FIN 3334 Troy University Financial Statement Analysis The case is to annalyze the financial statements of a company;
It needs to answer the following questions:
What can the historical income statements (case Exhibit 1) and balance sheets (case Exhibit 2) tell you about the financial health and current condition of Krispy Kreme Doughnuts, Inc.?
How can financial ratios extend your understanding of financial statements? What questions do the time series of ratios in case Exhibit 7 raise? What questions do the ratios on peer firms in case Exhibits 8 and 9 raise?
Is Krispy Kreme financially healthy at year-end 2004?
In light of your answer to question 3, what accounts for the firm’s recent share price decline?
What is the source of intrinsic investment value in this company? Does this source appear on the financial statements?
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Rev. Apr. 9, 2014
KRISPY KREME DOUGHNUTS, INC.
As the millennium began, the future for Krispy Kreme Doughnuts, Inc. (Krispy Kreme),
smelled sweet. Not only could the company boast iconic status and a nearly cult-like following,
it had quickly become a darling of Wall Street. Less than a year after its initial public offering, in
April 2000, Krispy Kreme shares were selling for 62 times earnings and, by 2003, Fortune
magazine had dubbed the company “the hottest brand in America.” With ambitious plans to open
500 doughnut shops over the first half of the decade, the company’s distinctive green-and-red
vintage logo and unmistakable “Hot Doughnuts Now” neon sign had become ubiquitous.
At the end of 2004, however, the sweet story had begun to sour as the company made
several accounting revelations, after which its stock price sank. From its peak in August 2003,
Krispy Kreme’s stock price plummeted more than 80% over the next 16 months. Investors and
analysts began asking probing questions about the company’s fundamentals, but even by the
beginning of 2005, many of those questions remained unanswered. Exhibits 1 and 2 provide
Krispy Kreme’s financial statements for fiscal years 2000 through 2004. Was this a healthy
company? What had happened to the company that some had thought would become the next
Starbucks? If almost everyone loved the doughnuts, why were so many investors fleeing the
popular doughnut maker?
Company Background
Krispy Kreme began as a single doughnut shop in Winston-Salem, North Carolina, in
1937, when Vernon Rudolph, who had acquired the company’s special doughnut recipe from a
French chef in New Orleans, started making and selling doughnuts wholesale to supermarkets.
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 late 1950s, Krispy Kreme had 29 shops in 12 states, many of which were
operated by franchisees.
This case was prepared by Sean Carr (MBA ’03), under the direction of Robert F. Bruner of the Darden
Graduate School of Business Administration. It was written as a basis for class discussion rather than to illustrate
effective or ineffective handling of an administrative situation. Copyright 2005 by the University of Virginia
Darden School Foundation, Charlottesville, VA. All rights reserved. To order copies, send an e-mail to
sales@dardenbusinesspublishing.com. No part of this publication may be reproduced, stored in a retrieval system,
used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying,
recording, or otherwise—without the permission of the Darden School Foundation.
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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. The business languished, however, and by the early 1980s,
Beatrice put the company up for sale.
A group of franchisees led by Joseph McAleer, who had been the first Krispy Kreme
franchisee, completed a leveraged buyout of the company for $24 million in 1982. McAleer
brought back the original doughnut formula and the company’s traditional logo. It was also
around this time that the company introduced the “Hot Doughnuts Now” neon sign, which told
customers when fresh doughnuts were coming off the line. The company still struggled for a
while, but by 1989, Krispy Kreme had become debt-free and had slowly begun to expand. The
company focused on its signature doughnuts and added branded coffee in 1996. Scott
Livengood, who became CEO in 1998 and chairman the following year, took the company
public in April 2000 in what was one of the largest initial public offerings (IPO) 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.
Krispy Kreme’s Business
After the company’s IPO, Krispy Kreme announced an aggressive strategy to expand the
number of stores from 144 to 500 over the next five years. In addition, the company planned to
grow internationally, with 32 locations planned for Canada and more for the United Kingdom,
Mexico, and Australia. Exhibit 3 provides an overview of the company’s store openings.
