Krispy Kreme Doughnuts Case

Krispy Kreme Doughnuts, Inc.

Summary: Vernon Rudolph, founder of Krispy Kreme Doughnuts in 1937, had acquired the doughnuts recipe from a French Chef and started making and selling doughnuts wholesale to supermarkets. As the product attracted many customers, he started his own factory and sold doughnuts directly to customers. There were fewer than 100 stores when he died in 1973 many of which were operated by franchisees. Beatrice Foods, who bought the company after Rudolph's death, changed the appearance and the recipe of the doughnuts. The business failed to make progress and was put for sale. Joseph McAleer, first franchisee, bought the company in 1982 and brought the old recipe back. Scott Livengood became CEO in 1998 and took the company public in April 2000. Price of Krispy Kreme share was $40.63 with a market capitalization of $500 million. The company generated revenues from four sources which are On-premises, Off-premises, manufacturing & distribution of product mix and machinery, and franchise royalties and fees.

In May 2004, Krispy Kreme announced adverse results and told investors to expect earnings 10% less than anticipated. They claimed that the sales were low due to high awareness of low-carbohydrate diets. Company also announced to close some of its shops. Krispy Kreme's shares fell to $22.51 a share. Krispy Kreme's troubles mounted more in the second half of 2004 and analysts became very pessimistic about the stock. SEC held an informal investigation into the company's accounting practices. Krispy Kreme earned an F grade for its earning quality. On the date of the SEC announcement, Krispy Kreme's shares fell to $15.71 and after a day, shares were trading for less than $10 a share.

Assessment: Though the company's reason for decrease in sales was increased awareness of the low-carbohydrate diet, it doesn't seem appealing. Can a diet fad have such a deleterious effect on the company's sales? Dunkin Donuts, one of its biggest competitors has not faced a similar problem because of the low-carb diet. As per the Wall Street Journal, Krispy Kreme was negotiating to purchase a struggling Michigan franchise. The franchise owed the company several million dollars. Krispy Kreme made an agreement with the other franchise asking them to pay accrued interest and promising to pay higher purchase price. Also, the company agreed to pay the store closing expenses. All this deal was made to boost their earnings. The interest paid by the franchise was recorded as the interest income which shows an immediate profit on the company's books. On the other hand, company recorded the purchase price on the balance sheet as an intangible asset called reacquired franchise rights. From the balance sheet, we can see a huge increase in the reacquired franchise rights from $49,354 in 2003 to $175,957 in 2004. This asset does not get amortized and hence is not deducted