By

Reymarr Hijara
Business Policy
[Teachers Name]

Krispy Kreme
A Case Study

INTRODUCTION
Krispy Kreme Doughnuts, Inc. (NYSE: KKD) operates as a branded retailer and
wholesaler of doughnuts and coffee. It engages in the ownership and franchising of
Krispy Kreme doughnut stores, which make and sell approximately 20 varieties of
doughnuts. These stores also offer an array of coffees and other beverages. As of January
31, 2010, there were 224 Krispy Kreme stores operated domestically in 37 U.S. states and
in the District of Columbia, and 358 shops in other countries around the world. Of the
582 total stores, 268 were factory stores and 314 were satellites stores.

STATEMENT OF THE PROBLEM

Krispy Kreme had lost focus on its operations, resulting in too many new stores being
opened in poor locations
Improperly trained franchisees, resulting in inefficient running of off-premise business
which lowered Krispy Kremes operational efficiency/income potential
Restructuring of store contracts that charged reduced fees for equipment and
ingredients and an improved store design
Low-carb diet trend that was considered to be gaining momentum

HISTORY
Krispy Kreme Doughnuts, Inc. is a retailer and wholesaler of doughnuts. Its principal
business is owning and franchising Krispy Kreme doughnut stores where over 20
varieties of doughnuts, including its Hot Original Glazed, are made, sold and distributed
and where an array of coffees and other beverages are offered. Krispy Kreme began a
single doughnut shop in Winston-Salem, North Carolina on July 13, 1937, where Vermon
Rudolph bought a secret yeast-raised doughnut recipe from a French chef from New
Orleans, rented a building in and began selling Krispy Kreme doughnuts. Within a short
time, Rudolph's products became so popular that he cut a hole in his factory's wall to sell
directly to customers, thus was born the central Krispy Kreme retail concept: the factory
store. By the 1940s and 1950s there were a small chain of stores that were mostly family-

owned, 29 shops in 12 states. During the 1960s Krispy Kreme had a steady growth
throughout the Southeast and began expanding.
After Rudolph's death, in 1973, Beatrice Foods bought the company and quickly
expanded it to more than 100 locations. Beatrice introduced other products, such as soups
and sandwiches, and cut costs by changing the appearance of the stores and substituting
cheaper ingredients in the doughnut mixture. By 1980 the company was starting to fail,
so Beatrice put it up for sale. A group of franchisees who had been the first Krispy Kreme
franchisees, completed a leveraged buyout of the company in 1982, and they also bought
back the original doughnut formula and the company's traditional logo. The company
struggled for awhile, but by 1989, Krispy Kreme had become debt-free and had slowly
begun to expand. A store was opened in New York in 1986, in 1999 one was opened in
California, and in December of 2001 there was a store opening in Toronto Canada.
On April 5, 2000, the corporation went public on the NASDAQ using the ticker symbol
KREM in what was one of the largest initial public offerings in recent years; one day
after the offering, Krispy Kreme's share price was $40.63, giving the firm a market
capitalization of nearly $500 million. On May 17, 2001, Krispy Kreme switched to the
New York Stock Exchange, with the ticker symbol KKD, which is its current symbol.
PricewaterhouseCoopers LLP served as Krispy Kreme's independent registered public
accounting firm for fiscal 2005, 2006, and 2007. The primary industry of Krispy Kreme
is fast food or restaurant and their ranking is 54 out of 54.
Krispy Kreme Doughnuts has had a rough go of it in the last few years. They have
showed an annual loss for the last three years beginning in their 2005 annual filing. This
is widely regarded to be a direct effect of their rapid expansion in the previous years. As
of October 2007 Krispy Kreme had Approximately 449 store locations (including satellite
stores) in 41 U.S. states and 11 foreign countries. However, things do look a little better
for them this year as compared to the two previous years. Krispy Kreme reported a net
loss for the third quarter of fiscal year 2008 of $798,000 as compared to a net loss of 7.2
million in the comparable previous year quarter.
However when you split the income generated into the categories of operating, financing,
and investing you get a better understanding of the health and well-being of the company.
At the end of the third quarter of 2007, they showed 22.11 million in operating income.
This number does however include 21.05 million in depreciation and depletion. 12.63
million was reported in the investing section. This is mainly due to the sale of property,
equipment, and the buying back of their franchises due to their rapid expansion. This
period of attrition is likely to continue until the companies size is at a sustainable level.
Also Krispy Kreme showed a net loss of 15.48 million in the financing activities section.
This is mainly due to the retirement of long-term debt held by the company.
Some of the significant internal events that the statement of cash flows shows are a little
troubling since they are not in what I would call the "good" category. The Company
recorded a net credit to impairment charges and lease termination costs of $268,000 in the
third quarter of 2007. This is compared to a charge of $5.4 million in the third quarter of
fiscal 2006. Most of the prior year charge relates to underperforming stores, including
stores closed and likely to be closed.

