Finance 4360
MWF 9:00
Group 4
David Lange
Jessica Leathers
Marlo Rouner
Patrick Rountree
Jenny Weaks
Table of Contents
Executive Summary.....................................................................................3
Recommendations:
Capital Spending..............................................................................4
Joint Venture....................................................................................7
Management Compensation...........................................................10
Works Cited...............................................................................................14
Appendix A: Company Overview.............................................................15
Appendix B................................................................................................18
2
Executive Summary
Krispy Kreme Doughnuts Inc. has become one of the most well known doughnut
manufacturing companies in America. The corporation has had huge success during the
first part of the millennium. However, in the past few years, Krispy Kreme has suffered
losses in revenues and prestige due to recent allegations of faulty accounting numbers.
They also are dealing with issues concerning a rapid expansion with a decline in sales.
The company must initiate actions that would improve the value of the firm and the
firm’s stock.
One recommendation consists of cutting capital spending for new franchises as well as
off-premises sales which will provide the company with a better chance for adding value
to the firm. While a new location increases sales by a small margin in the beginning, this
small margin declines and does not offset the associated expenses of Krispy Kreme’s
rapid expansion. Using this extra money for growth in research and development, Krispy
Kreme can better adjust its methods of both the needs of the company and the wants of
the customer. It will also create a more positive attitude in the minds of existing and
potential investors.
Secondly, Krispy Kreme should enter a joint venture with a hotel chain that will serve
Krispy Kreme doughnuts as part of the hotel’s breakfast. This kind of joint venture is
different from previous joint ventures because the company only sells the product to the
hotel as opposed to selling straight to consumers through other outlets. This will increase
the stability of sales for the corporation. Once this joint venture partnership is
established, sales should increase. The increased sales, combined with the closing of less
profitable Krispy Kreme stores, will let the company pay back their debt more quickly.
Less debt will equal less risk, which will reduce the required return on the stock and start
driving up the price.
Finally, Krispy Kreme would benefit from an effective bonus plan using EVA and the
related bonus bank. Currently, Krispy Kreme’s managers are being compensated based
mainly upon the company’s stock price. As long as management meets the target EVA,
the bonus bank should increase each year. This will lure senior management’s attention
to what is best for Krispy Kreme and its shareholders rather than only on the current
stock price. With EVA bonuses, the senior mangers will be forced to focus on its
existing stores as well as sustaining sales in new stores. A different incentive plan will
compel management to make decisions that increase, in both the long run and the short
run, the profitability and health of the firm, making shareholders more confident in the
growth of the company.
3
Capital Spending
A lack of consumer confidence has contributed greatly to the falling value of Krispy
Kreme’s stock price. Management has become consumed with surviving in the market
rather than increasing shareholder value. This is shown by the firm’s recent deal with
Credit Suisse First Boston in obtaining the $225 million term loan (Investor News).
Although this helps the firm in the short run to pay back their existing debt and pay other
financing expenses, in the long run it does not decrease the size of their debt causing
concern for shareholders that the firm may be pushed into financial distress if they are
unable to meet their debt payments. As the firm’s chance of financial distress increases,
bankruptcy costs (although, only 1-3% of firm value) and costs related to stockholder-
bondholder conflict also increase. However, more importantly there is an increase in loss
of confidence which can result in a loss of customers, creditors, and best employees
(Capital Structure). Thus, the stock price will continue to drop. Krispy Kreme has often
been compared to Starbucks, one of its competitors, due to their similarity in aggressive
expansion. By looking at Krispy Kreme’s Total Debt to Equity ratio of 0.31 compared to
Starbucks’ ratio of 0.0 and the industry of 0.51, Starbucks has the greater financial
strength (Reuters). The problem is Krispy Kreme uses their debt to continue to grow and
expand by opening new franchises which increases costs due to very expensive
equipment, materials, etc. The cost to open and fund one franchise is approximately $1.5
million (Business Journal). Currently these costs are not offset enough by sales to make
expanding worthwhile. Perhaps in the future, the company should consider opening more
stores, but as of now their operations are not doing well enough to justify the continued
growth of opening new stores.
