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The issue Krispy Kreme faces in regards to franchisees starts with their equipment and ingredients distribution.

Corporate requires all franchisees to purchase all equipment and ingredients through them, which is not an uncommon practice. However, the price that Corporate charges the franchisees for equipment and ingredients is at a large premium. Since the prices are at a premium, the long run success is jeopardized of each franchisee, in turn jeopardizing the entire corporation. Krispy Kreme is different from most other companies in the fact that, most successful organizations build their business around the royalty payment and not the equipment and ingredients charges. Growth rates for Krispy Kreme were exponential for the past few years. Despite their successful products, the company arguably grew too fast. This was a result that was not based solely on new franchisees, but rather the new franchisees combined with their already existing distribution channels. By allowing grocery stores to sell the doughnuts without an actual store in place, Krispy Kreme cuts potential costs but also cannot provide customers with the unique experience they built the company on. Furthermore, the presence of gas stations and kiosks selling Krispy Kreme doughnuts makes the product easily attainable by customers. While this may be a good thing, the original ways of Krispy Kreme was to make the product difficult to obtain, by default, which worked phenomenally. A constant progression of selective places to find their product toward more easily available would be work well, but the corporation introduced easier ways to get their product rapidly. The view of management had changed from a selective, quality driven product had changed to anywhere that customers could be found, you could find the product. company reacquired a seven-store franchise in Michigan, called Dough-Re-Mi Co., for $32.1 million. The company booked most of the purchase price as an intangible asset called "reacquired franchise rights," which it did not amortize, contrary to common industry practice. Krispy Kreme had also agreed to boost its price for Dough-Re-Mi so that the struggling franchise could pay interest owed to the doughnut maker for past-due loans. The company then recorded the subsequent interest payment as income. Unfortunately, Krispy Kreme has undergone heavy scrutiny for their choice of accounting preferences. With the reacquisition of a seven-store franchise in Michigan, the company booked the transaction as an intangible asset titled, Reacquired franchise rights. That in itself is not the main issue though. The issue that makes Krispy Kreme not a safe investment is the fact that the reacquired franchise rights do not get amortized. In the industry, this is unheard of, but not necessarily in violation of Generally Accepted Accounting Principles. So instead of having these intangible assets write-down throughout the year, they are arguably falsely boosting profits. Similarly, Krispy Kreme made a shady transaction when they offered a higher price to the seven store franchise in Michigan. By offering a higher price, the interest income they would receive would also increase; another false sense of the companys status. More likely however, was that the interest income would be used to pay off past-due loans and put the rest towards income. Neither of the above two instances are true, in the sense that most investors could look at financial statements and get a correct idea of the companys status. This shady business leads me to believe that Krispy Kreme is not a safe investment and no further stock should be purchased. In fact, the current

stock held in Krispy Kreme should be sold as soon as possible. Right now the accounting preferences Krispy Kreme uses are not violating GAAp, but they are definitely rope walking. Any company with financial stability and potential future gains in sight would not take the risk of using these accounting methods. Krispy Kreme also rolled into the price the costs of closing stores and compensating the operating manager and principal owner of the Michigan franchise to stay on as a consultant. Both of these expenses became part of the intangible "reacquired franchise rights" asset on the company's balance sheet, rather than costs that would have reduced the company's reported earnings. Krispy Kreme announced in a December 2004 8-K filing that it will need to make a pretax adjustment of between $3.4 million and $4.8 million to properly record the compensation as an expense. A second adjustment of some $500,000 will reverse the improper recording of interest income. Exhibit 8 in the case is a summary of financial ratios for Quick-Service Restaurants. While most numbers for Krispy Kreme seem to be much better than the other restaurants I feel that they are skewed. For example, bother the quick ratio and current ratio look very favorable for Krispy Kreme. However, the numbers are composed using current assets in each. This troubles me due to the accounting preferences of Krispy Kreme. If we were able to deduct the intangible assets they added in for the Michigan franchise, I believe the numbers would be much, much less. Similarly, the total asset turnover comparison to other restaurants is fairly low. This comparison may be able to give us a better understanding of the true status of Krispy Kreme. Total asset turnover is a representation of how many times inventory is created and sold during the period. However, if they were as stable as most the other numbers suggest they are, wouldnt they have a comparatively higher asset turnover ratio? Unfortunately, they do not. The number seems quite low, being second to last. I believe the numbers in most of these ratios are skewed in attempts to stabilize an already shaky company.

Half-Baked Krispy Kreme first reported solid growth, but has since announced that its results for 2001-2005 are not reliable. 2002 Total revenue* Net Income* Total long-term debt* Number of stores $394.4 $26.4 $3.9 218 2003 $491.6 $33.5 $62.4 276 2004 $665.6 $57.1 $146.2 357

Note: Figures for fiscal years ended in February *in $ millions Source: www.krispykreme.com

To get the full view of Krispy Kremes financial status, we can do a comparison to similar companies in the industry. Starbucks is arguably the most similar company, with the products and distribution channels uniquely similar. The coffee specialty house uses grocery stores to sell its products just like Krispy Kreme does. Interestingly, at the end of 2003, many of the financials of both companies were extremely close. However, the figures that represent liquidity are drastically different between the two companies. For instance, the long term debt to equity ratio for Krispy Kreme is 11.26%, whereas Starbucks ratio is roughly .21%. Because Krispy Kreme has such a high debt to equity ratio, it is clear that they have taken a very aggressive route by financing their desired growth through debt. Due to this, they incur an additional interest expense which will cause earnings to be even more volatile than previously. The most important comparison we need to consider between Krispy Kreme and the rest of the industry, specifically Starbucks, are their Net Sales figures (in millions). Krispy Kremes total for 2003 was $666, compared to Starbucks Net Sales of $4,076. With a company so similar to the setup of Starbucks, we would expect a financially strong company to show comparable results, however, the difference in is fairly significant. If we breakdown the financial ratios for Krispy Kreme alone, there is reason to be skeptical. While there are no definitive trends, that is in fact the issue. Examining debt to equity, between 2000 and 2001 there is a 48% decline, between 2001 and 2002 a 2.47% increase, 2002 and 2003 a 17% increase, and 2003 and 2004 a 8% decline. Clearly, the company does not have a strong focus on constant progression. Trends, or lack thereof, can be witnessed in other ratios like the Inventory turnover, ROE, and debt-to-capital. On a more simplified platform, we can look at the trends of analysts recommendations over the past four years. The overall consensus has been declining since day one. In 2001, 80% of analysts recommended to buy the stock, however, in January of 2005, only 14.3% still held that recommendation. The time in between illustrates a gradual decline as well.

Krispy Kreme Doughnuts, Inc.


Trevor Giroux January 29, 2012
BUS 428A Seminar in Financial Management

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