As of October 28, 2007, the Company's balance sheet shows the amount of cash and debt
of approximately $23 million and $88 million respectively. The maximum amount of
additional debt permitted by the Company's creditors and the amount of additional debt
available to the Company under those facilities is approximately $11 million at that date.
During the first months of 2008, the Company prepaid $21.9 million against the
Company's $110 million term loan taken out in February 2007. A large portion of these
payments was made to reduce the likelihood of violation of the financial covenants
contained in the Company's credit facilities.
In 2007 Krispy Kreme also settled some litigation held against them. Several class action
suits were filed against Krispy Kreme on behalf of the people that purchase the
companys publicly traded securities between August 21, 2003 and May 7, 2004. This
action stated that he company violated sections 10(b) (Manipulative and Deceptive
Devices) and 20(a) (Liability to Contemporaneous Traders for Insider Trading) of the
exchange act in connection to various public statement made by the company. These
different suits were eventually consolidated into one class action suit. The litigation was
settled in the amount of 14.4 million.
Using the ratios provided below we see that Krispy Kreme as a company is in
considerable financial trouble due to the earning per share and debt ratios. The company
is almost leveraged 1 to 1 with the asset that they have and their earning per share or EPS
is -5.45. At this current level it is very hard to attract new investors due to the probable
loss on the investment. Also if the company does default, there will be nothing left to
divide among shareholders after the creditors are finished.
Also the Return on Sales ratio is .39 which shows sales are defiantly not on par with the
amount of operating expenses that the company holds. The current ratio is the only one
that does not look bad at 1.71. This does show a possible recovery from the last few
dismal years of operation and would not be reflected in the other ratios because the time
has not elapsed to see the effect.
For the most part, with the exception of the EPS and return on sales, Krispy Kreme is on
par with the industry averages. The return on sales is lower, I believe, due to the highly
mechanical nature of production that is used in the making of their product line and to the
rapid expansion of the chain. A huge initial investment in machinery is required to
produce their product and this machinery is expensive. This is multiplied by the number
of store that they have in a market that did not grow as fast as supply.
The current stock price for Krispy Kreme is $2.56 (7:30 AM on 03/09/08). The lowest
stock price over the most recent 52 weeks is $2.23 while the highest stock price over the
most recent 52 weeks is $11.49. On April 5, 2000, the corporation went public on the
NASDAQ, On May 17, 2001, Krispy Kreme switched to the NYSE. As of June 29, 2007
there were 64, 647, 248 shares of Krispy Kreme common stock outstanding. There have
not been any stock splits since 2001. Shares in Krispy Kreme first traded on the
NASDAQ market on April 5, 2000.
Media hype, centered on Krispy Kreme's current financial issues, has depressingly
affected the company's reflection among investors and customers. This shows the
negative aspect to free publicity. Krispy Kreme has gotten into legal trouble with lawsuits