4
One recommendation is for Krispy Kreme to cut back on capital spending related to
increasing the number of franchises as well as off-premise sales that are not expected to
add to the value of the company. Currently, the mindset of the company is to increase the
amount of franchises in order to continue their growth. In the short run, this has been
profitable for Krispy Kreme because each new franchisee must buy mixes, sugar,
shortening, coffee, and the doughnut-making equipment from the corporation (10-K).
The majority of franchises show high weekly revenues at the beginning of start up, but
then start to decline after being in operation for a while. From 2000 to 2003 there has
been a steady increase in average weekly sales per franchised factory store; however,
during the time the company was aggressively expanding (2003-2004) average weekly
sales dropped from $58,000 to $56,000 (10-K). Also, the company recently announced
they expect to report a net loss for its fourth quarter ended January 30, 2005 (Market
Watch). These figures forecast future declines that could be avoided if the company
alters its strategy to expand. The company says the testing of off-premise sales in such
places as supermarkets and gas stations has also added to increased profits in 2004
because of their lower start-up and operating costs, but many news releases have reported
that consumers possess negative feelings toward these places of sale.
By cutting capital spending used to open new franchises and off-premise locations,
Krispy Kreme can use this money to focus their efforts on improving the existing
establishments. During 2004, the company opened 58 franchises, closed three, and
transferred sixteen from franchised factory stores to company owned stores (10-K). This
5
proves that the company’s franchises may not be as profitable as they were expecting.
Also, continued “investigation of accounting issues brought on by questionable purchases
of franchises” does not reflect positively on the profitability corporation (Market Watch).
By focusing their capital spending on areas such as research and development, which
they currently do not have, the company can benefit by applying this knowledge to
existing establishments. In addition, by cutting the number of off-premise locations,
Krispy Kreme will draw customers back to the retail stores resulting in increased profits.
Consumers will have more of a selection at the retail stores boosting revenues even
higher compared to the off-premise locations.
The potential downside of reducing capital spending on new franchises and off-premise
locations is that the company will lose the revenues they make from selling all of the
materials to the franchisers and the small profits they make at the other locations. These
downsides, however, only affect the company in the short run. In the long-term Krispy
Kreme will recover quickly from the short-term effects because the company will not be
concerned about the new franchises failing (Krispy Kreme currently buys back
franchisee’s equipment) or having declining profits, which reduces their costs. In
addition, consumer attitudes will improve through the decrease in off-premise locations
that are not found appealing. These effects will have a positive effect on shareholder
value.
6
Our recommendation of using less capital spending to fund new stores is not something
management at Krispy Kreme has already completed. In fact, the company mindset is
that they will increase their revenues by continuing to grow by opening new franchises.
For the year 2005, they plan to open approximately 120 new stores, the majority of which
are expected to be franchises (10-K).
Using capital spending in alternative ways, such as research and development, to redirect
the way in which Krispy Kreme grows as a company will increase the financial standing
of Krispy Kreme. This in turn will reflect increased value to their shareholders and
provide the company with a higher standing in the current market.
Joint Venture
Too much debt increases risk and therefore reduces the stock price (Capital Structure).
Since the corporation has acquired new financing, they now have enough funds to make
changes to their capital structure. We recommend the company work towards setting up
a joint venture. This will increase their sales and thus help the corporation to decrease
their debt which will drive up the stock price. As mentioned before, one problem is that
Krispy Kreme has been expanding at a rate that is too quick for sales to match. Krispy
Kreme’s assets and long-term debt increased at a rate that is absolutely phenomenal
compared to both Starbucks, and to their own sales per year. For example, from 2002-
2003, sales growths for both companies were relatively the same, but Starbucks only
increased their total assets by 19%, while Krispy Kreme increased theirs by 61%.
7
Furthermore, Starbucks reduced their long-term debt by 14%, but Krispy Kreme
increased theirs by a staggering 1,495% (See Appendix B).
