Company Background

Krispy Kreme Doughnuts, Inc. was founded in 1937 and is headquartered in Winston-Salem, North Carolina. Krispy Kreme is a major competitor in the restaurant industry, known primarily for its donuts. Near the end of 2004 and the beginning of 2005, the economy began to slow. Other business in competition with Krispy Kreme began to crowd into its market and expansion plans that Krispy Kreme had projected had to be scaled back due to falling sales. Consumer interest in reduced carbohydrate consumption, including ,but not limited to, the interest in and popularity of low carbohydrate diets, such as the Atkins and South Beach diet plans have been blamed for declining sales in pre-packaged (grocery store) donuts.

Krispy Kreme s Business Model

Krispy Kreme Doughnuts generated revenues through four primary sources: a. On Premise Sales revenue on this division accounted to 27% b. Off-Premise Sales revenue accounted to 40% c. Manufacturing and Distribution 29% d. Franchise royalties and fees 4%

Case Analysis
Cash and Cash Equivalents Cash and Cash Equivalents steadily increase from more than $3 million in 2000 to its high of $32 million in 2003. However at the start 2004, it was down by 50% from previous year to more than $20 million, and sharply down at the end of the first quarter of 2004, but it was up again at the beginning of 3Q2004.

Accounts Receivables The account receivables to its affiliates or maybe franchisees dramatically increased from year 2000 to 2004. This may indicate rapid expansion through new store openings thereby increases the amount of collectibles from its affiliates through the sales of mixtures, equipment, and ingredients. It may also indicate that its affiliates were not able to meet its obligations to the parent company due to lower sales or revenue. As seen on the Exhibit 3 (Store Growth), Store openings in 2004 numbered at 28 while store closing and stores acquired from franchisees totaled to 16. It is also important to note that other accounts receivables had also increased year on year. Inventories The inventories also increases year on year, and at the end of the 2Q2004 it has ballooned to more $33 million. This may indicate inefficiency on their operations as well as their inventory management system. Property and Equipment Because of rapid expansion, Krispy Kreme s property and equipment increases by 500 fold from 2000 to 2004. This is also proven by the increase in its depreciation and amortization in the same period covered. Reacquired Franchise Rights, Goodwill and Other Intangibles The Krispy Kreme brand is becoming known at faster paced and has become the darling of the Wall Street. It s Goodwill and other intangibles significantly increase from nothing in 2000 and 2001 to more $176 million in 2004. The significant increase may be attributed to value assigned to its recipes, trademarks, and trade names or logo. But the most important factor that contributes to its sharp increase is the re-acquisition of the franchise from non performing stores. This has triggered the alarm to investors as well as the SEC investigations.

Revenues From the four different sources of revenues, Krispy Kreme s revenue continues to grow at a very fast pace, from $220 million in 2000 to $665 million 2004. Additionally, the first 2 quarters revenue ending May and August showed an improvement quarter over quarter of the previous year. Its net income grew from $6 million in year 2000 to over $57 million in year 2004. Income from operations also increases steadily from fiscal year ending 1999 to fiscal year ending 2003. From more than $10 million to $102 million in just 5 years representing percentage growth of over 20% annually, this signifies strong year on year revenue from operations. However, revenue started to decline on the first and second quarter of 2004 compared to the same quarters of the previous year. Expenses Aligned with its rapid growth and high revenue, expenses also increase. From year 2000 to 2004, revenue from operations was enough to cover all expenses and other obligations. However, the company experienced is first quarterly loss at the end for 1Q2004 amounting to over $24 million.

Financial Health of Krispy Kreme Doughnuts Inc.

Growth As shown on exhibit 1, the company experienced a rapid growth over the period of 5 years. Over this period, the company is assumed to be financially healthy. However, with this rapid expansion, sustainability may be an issue as can be observed on the first quarter of 2004 where it registered its first quarterly loss. One may suspect it as the start of a new trend (downtrend), as there are signs of it being unsustainable. One of which is the closing of some stores, the reacquisition of franchisees and the new trend in diet across the US. On Exhibit 2, it shows huge asset growth over the past 5 years. The bulk of this growth however occurred on accounts receivables from affiliates and reacquired franchise rights, the very item that was the focus of the startling revelations in the Wall Street Journal in may 2004, which

describe the alleged aggressive accounting treatment , whereby the company did not amortize the value of these intangible assets. Exhibit 3, shows the aggressive expansion strategy of Krispy Kreme on both company-owned and franchised factory stores. Total factory stores growth average around 25% year-over-year while total franchised factory store grew at similar rate as factory stores.

