Krispy Kreme Doughnuts, Inc.

A Case Study

By: Wayne Parker

Introduction

Krispy Kreme Doughnuts was started in 1937 when Vernon Rudolph began selling his secret

recipe donuts to local grocery stores in Winston-Salem, NC. Throughout the 40’s and 50’s the business

grew and Krispy Kreme developed its own manufacturing process for its increasingly popular donuts,

unique production equipment and a distribution system to support its growing number of stores. All of

these advances helped to ensure consistency throughout the operations which eventually spread

throughout the Southeast. (KrispyKreme, 2009)

Krispy Kreme began to expand beyond its traditional market in the mid 1990’s by opening stores

in New York and California. In April of 2000 Krispy Kreme went public and began a national expansion

program that can only be described as highly aggressive. For the next three years Krispy Kreme could

apparently do no wrong but by early 2004 the company was under investigation by the SEC for

accounting irregularities and was eventually forced to restate earnings for the previous three years.

The analysis below is an attempt to understand if the punishment that Wall Street dished out to

Krispy Kreme was justified and whether or not accounting irregularities were the only issue that brought

down this darling of the market.

Underlying Concepts

The primary concept to keep in mind as we address Krispy Kreme’s collapse is the importance of

financial analysis of the company as it relates to its ability to create and sustain growth in the

marketplace. While an in depth discussion of financial analysis is unnecessary for the purpose of this

paper there are three major elements of financial analysis that are worth mentioning as their

importance to understanding the value of a company cannot be underestimated.

 First, financial analysis involves the comparison of a company’s performance to a benchmark,

usually of other firms. While disagreements have and will continue to occur about how to determine

the appropriate benchmark it is generally accepted that companies with similar product and customer

profiles provide a good point of comparison. The comparative waters become a bit murky when a

company provides a truly unique product mix, value proposition or possesses some other advantage

such as monopolistic power.

Financial analysis also involves the comparison of a company’s performance to its own past

performance. Known as trend analysis this type of comparison allows stakeholders to determine if

management is making sound decisions that are resulting in value creation over time. Such comparisons

are highly effective unless the company has made a significant acquisition or divestiture that

fundamentally changes the composition of the company.

Finally, financial analysis utilizes ratio analysis to help create an even playing field for the

comparison of financial statements across industry and time horizons. Ratio analysis is less about

comparing the financial results of a company to a benchmark and more about comparing the

relationships of financial results between two companies. For example, if Company A has sales of $10

and net profit of $2 its Profit Margin is 20%. If Company B has sales of $100 and profits of $15 its Profit

Margin is 15%. If one were to look at the profit dollars it would seem that Company B would be the

more profitable company however ratio analysis allows us to identify that Company A is more affective

at turning sales into net profit. For all of its benefits ratio analysis can be undermined by factors such as

seasonality, “window dressing” by firms who wish to make their firms look stronger, inflationary effects

on balance sheets as well as a mix of “good” and “bad” numbers which can provide confusion as to the

health of the organization.

 Underlying all of the above analysis concepts is the set of financial statements included in the

annual report which is issued by every publicly traded company in the United States. These financial

statements include the operating statement, the balance sheet, the statement of cash flows, and the

statement of retained earnings. While there are entire industries dedicated to the understanding and

interpretation of the rules regarding these financial statements the single most important element

regarding these documents is the perception by the market that they are true, factual, and trustworthy.

If any of these statements are deemed to be inaccurate the methods of analysis mentioned above

become skewed and are worthless to stakeholders.

As we will see, the leadership team at Krispy Kreme struggled to understand this singular fact.

This resulted in decision making that cost the company’s stakeholders dearly at a time when the future

of the company could not have been more optimistic.

How to Make a Buck on a 50 cent Donut!

Krispy Kreme employed a franchise model to help leverage its growth opportunities. As a result,

the company’s revenue was generated by the sale of product mix and machinery, franchising fees, as

well as the sale of its signature product sold in its own outlets and through other retailers. Note in the

graph below that a third of the company’s revenue is derived from its relationship with its franchisees.

(Bruner, 2007) This will be significant as we evaluate some of the tactics employed by the company

moving forward.
 KKD Revenue Channel Breakdown
Onsite Sales Offsite Sales
Product Mix & Machinery Franchisee Royalties & Fees
4% 27%
29%

40%

Franchising the Krispy Kreme Way!

At the height of its success becoming a franchisee of Krispy Kreme was considered a privilege.

The successful candidate had to have significant experience in the retail food business, have a net worth

in excess of $5 million, and have as much as $2 million ready to invest in getting a Krispy Kreme

operation up and running. The equipment cost alone, as much as $350,000 was enough to get into

many other franchises. For many, the investment was worth it as a Krispy Kreme operation could

generate $3 to $4 million in annual revenue with cash flow in the mid 20% range. Compare this 10% to

15% cash flow for other similar franchises and the investment begins to look worthwhile. (Adler, 2002)

Such returns created incredible demand for franchises throughout the United States and Krispy

Kreme, with franchise dollars generating such a large portion of its revenue growth, was happy to oblige

the demand. After all, growth was the mantra for the Winston-Salem based company that was under

increasing pressure to maintain its performance with each successful quarter. It appeared, for several

years at least, that the company had found a secret formula not only for donuts but also for growing a
local business into a national brand. In the beginning of 2000 there were 131 Krispy Kreme factory

stores, four years later there were over 357. Throughout this time span the ratio of stores owned by

Krispy Kreme to stores owned by franchisees remained almost the same dropping from 40.3% to 39.5%.

