8. Krispy Kreme Doughnuts in 2005: Are the Glory Days Over?

Teaching Notes
Overview
In early 2004, Krispy Kreme’s prospects appeared bright. With 357 Krispy Kreme stores in 45
states, Canada, Great Britain, Australia, and Mexico, the company was riding the crest of
customer enthusiasm for its light, warm, melt-in-your-mouth doughnuts. During the past 4 years,
consumer purchases of Krispy Kreme’s doughnut products had taken off, with sales reaching 7.5
million doughnuts a day. Considerable customer excitement—approaching frenzy and cult status
—often surrounded the opening of the first store in an area. For instance, when a new Krispy
Kreme opened in Rochester, N.Y. in 2000, more than 100 people lined up in a snowstorm before
5 a.m. to get some of the first hot doughnuts coming off the conveyor line; within an hour there
were 75 cars in the drive-through lane. Three TV stations and a radio station broadcast live from
the store site. The first Krispy Kreme store in Denver grossed $1 million in revenues in its first 22
days of operation, commonly had lines running out the door with a one-hour wait for doughnuts,
and, according to local newspaper reports, one night had 150 cars in line for the drive-through
window at 1:30 AM—opening day was covered by local TV and radio stations, and off-duty
Sheriff’s deputies were brought in to help with traffic jams for a week following the Denver
store’s grand opening.
To capitalize on all the buzz and customer excitement, Krispy Kreme added new stores at a
record pace throughout 2002-2003. The company’s strategy and business model were aimed at
adding a sufficient number of new stores and boosting sales at existing stores to achieve 20
percent annual revenue growth and 25 percent annual growth in earnings per share. In the just-
completed 2004 fiscal year, total company revenues rose by 35.4 percent, to $665.6 million
compared with the $491.5 million in the fiscal 2003. Net income in fiscal 2004 increased by 70.4
percent, from $33.5 million to $57.1 million. Krispy Kreme’s stock price had increased eightfold
since it went public in April 2000, giving the company a high profile with investors and Wall
Street analysts. In February 2004, Krispy Kreme stock was trading at 30 times the consensus
earnings estimates for fiscal 2005, a price/earnings ratio that was “justified” only if the company
continued to grow 20-25 percent annually.
In March 2004, Krispy Kreme executives said that the company should earn $1.16 to $1.18 per
share in fiscal 2005 (up from $0.92 in fiscal 2004) and that systemwide comparable store sales
growth should run in the mid-to-high single digits. Their expectations were that systemwide sales
would increase approximately 25 percent in fiscal 2005 (ending January 29, 2005) and that
approximately 120 new stores would be opened systemwide, including 20 to 25 smaller
doughnut-and-coffee-shop stores, during the next 12 months.
But as 2004 progressed, Krispy Kreme’s business prospects went from rosy to stark within a
matter of months. In a May 7, 2004 press release that caught investors by surprise, CEO Scott
Livengood said:
For several months, there has been increasing consumer interest in low-carbohydrate diets,
which has adversely impacted several flour-based food categories, including bread, cereal
and pasta. This trend had little discernable effect on our business last year. However,
recent market data suggests consumer interest in reduced carbohydrate consumption has
heightened significantly following the beginning of the year and has accelerated in the last
two to three months. This phenomenon has affected us most heavily in our off-premises
sales channels, in particular sales of packaged doughnuts to grocery store customers.
Livengood said the company was lowering its earnings guidance for the first quarter of fiscal
2005 to about $0.23 per share, down from about $0.26 per share. The company went on to
announce in the same press release that it was
 Divesting its recently acquired Montana Mills operation. The plan was to close the
majority of the Montana Mills store locations, which were underperforming, and pursue a
sale of the remaining Montana Mills stores. Management indicated the Montana Mills
divesture would entail write-offs of approximately $35-$40 million in the first quarter on
its Montana Mills investment and would likely involve further write-offs of $2-$4 million
in subsequent quarters.
 Closing six underperforming factory stores—four in older retail locations in below-
average retail trade areas and two commissaries.
 Lowering its guidance for fiscal 2005 diluted EPS from continuing operations, excluding
asset impairment and other charges described below, to between $1.04 and $1.06,
approximately 10% lower than prior forecasts. Including the Montana Mills charges,
diluted earnings per share from continuing operations were estimated to be between
$0.93 and $0.95 for fiscal 2005.
In the hours following the announcement, Krispy Kreme’s stock price was hammered in trading
—dropping about 20%.
On May 25, 2004, Krispy Kreme reported a $24.4 million loss for the first quarter of fiscal 2005,
blaming (1) trendy low-carb diets such as Atkins and South Beach for a decline in its sales in
grocery stores and (2) a $34 million write off of its investment in Montana Mills. The stock price
was down 37% since the May 7 lower earnings announcement and was trading at about $20.
At the company’s annual stockholders’ meeting on May 26, 2004, executives said the company
was slowing down expansion plans and had plans to counter consumer interest in low-
carbohydrate foods by adding a sugar-free doughnut to its product line-up. The company said it
planned to go forward with overseas expansion. The overseas expansion was concentrated in
Asia; 25 new stores were being planned for South Korea and on the horizon were stores in Japan,
China, Indonesia, the Philippines, and the Persian Gulf.
In late July 2004, the Securities and Exchange Commission launched an inquiry into the
company’s accounting practices regarding certain franchise buybacks. A Wall Street Journal
article in May had detailed questionable accounting in the $32.1 million repurchase of a
struggling 7-unit franchise in Michigan that was behind on its payments for equipment,
ingredients, and franchise fees, along with questionable accounting for another reacquired
franchise in southern California.
In late August 2004, Krispy Kreme reported its second quarter fiscal 2005 results:
 Systemwide sales increases of 14.8 percent as compared with the prior year’s second
quarter.
 An 11.5 percent increase in company revenue to $177.4 million (versus $159.2 million in
the second quarter of the prior year)—Company store sales increased 18.7 percent to
$123.8 million, revenues from franchise operations grew 13.7 percent to $6.8 million and
KKM&D revenues decreased 4.1 percent to $46.9 million (principally because of lower
equipment sales to franchisees opening new stores).
 Very small comparable store sales increases—sales at company-owned increased 0.6
percent and systemwide sales (at both company-owned and franchised stores) increased
only 0.1 percent.
 A decline in operating income from continuing operations for the second quarter of fiscal
2005 to $6.2 million, or $0.10 per diluted share, versus $13.4 million, or $0.22 per
diluted share, in the second quarter of fiscal 2004.
  Twenty-two new Krispy Kreme factory/retail stores were opened in 12 new markets, and
10 doughnut-and-coffee-shop stores were opened. Six company-owned factory/retail
stores and 3 doughnut-and-coffee shops were closed during the quarter.
The company said it had scaled back expansion plans and would only open approximately 75 new
stores systemwide (60 factory/retail stores and 15 doughnut-and-coffee shops) during fiscal 2005.
In November 2004, Krispy Kreme reported that the company lost $3.0 million in the third quarter
of fiscal 2005. Total revenues for the quarter, which included sales from company stores,
franchise operations and KKM&D, were up only 1.4 percent to $170.1 million (versus $167.8
million in the third quarter of fiscal 2004). Third quarter systemwide sales at both company-
owned and franchised stores were up 4.7 percent over the third quarter of fiscal 2004. The sales
increases were well below the 10 percent gains that management had forecast in August.
Management declined to provide systemwide sales and earnings guidance for the fourth quarter
of fiscal 2005 and withdrew its previous estimates of 10 percent systemwide sales growth made
in August.
In December 2004, Krispy Kreme announced that it had identified accounting errors related to its
acquisition of two franchises that could reduce net income for fiscal 2004 by 2.7 percent to 8.6
percent. It was, as yet, unclear whether it would have to restate its fiscal year 2004 results. A
special committee of the company’s board of directors was investigating the accounting
problems. The company’s outside auditor, PricewaterhouseCoopers LLP, said it refused to
complete reviews of Krispy Kreme’s financial performance for the first six months of 2005 until
the special committee completed its probe of the bookkeeping problems.
Then in mid-January 2005, Krispy Kreme’s board of directors took steps indicating that the
company’s deteriorating sales and financial problems were worse than expected. The company’s
board of directors forced Scott Livengood to retire. The board hired two outsiders with noted
expertise in turning around troubled companies to run the company; Stephen Cooper was named
CEO and Steven Panagos was named president and chief operating officer. Both executives came
to KKD from Kroll Zolfo Cooper, a company best known for presiding over the remains of Enron
and rejuvenating Sunbeam and Polaroid; Cooper was chairman of KZC and Panagos was a
managing director. The two new executives were assisted by a team of professionals from Kroll
Zolfo Cooper, with KZC being paid $440,000 per month for its services. Along with the
management changes, Krispy Kreme also announced that average weekly sales per factory store
were down 18 percent systemwide and down 25 percent at company stores for the eight weeks
ended December 26, 2004 (compared to the corresponding weeks of 2003). In mid-February
2005, Krispy Kreme’s stock was trading around $6 per share.