Krispy Kreme generated revenues through four primary sources: on-premises retail sales
at company-owned stores (accounting for 27% of revenues); off-premises sales to grocery and
convenience stores (40%); manufacturing and distribution of product mix and machinery (29%);
and franchisee royalties and fees (4%). In addition to the traditional domestic retail locations, the
company sought growth through smaller “satellite concepts,” which relied on factory stores to
provide doughnuts for reheating, as well as the development of the international market.
On-premises sales: Each factory store allowed consumers to see the production of
doughnuts; Krispy Kreme’s custom machinery and doughnut-viewing areas
created what the company called a “doughnut theater.” In that way, Krispy Kreme
attempted to differentiate itself from its competition by offering customers an
experience rather than simply a product. Each factory store could produce
between 4,000 dozen and 10,000 dozen doughnuts a day, which were sold both
on- and off-premises.
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Off-premises sales: About 60% of off-premises sales were to grocery stores, both
in stand-alone cases and on store shelves. The remainder were sold to
convenience stores (a small percentage were also sold as private label). The
company maintained a fleet of delivery trucks for off-premises sales.
Manufacturing and distribution: Krispy Kreme’s Manufacturing and Distribution
(KKM&D) division provided the proprietary doughnut mixes and doughnutmaking equipment to every company-owned and franchised factory store. This
vertical integration allowed the company to maintain quality control and product
consistency throughout the system. The company maintained its own
manufacturing facilities for its mixes and machines, and it provided quarterly
service for all system units. All franchisees were required to buy mix and
equipment from Krispy Kreme. KKM&D also included the company’s coffeeroasting operation, which supplied branded drip coffee to both company-owned
and franchised stores.
Franchise royalties and fees: In exchange for an initial franchise fee and annual
royalties, franchisees received assistance from Krispy Kreme with operations,
advertising and marketing, accounting, and other information-management
systems. Franchisees that had relationships with the company before the IPO in
2000 were called associates, and they typically had locations in heritage markets
in the southeastern United States. Associates were not responsible for opening
new stores. New franchisees were called area developers, and they were
responsible for developing new sites and building in markets with high potential.
Area developers typically paid $20,000 to $50,000 in initial franchise fees and
between 4.5% and 6% in royalties. Franchisees also contributed 1% of their
annual total sales to the corporate advertising fund.
Roughly 60% of sales at a Krispy Kreme store were derived from the company’s
signature product, the glazed doughnut. This differed from Dunkin’ Donuts, the company’s
largest competitor, for which the majority of sales came from coffee.
Holes in the Krispy Kreme Story
On May 7, 2004, for the first time in its history as a public company, Krispy Kreme
announced adverse results. The company told investors to expect earnings to be 10% lower than
anticipated, claiming that the recent low-carbohydrate diet trend in the United States had hurt
wholesale and retail sales. The company also said it planned to divest Montana Mills, a chain of
28 bakery-cafés acquired in January 2003 for $40 million in stock, and would take a charge of
$35 million to $40 million in the first quarter. In addition, Krispy Kreme indicated that its new
Hot Doughnut and Coffee Shops were falling short of expectations and that it had plans to close
three of them (resulting in a charge of $7 million to $8 million). Krispy Kreme’s shares closed
down 30%, at $22.51 a share.
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Then, on May 25, the Wall Street Journal published a story describing aggressive
accounting treatment for franchise acquisitions made by Krispy Kreme.1 According to the article,
in 2003, Krispy Kreme had begun negotiating to purchase a struggling seven-store Michigan
franchise. The franchisee owed the company several million dollars for equipment, ingredients,
and franchise fees and, as part of the deal, Krispy Kreme asked the franchisee to close two
underperforming stores and to pay Krispy Kreme the accrued interest on past-due loans. In return
for those moves, Krispy Kreme promised to raise its purchase price on the franchise.
According to the Journal, Krispy Kreme recorded the interest paid by the franchisee as
interest income and, thus, as immediate profit; however, the company booked the purchase cost
of the franchise as an intangible asset, under reacquired franchise rights, which the company did
not amortize. Krispy Kreme also allowed the Michigan franchise’s top executive to remain
employed at the company after the deal, but shortly after the deal was completed, that executive
left. In accordance with a severance agreement, this forced Krispy Kreme to pay the executive an
additional $5 million, an expense the company also rolled into the unamortized-asset category as
reacquired franchise rights.