Financial analysis at the end of FY 2003 indicated that company was doing well but there were

chinks in the armor. The company was highly liquid with both its quick and current ratios trending from

1.05 to 2.72 and 1.39 to 3.25 respectively from 2000 to 2003. Krispy Kreme outperformed its

competitors in this area with Panera Bread having the next best quick ratio at 1.34 and the next best

current ratio at 1.58. Krispy Kreme was also among the highest in its peer group in EBIT at 15.34% and

net profit margin at 8.58%. This was surpassed by only three out of eleven other competitors.

While such measures are promising the company also had opportunities in its model. The

company had failed to effectively leverage itself to ensure it maintained an adequate return for its

investors. This is revealed in its below average equity multiplier, return on assets and return on equity

as well as its debt to equity ratios all of which were some of the lowest in its peer group. As a result,

Krispy Kreme had to work harder to earn an acceptable return on each dollar it invested.

The failure to adequately balance debt with assets and equity increased pressure on the

management team which ultimately lead it make decisions that would cripple the company for years to

come.

Look Out For The Hole!

In response to demands for continued revenue and profit growth the leadership at Krispy Kreme

continued an aggressive expansion program. However, the methods used by the management team to

generate the needed growth were not sustainable for several reasons.
 First, they began saturating some markets. While such market penetration techniques were

profitable for the parent company they left Franchisees in a bind. While the opening of a new location

may have increased sales in the area by 50% they could have potentially reduced the sales of the

existing location below the breakeven threshold. In the long run this would create dissatisfaction and

distrust on the part of the franchisees. The same franchisees who were responsible for generating 33%

of the revenues for the company and accounted for 60% of the company’s locations.

The second mistake made by Krispy Kreme was their failure to stay focused on their core

product. Considered heretical by many, they began opening satellite stores in which there was no

production. These satellite stores were supported by other factory stores and lacked the “donut making

theatre” that had made the factory stores so popular. Krispy Kreme further deviated from their core

product by purchasing Montana Mills, a chain of 28 bakery cafes. Perhaps the low point of this identity

crisis was when Krispy Kreme tried to respond to the low-carb craze with a sugar-free donut.

The third mistake made by the management team was aggressive and irregular accounting.

Krispy Kreme irregularly accounted for the purchase of a Michigan Franchise failing to properly amortize

the purchase as an intangible asset under which the purchase was booked. Krispy Kreme’s repurchase

of a stake in Golden Gate Donuts was also scrutinized and the company later revealed that it would have

to make adjustments for improperly recorded expenses related to management compensation.

Furthermore, it was discovered that one of the beneficiaries of the buyout was the ex-wife of Krispy

Kreme’s CEO at the time, Scott Livengood.

On top of these issues it appears that Krispy Kreme was paying excessive prices to repurchase

franchises which were owned by former directors and or board members. In 2003 the company paid an

average of $11.2 million per store for a six store franchise owned in part by in part by former Krispy

Kreme board member and chairman and CEO Joseph A. McAleer Jr. and longtime director, Steven D.
Smith. This price dwarfed the $4.6 million per store paid by the company for the Michigan stores earlier

in the same year. (O’ Sullivan 2005)

Highlighting these irregularities is the consistent turnover of CFOs throughout this time period.

In the four year period from 2000 to 2004 Krispy Kreme had three different CFOs. While the cause of

such a high churn rate at the executive level is subject to debate one likely reason is that the numbers

brought to the CEO by the CFO were deemed unacceptable. If the CFO was unable to produce

acceptable numbers and unwilling to make illegal adjustments then there could have been pressure

from the top for them to move on.

The final problem is the weak last line of defense. The board of directors should have identified

these issues and taken action but the board lacked independence. Much of the board members were

insiders who remained from when the company was privately owned. They lacked the knowledge to

institute a strong corporate governance program within the framework of a publicly traded company.

Recommendation

Did Krispy Kreme deserve the punishment that it received at the hands of the market? I believe

it did for several reasons. As mentioned above in the concept module portion of this paper the single

most important underlying factor in the financial analysis of a company is faith that the company is

providing true and accurate financial statements. While moves to correct this have been made such as

creating an independent board, replacing the executive level management team and the creation of a

stringent corporate governance program it will be some time before stakeholders trust Krispy Kreme.

Furthermore, the reduction in market capitalization was deserved for reasons beyond

accounting irregularities. Krispy Kreme appeared to have had a fundamentally flawed business model

that depended too much on the sale of donut mix and equipment to its franchisees. This
overdependence misaligned the parent company with the franchisees. It would be difficult for Krispy

Kreme to turn itself around without evaluating portions of its business model and ensuring that all

parties involved had one goal in mind, selling more donuts!

Where Are They Now?

Currently Krispy Kreme, ticker symbol KKD, is trading just over $1 per share with a market

capitalization of approximately $80 million. Revenues for the trailing twelve months were $403 million

with profit margins of -8.82%. The high watermark for both of these key metrics was in 2004 when the

company recorded $665 million in sales and a 8.58% profit margin. There are currently 500 locations

operating under the Krispy Kreme banner. It remains to be seen if Krispy Kreme will find its way back to

its previous success.

References

Carlye Adler (2002) Would You Pay $2 Million For This Franchise? Fortune Small Business

http://money.cnn.com/magazines/fsb/fsb_archive/2002/05/01/322792/index.htm

Brigham / Ehrhardt (2008) Financial Management Theory and Practice 12 th Edition Thomson
Southwestern

Krispy Kreme (2009) Company Website http://www.krispykreme.com

What’s Really Inside Krispy Kreme? (Christopher Palmeri / Amy Borrus)

http://www.businessweek.com/magazine/content/04_33/b3896103_mz020.htm

http://articles.latimes.com/2003/jun/08/business/fi-krispy8

Kremed, by Kate O’ Sullivan CFO Magazine June 1, 2005

http://www.cfo.com/printable/article.cfm/4007436

Bruner (2007), Case Studies in Finance The McGraw-Hill Companies