Suggestions for Using the Case

This freshly-written and thoroughly updated version of the Krispy Kreme case, describes the
rapid rise and swift, surprising fall of Krispy Kreme. The focus and content of this latest version
of the case makes it an eminently suitable candidate for:
 Giving students practice in diagnosing what has gone wrong with a high-flying company
and figuring out what it will take to get the company back on track. Krispy Kreme had a
“winning strategy”—how did KKD’s strategy turn into a “losing strategy” so quickly and
so unexpectedly? What went wrong? Was all that happened in 2004-2005 “predictable?”
 Drilling students in the use of SWOT analysis.
 Drilling class members on competitive strength analysis—as per Table 3.4 in Chapter 3.
 Having students do a probing assessment of a company’s financial performance and the
profitability of its business model.
  Having students debate whether this company has serious ethical problems—and, if so,
what should be done to correct them. Can shareholders ever expect to recover from the
deep declines in the company’s stock price that have occurred over the past 9 months?
 Giving students practice in proposing how to turn a once successful but now troubled
company around—if, indeed, things can be turned around. Or, should students simply
conclude that the bubble has burst, the glory days are gone forever, and that there’s little
that can be done to revive the company’s prospects and restore its profitability?
Very likely, this case will prove immensely popular with students and should be a winner in
terms of stimulating a lively class discussion—especially if there are Krispy Kreme stores in your
area (or even just those of Krispy Kreme’s rivals). Students will easily identify with the
company’s product, and the ins and outs of the doughnut business will prove relatively easy for
the class to grasp.
Because there’s a host of solid, timely strategy issues to explore in assigning this case, we think a
full 75-minute class will be needed to cover the main teaching points.
We think the Krispy Kreme case is very good choice for either written analysis or oral team
presentations. Our suggested assignment questions are as follows:
1. What went wrong at Krispy Kreme? What actions should the new top management take to try
to get things back on track? Is now a good time to buy stock in this company? Please justify
your answer using whatever tools and concepts of strategic analysis you deem appropriate.
2. Stephen Cooper, Krispy Kreme’s newly-appointed CEO, has employed you as a special
assistant to help him do a probing assessment of Krispy Kreme’s business model, strategy,
and competitive strength as a guide to trying to get Krispy Kreme back on track. Your
assignment is to prepare a 4-6 page report that (a) identifies the major elements of Krispy
Kreme’s strategy, (b) sets forth the pros and cons of this strategy, with special emphasis on
pinpointing the strategy aspects that appear flawed, (c) diagnoses Krispy Kreme’s financial
performance in each of its three business segments going into 2004, (d) incorporates a
thorough SWOT analysis and the chances of turning things around, (e) compares Krispy
Kreme’s competitive strength with that of key rivals, (f) identifies the major issues that
Krispy Kreme management needs to address as of early 2005, and (g) recommends a
comprehensive set of actions to address these issues. Your report should contain whatever
supporting tables and exhibits you deem appropriate (in addition to the 4-6 pages of text), and
it should definitely reflect solid number-crunching of the financial and operating data
provided in determining what went wrong at Krispy Kreme and what it will take to return the
company to profitability..

Assignment Questions
1. What were the chief elements of Krispy Kreme’s strategy as of early 2004? Do you see any
reason to believe that the company was headed for big trouble in mid-2004—or was what
happened to the company in 2004 a “legitimate” surprise?
2. What is your assessment of Krispy Kreme’s financial performance prior to 2004? What was
the most profitable part of Krispy Kreme’s business as of the end of fiscal 2003?
3. What is your diagnosis of what went wrong at Krispy Kreme in 2004 to produce the sudden
downturn in the company’s financial performance? What caused the company’s financial
performance to crash so quickly when the company’s future and growth prospects seemed so
bright?
4. Do you think top management was employing “aggressive” accounting tactics to try to cover
up disappointing earnings problems and keep the stock price pumped up? Do you see
anything unethical going on here? Why or why not? What evidence supports your views?
5. What does a SWOT analysis reveal about Krispy Kreme’s overall situation as of early 2005?
6. What is your assessment of Krispy Kreme’s competitive strengths and weaknesses in
comparison with key rivals as of 2004? Does the company possess the competitive strength to
mount a comeback?
7. On the basis of your competitive strength assessment above, what do you think of Krispy
Kreme’s turnaround prospects? Just how good are they? Is a comeback feasible? What
evidence supports your answer?
8. What major issues besides how to make a comeback do you think that Krispy Kreme
management needs to address?
9. What recommendations would you make to Krispy Kreme management to return Krispy
Kreme to profitability by the end of 2005 (or in 2006 at the latest)?