The company relies too much on new locations to produce revenue when “Krispy Kreme
doughnuts” were something of a fad and have lost some popularity due to the low-carb
diet craze. The prestige of the Krispy Kreme name has been tarnished somewhat due to
the ongoing analysis of their accounting practices and the official SEC examination. This
continues to affect Krispy Kreme because as a result they are still unable to file their 10-
K report for the fiscal year ending January 30, 2005 (NT 10-K). The combination of
declining popularity and expansion, which is too ambitious, has driven their stock price
down.
By closing locations that are not generating enough revenue, and refocusing their efforts
into a joint venture, the company will gain a larger and more stable market share. Krispy
Kreme should partner with a hotel chain, such as a Holiday Inn, and rely on these entities
to sell their doughnuts, either with or without the Krispy Kreme name. A joint venture of
this nature will work because Krispy Kreme’s sales to each hotel will be continuous and
stable based on the quantity of doughnuts the hotels purchase. Hotels usually offer a
breakfast, either complementary or purchased. Therefore, the hotel chain will benefit
from the joint venture by replacing the costs associated with making their current
breakfast pastries in place of Krispy Kreme doughnuts. The decision to associate the
name, Krispy Kreme, with the product would be made by the hotel chain, but either way
Krispy Kreme will benefit from the continuous sales made to the hotels. However, if the
8
Krispy Kreme name is associated with the hotel, this would act as a competitive
advantage for the hotel chain.
The only problems Krispy Kreme might experience are the long-term leases and fixed
costs that may still exist even if they close down certain stores, and any surcharge
Holiday Inn (or whoever) may charge by agreeing to a joint venture. To handle the fixed
costs that might not subside, Krispy Kreme can include the costs as part of their initial
price when selling the doughnuts to the hotels. In the future, the price will decrease when
they begin to recover their losses or when the leases start expiring. Also, reducing the
fixed costs may be unavoidable, but by pairing up with hotel chains they will be able to
increase their revenue from where it currently stands and still be better fit to meet those
expenses.
Even if the hotel chains charge Krispy Kreme a high rate to create the joint venture, the
increase and stability of sales will outweigh the cost. It will be easy to come up with a
price that is more than fair to equally compensate both the hotel chain and Krispy Kreme
because there will not be any real expenses for making this partnership. Neither
company will have to open any locations, buy any new property or move anything
around.
Creating this kind of joint venture will greatly increase Krispy Kreme’s revenue and start
to stabilize their sales. As mentioned before, Krispy Kreme has mainly relied on sales in
their store locations. However, they have attempted to sell their products inside gas
9
stations, supermarkets, and various other places, which minimize the risk of
underperforming at traditional store locations (10-K). When people stay overnight at a
hotel, however, breakfast is something many will want first thing in the morning, and
when their limited amount of choices includes a Krispy Kreme doughnut, the chance of
Krispy Kreme to continue their joint venture with the hotels increases. This particular
form of joint venture is not something the corporation has attempted in the past.
Once the joint venture is established, Krispy Kreme should start to pay back the massive
amount of debt they have accrued. While more debt is a great tax shelter, it also
increases the amount of risk and therefore causes investors to expect a greater return,
which in this instance means a lower stock price (Capital Structure). Once the company
pays off a large part of their bank loan, they will have a much lower risk. Thus, the
decrease in risk and the added stability will drive the stock price back up.
Management Incentive
Currently Krispy Kreme’s bonus incentive is based on financial and non-financial
measures. The main factor for its bonus structure is stock price (10-K). When a bonus
structure is based mainly on stock price, senior managers focus more on the short run
stock price and the current earnings to boost that stock price. A more effective way to
use bonus incentives is to use the economic value added formula (EVA), and the related
bonus bank (EVA and Agency).
10
Krispy Kreme should rewrite its bonus plan to use EVA and the related bonus bank.
First, the EVA bonus for the current year is calculated with the formula, and then this
bonus is put into the bonus bank. One-third of the bonus bank is then paid out to the
manager for whom the bonus is being calculated. This amount is then deducted from the
bonus bank (Agency). As long as management meets the target EVA, the bonus bank
should increase each year. This will force senior management to focus on what is best
for Krispy Kreme and its shareholders rather than only on the current stock price.
