leverage to be under 3x in the next 12 months. In accordance with our dividend policy, we expect to pay an initial cash dividend of three and a half cents per share for the quarter ending October 3, 2021. Thereafter, we expect to maintain a stable quarterly dividend until we reach our long-term net leverage policy of 2x. With this, I will now hand it over to Mike for some closing remarks.

Hey John, thanks for the questions. You're right. The first thing to highlight is that in the international businesses where we have the mature hub and spoke model, we do drive very high margins, and in Q2 we saw even higher margins with the additional points of access that we were able to generate there during the COVID disruption. We're implementing the same model in the US, and now we are indeed seeing the same benefits, particularly as we add delivered fresh daily doughnuts, which are now across all our channels in the US. We are able to leverage the fixed costs back at the production hubs and drive up margins. What we're seeing right now is the changes accelerating. We're already at the end of Q3 at our year-end goal for DFD doors of 5,300. So, in effect, the transition is moving even faster in the US, and that means we've hired more Krispy Kremers than ever before. We hired 1,700 people in quarter two alone. So with this level of change accelerating even the transition to hub and spoke, we've seen some additional implementation costs. You can imagine more training costs, more overtime as we fill the vacancies, and hence why the margin, as you point out, is a little bit lower in the US. But actually, when you exclude the branded sweet treats line, which is a new business that we opened up last year, the entry into New York which just happened last year, and of course we have reduced traffic still in the city there, and the most recent acquisitions are core fresh donut businesses doing already in the US over 15% EBITDA margin. So we do have line of sight and indeed many ways greater confidence in our ability to drive EBITDA margin improvement towards those international levels. Now in Q3, we are seeing commodity cost pressure coming through a little more on wheat, on edible oils, and sugar. The markets are all coming strong, hence our decision to take a price increase in September. Towards the end of the quarter though, you're right: quarter four is when we will see in the US the benefits of both that price increase and the efficiencies from the hub and spoke model, which as I said is going faster than even we expected. You asked about long term. We don't expect to close the gap all the way to those international margins. The international businesses were built effectively greenfield with hub and spoke in mind, whereas in the US we have a legacy business that we're transitioning. There will be production hubs, Hot Light Theater shops that we never add spokes to, so there is some inherent inefficiency there. We also, as I mentioned, are bringing on businesses like branded sweet treats to become more profitable over time. So the transition will be a multi-year transition, but we will see 15% EBITDA margins in the US in the years to come.

Hi Sergio, you bet. We are always pursuing positive mix opportunities because we are continuously innovating with specialty donuts that we tend to price at premium price points. That is an ongoing part of our strategy. As a fresh donut provider, we're always in a position to do that. People get excited about the innovations we bring to the marketplace. More specifically in September, what we're talking about is taking up menu prices for our core donut business, our core dozens business. It will vary across the country depending on local market specifics. We're very thoughtful and targeted as to what is the appropriate price point for different regions, different cities. That price increase is intended to cover the commodity inflation that I mentioned. Also, we are seeing wage inflation typical of what you're seeing across the industry and actually in line with our expectations. The commodities are a little bit higher, and hence the need to lean in on pricing in September. But as a fresh-only donut business, it's a special occasion, infrequent purchase. We have plenty of ability to bring that pricing. We know people love our dozen doughnuts, and so we have no concern about the ability for that to flow through to the bottom line.

Hi David. The biggest bucket of increased costs on the P&L is of course in our operating expenses. Driven by the biggest parts of our P&L, which are labor. As I mentioned before, we're investing in labor in line with the expansion of the system in the US. We're investing in labor with the investment in the growth across the world. We have seen that increase in line with the market. The next biggest area of increase would definitely be on the product side, and we've seen that grow a bigger headwind than we expected. But that's as much as I can give.

