Back at It Again at Krispy Kreme Spiral Cut

What could exist more than perfect than a Krispy Kreme doughnut? Hot from the fryer and loaded with sugar, the Original Glazed is practically irresistible. For a fourth dimension, Krispy Kreme'south stock seemed irresistible, too. When the company went public in April 2000, at the acme of the Internet cyclone, investors flocked to buy into a business organisation they could sympathize. An old-fashioned franchise based in Winston-Salem, North Carolina, Krispy Kreme Doughnuts Inc. boasted solid fundamentals, calculation stores at a rapid clip and showing steadily increasing sales and earnings.

Only Krispy Kreme also had a mystique. Its doughnuts, available for many years only in the Southeast, had attracted a devoted, even fanatical, customer base. When the company decided to go national, it opened franchises in locations guaranteed to generate buzz — Manhattan, Los Angeles, Las Vegas — and customers lined up around the cake. By August 2003, KKD was trading at most $fifty on the New York Stock Exchange, upwards 235 percent from its initial public offering toll of $21 on Nasdaq, and Fortune magazine was calling Krispy Kreme the "hottest brand in the land." For the fiscal year ended in Feb 2004, the company reported $665.6 1000000 in sales and $94.seven million in operating profit from its nigh 400 locations, including stores in Australia, Canada, and South Korea.

And then, just equally chop-chop as its popularity spiked, Krispy Kreme pitched into a steep downward spiral that may yet end in bankruptcy. The company'south woes surfaced in May 2004, when then-CEO Scott Livengood blamed low-carbohydrate diet trends for Krispy Kreme'due south kickoff-ever missed quarter and starting time loss equally a public company. That raised analysts' eyebrows, as blaming the Atkins diet for disappointing earnings carried a whiff of desperation.

The Securities and Exchange Commission came knocking in July 2004, making an breezy inquiry into Krispy Kreme's buybacks of several franchises. As the stock price plunged, shareholders filed conform. Franchisees alleged channel stuffing, claiming that some stores were getting twice their regular shipments in the final weeks of a quarter then that headquarters could make its numbers. The SEC upgraded its inquiry to "formal" status in October 2004. Boilerplate weekly sales, a key retailing mensurate, fell fifty-fifty as the visitor continued to add stores. In January 2005, Krispy Kreme decided to recapitulate its financials for much of fiscal 2004. Livengood was replaced every bit CEO by turnaround specialist Stephen Cooper, who likewise kept his other job: acting CEO of Enron Corp.

The post-obit month, the company announced that the United States Attorney'south Role of the Southern District of New York was also joining the fray — a move indicating concern near possible criminal misconduct. In Apr, Cooper shored up the business by securing $225 million in new financing. The company appear that it expected a loss for its latest quarter, and warned investors not to rely on its published financials for financial 2001, 2002, and 2003, and the first three quarters of fiscal 2005, in improver to those for 2004. Past early on May, Krispy Kreme all the same hadn't filed its restated financials, and its shares were trading around $6.

What went wrong? How could a company in business for nearly 70 years, with an almost legendary product and a loyal customer base, fall from grace and so quickly? The story of Krispy Kreme's troubles is, at bottom, a case study of how not to grow a franchise. According to one count, at that place are at least 2,300 franchised businesses in the United States, and many are extremely successful. Simply there are pitfalls in the franchise model, and Krispy Kreme — through a combination of ambition, greed, and inexperience — managed to stumble into most of them.

Aggressive Growth

From its humble beginnings in 1937 as a family-endemic business organization, Krispy Kreme slowly enlarged its footprint in the Southeast. In 1976, 3 years afterwards founder Vernon Rudolph died, the company was sold to Beatrice Foods Co.; in 1982, a group of franchisees bought information technology back. In 1996, the visitor began to stake its claim as a national franchise.

But in one case Krispy Kreme went public, "there was enormous pressure, as there is for all companies, to grow very quickly and sustain growth quarter afterward quarter after quarter," comments Steven P. Clark, an assistant professor of finance at Belk Higher of Business concern at the University of North Carolina at Charlotte. Unfortunately, adds Clark, "this was non the sort of business that was going to take that kind of unending growth."

McDonald'southward Corp. is the gold standard in franchising, driving such profitability to private restaurants that franchisees are eager to bring together the arrangement and follow the company'south stringent operating guidelines. But Krispy Kreme concentrated on growing revenues and profits at the parent-company level, while its outlets struggled. "You can oft go a system to abound really big even when particular outlets aren't actually assisting," notes Scott Shane, SBC Professor of Economics at Case Western Reserve Academy'due south Weatherhead School of Direction and an expert on franchising. Franchises, he explains, suffer from "goal conflict": while the franchisor aims to maximize sales, and thus boost royalty payments, the franchisee needs to maximize profits. If a franchisor packs a market with outlets to boost its own growth, it hurts the system in the long run by forcing units to compete with ane another.