In 2004 Krispy Kreme did not pay any senior level bonuses because of its fall in stock
price (Homepage). The corporation’s senior managers are focusing on expanding very
rapidly and relying on the high first year sales of new stores to raise its stock price.
Currently, a higher stock price allows management to receive a bonus (because
management’s bonus is based mainly on stock price). With EVA bonuses, the senior
mangers will be forced to focus on its existing stores as well as sustaining sales in new
stores. This will ultimately have the positive effect on the stock price that the senior
managers are seeking. These actions will pull the senior manager’s attention away from
the current year only and force management to emphasize decisions reflecting the long
run, resulting in more shareholder confidence in management decisions.
There are potential downsides to EVA and the bonus bank. The first downside is that in
less profitable years, managers are still paid a bonus. The second downside is that in the
next few years (profitable or not), is when the bonus suffers. The third downside of
implementing EVA and the bonus bank is these solutions may not be completely
11
effective in taking management’s focus off the short run. In order to alleviate these
downsides, Krispy Kreme may choose to not pay bonuses in the years in which EVA is
not above a certain minimum level. This would not be a true bonus bank, but it would
forgo most of the short-term concern and force senior management to focus on the long-
term goals of Krispy Kreme and its shareholders. Another solution is to give senior
managers a bonus, in either profitable or non-profitable years, and force management, by
contract, to purchase Krispy Kreme shares and hold these shares. This will align
management decisions with shareholder decisions.
Changing the incentive for management compensation is practical because without some
other form of bonus structure, senior management will focus solely on making the
corporation’s stock price increase. This entirely short-term focus will be detrimental to
Krispy Kreme in the long run. The corporation’s current method of earning a bonus,
opening as many stores as possible and relying on the high sales in the first years to boost
the stock price, is not the best plan for Krispy Kreme and its shareholders because
management is focused solely on the short run and stock price. Krispy Kreme has not
tried to instate this plan yet. In Krispy Kreme’s 2004 10-K, a vague outline of Krispy
Kreme’s current incentive plan is presented. Krispy Kreme does not use EVA; its
management incentive is based on other measures (10-K)
This opportunity is present because Krispy Kreme needs to turn management’s focus on
the long-term value of the firm. Currently management compensation is attractive
because of high stock options. However, the corporation did not pay senior level bonuses
12
in 2004; consequently, managers will be desperate for a bonus. Thus, senior managers
will continue to focus solely on making Krispy Kreme’s stock price high in the short run
and not on what is best for Krispy Kreme and its shareholders long-term. The
corporation needs a better measure of performance and bonus structure.
13
WORKS CITED
The Business Journal. “Krispy Kreme growth hits new phase.” February 13, 2004.
<http://triad.bizjournals.com/triad/stories/2004/02/16/story1.html>.
Investor News. “Krispy Kreme Announces $225 Million Financing.” Investor News.
4 April 2005.
Krispy Kreme. Homepage. <www.krispykreme.com>
Krispy Kreme. “SEC Form 10-K.” United States Securities and Exchange Commission
Filing. 16 April 2004.
Krispy Kreme. “SEC Form NT 10-K.” United States Securities and Exchange
Commission Filing. 18 April 2005
Market Watch. “Krispy Kreme’s got more money woes.” April 19, 2005.
<http://www.marketwatch.com/news/yhoo/story>
Reuters. Krispy Kreme: Key Ratios. 18 April 2005. <www.yahoo.investor.reuters.com>.
Rich, Steve. “Agency.” Finance 4360 Lecture Notes. Spring 2005.
Rich, Steve. “Capital Structure.” Finance 4360 Lecture Notes. Spring 2005.
Rich, Steve. “Economic Value Added.” Finance 4360 Lecture Notes. Spring 2005.
Yahoo Finance. Direct Competitor & Financial Statements Comparison. 19 April 2005
<http://finance.yahoo.com >
14
Appendix A
Overview of Krispy Kreme Doughnuts, Inc.