being filed against the company and the United States Securities and Exchange
Commission (SEC) looking into its accounting methods. Demonstrating that Krispy
Kreme is not as well-off as some people might have assumed. When Krispy Kreme
repurchased one of its franchises, it did so in a way that evades the need to deduct their
value gradually from future earnings. Krispy Kreme was trying to make its profits seem
greater than they actually were because they were not taking into account the fact that the
value of those stores would decrease every year; which would as a result decrease its
profits. Stockholders were given the wrong impression about into believing that Krispy
Kreme was more financially sound then it actually was, causing more people to invest
then actually would have if they had more accurate information. Krispy Kreme
dishonored its legal and ethical responsibilities to its stockholders and as a result,
stockholders have filed lawsuits against the company. Even if the company manages to
battle the lawsuit and the SEC investigation, its name has been brought down because of
these situations and its stock price may continue to decline for a long time. The company
is not built for long-term success since it depends on a single product line. Since every
field of business encounters fierce competition, Krispy Kreme might not be able to keep
up with Dunkin' Donuts and Starbucks. Krispy Kreme has been unable to effectively
offer the complete value package. All in all, the company seems to be heading into rocky
waters and may not be able to get themselves back to where they were in the beginning.

CASE FACTS
Krispy Kremes rapid expansion may have been the reason for its rapid fall. Recently
becoming a publicly traded company in April 2000, Krispy Kreme shares had seen
amazing growth as they were selling for 62 times earnings. Naturally, this created a buzz
around Wall Street, and an obsession with Krispy Kreme began as it became one of the
hottest stocks on the market. Yet, analysis of the fundamentals of Krispy Kreme needed
to by analyze to see the true threats the company had brought upon itself.
Analysis of Krispy Kremes business model and strategy gives a good insight as to how
the company had become so successful. Within their revenue generation, Krispy Kreme
had four main sources: on premise sales (27%), off-premise sales (40%), manufacturing
and distribution of product mix and machinery (29%), and franchise royalties and fees
(4%). Taking a quick snapshot of these percentages, we find that roughly 67% of their
revenue comes from selling their finished product with the remainder coming from
producers/owners.
The nature of these revenues may be part of the reason for the fall of Krispy Kreme. An
analysis of their revenues shows:
At first glance, it may appear that Krispy Kremes different income sources may give it a
diversified revenue stream. However, with only two thirds of their revenue coming from
sales to the end customer, the remainder 33% needs to be analyzed to how it affects the
margins of Krispy Kreme. Krispy Kreme requires all of its franchise stores to purchase
the proprietary doughnut mixes and doughnut making equipment directly from their

Manufacturing and Distribution division which also provided quarterly service to all
system units. Yet, these were mostly one time purchases by startup franchises, and in
turn, the sales level of the machinery was directly related to growth in the number of
stores. As the Wall Street Journal article stated, Krispy Kreme has relied for a significant
chunk of its profits on high-margin equipment that it requires franchisees to buy for each
new store. This statement further shows that an aggressive expansion policy (in number
of stores) would be vital for Krispy Kreme to grow its annual revenue, especially with the
high margin it receives on these items.
Moreover, royalties and fees were a source of income for Krispy Kreme as up to $50,000
were paid in franchise fees with an additional 6% in royalties along with 1% of a
franchises total annual sales were given to the corporate advertising fund. When looking
at these two sources of income, one-third of Krispy Kremes revenue, there is ample
reason for Krispy Kreme to pursue aggressive expansion of its business. Being a darling
of Wall Street had created pressure on the executives of Krispy Kreme to continue
outperforming expectations, and expansion was the only way to continue receiving the
high margin income from selling machinery.
However, the aggressive expansion that Krispy Kreme pursued also played a part in its
own financial downfall. By expanding so quickly, Krispy Kreme had diluted its cult
status which had originally made it so popular. A number of analysts following Krispy
Kreme had come out with recent statements, commenting on the growing uncertainty of
Krispy Kremes business strategy and accounting practices. Some items the analysts
commented on regarding revenues were
Krispy Kreme has gotten itself into a lot of trouble. If they can escape the lawsuits and
SEC investigation without going out of business, some changes need to be made. A
mission, vision, plan for expansion, as well as long-term and short-term goals need to be
established. The mission, vision, and objectives need to be clearly stated, precise, and to
the point. The information should be easily accessible to both employees and customers.
Stores that are not successful need to be shut down to reduce unnecessary expenses. The
focus should be on making stores in the U.S. successful before worrying about stores in
other countries.