Sure thing. The first thing is goals and targets, and you're right: we have aspirations for high margins. The reason I gave some specific details earlier on the UK is because even in the most mature hub and spoke cities, we can continuously add more points of access and drive even more efficiency. The first thing to say is across the whole system, we are looking to leverage the omni-channel model to bring more efficiency. We talk a lot about hubs where we have spokes and adding DFD, leveraging the fixed cost there. We're definitely doing that. But even in hubs without spokes, with e-commerce now a permanent change and a permanent addition to our channels, we're able to drive efficiency by having those transactions, which are highly incremental, flow through at higher average transaction values to the bottom line. So it's a system-wide effort. Now, there's also a portfolio of cities. You're absolutely right, we have some cities where the hub and spoke model is already a little more advanced, whether it be somewhere like Atlanta, which just reflects the history and great heritage of the company, or somewhere like Tampa, where we acquired the franchise and went from being low single digit margins to low 20% margins in less than 18 months by improving operations, adding spokes, and of course establishing a full omni-channel business in that area. We'll be doing that across the system. We made acquisitions at the end of last year in Dallas and Houston, which, without spokes and with some operating challenges, have been loss making. New York we entered last year in the midst of a pandemic. We have a lot of confidence there. We're seeing the business strengthen, but it's still heavily diluted to the system as we wait for the full return of traffic and tourists. So it's a combination of efforts across the board and in targeted cities where we can add particularly delivered fresh daily doors. That's why I talk a lot about the excitement we have right now with more DFD doors being added to the US system than we even expected. Looking at that north star of somewhere like the UK, where they are able, once they've got the critical mass and maturity of the hub and spoke model, to drive extraordinary EBITDA margins, it's very exciting for us to see that. But the implementation costs are real. Hiring people, adding drivers, adding routes right now in this tight labor market means that we have to have people working overtime. It means that we're training more people than ever before. That's what we mean by those implementation costs. Because it's a big transformation and change, and we're in the heart of the implementation of that. Once that settles, the new labor management systems, demand planning systems that we've invested in will really start to help us leverage the efficiency in each of those cities where we're adding these DFD doors. But right now, through the implementation, it's natural that we need to invest to make sure we're set up for long-term profitable growth.

Hi, thanks Michael. I think two main drivers to point to. The first is that we have, as part of the transformation and learning from international, been really focused on the high quality doors. Of course, they need to be local to the donut shop so the donuts are fresh, but they also need to have the right level of traffic. So we have been really thoughtful on those doors and have walked away from doors versus past years where the volume and traffic doesn't warrant a fresh donut cabinet. The second is the nature of the product and the price point. We are now talking only 100% fresh doughnuts. Would you believe it, but a year ago, 38% of our donuts in the US were not fresh daily. Now it's 100%. We now sell them always at the same price point as you would get in your local Krispy Kreme doughnut shop. So that comparison reflects a combination of better quality doors. There are less of them than we had in that old legacy wholesale business, but they're better doors that will be more profitable. The first thing that drives that profitability is having a higher price point, and that is driving the weekly sales up. We're thrilled to see that across all our customers.

Sure thing, Mike. I'll add a couple of data points. The investment in these production lines is directly a result of conversations with customers, both our launch customer Walmart and other customers in other channels, and looking out over the next couple of years, what we need to deliver on that. Hence, I referenced a capacity increase of about 200%, and that's in line with how we'd expect to increase the business out to 2023 effectively, up to about a three-fold increase in the business. That is exciting but would still give us probably only around about a 4% share of the enormous sweet snacks category. We do believe that with the strength of the Krispy Kreme brand that Mike talks about, there's room to grow faster than that and beyond that. But right now, we're focused on the product selection that we have, adding the new flavors as I mentioned earlier, and expanding only with doughnut-like snacks. In terms of profitability, it has, as we've been subscale and only just now started automating the process, been actually a negative on our bottom line. It will be dilutive next year still, we think, but it quickly, because fundamentally it is a premium priced proposition, will be in line or even better in that time frame from a margin point of view. So we're excited to see the development of the business. Our customer Walmart, our new customers, are also excited to bring it to the market, so we'll keep investing behind it appropriately.

Hi, and thanks for staying on with us today. Yes, the assumptions you mentioned, which are the long-term assumptions, are in line with our current expectations as well. The IPO not being that long ago, we already could see the wage pressure and, to a certain extent, the commodity pressure as well. I must admit, the commodity pressure in the short term has just been quite extraordinary, and so in the very short term, it's a little bit higher than we expected. But the long term is in line with our expectations. All our plans, with the focus on specialty dozens, making sure that we only ever have deliver fresh daily donuts with their price point, the mass premium price point of branded sweet treats, and of course all our businesses across the world offering fresh dozens, we know that we can cover those headwinds on cost by investing in our Krispy Kremers, making sure we always have the best quality ingredients, and indeed delivering on the bottom line because the biggest benefit to that bottom line is the hub and spoke efficiencies coming through. So these are all things that we are aware of, we are used to dealing with. Hence why our immediate decision to go to the September price increase, and we remain confident in our expectations for 2021 and the long-term algorithm as well.