DuPont Analysis
D u o n t R a tio A n a ly s is o is y 2000 2001 R tu n 's P 2002

2.10% 2.20% 5. 7%

1.75% 1.3 % .59%

1.54% 1.3 % 10.33%

1.20% 1.50% .1 %

1.01% 1.4 % . 4%

Return on Equity (ROE) and Return on Assets (ROA) both declined from 2002 to 2004. In 2002, ROA showed significant improvement due to increase in profit margin. But in 2003 and 2004, even if the profit margin continues to improve, ROA and ROE declined primarily due to lower leverage ratio and lower asset turnover. Asset turnover in 2004 fell to less than half of 2000. In short profit margins maybe high but the reasons for declining asset turnover need more investigation. Liquidity Ratio The company s liquidity ratios from the 2000 2004 are strong and continued to improve. Its

current ratio more than doubled from 1.05 in 2000 to 2.72 in 2004. In the same case, its current ratio is also very strong from 1.39 in 2000 to 3.25 in 2004.

R tu n

n A s s ts

P o it a in (P o i t /Sa l s ) A s s t Tu n o (Sa l s /A s s t ) L a (A s s t s / q u i t y )

2.70%

4.90%

. 9%

. 1%

.5 %

q u ity

12.47%

11.72%

14.0 %

 
o an 2003 12.25%

   

2004 12. 2%

Leverage Ratio The leverage ratios show that the company has been increasing its proportion of debt, but the balance sheet also indicates that the company s equity has been increasing as well. Its total shareholders equity increases from $105 million in 2000 to more than $660 million in 2004. Times interest earned has dropped significantly from 124 in 2002 to 23 in 2004. The meager returns on equity, relative to the improving profit margins, appear to be a significant issue. Activity Ratio Receivables turnover is relatively good as it stayed almost on the same level from 2000 to 2004, with the latter year being lower as compared from the previous years. Similarly, Inventory turnover ratio also stayed with 17.76 to 20.84 ranges. Asset turnover ratio on the other hand is dwindling over the 5 year period. Sales over total asset were down more than 50% from 2.10 in 2000 to only 1.01 in 2004. Cash turnover ratio shows similar story. Profitability Return on Assets (ROA), Return on Equity (ROE), Operating Profit Margin, and Net Profit Margin all indicates that company is doing well as the trend is increasing over the years. With the exception of the ROA and ROE which is stagnant even if the assets and equity increased significantly. Peer Comparison Exhibit 8 shows detailed information of its peers. Starbucks may be the more appropriate company to compare with, however the analysis can still be compared to the whole quickservice restaurants regardless of their retail focus. In general, a comparison of Krispy Kreme with its peers suggests that Krispy Kreme is significantly more liquid, turn receivables and inventory moved slowly, and has less financial leverage than its peers. Comparing it with industry average (Exhibit 9), Krispy Kreme has significantly more receivables and intangibles, higher operating expenses, but better profit margins than its peers. Looking at the Income Statements alone and comparing it with its peers

shows that the company is growing aggressively, extending substantial credit affiliates, amassing substantial unamortized assets on its balance sheet in the form of reacquired franchise rights, and yet remains profitable and competitive with its peers. Of course looking at it now, those snapshots from Income Statements and balance sheets shows that it did not reflect the future picture of the company as it continue to decline and its stock price plummeted to as low as around $1 a share. The Drop in tock Prices Investors reacted negatively when Krispy Kreme disclosed that its sales on the second quarter was down by 10%, the divestiture of Montana Mills, failure of the new Hot Doughnut and Coffee to take off, closure of some of the stores which all will result to lower overall sales. And most of all the revelation of the Wall Street Journal regarding accounting treatment of the franchise reacquisition made by Krispy Kreme deteriorated investor s confidence. These news and disclosures may be a tail sign of poor revenue in the future. All of these news and disclosure raise questions on its fundamentals whether it can sustain its growth in the succeeding quarter or years ahead. It affected the market expectations of future earnings or performance. In 2000, its stock was trading around $40 which has a very high P/E ratio and investors are willing to pay premium because of its aggressive expansion plans. When these plans did not materialized, investors started to flee the company s stocks as seen on the reevaluations of most analysts from buy to hold and then to sell. Stock price fell so much because of the uncertainty of the future earnings as stock prices reflects future earnings rather than present cash flow. Most of the analysts on exhibit 5 also show that estimated EPS for the latter part of 2004 steadily declined which eventually reflected on the stock prices in the succeeding months.