Video"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," says Shane. Thus 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. The waning of a fad? Perhaps. But citing the issue of "significantly declining new unit returns" in August 2004, J.P. Morgan analyst John Ivankoe wrote: "These returns declined as [the] incremental appeal of each new retail store fell upon market penetration." A year earlier, Ivankoe had downgraded the stock from "neutral" to "underweight," the equivalent of a "sell" rating.
Getting Greedy?
Having to share markets with other outlets isn't the only handicap for franchisees. In addition to the standard franchise fee and royalty payments, Krispy Kreme requires franchisees to buy equipment and ingredients from headquarters at marked-up prices. This strategy, while not unheard of, can hurt franchisees in the long run.
"There are a couple of ways that franchise companies can look at the selling of equipment and formula," says Steve Hockett, president of FranChoice Inc., a company that matches potential franchisees with franchisors. "One is that it's a true profit center, even to the point where companies can be aggressive on pricing. But most successful franchise companies build their business around the royalty payment; they don't build it around equipment sales." Over time, says Hockett, "the franchisor is more likely to succeed by building profitable franchisees that can make royalty payments."
Giant Krispy Kreme competitor Dunkin' Donuts, for example, doesn't "generally sell equipment or product to [its] franchisees," says Kate Lavelle, CFO of the 6,400-store chain. "We have a strong royalty stream that is based solely on store sales." This model, says Lavelle, "keeps company and franchisee interests aligned."
Krispy Kreme, on the other hand, raked in $152.7 million — 31 percent of sales in 2003 — through its Krispy Kreme Manufacturing and Distribution (KKM&D) division, which sells the required mix and doughnut-making equipment. With initial equipment packages selling for $400,000, KKM&D can have operating margins of 20 percent or greater. But what's good for the franchisor's bottom line isn't necessarily good for the franchisee's. "[Raw ingredients and equipment] are sold to franchisees at what [is] an exceptionally high margin.... It is difficult to say how much this margin needs to drop to support franchise operations, but it must," wrote Ivankoe in an August 2004 report.
The Thrill Is Gone
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."
In what amounted to an act of heresy to Krispy Kreme devotees, the company also added smaller "satellite" stores that didn't actually make doughnuts. Unlike its factory-style franchises where customers could watch as the pastries were showered in glaze — "doughnut-making theater," the company called it — some new stores offered doughnuts that had been made elsewhere. Other products were added to the menu, too, including a line of high-carb, high-calorie frozen drinks, or "drinkable doughnuts," as people dubbed them.
Straying further from the appeal of its key product, in May 2004 the company announced that it was developing, of all things, a sugar-free doughnut, in response to the popularity of low-carb diets. (The sugarless doughnut has yet to be rolled out, however, and the new management team is reviewing the concept.)
Fudging the Numbers
As Krispy Kreme pursued its ambitious growth strategy, it was making missteps in the finance department as well.
Except for the company's plan to finance a $35 million mixing plant in Illinois with an off-balance-sheet synthetic lease — a plan the company scuttled in February 2002, in the face of post-Enron suspicions — Krispy Kreme's accounting seemed unremarkable until October 2003. That's when the company reacquired a seven-store franchise in Michigan, called 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 2004 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 some $500,000 will reverse the improper recording of interest income.
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