Teaching Outline and Analysis

You might want to preface the evaluation of Krispy Kreme’s strategy and growth prospects with
a brief summary of what competition is like in the doughnut industry. Several competitive
features stand out:
 Competition among doughnut-making rivals is largely fought in local markets—
doughnut shops located close to each other or along the same traffic routes are very much
in competition for passersby and neighborhood shoppers. Doughnut shops also compete
with the bakery departments of supermarkets and with convenience stores that stock
doughnuts in their bakery cases. But it is doubtful that a doughnut shop competes with
other doughnuts sellers more than 5 miles away. In many respects doughnuts shops are
like fast food outlets—people will not typically drive more than 5 miles or go far out of
their way to patronize a particular shop or location regularly (although they may do so on
special occasions).
 The national chains compete with one another on such factors as:
 Product quality and appeal (Who has the freshest, best-tasting doughnuts?).
 Convenience and location (Who has the doughnut shop that is easiest for me to get
to?).
 Overall menu offerings (What else can I get besides doughnuts?).
 Unit dE9cor, ambience, cleanliness, interest, and street appeal (Do I like to go there?)
 Brand reputation/name recognition (Is this a place I have heard of before or trust or
want to try?)
 Rivalry is relatively moderate at present among the national doughnut chains—only units
located within several miles of one another put the chains in strong competition.
 Doughnut makers face very strong competition from substitute products, particularly
those that are perceived by consumers to be healthier or more nutritious.
1. What were the chief elements of Krispy Kreme’s strategy as of early 2004?
Do you see any reason to believe that the company was headed for big
trouble in mid-2004—or was what happened to the company in 2004 a
“legitimate” surprise? Which one of the five generic competitive
strategies best characterize Krispy Kreme’s strategy?
Students ought to have little trouble identifying the main elements of Krispy Kreme’s
strategy, since they are laid out rather plainly in the case. But going to the board and
recording student responses is useful stage-setting for a probing evaluation of what went
wrong and why the company’s financial performance crashed in 2004. The following strategy
components ought to be highlighted:
 Rapidly expand the number of stores in the U.S. and parts of Canada, primarily through
the efforts of franchisees. Up until fiscal year 2004, a majority of the new stores being
opened were franchised as opposed to company-owned—see case Exhibit 9. In fiscal
2004, KKD management greatly accelerated the opening of new company-owned stores
—42 company-owned stores were opened versus only 39 new franchised stores. Students
ought to pick up on this shift in the mix of new stores—from the majority being
franchised to the majority being company-owned.
 Continue expanding internationally by opening stores in areas where doughnuts are a
product known to local consumers. KKD had opened its first factory store in Europe,
located in the world-renowned department store Harrods of Knightsbridge, London (and
had plans for another 25 stores in Britain and Ireland by 2008); management was
pursuing efforts to continue expansion in Australia (the first store in Australia was
opened in 2003 in Sydney), Canada, and Mexico.
 Grant franchises only to candidates who have experience in operating multi-unit food
establishments and who have the capital to adequately finance the opening of new Krispy
Kreme stores in their territory. Using franchising to grow the total number of stores, as
opposed to growing solely through the opening of company-owned stores, permitted
faster expansion of the total number of stores and conserved the company’s limited
capital for other expansion efforts (constructing the new doughnut mix plant, for
example).
 Build a vertically-integrated value chain by (1) supplying doughnut mixes to all stores,
(2) making the doughnut equipment used at all Krispy Kreme stores, and (3) supplying
coffee products used in making hot and cold coffee beverages.
 KKD’s manufacturing and distribution division has plants in North Carolina and
Illinois that manufacture the doughnut mix used in all stores. And KKM&D also
manufactures the proprietary doughnut-making equipment used at both company-
owned and franchised stores. Selling ready-mixed ingredients and doughnut-making
equipment to franchisees has been a major source of revenue and profits for Krispy
Kreme—KKD makes money on every doughnut sold at franchised stores (aside from
the royalties on franchised store sales) because KKM&D sells them the ingredients
for the doughnuts at a profit to the company—see case Exhibit 2 showing the
revenues and operating profits of the KK manufacturing and distribution division.
 The acquisition of Digital Java and the recent introduction of new coffee drinks in
Krispy Kreme stores using Digital Java products have made it possible to make
additional profits on supplying coffee to company-owned and franchised stores. At
the same time, the Digital Java acquisition gave KKD the capability to control the
sourcing and roasting of its coffee and ensure quality standards (via recipe
formulation and roast consistency).
 Krispy Kreme’s vertically-integrated strategy and business model involved
generating revenues and profits from four sources:
— Sales at company-owned stores.
— Royalties based on a percentage of sales revenues at franchised stores
— Franchise fees paid by franchisees for each new store they opened.
 — Sales of doughnut mixes, customized doughnut-making equipment, and coffees
to franchised stores. (The doughnut mixes, coffee supplies, and doughnut-making
equipment that was supplied to company-owned stores showed up as costs for
these stores, not revenues as revenues for KKD. The revenues came form the
sales of doughnuts and coffees sold at company-owned stores.)
 Grow on-premise store sales both by selling upscale hot and cold coffee drinks and other
beverages and by attracting new and repeat customers on a regular basis. The acquisition
of Digital Java coffees allowed KKD to upgrade the caliber and prices of its coffee
offerings, thereby bringing its in-store coffee offerings into closer alignment with the hot
doughnut experience that made its stores and products so appealing. Beverage sales
accounted for about 10 percent of store sales, with coffee accounting for about half of the
beverage total and the other half divided among milk, juices, soft drinks, and bottled
water. In the years ahead, Krispy Kreme hoped to increase beverage sales to about 20
percent of store sales.
 Rely upon free media publicity, product giveaways, and word-of-mouth to attract
customers to stores—so far, KKD has encountered no need to spend money on
advertising. Store traffic has boomed without advertising in many locations (especially
those where KKD was opening its first store and garnering “free”’ publicity in the local
media)—strong evidence of the power of the company’s brand name and reputation
among consumers and the drawing power of its “hot doughnuts now” strategy.
 Build and strengthen the Krispy Kreme brand name—capitalize on all the publicity and
hype by entering new geographic areas without having to spend much to introduce the
product and the brand (boosts margins and profits!).
 Utilize the doughnut-making capacity at the retail store to manufacture doughnuts for off-
premise sales to supermarkets, convenience stores, truck stops, and so on. Most stores
installed considerably more doughnut-making capacity than needed just to supply in-store
sales—thus making the retail stores really “factory stores” that could supply KK
doughnuts to other area retailers. It was a key strategy element at each franchised and
company-owned store to grow off-premise sales by
 marketing Krispy Kreme doughnuts to area supermarkets, convenience stores, truck
stops, and other retail outlets where doughnut sales potential existed.
 by working closely with community groups of all types to promote sale of Krispy
Kreme products for fund-raising campaigns, and
 by pursuing new distribution outlets such as sales at sporting events, airports, college
and university campuses, high traffic business establishments, and perhaps online
sales and delivery (as was being tried by the Las Vegas franchisee).
Students should understand that stores generated revenues in three ways:
 On-premise sales of doughnuts.
 On-premise sales of coffee and other beverages.
 Off-premise sales of branded and private-label doughnuts to local supermarkets,
convenience stores, other types of retail outlets, and fund-raising groups. Krispy
Kreme stores actively promoted sales to schools, churches, and civic groups for fund-
raising drives.
 Once the chief elements of the strategy have been identified, then you can poll the class as to
which of the five generic strategies that KKD is using. We think the company’s strategy is
very clearly one of focused differentiation (coupled with vertical integration). It is focused in
the sense that KKD’s menu offerings are narrower than those of its rivals—KKD is first and
foremost a doughnut company. And its strategy is focused because the company is catering to
that specific population niche that likes doughnuts, especially hot, fresh ones. Some students
might want to classify KKD’s strategy as one of broad differentiation, partly because KKD
does have beverage offerings and is adding items to the menu and partly because the
company’s consumer base is “broad” and cuts across many demographic groups. It may not
be worth quibbling over this—the really key part of the strategy is “differentiation.” We like
focused differentiation rather than broad differentiation because we think the company’s
market target is comparatively narrow (but there’s room for disagreement here). But there is a
strong vertical integration element to the strategy as well (as discussed above).
The class should have no trouble concluding that the company’s strategy worked quite nicely
up until 2004—as indicated by the statistics in case Exhibits 1 and 2 and elsewhere. The
company has very definitely gained market share—current sales of 7.5 million Krispy Kreme
doughnuts daily translates into sales of nearly 2.7 billion doughnuts annually, equal to about a
24% share of the 10-12 billion a year volume doughnut industry. This compares with sales of
about 3.5 million doughnuts daily in 2001.
2. How does Krispy Kreme’s strategy connect to its business model? Are
they well-matched?
Krispy Kreme’s business model involved generating revenues and profits from four sources:
 Sales at company-owned stores.
 Royalties from franchised stores.
 Franchise fees from new store openings.
 Sales of doughnut mixes, customized doughnut-making equipment, and coffees to
franchised stores.
It should be clear from the strategy identification exercise above that the strategy flows
beautifully from the business model—they are very much in sync. Indeed, it is fair to say that
the company’s strategy has been crafted around the four revenue-generating pieces of the
business model and, so far, management has not drifted from pursuing the model or
considered changing the model that it developed in the late 1990s. It is probably worth a
couple of minutes of class time to point this out and to further drive home what the term
business model means and how it relates to and differs from the term strategy.
The table below, which is excerpted from Case Exhibit 2 indicates that all 4 revenues sources
are delivering good profits:
Fiscal Years Ending
Jan. 30, Jan. 20, Feb. 3, Feb. 2, Feb. 1,
2000 2001 2002 2003 2004
Operating Income by
Business Segment (before
depreciation and amortization)
Company store operations $ 18,246 $ 27,370 $ 42,932 58,214 83,724
Franchise operations 1,445 5,730 9,040 14,319 19,043
KK manufacturing & distribution 7,182 11,712 18,999 26,843 39,345
Total $ 10,838 $ 23,507 $ 41,887 59,817 102,086*
Unallocated general and
administrative expenses $(16,035) $(21,305) $(29,084) $(30,484) $(38,564)
 *Totals include operations of Montana Mills, a business which was acquired in April 2004 and
divested during fiscal 2005.
Source: Company SEC filings and annual reports.