Compiled from their Annual Report on form 10-K
Krispy Kreme Doughnuts, Inc. is a specialty retailer of doughnuts whose primary form of
business is owning and franchising doughnut stores providing delicious doughnuts to
thousands of customers around the globe. Income is generated from three sources
including sales at company-owned stores, franchise fees and royalties from franchise
stores, and a “vertically integrated supply chain.”
Facilities
Krispy Kreme currently has 443 factory stores in operation. Efforts in opening new
stores have primarily been focused on markets with over 100,000 households and while
the corporation plans to continue expansion in these current markets, it is also expanding
into smaller forms of business with the doughnut and coffee shop, the fresh shop, and the
kiosk formats. The corporation also is continuing to increase the doughnut market
internationally. Krispy Kreme’s Annual Report states, “Ultimately, we believe that the
opportunity for growth through expansion internationally is at least as great as the
domestic opportunity.”
Products and Services
Store revenues are earned through production and distribution of doughnuts. Each store
offers a variety of doughnuts, including the “signature Hot Original Glazed and nine
other prescribed varieties.” Each traditional store also acts as a doughnut factory with the
ability to produce up to 10,000 dozen doughnuts per day. Each franchise store
manufactures their own doughnuts using a “doughnut-making theater” designed to
15
provide the customers with a unique way of experiencing first-hand the process of
making the doughnut as well as a way to visibly reinforce commitment to quality and
freshness. Krispy Kreme has also been working to create first-class beverages to
complement their doughnuts. The corporation currently purchases most of the beverages
offered in their retail stores through third party vendors. However, through an acquisition
made in 2002, they gained significant coffee roasting expertise and are now in the
process of implementing their own beverage program. These beverages include coffees,
espressos, and even frozen drinks. With this action, Krispy Kreme hopes to gain a
significant market share in an industry where coffee is an essential part of breakfast.
Suppliers and Customers
Krispy Kreme Manufacturing and Distribution operates three distribution centers
supplying all food ingredients including their own doughnut mix, coffee, juices, signs,
display cases, uniforms, and other various items. They also manufacture and sell
doughnut-making equipment.
Employees
As of February 1, 2004, Krispy Kreme employed 6,982 people who are comprised of the
following: 291 administrative offices, 263 in manufacturing and distribution centers,
6,190 store employees, and 238 in Montana Mills stores. The chief operating officer,
along with other corporate officers responsible for store operations, is required to
participate in corporate interaction with store operations, division directors and all store
management. Store staffing varies depending on the size of the store. Stores with sales
through all channels have about 35 employees handling on-premises sales, processing,
production, bookkeeping, sanitation, and delivery personnel.
16
Competitors
Krispy Kreme’s competition includes retailers of doughnuts and snacks sold through
supermarkets, convenience stores, restaurants, and retail stores. The largest competitor is
Dunkin’ Donuts, which has the largest number of outlets in the doughnut retail industry.
Krispy Kreme has also considered Starbucks as a competitor due to both of the
companies’ recent and rapid expansion as well as quality of coffee and pastries. (Yahoo
Finance). Other competitors include regionally- and locally-owned doughnut shops and
other retailers who sell sweet treats such as cookie stores and ice cream stores.
Industry Trends
The doughnut industry is highly fragmented. Krispy Kreme hopes to have a growth in
sales in upcoming years and focuses on marketing to two-income households as well as
on-the-go consumers who may eat away from home. The corporation views the
fragmented competition in the industry as an opportunity for continued growth as well as
a way to generate positive and creative ideas for keeping the doughnut market thriving.