SWOT ANALYSIS

STREGNTHS

Diversification of product
offerings
Expansion into a more global
marketplace
Co-branding opportunities
Expansion into premium
coffee lines

Limited menu items

Markets are leaning
toward
healthier foods
Heavy competition

Healthier product
alternatives available
Stiff competition from
several similar
companies

THREATS

OPPORTUNITIES

WEAKNESES

Affordability of products
Well-established and long
running company
Long-term company values
Loyal and strong customer
base
Nationally known brand of
donuts
Doughnut making theaters
Strong community
relationships
"One-of-a-kind taste"

COURSE OF ACTION
I think Krispy Kreme has good growth prospects. They rank high in competitive
strengths. An extremely important advantage Krispy Kreme has is their brand name. I
agree! This provides a huge source of competitive advantage over their competitors.
Although Krispy Kreme has done a successful job in securing their position and
maintaining a competitive strategy, they continually have to take strategic actions to stay
ahead of their competitors. If Krispy Kreme is to realize its target growth in earnings,
there will have to be an increase in demand for product.
I think Krispy Kreme's management needs to address the issue of advertising. They have
depended on word of mouth, new store openings and strong community relationships for
too long. With all the different doughnut shops around they need to advertise what a great
place they have. They should advertise that you can actually see the doughnuts being
made in the doughnut making theater and that when the neon light says "Hot Donuts"
they are hot off the press. In today's competitive market you have to have your face or
gimmick everywhere to get people to remember you. I love Krispy Kreme doughnuts but
I never knew any of this until making this report.
I would recommend diversification to Krispy Kreme's management to sustain the
company's growth and profitability. They should look into other avenues to generate
revenues throughout the day because doughnuts are more of a morning item. If they
would start including sandwiches or bagels like Tim Horton's, they would attract a wider
customer base. I believe Tim Horton's restaurants have a great future for exactly the
reason stated, a wider customer base. If a person goes in at lunch to grab a quick
sandwich, I'm sure a doughnut or two would be in the bag. I know their goal is to make
the best doughnut, but in today's health conscious society, you have to have products that
suit the needs of a variety of people.

RECOMMENDATION
If the accounting practices would be changed for Krispy Kreme, the assets/equity ratio
would be lower with the amortization of their intangible assets. At the end of 2003,
Krispy Kreme is more towards the lower end on this ratio, and with a change to their
largest single assets, this ratio would drop probably to the lowest value of all comparable
firms.
We can also use profitability ratios to see where Krispy Kreme currently stacks up against
similar firms. Return on equity may be the most telling as Krispy Kreme, without
amortization expenses, is in line with the lower end of comparable firms but just barely.
The large amount that may need to be written off for the amortization of their intangible
assets could reduce this ratio, for possibly longer than just a year or two.
A look at Krispy Kreme with adjusted accounting practices for the amortization of
intangible assets needs to be looked at. First, we are amortizing these franchise rights
over a 15 year period using the total of $174.5 million. We find a yearly, non-cash,
amortization expense of $11.633 million with the possibility of this amount increasing as