3. What is your assessment of Krispy Kreme’s financial performance? What

is the most profitable part of the business? Does the company’s
performance indicate that the strategy is working well up until the bubble
burst in Spring 2004?
It is pretty clear from the data in case Exhibits 1, 2, and 9 that Krispy Kreme’s financial
performance through fiscal 2004 (ending February 1, 2004) has been quite good. But we
think it always best to signal students that such overall judgments must be supported with a
host of specifics (number-crunching is essential and is definitely in order here, given the
skepticism expressed by analysts in the opening paragraphs of the case).
 From case Exhibit 1, students can calculate that KKD’s total revenues have grown at a
compound average rate of 31.8% since fiscal 2000. From the end of fiscal year 2000 to
the end of fiscal year 2004, KKD’s total revenues increased a healthy 202.2%.
 Net income has increased from $5.96 million in fiscal year 2000 to $57.1 million in fiscal
2004—an impressive compound average growth rate (CAGR) of 75.9%. However, recent
events indicate that “aggressive” accounting may have pumped up the firm’s profitability
more than was actually justified.
 As indicated in case Exhibit 9, the number of Krispy Kreme stores systemwide has in
creased from 120 in February 1998 to 357 in February 2004.
 As indicated in case Exhibit 9, systemwide sales (which includes company-owned and
franchised stores) are up from $203.4 million in fiscal year 2000 to $984.9 million in
fiscal year 2004—a pretty impressive 48.3% CAGR.
 As indicated in case Exhibit 9, average weekly sales at company-owned stores jumped
sharply from $42,000 in fiscal year 1998 to $76,000 in fiscal year 2003, but then declined
to $73,000 in fiscal 2004—the first red flag in the numbers!
 As indicated in case Exhibit 9, average weekly sales at franchised stores has climbed
from $23,000 in fiscal year 1998 to $58,000 in fiscal year 2003, but then slid to $56,000
in fiscal 2004—another clear sign of sales weakness.
 As indicated in case Exhibit 9, comparable store sales growth in every fiscal year from
1998 through 2004 was in double digits at both company-owned stores and franchised
stores, signaling very positive results from efforts to grow sales at existing stores.
 From case Exhibit 2 students can do some quick number-crunching to determine that
profit margins in all three of KKD’s business segments are good and improving rapidly:
Fiscal Years Ending
Jan. 30, Jan. 20, Feb. 3, Feb. 2, Feb. 1,
2000 2001 2002 2003 2004
Operating Profit Margins by
Business Segment (excluding
depreciation and amortization)
Company store operations 13.0% 15.1% 16.1% 18.2% 18.9%

Franchise operations 27.4 61.4 64.5 74.2 79.9

KK manufacturing & distribution 14.7 15.5 16.6 17.6 20.4

Overall average 4.9% 7.8% 10.6% 12.2% 15.3%

 The profit margin gains suggest that the addition of new stores is giving KKD the volume
and scale of operations needed to help lower unit costs in KKM&D—scale economies are
apparently being realized. The new state-of-the-art plant in Illinois for mixing and
distributing ingredients has almost certainly helped lower costs and boost the operating
margins in the KK&D division. What students need to realize here is that KKD makes
money on every doughnut that franchisees sell—it gets 4.5% in royalties from each dollar
of sales at franchised stores, plus it realizes a profit on ingredient mixes and coffees that
it supplies to these stores. In addition, the KK&D group makes profits from sales of
doughnut-making equipment and from supplying coffee to the retail stores.
The data in case Exhibits 1, 2, and 9 make it feasible to estimate just how much profit
KKD makes on each dollar of franchise store sales.
 The difference between KKD’s sales (case Exhibit 1) and systemwide sales (case
exhibit 9) equals sales of franchised stores; thus in fiscal 2004, with systemwide sales
of $984.9 million and company store sales of $441.9 million, franchised store sales
were $543.0 million.
 KKM&D realized operating income (before depreciation and amortization) of $39.3
million in fiscal 2004 on its sales of doughnut-making equipment, doughnut mixes,
and coffee to franchisees. This equates to profits of $.072 per dollar of sales at
franchised stores; add to this the 4.5% royalty per dollar of sales (of which 79.9%
ended up as operating income in fiscal 2004), and one can see that KKD realizes
about $0.117 in operating income (before depreciation and amortization) for each
dollar of sales made by franchisees.
 Students also ought to realize that the more new stores opened by franchisees, the
more that KKD collects in new franchise fees and the more doughnut-making
equipment it sells to equip the new franchised stores. KKD’s revenues from franchise
operations are rising in case exhibit 2 because more new franchised stores are being
opened each year (and perhaps because KKD is also raising the prices that
franchisees have to pay for doughnut-making equipment).
Key Point. Students also ought to realize that if the number of franchisee store
openings falls off—as it is going to do in fiscal 2005 and perhaps beyond, given the
host of troubles that have unfolded at KKD, then KKD’s revenues and profits are
going to suffer considerably since so much of the revenue it gets from franchise
operations ends up as operating income (79.9% in fiscal 2004).
 KKD used proceeds from its initial public stock offering to pay off all of its long-term
debt in fiscal 2001—see the Balance Sheet data in case Exhibit 1. Long-term debt
(including current maturities) was a minimal $4.6 million at the end of fiscal 2002 but
spiraled to $60.5 million at the end of fiscal 2003. KKD’s debt climbed even more in
fiscal 2004 to $137.9 million—almost certainly to help finance the rapid increase in the
number of new company stores that were opened in fiscal 2004.
The company may well have been able to handle this higher debt load had it continued to
growth and profit from new store openings during fiscal 2005, just as it had the prior 5
fiscal years. But the collapse of sales growth during fiscal 2005 may result in cash flow
problems and make the debt of $137.9 million far more burdensome than management
had anticipated. The new top management at KKD will, undoubtedly, have to contend
with some financial problems of a nature that cannot be discerned from the historical
financial data presented in case Exhibit 1.
 Based on the information in case Exhibit 1, KKD’s operating expense ratios have
declined significantly the past four years and the net profit margin has climbed
considerably since fiscal 2000. However, the jump in fiscal 2004 may be partly due to the
company’s questionable accounting practices.

