Krispy Kreme Doughnuts, Inc.

Krispy Kreme Doughnuts, Inc. Ratio Analysis Liquidity Ratios As shown in Exhibit 1, quick ratio for Krispy Kreme gradually rose from 1.05 to 2.72, during 2000 to 2004. And current ratio changed with the similar pattern. Generally, a quick ratio of 1 is considered good in most industries. As for Krispy Kreme, the quick ratio is always higher than 1, and the highest point is 3.25 in 2004. This means that the company had good liquidity. However, on May 2 , 2004 just about the time Krispy Kreme announced adverse results, both the quick ratio and the current ratio of the company decreased. From the Krispy Kreme’s balance sheets we can see that within three months the company’s current assets decreased by 22,899, while inventories increased. And current liabilities increased 9813, as book overdraft and accrued expenses increased remarkably. Compare to other quick-service restaurant as per exhibit 2, Krispy Kreme’s quick ratio and current ratio both are much higher. While the average liquidity ratios of these 12 companies are 0.795 and 1.170, which are lower than half of the ratios from Krispy Kreme. Thus, the Krispy Kreme held much more current assets than needed. And the current assets may lose efficiency.

Leverage Ratios As shown from Exhibit3&4, after 2000, both Krispy Kreme’s debt-to-equity ratio (D/E) and debt-to-capital ratio (D/C) are in a low level, which is better. It’s more notable when compared with other quick-service restaurant. The average debt-to-equity ratio and debt-to-capital ratio are 53.41% and 64.18%. Krispy Kreme’s debt-to-equity ratio and debt-to-capital ratio are 11.26% and 10.12%. Krispy Kreme held less debt compared to shareholders’ equity. So the company raised money mainly from equity financing than debt financing. Activity Ratios From Exhibit 5, we can gather that the inventory, receivables and asset turnover from 2000 to 2004 are relatively stable. The activity ratio with the greatest fluctuation is the cash turnover ratio. This fluctuation can be attributed to the increased cash holdings KKD held from 2000 to 2003.

Exhibit 6 illustrates how Krispy Kreme’s activity ratios are much lower than the industry average. Receivables turnover for Krispy Kreme was 9.7. The industry average was 37.51. This indicates that debtors of Krispy Kreme are slow in paying back the company. If we calculate the days’ in sales receivable, the industry average is 9.73 days whereas Krispy Kreme takes 37.63 days to collect its debts. This increases the chances of bad debt. The exhibit also highlights Krispy Kreme’s poor inventory turnover, 17.76, which suggests that the doughnut company had too much capital tied up in inventory especially when compared to the fact that the industry’s average inventory turnover was 64.69. Krispy Kreme’s asset turnover rate, at 1.01, is also lower than the industry average of 1.615. This conveys the fact that Krispy Kreme isn’t efficiently managing its assets. Profitability Ratios As shown in exhibit 7, the net profit margin and operating profit margin are trending upwards from 2000 to 2004. Return on assets and equity declined from 2002 to 2003.

This was partially due to the equity loss incurred by Krispy Kreme on joint ventures. As shown in exhibit 8, Krispy Kreme is on par with the industry average as far as profitability ratios are concerned. In fact, the EBIT margin for Krispy Kreme, 15.34, is higher than the industry average of 12.18. Warning Signs: Below are the warning signs appeared in Krispy Kreme regulatory filings well before the stock price started to fall: Changes in CFO/COO Position There was a constant change in the CFO position. Just after the IPO in 2000, Krispy Kreme replaced longtime Chief Financial Officer Paul Beitbach with John Tate. Breitbach was a traditional conservative CPA, while Tate was a more aggressive financial type who was forced out as CFO of Williams-Sonoma after missing two quarterly earnings forecasts. (Understandably, he made sure not to miss any earnings targets while at Krispy Kreme.) Tate was promoted to COO in 2002, and longtime controller Randy Casstevens was promoted to the top finance spot. Casstevens lasted less than eighteen months and turned in a “purely voluntary” resignation just five months before the company’s first quarterly earnings shortfall. To replace Casstevens, the company brought in Michael Phelan, a key member of the investment banking team that executed Krispy Kreme’s IPO and follow-on offering, who in turn lasted less than two years in the position.

Insider Share Dumping When Krispy Kreme went public in 2000, about 75% of its shares were “locked up” – insiders who owned them were not permitted to sell for an eighteen-month period. As soon as the lockup period expired, executives and board members sold 1.85 million shares, or 20% of the shares subject to the lock-up agreement. By 2004 CEO Livengood had sold over 1 million shares (about 40% of his holdings) for net proceeds of over $40 million, despite having previously made pledges that he wouldn’t sell company stock. The high level of stock sales by insiders while the company was issuing glowing financial reports should have alerted shareholders to a potential problem. Synthetic Leasing Soon after it went public, Krispy Kreme arranged to finance a new $35 million factory in Effingham, Illinois with a synthetic bank-financed lease, which would allow them to keep a large long-term debt off their balance sheet and avoid raising their debt ratio from 26% to 36%.

Executive Conflict Of Interest (1) In early 2003 Krispy Kreme spent $39 million to acquire Montana Mills, a chain of 30 upscale “village bread stores” based in Rochester, N.Y. Almost $30 million of the purchase price was allocated to goodwill, although the concept was unproven and Montana Mills had never previously shown a profit. In what appears as an obvious conflict of interest, COO John Tate had served on the Montana Mills Board of Directors for 14 months previous to the acquisition. Not surprisingly for a non-core venture, Montana Mills showed a $2 million loss in the year after it was acquired, and in mid-2004 the chain was closed down, causing a $35 million income statement charge. (2)

In its first two years as a public company, Krispy Kreme had a policy which allowed senior executives to make private investments in newly-established area franchisees, and Scott Livengood eventually had ownership stakes in seven large franchised operations. In an arrangement reminiscent of old-fashioned extortion operations, Livengood and other Krispy Kreme executives were allowed to “muscle in” on new franchise deals – they could purchase equity stakes even when the franchisee group did not want them as partners. Krispy Kreme Accounting Red Flags: A Classic Case of “Accounting Fraud” 1) Krispy Kreme was very aggressive in its revenue recognition. 2) The largest single franchise buyout ($67 million) was owned by two present and past Krispy Kreme Board members. 3) The price paid for most of the buyouts was $11.2 million per store at a time when a new franchise could be set up an equipped for about $1.5 million. 4) They bought out a struggling Michigan franchisee and agreed to raise the purchase price from $26 million to $32 million so that the franchisee could afford to close two stores and to settle its overdue debts owed to Krispy Kreme, thus avoiding a bad debt loss.

CONCLUSION During the Krispy Kreme stock price run-up of 2000-03, a series of early warning signs appeared, but investors seemed to ignore them. While each of these signs individually do not presage a coming disaster, when taken as a whole they should have served as a warning to investors:  Extensive insider share-selling Significant conflicts of interest among senior managers and the Board of Directors An unwise investment in a non-core business High turnover in the CFO position A willingness to buy out the franchise rights of insiders at premium prices History of operating losses at the franchisee level, a willingness to use accounting games to avoid putting debt on the balance sheet A disturbingly consistent trend of beating quarterly EPS targets by just enough to earn significant bonuses for executives.

Wise investors should not have been surprised when the stock price began to fall precipitously in 2004. And from our point of view this company would have done better with its conservative approach and high morality on part of top Management.