Krispy Kreme continues to reacquire franchises. Plugging this into the income statement
for fiscal year 2003, we find that the income from operations would be reduced to
(102,086 11,633) $90,453,000. Adjusting the income statement further, we add the $5
million dollar severance package as an expense in the 2003 period, and we find that
adjusted income before taxes would be roughly $85,453,000. Using the same tax bracket,
net income would be roughly $51,528,159 for the period.
This is a drastically lowered income for the period than what Krispy Kremes aggressive
accounting reported as the numerical difference is nearly $6 million dollars. When
continuing this to a per share basis, we find that the EPS was actually
($51,528,159/62,100,000) $.83. A decrease as large as this (10%) shows how
amortization would affect Krispy Kremes financial standing as viewed by
investors/analysts. From earlier, this type of change would be seen in the next 15 years as
the value of these intangible assets would be amortized over that time. So, similar
changes to the reported income and EPS in the fiscal year 2004 and on would be different
than reported under current practices.
These lower EPSs would, in turn, affect the financial valuation of Krispy Kreme, and
without question, would lower the market value of its share price. Having the lower share
price coincides with the above analysis of ratios such as L-T Debt/Equity. The market
value of equity would now be lowered, potentially to the level that this ratio now
coincides with other firms within the industry. Also, important items such as times
interest earned would be lowered. The ratio would drop from the reported 23.15 in 2003
to 20.52. While this still higher than comparable firms, it is just one measure that would
be lowered, resulting in the view of an overall less financially stable firm from outsiders.
Looking at Exhibit 8, we see the operating expense as a percent of sales of 76.2% for
Krispy Kreme. This is much higher than the average for limited-service restaurants, and
in turn, their operating profit margin is much higher than the average. However, if we
take the amortization into account, the operating expense percent will go up as the
operating margin ratio will go down, each being closer to the average for the industry. It
is clear, even if the average firm does not have reacquired franchises that amortizing
these intangible assets is the correct path for Krispy Kreme to pursue.
When looking at the income statement over the past years, one can see the growth Krispy
Kreme has experienced over that span. Large jumps such as the net income in 2003 when
compared to the end of fiscal year 2004 are due to the rapid expansion that executives
desired to meet the increasing expectation put upon them to achieve forecasts. However,
loses were experienced during the Q1 2004 year when restructuring took place. This
could have been a misleading endeavor to outsiders who may interpret this as steps taken
to fix their amortization and intangible asset situation.
When looking at the WACC for Krispy Kreme, we find a number for the fiscal year 2004
of roughly 10.67%. This number has not dropped drastically over the past fiscal years
even with such a significant decline of its stock price.

CONCLUSION
With a SEC investigation, an internal inquiry, imminent credit default, and the possibility
of being removed from the New York Stock Exchange, Krispy Kreme needed answers
quickly. After analysis of the situation, the recommendation for a change of the
accounting procedures for Krispy Kreme seems to be the best route to correct their
current situation. The devaluation of their stock has stemmed from the issues regarding
their accounting practices. As shown above, the proper accounting practices seem to be
in-line with amortizing the reacquired franchise rights. By doing so, there may not have
been such an over inflation of Krispy Kremes share price. Amortizing these intangible
assets, while not necessary under accounting standards, seems to the norm for the
industry and would have lowered reported income for Krispy Kreme.
Furthermore, this would have decreased analyst expectations and may not have led
Krispy Kreme to become such a largely followed security. In turn, this may have reduced
the pressure on Krispy Kreme executives to expand to meet market expectations
(expansion and its role in revenue/margin growth was explained earlier). More focus
could then be put on properly training new managers/owners and improving the
efficiency of its off-premise sales. These are results of the domino effect of the aggressive
accounting practices of Krispy Kreme, and a correction of financial statements and
accounting practices can help Krispy Kreme avoid future incidents as well as help Krispy
Kreme and its stakeholders better understand where the company lies in terms of
financial sustainability. I would not currently recommend a buy for Krispy Kreme as all
of these factors contribute to the uncertainty for the future of the company, lowering
growth expectations, cash flow forecasts, and the company image as a whole.