Fiscal Years Ending

Jan. 30, Jan. 28, Feb. 3, Feb. 2, Feb. 1,
2000 2001 2002 2003 2004
Operating expenses as a
% of revenues 86.3% 83.4% 80.4% 77.6% 76.2%
General and administrative
expenses as a % of revenues 6.7% 6.7% 7.0% 5.9% 5.5
Net income as a %
of revenues 2.7% 4.9% 6.7% 6.8% 8.6%

The numbers in case Exhibits 10, 11, and 12 show the extent of the deterioration in Krispy
Kreme’s financial performance during the first nine months of fiscal 2005. It is worth a
couple of minutes of class time to make sure that students have digested the information in
these three exhibits.
 The numbers in case Exhibit 10 showing the declines in average weekly sales and
comparable store sales during the first three quarters of fiscal 2005 are pretty alarming
and suggest very rapid sales deterioration.
 Krispy Kreme went from earning $40.7 million in the first nine months of fiscal 2004 to
losing $21.7 million in the first nine months of fiscal 2005—see case Exhibit 11. This is a
stunning turn of events, only some of which can be attributed to the “disaster” of the
Montana Mills acquisition.
 According to case Exhibit 3, sales and operating profits have held up pretty well in two of
the company’s three business segments—franchise operations and KK M&D. The big hit
in operating income has been in company store operations, as shown below.

Nine Months ending Nine Months ending

November 2, 2003 October 31, 2004
Revenues by Business Segment

Company store operations $317,158 $369,593

Franchise operations 17,555 20,060

KK manufacturing & distribution 140,885 142,288

Total $475,598* $531,941

Operating Income by Business Segment

(before depreciation and amortization)

Company store operations $ 61,969 $ 41,797

 Franchise operations 13,721 14,694

KK manufacturing & distribution 27,824 26,706

Total 103,514* 83,197

Unallocated general and

A0A0administrative expenses $(28,571) $(36,293)

*Totals do not include operations of Montana Mills, a business which was acquired in April 2004
and divested during fiscal 2005; nine month revenues for Montana Mills were $4,481,000 and the
operating loss at Montana Mills was $1,408,000.