The company denied any wrongdoing with this practice, maintaining it had accounted for
its franchise acquisitions in accordance with generally accepted accounting principles (GAAP).
On July 29, however, the company disclosed that the U.S. Securities and Exchange Commission
(SEC) had launched an informal investigation related to “franchise reacquisitions and the
company’s previously announced reduction in earnings guidance.” Observers remained
skeptical. “Krispy Kreme’s accounting for franchise acquisitions is the most aggressive we have
found,” said one analyst at the time. “We surveyed 18 publicly traded companies with franchise
operations, four of which had reacquired franchises, and they had amortized them. That clearly
seems like the right thing to do.”2 Over the previous three years, Krispy Kreme had recorded
$174.5 million as intangible assets (reacquired franchise rights), which the company was not
required to amortize. On the date of the SEC announcement, Krispy Kreme’s shares fell another
15%, closing at $15.71 a share.
Analysts’ Reactions
Since the heady days of 2001, when 80% of the equity analysts following Krispy Kreme
were making buy recommendations for the company’s shares, the conventional wisdom about
the company had changed. By the time the Wall Street Journal published the article about Krispy
Kreme’s franchise-reacquisition accounting practices in May 2004, only 25% of the analysts
following Krispy Kreme were recommending the company as a buy; another 50% had
downgraded the stock to a hold. Exhibits 4 and 5 provide tables of aggregate analysts’
recommendations and EPS (earnings per share) estimates. As Krispy Kreme’s troubles mounted
during the second half of 2004, analysts became increasingly pessimistic about the stock:
1
Mark Maremont and Rick Brooks, “Krispy Kreme Franchise Buybacks May Spur New Concerns,” Wall Street
Journal, May 25, 2004.
2
Gretchen Morgenson, “Did Someone Say Doughnuts? Yes, the SEC,” New York Times, July 30, 2004.
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-5Analyst
John Ivankoe,
J.P. Morgan
Securities
Jonathan M. Waite,
KeyBanc Capital
Markets
John S. Glass,
CIBC World
Markets
Glenn M. Guard,
Legg Mason
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Comment
In addition to the possibility of an earnings restatement, we
believe many fundamental problems persist, exclusive of any
“low-carb” impact. Declining new-store volumes are
indicative of a worsening investment model, and we believe
restructured store-development contracts, a smaller store
format, and reduced fees charged for equipment and
ingredients sold to franchises are necessary.
We believe that the challenges KKD faces, including margin
compression, lower returns, an SEC investigation, and product
saturation, currently outweigh the company’s positive drivers.
In addition, shares of KKD are trading at 16.6× CY05 earnings
versus its 15% growth rate. As such, we rate KKD shares
HOLD.
Krispy Kreme’s balance sheet became bloated over the past
two years by acquisition goodwill that will likely need to be
written down. As a result, KKD’s return on invested capital
has plunged to about 10% versus 18% two years ago prior to
these acquisitions. We’d view a balance sheet write-down,
including eliminating a significant portion of the $170+
million in “reacquired franchise rights,” as a first step in the
right direction.
Date
July 29, 2004
In our opinion, management was not focused on operations the
way it should have been. As a result, too many units were
opened in poor locations as the company tripled its unit base
since 2000. Additionally, we believe that franchisees were not
trained properly as to how best to run their off-premises
business. As a result, we believe many units are losing money
off-premises, and franchisees are not motivated to grow that
business. It also appears to us that basic blocking and tackling,
execution, and cost discipline were seriously lacking in both
the company and franchise systems, resulting in inefficiencies.
Nov. 23, 2004
Oct. 12, 2004
Nov. 8, 2004
As the headlines about the SEC investigation and Krispy Kreme’s other management
issues continued (e.g., Krispy Kreme’s chief operating officer stepped down on August 16,
2004), observers looked more critically at the fundamentals of Krispy Kreme’s business. In
September, the Wall Street Journal published an article that focused attention on the company’s
growth:
The biggest problem for Krispy Kreme may be that the company grew too quickly
and diluted its cult status by selling its doughnuts in too many outlets, while
trying to impress Wall Street. The number of Krispy Kreme shops has nearly
tripled since early 2000, with 427 stores in 45 states and four foreign countries.
