Case #7: KRISPY KREME DOUGHNUTS, INC.

Synopsis and Objectives This case considers the sudden and very large drop in the market value of equity for Krispy Kreme Doughnuts, Inc., associated with a series of announcements made in 2004. Those announcements caused investors to revise their expectations about the future growth of Krispy Kreme, which had been one of the most rapidly growing American corporations in the new millennium. The task is to evaluate the implications of those announcements and to assess the financial health of the company. This case is intended to be introductory as it can provide a first exercise in financial statement analysis and lay the foundation for two important financial themes: the concept of financial health, and the financial-economic definition of value and its determinants. Questions 1. What can the historical income statements (case Exhibit 1) and balance sheets (case Exhibit 2) tell you about the financial health and current condition of Krispy Kreme Doughnuts, Inc.? 2. How can financial ratios extend your understanding of financial statements? What questions do the time series of ratios in case Exhibit 7 raise? What questions do the ratios on peer firms in case Exhibits 8 and 9 raise? 3. Is Krispy Kreme financially healthy at year-end 2004? 4. In light of your answer to question 3, what accounts for the firms recent share price decline? 5. What is the source of intrinsic investment value in this company? Does this source appear on the financial statements? Epilogue On January 18, 2005, amid an accounting inquiry, shareholder lawsuits, and weakening earnings, Krispy Kreme Doughnuts, Inc., replaced Scott Livengood, the companys chairperson, president, and chief executive officer, with a leading restructuring expert. The companys share price rose 10% on the news, and analysts were quoted as saying they believed the company still had a strong enough brand to survive. With the announcement, the companys lenders agreed to give the beleaguered doughnut chain a three-month extension to deliver its restated financials without triggering a default on its

$150-million credit facility. In subsequent months, as part of a program of cost-cutting and restructuring measures, Krispy Kreme cut its corporate, manufacturing, and distribution workforce by 25% and sold off its corporate airplane for $30.5 million in cash. Even so, the companys legal woes mounted as the U.S. Attorneys Office for the Southern District of New York announced its own investigation into Krispy Kremes franchise repurchases; separately, plaintiffs in a class-action lawsuit alleged the companys employees lost millions of dollars in retirement savings because company executives hid evidence of declining sales and profits. In April 2005, the company announced it would delay the filing of its annual report for the year ended January 30, 2005 as it looked into its accounting practices, and that it expected to report a net loss for the fourth quarter of 2004. In June, six top executives resigned or retired from the company after a special committee of directors investigating the companys finances concluded they should be fired. Near the end of 2005, the companys board of directors announced it had initiated a search for a permanent chief executive. On November 2, 2005, Krispy Kremes shares closed at an all-time low of $4.45.

DuPont Ratio Analysis of Krispy Kremes Performance

Return on Equit

Evaluating the Financial Health of a Company 1. Is the company in, or approaching, financial difficulty? Most companies are not in financial distress, but it makes sense to check for this possibility immediately as a way to eliminate at least one end of the spectrum. Firms in financial difficulty display several of the following conditions: a. Low or negative earnings. Profitability ratios, which are based on net earnings and operating earnings, can reveal difficulties in the firms ability to cover its costs. b. Negative cash flow. Lengthening activity ratios versus the firms history and versus its industry, plus changes in the sources-and-uses-of-funds statement, will indicate problems in generating cash internally. c. High financial leverage, revealed by a high debt-to-equity ratio or a high debt-to-capital ratio and a low EBIT-to-interest ratio relative to the firms own history and relative to average ratios for the firms industry. d. Low liquidity, as evidenced by low current ratio, low quick ratio, low cash balance, low turnover of accounts payable, and, generally, difficulty in meeting cash obligations as they come due. Missed dividend or interest payments are strong signals of difficulty. e. Low stock prices, compared with historical levels and with price-toearnings ratios of peer companies. 2. If the company is not in financial difficulty, is it financially fit? Some companies are healthy in the sense that they survive year after year, but they do not exhibit robustness against the potential challenges of their industry. Those companies often appear in the lower half of their industry peer group in terms of the major categories of financial ratios. Financially fit companies are more profitable, turn their assets faster, are more liquid, and use financial leverage more judiciously than their peers. More importantly, coherence exists between the financial standings and the business strategies of fit companies. Managements statements of goals and policies will seem reasonable in light of the current financial standing of a fit company: Growth appears likely to be sustainable, resources will be applied toward activities that will ultimately strengthen financial standing further, and financial reserves exist to guard against unforeseen troubles.

3. If the company is financially fit, is it excellent? Many companies are fit; few are truly excellent from a financial point of view. The hallmark of an excellent company is its ability to deliver superior returns to its investors consistently over time. Many firms can take actions in the short run that deliver returns for a year or two but, in free markets, competitors rapidly imitate successful strategies. Realizing superior investment returns consistently over time is extremely difficult.

The marks of financially excellent firms include high returns on equity and assets, a high price-to-earnings ratio, a high market-to-book ratio, and a steadily rising stock price. Other financial ratios and the DuPont system of ratios can yield insights into the sources of superior returns.

By breaking down the question of financial health into those categories, the general manager will be able to differentiate degrees of performance more effectively. At the end of the day, however, financial analysis based on ratios, financial statements, and stock prices engenders good questions rather than the absolute truth about a company. Financial analysis is an imperfect art because its sources of information are estimates rather than reality. In addition, financial health is a moving target. For those reasons, the best general managers use financial analysis as though it were a lamp shining on a dim landscape, recognizing that it neither shines very far into the future nor does it illuminate current conditions completely.