Total revenues at company-owned stores continued to rise briskly in the first nine months of
fiscal 2005 (up 16.5% over the first nine months of fiscal 2004) because new stores were
being opened. Students should be clear here that total sales of doughnuts at Krispy Kreme
rose during 2004—due to new store openings. The problem at Krispy Kreme is declining
average weekly sales per store and falling sales at existing stores—which are fairly clear
signs of store overexpansion and cannibalization of existing store sales by newly opened
stores.
Some questions you may want to pose for class debate:
 Why didn’t management see this overexpansion/cannibalization coming? Why was
management surprised, as apparently they were (given the rosy projections made in
March 2004)?
 Why were efforts to open new stores not predicated on scattering new store openings
more widely, rather than risking store oversaturation in existing markets?
 Were KKD executives (and maybe franchisees) overly optimistic about how many
doughnuts they could sell in a given market area if they simply got the doughnuts into
more and more retail outlets?
4. What is your diagnosis of what went wrong at Krispy Kreme in 2004 to
produce the sudden downturn in the company’s financial performance?
What caused the company’s financial performance to crash so quickly
when the company’s future and growth prospects seemed so bright?
This is a very important question and is well worth spending 5 to 10 minutes of class time to
make sure that students have some solid and supportable answers.
We think there are several reasons for the bursting of the bubble at Krispy Kreme:
 The biggest reason, we think, is oversaturating some geographical areas with stores,
such that new stores cannibalize sales from existing stores. There is good evidence in the
case that the first store in a major metropolitan area does very, very well. But as
progressively more stores are added, the newly-added stores are unlikely to generate the
same high levels of customer traffic. Moreover, students ought to realize that off-premise
sales are a very important part of KKD’s strategy. Each store is not only a retailer but
also a “factory store” that supplies doughnuts at wholesale to other area retailers with
potential for selling doughnuts. If there are just one or two stores in a large metro area,
then each store has plenty of off-premise business that it can pursue and supply with
doughnuts. But as the number of factory stores increases in a given metro area, then the
 off-premise sales potential in the area is divided among 4 to 6 stores rather than just 1 or
2 or 3, which is likely to mean that a franchisee with 4 to 6 stores in a metro area may
have a hard time achieving the average weekly sales volume that would be achievable
with only 1-3 stores. Thus, we think there is good reason to believe that the declines in
average weekly sales in fiscal 2004 as compared to fiscal 2003 (and the further sharp
drop in average weekly sales in fiscal 2005 which was detailed in the end of the case) are
due, in large part, to overexpansion in areas where KKD already had stores.
 What we know for sure is that the number of new store openings accelerated in 2004-
2005, as compared to earlier years.
 We also know that KKD was pressuring its franchisees to open factory stores more
quickly.
 And we know that KKD’s strategy involved aggressive pursuit of off-premise sales—
since the amount of doughnut-making capacity installed at retail stores was greatly in
excess of what was needed to supply on-premise sales.
 There’s reason to believe that opening so many factory retail stores in a limited
geographic area generated too much doughnut-making capacity relative to the
volume of sales that could developed at off-premise outlets—in other words, there
was not a big enough market for the off-premise sales of KKD doughnuts at local
retail outlets to justify all the doughnut-making capacity that was installed at the
factory stores. Hence the decline in average weekly sales at stores as new stores
cannibalized sales (both on-premise and off-premise) from existing stores.
Consequently, there’s a basis for attributing some of the sales problems at existing stores
—the decline in average weekly sales and the sharp drop in same store sales growth—to
having too many factory stores in certain geographic locations.
 A second reason is that the low-carb diet fad may well have begun to cut into sales of
Krispy Kreme doughnuts—even though KKD had escaped its impact earlier. Carb-aware
customers may simply have decided to begin cutting back on their doughnut purchases in
2004—although it is hard to believe that such customers were not aware of the nutrition
problems with doughnuts earlier or that people on low-carb diets suddenly decide to
refrain from purchasing Krispy Kreme doughnuts—millions of people allegedly went on
low-card diets well before 2004. Clearly, Krispy Kreme’s prior CEO, Scott Livengood,
stated his belief that low-carb diets were a factor in the sales falloff—whether this was
just a convenient scapegoat for explaining away the softness in KKD’sd sales or whether
he had access to hard data that such was case cannot be determined. But the popularity of
low-carb diets and heightened consumer awareness of the difference between good carbs
and bad carbs is at least a plausible partial explanation of the dropoff in sales of Krispy
Kreme doughnuts.
 A third reason is that there may have been signs of slowing growth earlier than 2004,
which management kept quiet about or else managed to hide with its accounting
practices. Apparently, some of the company’s franchisees got into financial difficulty,
and KKD management quietly helped bail them out with loans or buyouts that did not
come to light until 2004. But if some franchisees did get into financial trouble, the reason
almost surely was that they were opening too many stores too quickly—such that they
took on too much debt and/or that some of the new stores turned out to be “low
performers” unable to generate the expected sales volumes (probably due to inability to
generate sufficient off-premise sales, since customer traffic at retail stores appears to
have held up rather well). There was no reason for franchisees to encounter financial
problems if their newly-opened stores were performing anywhere close to the numbers
shown in case exhibit 3.
 KKD management would have been in position to know the reasons for why some of its
franchisees were financially troubled. But information about troubled franchisees did not
come to public light until 2004 and we can only speculate as to what brought on these
financial troubles (since no hard information has been released by KKD)—certainly it
was in management’s best interest to keep any financial difficulties of its franchisees
quiet. But if franchisees were getting financially overextended because they were
overexpanding and their newly-opened stores were cannibalizing sales from existing
stores, one would think that KKD would quickly back off of saturating a given metro area
with too many stores and, instead, turn its attention to opening new stores in areas where
there were no factory stores close enough to erode the off-premise sales of existing
factory/retail stores. And KKD management should have so notified its franchisees to
begin to do the same. So given the lack of hard information, it is difficult to say
definitively what causes underlie the financial problems of troubled KKD franchisees or
what “deals” KKD management made to take over or bail out these franchisees. But there
is enough information in the case to conclude that there are some problems here that have
contributed to the falloff in KKD’s growth and financial performance.
5. Do you think top management was employing “aggressive” accounting
tactics to try to cover up disappointing earnings problems and keep the
stock price pumped up? Do you see anything unethical going on here?
Why or why not? What evidence supports your views?
There is enough evidence in the case to conclude that “accounting irregularities” definitely
exist at the company. The severity and extent of the irregularities is less clear. And we cannot
be absolutely certain as to whether they represented a deliberate effort on management’s part
to make KKD’s financial performance look better than it really was or whether the
accounting “errors” were “inadvertent” and immaterial.
We suggest having the class debate this issue and express their opinions. In our view, there is
strong reason to believe that the accounting irregularities were “deliberate” (although the
company’s outside auditors may well have said they were OK at the time—which, to some
extent, gets management off the hook). But clearly the company’s auditors are now cautious
and very concerned—since PricewaterhouseCoopers refused to complete reviews of Krispy
Kreme’s financial performance for the first six months of 2005 until the special committee of
the board of directors completed its probe of the company’s bookkeeping problems.
We strongly suspect that the committee of board members will report problems with the
company’s accounting and that the SEC investigation will result in punitive action of some
sort. Certainly, students should see enough signs of problems to be suspicious of
management’s actions and motives. We also suspect that these accounting problems have
something to do with Scott Livengood’s early retirement—he most likely was briefed on the
accounting treatments being applied by the CFO and could well have had discussions with
the company’s outside auditor concerning their propriety.
In short, there is a basis for concluding that the company has some ethical issues which need
to be addressed by the new top management team.
6. What does a SWOT analysis reveal about Krispy Kreme’s situation as of
early 2005?
Krispy Kreme’s Resource Strengths and Competitive Assets
 The passion that customers have for Krispy Kremes and the valuable word-of-mouth
advertising it provides
 A strong brand image and good product reputation with consumers (While recent events
have clearly tarnished the company’s reputation with investors and Wall Street, the image
and appeal of Krispy Kreme products with doughnut-lovers/loyal customers would seem
to remain largely intact—many customers may be unaware of the company’s current
difficulties or care less)
 Krispy Kreme has the largest market share in doughnuts of any competitor—Dunkin
Donuts sells about 4.4 million doughnuts daily versus 7.5 million for Krispy Kreme. In
the last two years, KKD has blown past Dunkin Donuts in daily sales volume (in 2001
KKD’s daily volume was about 3.5 million).
 Joe LeBeau’s secret recipe for yeast-raised doughnuts has given the company a high
quality product with strong buyer appeal (in comparison to other doughnut brands and
doughnut retailers)
 Proprietary doughnut-making equipment, and the capability to supply it to franchisees at
profitable prices
 The company’s vertically integrated value chain—the company makes money selling
coffee products, doughnut-making ingredients, and doughnut-making equipment to its
franchisees. Vertical integration is a solid competitive strength for KKD and seems to
have major potential for giving the company a competitive advantage (or at the very
least, helping boost profit margins)
 The ability of the company to garner so much valuable free publicity when it opens its
first stores in an area and thereby avoid having to spend monies for advertising to
introduce its products in new markets
 The popularity of the company’s doughnuts has made it easy to attract top caliber
franchisers because of the profitability of Krispy Kreme stores—see case Exhibit 3; of
course, recent events are certain to make franchisers much more cautious in agreeing to
open new stores
 KKD has a strong balance sheet; KKD’s capital requirements to finance expansion via
