What could be more perfect than a Krispy Kreme doughnut? Hot from the fryer and loaded with sugar, the Original Glazed is practically irresistible.
For a time, Krispy Kreme’s stock seemed irresistible, too. When the company went public in April 2000, at the peak of the Internet whirlwind, investors flocked to buy into a business they could understand. An old- fashioned franchise based in Winston-Salem, N.C., Krispy Kreme Doughnuts Inc. boasted solid fundamentals, adding stores at a rapid clip and showing steadily increasing sales and earnings.
But 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 block. By August 2003, KKD was trading at nearly $50 on the New York Stock Exchange, up 235 percent from its initial public offering price, and Fortune magazine was calling Krispy Kreme the “hottest brand in the land.”
For the fiscal year that ended in February 2004, the company reported $665.6 million in sales and $94.7 million in operating profit from its nearly 400 locations, including stores in Colorado.
And then, just as rapidly as its popularity spiked, Krispy Kreme pitched into a steep downward spiral that included its first-ever earnings loss as a public company, a Securities and Exchange Commission investigation and the ousting of chief executive Scott Livengood.
Last month, Krispy Kreme parted company with six of its top executives in operations, finance, business development, manufacturing and distribution after an internal inquiry recommended they be discharged. Five resigned, and one retired.
What went wrong? How could a company in business for nearly 70 years, with an almost legendary product and loyal customers, fall from grace so quickly?
The story of Krispy Kreme’s troubles is, at bottom, a case study of how not to build a franchise. According to one count, there are at least 2,300 franchised businesses in the United States, and many are extremely successful. But 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.
Rooted in the Southeast
From its humble beginnings in 1937 as a family-owned business, Krispy Kreme slowly enlarged its footprint in the Southeast. In 1976, three years after founder Vernon Rudolph died, the company was sold to Beatrice Foods Co.; in 1982, a group of franchisees bought it back. In 1996, the company began to stake its claim as a national franchise.
But once Krispy Kreme went public, “there was enormous pressure, as there is for all companies, to grow very quickly and sustain growth quarter after quarter after quarter,” says Steven P. Clark, an assistant professor of finance at Belk College of Business at the University of North Carolina at Charlotte. Unfortunately, Clark adds, “this was not the sort of business that was going to have that kind of unending growth.”
McDonald’s Corp. is the gold standard in franchising, driving such profitability to individual restaurants that franchisees are eager to join the system and follow the company’s stringent operating guidelines.
But Krispy Kreme concentrated on growing revenues and profits at the parent-company level, while its outlets struggled.
“You can often get a system to grow really large even when particular outlets aren’t really profitable,” notes Scott Shane, an expert on franchising and SBC professor of economics at Case Western Reserve University’s Weatherhead School of Management in Cleveland.
Franchises, he explains, suffer from “goal conflict.” While the franchiser aims to maximize sales, and thus boost royalty payments, the franchisee needs to maximize profits. If a franchiser packs a market with outlets to boost its own growth, it hurts the system in the long run by forcing units to compete with one another.
“You might add another outlet in a market and increase your sales by 50 percent, but you might have turned franchisees in that market from profitable to unprofitable,” Shane says. So Krispy Kreme reported nearly a 15 percent increase in second- quarter revenues from fiscal 2003 to fiscal 2004, but same- store sales were up just a tenth of a percent during that time.
Just another doughnut?
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 restaurant units, but also roughly half of their sales started going to grocery stores, gas stations, kiosks. Anywhere that consumers could be found, you could find a Krispy Kreme.”
As Krispy Kreme pursued its ambitious growth strategy, it was making missteps in the finance department as well.
In October 2003, the company reacquired a seven-store franchise in Michigan, Dough-Re- Mi Co., for $32.1 million. The company booked most of the purchase price as an intangible asset called “reacquired franchise rights,” which it did not amortize, contrary to common industry practice.
Krispy Kreme had also agreed to boost its price for Dough- Re-Mi so that the struggling franchise could pay interest owed to the doughnut-maker for past- due loans. The company then recorded the subsequent interest payment as income.
Krispy Kreme also 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 part of the intangible “reacquired franchise rights” asset on the company’s balance sheet, rather than costs that would have reduced the company’s reported earnings.
Krispy Kreme announced in a December 8-K filing that it 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 adjustment of about $500,000 will reverse the improper recording of interest income.
On top of the questionable accounting, Krispy Kreme may have paid inflated prices for some of the franchises it bought back. In 2003, the company spent $67 million to repurchase six stores in Dallas and rights to stores in Shreveport, La., that were owned in part by former Krispy Kreme board member and chairman and CEO Joseph A. McAleer Jr. Another longtime director, Steven D. Smith, was also part-owner.
Compared with the $32.1 million paid for the Michigan stores that same year, the number sounds high – $11.2 million a store versus $4.6 million. A lawsuit filed by another former franchisee alleges that a higher bid was offered but ignored.
When Krispy Kreme was a fast-growing private company, it was easy to conceal weaknesses in management and corporate governance. But those weaknesses were magnified by the pressures of the public markets, particularly when the company’s growth strategy started to stumble, says Ric Marshall, chief analyst at governance watchdog The Corporate Library.
Although Krispy Kreme today looks like a company becalmed, if not sinking, some observers believe it will regain momentum.
Signs of recovery
With the replacement of Livengood with turnaround specialist Stephen Cooper in January, the revamped board – in which eight of the 10 directors are fully independent, according to The Corporate Library – has shown that it is serious about making a turnaround.
Since his arrival, Cooper has lined up $225 million in new debt financing to help Krispy Kreme meet its immediate cash-flow needs. Cooper also announced a cost-cutting program that includes a 25 percent reduction in head count.
Clark of UNC-Charlotte suggests the company may need to go private or sell itself to another large chain, such as McDonald’s.
“But I’m not sure that buyers are exactly lining up at the door,” he adds.
KeyBanc’s Waite calls an acquisition doubtful, in part because he says the company is “not terribly cheap,” given the amount of work needed to get it back on track. Indeed, Waite hasn’t ruled out the possibility of bankruptcy.
“The biggest thing they have to do is bring on an operator,” he says. “They need an industry insider who can stem the drop 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 first place: really good doughnuts.
“They need to emphasize the hot-doughnut experience,” says Waite, “rather than the cold, old doughnut in a gas station.”