"You might add another outlet in a market and increment your sales past l percent, but you might accept turned franchisees in that market from profitable to unprofitable," says Shane. Thus Krispy Kreme reported nearly a 15 percent increase in second-quarter revenues from financial 2003 to fiscal 2004, just aforementioned-store sales were upwardly just a 10th of a per centum during that time. The waning of a fad? Perhaps. Merely citing the issue of "significantly failing new unit returns" in August 2004, J.P. Morgan analyst John Ivankoe wrote: "These returns declined equally [the] incremental appeal of each new retail store fell upon market penetration." A year earlier, Ivankoe had downgraded the stock from "neutral" to "underweight," the equivalent of a "sell" rating.

Getting Greedy?

Having to share markets with other outlets isn't the only handicap for franchisees. In add-on to the standard franchise fee and royalty payments, Krispy Kreme requires franchisees to purchase equipment and ingredients from headquarters at marked-upward prices. This strategy, while not unheard of, tin can injure franchisees in the long run.

"There are a couple of means that franchise companies tin can look at the selling of equipment and formula," says Steve Hockett, president of FranChoice Inc., a company that matches potential franchisees with franchisors. "One is that it'southward a true profit center, even to the indicate where companies can be aggressive on pricing. But most successful franchise companies build their business around the royalty payment; they don't build information technology effectually equipment sales." Over time, says Hockett, "the franchisor is more probable to succeed by building profitable franchisees that can brand royalty payments."

Behemothic Krispy Kreme competitor Dunkin' Donuts, for case, doesn't "generally sell equipment or product to [its] franchisees," says Kate Lavelle, CFO of the 6,400-store chain. "Nosotros have a stiff royalty stream that is based solely on store sales." This model, says Lavelle, "keeps visitor and franchisee interests aligned."

Krispy Kreme, on the other mitt, raked in $152.7 million — 31 per centum of sales in 2003 — through its Krispy Kreme Manufacturing and Distribution (KKM&D) partition, which sells the required mix and doughnut-making equipment. With initial equipment packages selling for $400,000, KKM&D can have operating margins of 20 per centum or greater. Only what's skillful for the franchisor's bottom line isn't necessarily skillful for the franchisee's. "[Raw ingredients and equipment] are sold to franchisees at what [is] an exceptionally high margin…. It is hard to say how much this margin needs to drop to support franchise operations, but information technology must," wrote Ivankoe in an Baronial 2004 written report.

The Thrill Is Gone

In its quest for growth, Krispy Kreme also squandered some of its mystique. "They became ubiquitous," says Jonathan Waite, an analyst for KeyBanc Capital Markets in Los Angeles. "Not just in sheer numbers of eating place units, only also roughly half of their sales started going to grocery stores, gas stations, kiosks. Anywhere that consumers could exist found, yous could discover a Krispy Kreme."

In what amounted to an deed of heresy to Krispy Kreme devotees, the company also added smaller "satellite" stores that didn't actually make doughnuts. Unlike its factory-style franchises where customers could watch as the pastries were showered in glaze — "doughnut-making theater," the company called it — some new stores offered doughnuts that had been made elsewhere. Other products were added to the menu, too, including a line of high-carb, high-calorie frozen drinks, or "drink doughnuts," every bit people dubbed them.

Straying further from the appeal of its primal product, in May 2004 the visitor announced that it was developing, of all things, a sugar-free doughnut, in response to the popularity of low-carb diets. (The sugarless doughnut has all the same to be rolled out, however, and the new management team is reviewing the concept.)

Fudging the Numbers

As Krispy Kreme pursued its ambitious growth strategy, it was making missteps in the finance department too.

Except for the company's plan to finance a $35 1000000 mixing plant in Illinois with an off-balance-sheet constructed lease — a plan the company scuttled in February 2002, in the face of post-Enron suspicions — Krispy Kreme's accounting seemed unremarkable until October 2003. That's when the company reacquired a seven-store franchise in Michigan, called Dough-Re-Mi Co., for $32.i million. The visitor booked nearly of the purchase price as an intangible asset called "reacquired franchise rights," which information technology did non amortize, contrary to common manufacture practice. Krispy Kreme had also agreed to boost its toll for Dough-Re-Mi so that the struggling franchise could pay involvement owed to the doughnut maker for by-due loans. The company and then recorded the subsequent interest payment as income.

Krispy Kreme besides 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 role of the intangible "reacquired franchise rights" asset on the company'southward residual sheet, rather than costs that would have reduced the company's reported earnings. Krispy Kreme announced in a December 2004 8-K filing that information technology 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 aligning of some $500,000 will reverse the improper recording of interest income.