franchises are not particularly large and seem well within the company’s means (despite
its relatively small size vis-E0-vis some of its competitors)
 The company’s strategy and business model seem very well-conceived and are running
on all cylinders—all 3 business segments are profitable and becoming more so
Krispy Kreme’s Resource Weaknesses and Competitive Liabilities
 The sudden downturn in sales during 2004 will make franchisers far more reluctant to
rush into opening new stores—especially in areas when there are already several Krispy
Kreme stores. This will make it much harder to grow KKD’s business.
 A falloff in new store openings by franchisees will cut heavily in the revenues KKD
receives from franchise operations and into the company’s profits—see the revenue and
operating profit figures for franchise operations in case Exhibit 2. In turn, this could hurt
cash flows generated by operations and put KKD in a cash squeeze—perhaps hurting its
ability to make debt payments and generate the working capital needed to support the
opening of additional company stores.
 The fact that the board of directors replaced Scott Livengood with 2 top executives from
Kroll Zolfo Cooper, a company best known for presiding over the remains of Enron and
rejuvenating very troubled companies, strongly suggests that Krispy Kreme has serious
financial problems.
 The Montana Mills acquisition, which seemed sensible at the time, has proved to be a
financial disaster and has compounded the company’s losses in fiscal 2005—see case
Exhibit 11. However, students should pick up on the fact that the acquisition was made
 with shares of company stock (not cash) and the reported losses on the divestiture are
mostly “paper losses” not “cash losses”—the only portion of the losses associated with
Montana Mills that have a negative cash impact are those due to the operating losses at
Montana Mills (according to the footnote to case Exhibit 12, nine month revenues for
Montana Mills were $4,481,000 and the operating loss at Montana Mills was
$1,408,000).
 Several rivals are larger (in terms of revenues and number of outlets) and are well-
established in their markets—Krispy Kreme may find it tougher to compete with them
head-to-head now that the newness and excitement over KK products seems to be
wearing off and as future expansion of KKD’s business forces it to enter the market
strongholds of rivals—which it seems to have largely avoided so far. Both Dunkin’
Donuts and Tim Hortons appear to be gearing up for expansion and will certainly defend
their markets positions with some vigor—and neither are as dependent on doughnut sales
as is KKD.
 Krispy Kreme management has no proven experience in foreign markets—and successful
expansion into foreign markets may be critical to growing KKD’s business in the years
just ahead.
 Krispy Kreme’s core doughnut products do not appeal to health/weight/nutrition/low-
carb conscious consumers.
 Given that the overall doughnut market is growing slowly, KKD’s sales and market share
gains in 2005-2006 will have to come at the expense of rivals (and from additional store
openings—in years past, KKD’s expansion and cult following helped grow an otherwise
stagnant market, but is the KKD “fad” fading or already over? The falloff in KKD’s sales
in 2004 raise serious questions about how easy it will be to revive enthusiasm for Krispy
Kreme doughnuts in the U.S. market.
Market Opportunities
 Introduce a sugar-free doughnut and perhaps a reduced-carb doughnut that will be seen
by customers as an acceptable and tasty product—thus helping revive demand and sales
volume.
 If the smaller doughnut and coffee shops prove to be profitable, then opening such stores
in high-traffic locations (not near KKD factory stores) may be a good option for boosting
in-store sales of KKD doughnuts; such stores can be supplied by nearby factory stores
(but this would make it hard to use the strategy of drawing in passersby with the “Hot
Doughnuts Now” flashing sign since these shops might not be equipped with doughnut-
making equipment). Nonetheless, such stores are a way to attract regular customers who
are unwilling to drive more than 3-4 miles or travel more than 10 minutes to a factory
store.
 Adding stores in areas that currently do not have a Krispy Kreme store—i.e. markets of
less than 100,000 households); developing a somewhat smaller store format with
doughnut-making capability would enable penetration of towns with less than 100,000
households
 Attract a broader range of customers and sell more products to existing customers by
enhancing present menu offerings
 Expansion into international markets
External Threats to Krispy Kreme’s Future Profitability
 Consumers continue to be health and nutrition conscious, causing many to avoid
doughnuts and resulting in continued slow/stagnant overall market growth for doughnuts.
The current low-carb (and bad-carb avoidance) craze now in vogue poses a particularly
 significant threat to sales of doughnuts—see the nutrition data on KKD’s doughnuts
provided in the case. There’s strong reason to believe that efforts to promote healthy
eating and to combat obesity (a growing problem worldwide) will continue and not abate.
 Flat sales for doughnuts marketwide pose threats to a KKD comeback. Stagnant
doughnut sales (at around 10-12 billion per year in the U.S.) means that for KKD to grow
unit sales it must win sales and market share away from other doughnut sellers—which is
typically a much harder and less profitable proposition. Ideally, consumer enthusiasm for
Krispy Kremes would have the effect of stimulating overall buyer demand and
consumption, upping industrywide sales over time to say 15 billion annually and thus
moderating the need for KKD to grow its sales at the expense of other industry
participants.
 KKD’s rivals, concerned about Krispy Kreme’s rapid growth and market share gains and
erosion of their own market positions, are certain to strongly defend their present market
positions and seem to be on the verge of launching strategic offensives to grow their
business. Such offensives are likely to include opening stores in more geographic
locations, a more diverse menu selection, improving the quality and appeal of their
doughnut offerings (particularly hot doughnuts), and introducing healthier types of
doughnuts so as to make it much tougher for Krispy Kreme to gain sales and market
share at their expense—this could precipitate a lively and perhaps costly battle for market
share that erodes profit margins and cuts into overall profitability.
 A comeback becomes much harder for KKD to pull off if the “fad” of Krispy Kreme
doughnuts continues to dissipate, customer enthusiasm for doughnuts wanes somewhat,
the KKD “novelty” wears off, and the local media coverage of new KKD store openings
becomes a thing of the past—such that KKD is forced to advertise to maintain/grow sales
levels at stores and off-premise outlets.
 Conclusions
Krispy Kreme’s situation, though highly favorable going into 2004, has swiftly become far
less attractive, partly because of accounting irregularities that have impaired its ability to
raise capital for a turnaround effort and future expansion and partly because of an alarming
deterioration of sales at existing stores. The events of 2004 have called the company’s growth
strategy into serious question and thrust the company into disarray. The fact that the new
management team at Krispy Kreme comes from Kroll Zolfo Cooper, a company best known
for presiding over the remains of Enron and rejuvenating very troubled companies, strongly
suggests that Krispy Kreme has serious financial problems.
But despite all the current problems, KKD still has some important resource strengths and
competitive assets that can be used to make a market comeback. The company has several
opportunities it can pursue to restore profitability and resume modest growth (although
growth is never likely to return to former levels). There would seem to be room for KKD to
open several hundred more stores in North America (Dunkin’ Donuts has 4,400 outlets in the
U.S. alone and 6,200 outlets worldwide; Tim Hortons has over 2,500 stores (mostly in
Canada—a much less populous market). KKD had less than 450 stores going into 2005 (and
only 357 at the end of fiscal 2004). The international market is wide open for KKD, although
it is unclear just what market potential there is for Krispy Kreme in the international arena.
Aside from trying to saturate metro locations with too many factory stores (in hopes of
attracting a broader base of customers), KKD’s strategy seems fairly solid. It has an
appealing doughnut product that sells itself via word-of-mouth, a loyal base of customers,
and a good business model predicated on vertical integration. Its backward vertical
integration into doughnut-making equipment, doughnut mixes, and coffee allows it to make
good margins in supplying franchisees. It has attracted some capable and experienced
franchisees.
There is a basis for making a market comeback if the company is not swamped by its
accounting problems and if it can escape a cash crunch in the near term. But the glory days
are probably over—the company’s future growth is likely to be much more modest than
occurred during 2000-2003. The threat listed in the SWOT analysis above are real and potent
enough to preclude rapid growth.
If the company gets through its current crisis, new executive leadership will have to be
brought in. The current CEO and COO are just temporary hires brought in by the board of
directors to guide the company through the current crisis and get the company back in decent
financial shape.
7. What is your assessment of Krispy Kreme’s competitive strengths and
weaknesses in comparison with key rivals as of 2004? Does the company
possess the competitive strength to mount a comeback? Please use the
methodology in Table 3.4 of Chapter 3 in arriving at your answer.
There is ample data in the case for students to do a solid competitor strength assessment using
the methodology described in Table 3.4 of Chapter 3. It is well worth 10-15 minutes of class
time to drill students on proper use of this analytical tool and thereby put some punch behind
their “opinions” as to whether in the aftermath of 2004 KKD still has adequate resources and
competitive capabilities to make a comeback and compete effectively against its rivals in the
doughnut industry. If you have assigned students to do the Case-TUTOR exercise for the
Krispy Kreme case in preparing for class, then they should be primed to respond to your
questions about KKD’s competitive strengths vis-E0-vis rivals since doing a competitive
strength assessment like that shown below is part of the exercise.
 Our unweighted and weighted competitive strength assessments are shown in Table 1 of this
note. We think product quality/appeal and geographic coverage are probably the two most
important measures of competitive strength in the doughnut industry. Most everyone knows
about doughnuts—so the trick to getting people to buy them and to do so regularly will have
a lot to do with their taste, freshness, and word-of-mouth reputation among doughnut
enthusiasts. KKD’s differentiating focus on “hot doughnuts now” has very high appeal
among consumers, judging by all the reactions and comments in the case. Geographic
coverage is important in being able to access doughnut enthusiasts—more store locations
means more market access.
Our ratings of reputation/image in the table below are based on customer opinion rather than
investor/Wall Street opinion. Clearly, KKD’s reputation has taken a big hit with financial
community, but we don’t see this as hurting the longstanding appeal of its doughnuts—all
doughnut makers suffer from the adverse nutritional aspects of their product. Our ratings on
brand image are intended to be relative to other brands.