17
Appendix B
KKD vs SBUX
(All numbers, except percentages, are in thousands of dollars)
% %
Change Change
Calculation from Calculation from
2002 - 2003 -
2003 2004
KKD
Total Sales (491,549 – 394,354)/394,354 = +25% (665,592 – 491,549)/491,549 = +35%
Total Assets (410,487 – 255,376)/255,376 = +61% (660,664 – 410,487)/410,487 = +61%
LT Debt* (62,406 – 3,912)/3,912 = +1,495% (146,224 – 62,406)/62,406 = +134%
SBUX
Total Sales (4,075,522 – 3,208,908)/3,288,908 = +24% (5,294,247 – 4,075,522)/4,075,522 = +30%
Total Assets (2,729,746 – 2,292,736)/2,292,736 = +19% (3,390,548 – 2,729,746)/2,729,746 = +24%
LT Debt* (4,354 – 5,076)/5,076 = -14% (3,618 – 4,354)/4,354 = -17%
* Short term debt remained virtually unchanged during all three periods
All numbers used in calculations are taken from the following financial statements
gathered from Yahoo! Finance.
18
Krispy Kreme
Partial Balance Sheet: Partial Income Statement:
PERIOD ENDING 1-Feb-04 2-Feb-03 3-Feb-02 PERIOD
ENDING 1-Feb-04 2-Feb-03 3-Feb-02
Total
Assets Revenue 665,592 491,549 394,354
Current Assets Cost of
Cash And Revenue 507,396 381,489 316,946
Cash
Equivalents 21,029 32,203 21,904
Gross
Short Term
Profit 158,196 110,060 77,408
Investments - 22,976 15,292
Net
Receivables 83,092 58,106 45,823
Inventory 28,864 24,365 16,159
Other Current
Assets 5,659 3,478 2,591
Total Current Assets 138,644 141,128 101,769
Long Term Investments 20,035 11,215 16,100
Property Plant and
Equipment 284,716 202,558 112,577
Goodwill 19,865 - -
Intangible Assets 187,859 48,703 16,621
Accumulated Amortization - - -
Other Assets 9,545 6,883 8,309
Deferred Long Term Asset
Charges - - -
Total Assets 660,664 410,487 255,376
Liabilities
Current Liabilities
Accounts
Payable 42,509 35,036 36,742
Short/Current
Long Term
Debt 2,861 4,201 4,602
Other Current
Liabilities 8,123 20,450 11,189
Total Current Liabilities 53,493 59,687 52,533
Long Term Debt 146,224 62,406 3,912
Other Liabilities - - 4,116
Deferred Long Term
Liability Charges 6,417 9,849 4,657
Minority Interest 2,323 5,193 2,491
Negative Goodwill - - -
Total Liabilities 208,457 137,135 67,709
19
Starbucks
Partial Balance Sheet: Partial Income Statement:
PERIOD ENDING 3-Oct-04 28-Sep-03 29-Sep-02
Assets
Current Assets
Cash And
Cash
Equivalents 299,128 200,907 174,572
Short Term
Investments 353,881 149,104 227,662
Net
Receivables 203,876 175,901 139,779
Inventory 422,663 342,944 263,174
Other
Current
Assets 71,347 55,173 42,351
Total Current Assets 1,350,895 924,029 847,538
Long Term Investments 306,926 280,416 105,986
Property Plant and
Equipment 1,551,416 1,384,902 1,265,756
Goodwill 68,950 63,344 19,902
Intangible Assets 26,800 24,942 -
Accumulated
Amortization - - -
Other Assets 85,561 52,113 53,554
Deferred Long Term
Asset Charges - - -
Total Assets 3,390,548 2,729,746 2,292,736
Liabilities
Current Liabilities
Accounts
Payable 624,147 534,505 419,621
Short/Current
Long Term
Debt 735 722 710
Other
Current
Liabilities 121,377 73,476 117,159
Total Current
Liabilities 746,259 608,703 537,490
Long Term Debt 3,618 4,354 5,076
Other Liabilities 144,683 1,045 1,036
Deferred Long Term
Liability Charges 21,770 33,217 22,496
Minority Interest - - -
Negative Goodwill - - -
19
PERIOD
ENDING 3-Oct-04 28-Sep-03 29-Sep-02
Total
Revenue 5,294,247 4,075,522 3,288,908
Cost of
Revenue 2,191,440 1,685,928 1,350,011
Gross
Profit 3,102,807 2,389,594 1,938,897
Total Liabilities 916,330 647,319 566,098
20