Krispy Kreme'southward repurchase of its northern California stores from a group of investors is also nether scrutiny. In Feb 2004, the company paid $16.8 million to buy the 33 per centum of Golden Gate Doughnuts LLC information technology did not already own. One of the beneficiaries of the buyout was the ex-wife of CEO Scott Livengood. The visitor failed to disclose this fact, although Adrienne Livengood'southward stake was valued at approximately $1.5 million. While the decision non to reveal the connection looks bad, "this is only a significant legal outcome if information technology somehow could be established that [Livengood] was seeking some kind of personal turn a profit or proceeds through his ex-wife, equally opposed to truly serving the company'due south involvement," says Carl Metzger, a partner with Goodwin Procter LLP in Boston.

In its Dec viii-Yard, Krispy Kreme revealed that at that place would need to be adjustments fabricated to the accounting for the Golden Gate Doughnuts buy besides — a full of $3.five million to correct improperly recorded compensation expenses and management fees that had been included in the purchase toll. The company will also brand a similar correction to fix errors made in the acquisition of a franchise in Charlottesville, Virginia.

On top of the questionable accounting and the lack of disclosure, Krispy Kreme may have paid inflated prices for some of the franchises information technology bought back. In 2003, the company spent $67 million to repurchase six stores in Dallas and rights to stores in Shreveport, Louisiana, that were owned in part by one-time Krispy Kreme board fellow member and chairman and CEO Joseph A. McAleer Jr. Another longtime director, Steven D. Smith, was too part owner. Compared with the $32.1 meg paid for the Michigan stores that aforementioned twelvemonth, the number sounds high — $11.2 meg versus $4.6 million per store. A ceremonious accommodate filed by another sometime franchisee alleges that a higher bid was offered just ignored.

"I asked a lot of questions about why they paid and so much for those acquisitions," says i analyst. "I don't call up I always truly got an answer. They told me information technology was a different fourth dimension in terms of valuation, but those were pretty exorbitant prices." The SEC, presumably, will insist on an answer in the class of its investigation.

Who Minded the Store?

The company's own investigation, every bit detailed in an Apr notification to the SEC, has turned upward accounting bug in other areas, too, involving derivatives, leases, equipment sales, and the consolidation of a bankrupt subsidiary. Even if these turn out to be mostly peccadilloes, they enhance a question: Who was minding the store in the finance department?

Equally it turns out, a lot of people. From 2000 to 2004, Krispy Kreme employed three different CFOs. John Tate joined just after the company went public, in October 2000, after xviii months at kitchenware retailer Williams-Sonoma Inc. Tate was promoted to main operating officer in 2002, and Randy Casstevens, the company'due south longtime controller, took the top finance spot. Casstevens, who had spent most of his career at Krispy Kreme, had never been CFO of a public company earlier. Afterwards adding the master governance officer function to his duties, Casstevens left in December 2003 in a move he then called "purely voluntary," just 5 months before the company announced its beginning earnings miss. (Now working as a career counselor at Wake Forest University in Winston-Salem, Casstevens declined to exist interviewed for this story.)

To replace Casstevens, Krispy Kreme brought in current finance primary Michael Phalen, who had worked with Krispy Kreme equally an investment banker for CIBC World Markets and Deutsche Banc Alex. Brownish, but had never held a CFO post before. The visitor declined to make Phalen available for an interview. John Tate, meanwhile, departed in August 2004, and is now the operations caput at Restoration Hardware, working once again with his former boss from Williams-Sonoma. Tate did not render telephone calls for comment.

Company watchers come to unlike conclusions near the meaning of the CFO churn. Ric Marshall, chief annotator at governance watchdog The Corporate Library, says the turnover may mean the CFOs were trying to raise red flags most the company's financial state. "To me, this says the real numbers the CFOs were coming upwardly with were numbers that the residual of management didn't desire to hear. They were looking for a CFO who was going to tell them good news." Adds Goodwin Procter's Metzger, "It may be that a particular CFO is the one who brought these issues to the visitor'due south attending. Y'all just don't know." But the fact that Tate and Casstevens were both promoted earlier leaving indicates that they were on good terms with the board and their beau managers. All three CFOs answered to Livengood, whose 27 years at the company gave him far greater tenure than any of the finance chiefs.

Stephen Mader, vice chairman of executive recruiter Christian & Timbers, says the CFOs simply may not have been up to the task of guiding a high-growth franchise through the public markets. "This happens a lot with companies that enter the public arena that had done well under before atmospheric condition, but don't have the experience in the public markets," he says. "You could merely take cypher more hither than a lot of marginal competence for running a company of that magnitude."