Some 20,000 supermarkets, convenience stores, truck stops, and other outside
locations also sell the company’s doughnuts.
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Another issue is that Krispy Kreme has relied for a significant chunk of profits on
high profit-margin equipment that it requires franchisees to buy for each new
store. Its profits have also been tied to growth in the number of franchised stores,
because of the upfront fee each must pay.3
In September 2004, Krispy Kreme announced that it would reduce its number of new stores for
the year to about 60 from the previously announced 120.
Restatement Announced
On January 4, 2005, Krispy Kreme’s board of directors announced that the company’s
previously issued financial statements for the fiscal year ended February 1, 2004 (FY2004),
would be restated to “correct certain errors.” The board determined that the adjustments, which
principally related to the company’s “accounting for the acquisitions of certain franchisees,”
would reduce pretax income for FY2004 by between $6.2 million and $8.1 million. The
company also expected to restate its financial statements for the first and second quarters of
FY2005.
Krispy Kreme also said it would delay the filing of its financial reports until the SEC’s
investigation had been resolved and the company’s own internal inquiry was complete. However,
the failure of the company to provide its lenders with financial statements by January 14, 2005,
could constitute a default under the company’s $150-million credit facility. In the event of such a
default, Krispy Kreme’s banks had the right to terminate the facility and to demand immediate
payment for any outstanding amounts. Krispy Kreme’s failure to file timely reports also placed
the company at risk of having its stock delisted from the New York Stock Exchange (NYSE). By
the end of the next day, Krispy Kreme’s shares were trading at less than $10 a share.
Most analysts felt that Krispy Kreme’s lenders would grant the company a waiver on its
credit-facility default, and few felt the company was truly at risk of being delisted from the
NYSE. The board’s announcement, however, served only to raise more questions about the
company. Since August 2003, the company had lost nearly $2.5 billion in its market value of
equity. Exhibit 6 illustrates the stock-price patterns for Krispy Kreme relative to the S&P 500
Composite Index. Were the revelations about the company’s franchise accounting practices
sufficient to drive that much value out of the stock? Were there deeper issues at Krispy Kreme
that deserved scrutiny? Exhibits 7, 8, and 9 provide analytical financial ratios for Krispy Kreme
and a group of comparable companies in the franchise food-service industry.
3
Rick Brooks and Mark Maremont, “Ovens Are Cooling at Krispy Kreme as Woes Multiply,” Wall Street
Journal, September 3, 2004.
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-7Exhibit 1
KRISPY KREME DOUGHNUTS, INC.
Income Statements (in thousands, except per-share amounts)
Total revenues
Operating expenses
General and administrative expenses
Depreciation and amortization expenses
Arbitration award
Provision for restructuring
Impairment charges and closing costs
Jan. 30,
2000
Jan. 28,
2001
Feb. 3,
2002
Feb. 2,
2003
Feb. 1,
2004
220,243
190,003
14,856
4,546
300,715
250,690
20,061
6,457
394,354
316,946
27,562
7,959
491,549
381,489
28,897
12,271
9,075
665,592
507,396
36,912
19,723
(525)
Three Months Ended Three Months Ended
May 5,
May 2,
Aug 3,
Aug. 1,
2003
2004
2003
2004
148,660 184,356
112,480 141,383
8,902 10,664
4,101
6,130
(525)
159,176 177,448
120,573 145,633
9,060 11,845
4,536
6,328
7,543
1,802
Income from operations
Interest income
Interest expense
Equity loss in joint ventures
Minority interest
Other expense, net
10,838
293
(1,525)
23,507
2,325
(607)
(706)
(716)
(20)
41,887
2,980
(337)
(602)
(1,147)
(235)
59,817 102,086
1,966
921
(1,781)
(4,409)
(2,008)
(1,836)
(2,287)
(2,072)
(934)
(13)
23,702 18,636
227
176
(866) (1,433)
(694)
(575)
(616)
(126)
(25)
(156)
25,007 11,840
205
226
(997) (1,366)
(802)
(399)
(616)
267
(343)
114
Income before income taxes
Provision for income taxes
Discontinued oper…
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