Electric current finance main Phalen "is a capable guy," comments Waite. "If y'all look at his bounty structure, it's mainly stock options. He has incentive to go the ship righted." Only Mader is less optimistic about the CFO'southward chances. "It's very rare to accept a company into bankruptcy or a turnaround stage and hold on to the existing CFO to exercise it," he says. "You need someone with no baggage, no sacred cows, who can look at things with objectivity."

A Missing Ingredient

When Krispy Kreme was a fast-growing private company, it was easy to conceal weaknesses in direction and corporate governance. Merely those weaknesses were magnified by the pressures of the public markets, particularly when the company's growth strategy started to stumble, says Marshall. "When y'all don't have a fully independent board property management responsible for operational and strategic shortcomings, a machine moving that quickly is going to autumn autonomously," he says. "They really weren't able to sustain the growth rate."

Until recently, Krispy Kreme'south board was stocked with insiders left over from the company'due south days equally a private business, including some, like McAleer and Smith, who owned franchises. And until early 2002, the company maintained a fund through which 35 executives could invest in franchisees, potentially creating conflicts of interest. Management elected to dissolve the fund as part of a push to improve governance.

In another questionable movement, in 2003, Krispy Kreme purchased Montana Mills Bread Co., a bakery-café chain at which Tate, then primary operating officeholder, was a manager. Tate has said he was not involved in discussions about the transaction. Krispy Kreme put Montana Mills upwards for sale a year after, after paying approximately $40 million in stock for the business and so recording a $34 million charge upon closing well-nigh Montana Mills stores. Together with the problematic franchise buybacks, the transaction smacks more of an insider deal than uncomplicated incompetence.

A farther warning sign of weak governance was the outsized bounty package awarded to former CEO Livengood, says Marshall. Livengood's full compensation was more than 20 percentage greater than the median for similar-size companies, according to The Corporate Library. Despite the visitor'southward reject, Krispy Kreme'south board allowed Livengood to retire with a six-calendar month consulting position that will pay him $275,000. He holds $one.vii million in options in addition to nigh 100,000 shares of Krispy Kreme stock. Livengood also continues to receive health benefits through the company, but he will no longer have use of the company jet, since one of new CEO Cooper's first moves was to sell off the aircraft lease.

"When we see patterns of excessive bounty, that is normally an indicator that the board is not sufficiently independent," says Marshall. Equally a result of the board's coziness, he says, no one stepped in to claiming Krispy Kreme's motion away from the fresh-doughnut model, and no i questioned the aggressive accounting for franchise buybacks. "It was a classic governance failure," sums up Marshall.

A Fresh Start

Although Krispy Kreme today looks similar a visitor becalmed, if not sinking, some observers believe information technology will regain momentum. "Krispy Kreme every bit a company however has a lot of value in its proper name and in its product," says attorney Metzger. "There should be a fashion for the company to keep to abound the business."

With the January 2005 replacement of Livengood with Cooper, the revamped board — in which 8 of ten directors are fully independent, co-ordinate to The Corporate Library — has shown it is serious about making a turnaround. Since his arrival, Cooper has lined upward $225 million in new debt financing led past Credit Suisse Get-go Boston, Argent Signal Finance, and Wells Fargo Foothill Inc. to aid Krispy Kreme meet its immediate cash-flow needs. Cooper also announced a toll-cut program that includes a 25 per centum reduction in head count.

UNC'southward Clark suggests the company may need to go individual or sell itself to some other large chain, like McDonald'south. "But I'm non sure that buyers are exactly lining upwards at the door," he adds. KeyBanc'south Waite calls an acquisition doubtful, in function because he says the visitor is "not terribly inexpensive," given the corporeality of work needed to get information technology back on runway. Indeed, Waite hasn't ruled out the possibility of bankruptcy. "The biggest affair they take to do is bring on an operator," he says. "They need an industry insider who tin can stem the drib in sales at the unit level — somebody who knows how to drive organic sales growth."

Ultimately, Krispy Kreme needs to get back to what fueled its phenomenal growth in the showtime place: actually good doughnuts. "They need to emphasize the hot-doughnut experience," says Waite, "rather than the cold, one-time doughnut in a gas station."

Kate O'Sullivan is a staff writer at CFO.

Half-Broiled Krispy Kreme first reported solid growth, simply has since announced that its results for 2001-2005 are not reliable.
	2002	2003	2004
Total revenue*	$394.4	$491.six	$665.six
Net Income*	$26.iv	$33.5	$57.1
Full long-term debt*	$3.9	$62.four	$146.2
Number of stores	218	276	357
Note: Figures for fiscal years ended in February *in $ millions Source: www.krispykreme.com

fosterhiscirs.blogspot.com

Source: https://www.cfo.com/strategy/2005/06/kremed/

Share this post