Table 1 COMPETITIVE STRENGTH ASSESSMENTS OF

SELECTED DOUGHNUT INDUSTRY RIVALS

Key Success Factor/Competitive Importance Krispy Kreme Dunkin’ Donuts Winchell’s

Strength Measure Weight Rating Score Rating Score Rating Score
Breadth of product line 0.15 4 0.60 8 1.20 7 1.05
Reputation/image 0.15 10 1.50 8 1.20 4 0.60
Product quality/appeal 0.25 10 2.50 6 1.50 4 1.00
Geographic coverage 0.20 4 0.80 9 1.80 3 0.60
Supply chain capabilities 0.10 9 0.90 5 0.50 5 0.50
Financial strength 0.15 3 0.45 10 1.50 2 0.30
Sum of the weights 1.00
Totals of Ratings/Scores 40 6.75 46 7.70 25 4.05

Key Success Factor/Competitive Importance Tim Hortons LaMar’s

Strength Measure Weight Rating Score Rating Score
Breadth of product line 0.15 9 1.35 4 0.60
Reputation/image 0.15 8 1.20 3 0.45
Product quality/appeal 0.25 6 1.50 9 2.25
Geographic coverage 0.20 7 1.40 1 0.20
Supply chain capabilities 0.10 5 0.50 3 0.30
Financial strength 0.15 7 1.05 1 0.15
Sum of the weights 1.00
Totals of Ratings/Scores 42 7.00 21 3.95
 Conclusions: Students can differ in their competitive strength evaluations because of
different weightings, different strength measures, and different rating scores. But we think
they should conclude that KKD has the resource strengths and capabilities to do well against
other industry participants, assuming it can survive the current crisis. We see KKD as quite
strong vis-E0-vis competitors with regard to product quality/appeal (especially on the hot
doughnut factor), supply chain capabilities (its vertical integration strategy is a good one),
and brand name/reputation (the KKD doughnut brand is strong despite what transpired in
2004). KKD lacks the geographic coverage of Dunkin’ Donuts (in terms of outlets);
geographically, Tim Hortons is very strong in Canada and is a well-managed brand with an
effective strategy of expanding via franchised stores. But Tim Hortons, with only 200 stores
in the U.S., is well behind KKD in building a national presence across the U.S. (and is
unlikely to pursue expansion across as wide an area of the U.S. as KKD). Winchell’s is
fading quickly and is a factor only in Southern California. Hortons and Dunkin Donuts have
menu lineups that increase their appeal to customers not expressly wanting doughnuts, which
in some respects is an advantage (particularly in attracting store traffic for lunches and
snacks). LaMar’s apparently has a great doughnut, but it only has 32 outlets open or under
development in a limited number of geographic areas. LaMar’s is a major factor only in
Denver with 8 stores—a market where KKD already has a presence (its initial Denver store
was a big hit in the local market).
The big question at KKD right now is the company’s financial situation. How bad are the
accounting issues and does KKD have the financial stamina to ride out the current sales
downtown, manage is debt burden, and generate the internal cash flows necessary to fund
further expansion of company stores? What will be the response of its franchisees to the sales
downturn at existing stores? Can franchisees be convinced to open more new stores—
especially in areas where KKD has no market presence?
We think students should conclude that KKD has a good enough product and enough
competitive strengths and capabilities to mount a comeback in the marketplace. Now is
definitely not the time to surrender. If KKD can get its financial and accounting house in
order, then there are enough market opportunities out there for KKD to return to profitability.
8. What major issues do you think that Krispy Kreme management needs to
address in 2005?
Clearly the overriding issue at KKD in 2005 is “how to make a market comeback.” What
changes in strategy are needed? All students will see this issue. And it has several facets.
 How to cure the problems of overexpansion—too many stores in a limited geographic
area?
 How to stem the declines in same store sales and get comparable store sales growth back
into the positive column quickly?
 What needs to be done to allay fears and concerns among franchisees about the potential
for opening new stores? Continued opening of new stores needs to be a top priority.
 Should new store openings in the near term be mainly franchised factory stores as
opposed to company-owned stores?
 What strategy changes are needed in terms of the geographic locations for opening new
stores—should the emphasis be on expanding domestically (in areas where KKD does
not have a market presence) or pushing more quickly into promising foreign markets?
 How fast should KKD pursue international expansion in light of the developments of
2004? How many and which cities/countries to enter?
 Whether and when to begin opening stores in markets with fewer than 100,000
households? When should KK start to experiment with smaller stores sizes?
  Are changes needed in KKD’s menu offerings? What type of new menu offerings ought
to be considered?
But what else besides changing the strategy needs to be addressed? A thoughtful and incisive
list of candidate issues ought to include the following:
 How serious are the accounting issues and what can be done to clear all the accounting
and bookkeeping-related problems up as rapidly as possible and get this issue behind the
company?
 Where should KKD look for next-generation executive leadership—inside the company
or outside? Should the board begin to contemplate who to bring in once the two
executives from Kroll Zolfo Cooper have gotten the company’s financial and accounting
problems resolved?
We like to go to the board and record all the issues that the class believes management needs
to address. This list then becomes the basis for making action recommendations—students
should be expected to propose action recommendations for each of the issues and problems
identified.
9. What recommendations would you make to Krispy Kreme management to
return the company to profitability by the end of 2005 (or in 2006 at the
latest)?
Based on the issues identified above, we think actions along the lines indicated below are in
order:
 One of the first orders of business must be to get KKD’s accounting and financial
problems straightened out as quickly as possible. All of the accounting irregularities
needed to be corrected immediately, prior-year earnings restated as needed, and
settlement talks with the SEC concluded. If the reasons for the problems involved
unethical actions on the part of still-employed company executives (probably the CFO
and other financial officers), then a strong case can be made that these executives should
be replaced. Failure to replace executives found to be responsible for costly and
embarrassing unethical conduct sends a clear signal that the company is tolerant of such
behavior and has suspect ethical standards.
 A second priority should be to develop a “better for you” doughnut line with less sugar
and the use of whole grain flours (good carbs) rather than bleached white flour (bad
carbs). Clearly there are major nutritional issues with the company’s doughnuts. On the
road ahead, the company is likely to find itself waging an uphill battle to grow sales
unless it is in position to offer customers “better for you” or ideally “good for you”
doughnuts, given that the trend to “eating healthy” is almost certain to continue and
involve more and more people and given that obesity issues are being given increased
attention in the media.
 We would recommend avoiding expanding the menu to items outside the doughnut-
coffee line for the time being. The greater priority should be to rekindle buyer demand for
KKD doughnuts and this, sooner or later, will hinge on successful efforts to offer a
“better for you” line of doughnuts. KKD does not need to fragment management attention
and scarce financial resources at this point—which an effort to broaden menu offerings to
include sandwiches, etc. would surely do.
 KKD management should meet with franchisees and review the plans for opening new
stores—while more stores are probably desirable in major metropolitan areas, the
company and its franchisees should reevaluate the number of factory stores that are
needed to serve metro areas. Store profitability hinges on being able to generate sufficient
on-premise and off-premise sales to achieve single digit comparable store sales growth on
 a sustained basis. We think there is pretty clear evidence that KKD management and
franchisees have overestimated the number of factory stores that local metro markets can
support over the longer term. Insofar as the strategy for store expansion is concerned, we
think most students should propose something akin to the following:
 Store expansion efforts in 2005-2006 should be concentrated in areas where there are
currently no KKD factory stores (or at least no more than 1 or 2 if the local market is
a large metro area).
 Care should be taken not to locate new stores in local areas where there are already
numerous Dunkin Donuts and/or Tim Hortons stores. Going head-to-head against
nearby (across-the-street or just-down-the-street) Dunkin Donuts or Tim Hortons
stores needs to be scrupulously avoided at this juncture. The lesson that KKD needs
to have learned is that the more stores that are added the greater the potential for
cannibalization or head-to-head (across-the-street or just-down-the-street)
competition from other local sellers of doughnuts.
 KKD should pursue expansion into foreign markets—there would seem to be plenty
of foreign locations where a new Krispy Kreme store could create customer
excitement and build a “cult following.” The store in Sydney, Australia seems to
have been a big hit, and KKD should try to replicate such “home runs” in 5-10
foreign locations in 2005 and another 10-15 foreign locations in 2006.
If head-to-head competition with nearby Tim Hortons units can be avoided, we
believe Canada is a natural place for expansion, chiefly because Canadian stores can
be supplied fairly easily with doughnut mix, coffee products, and doughnut-making
equipments using the distribution network that KKD has built for the U.S. A
Canadian franchisee has already begun opening stores in the eastern portions of
Canada.
One of the biggest problems we see with KKD’s entry into foreign markets is what
this will do to the economics of KKD’s vertical integration/supply chain strategy.
How economical can a KKD store in London, England or Sidney, Australia be
supplied with coffee products, doughnut mix, and doughnut-making equipment from
KKD’s supply chain/distribution network in U.S.? This is an important matter
because the company’s KK manufacturing and distribution division generates
considerable profits from supplying franchisees with coffee products, doughnut mix,
and doughnut-making equipment. Given its current financial problems and urgent
need to restore profitability, KKD does not need to pursue expansion efforts in
foreign markets that could prove only marginally profitable.
 Until KKD gets back on its feet financially, the main store expansion effort should be
to open franchised factory stores as opposed to company-owned factory stores.
 KKD management should explore the merits of smaller stores sizes and designs.
Such stores would seem more appropriate for entering markets of fewer than 100,000
households plus a smaller store design might be more suitable for efforts to “build
out” or scatter stores throughout the larger metropolitan markets that already have
enough dough-making capacity at existing factory stores to handle off-premise sales
to area retailers.
 There may be some merit in considering whether an advertising campaign is needed to
help rejuvenate sales at existing stores. Such a campaign would make sense if and when
the company is ready to roll out a sugar-free or “better-for-you” line of doughnuts.
Management has got to find ways to create new excitement about its product offerings
and spur both on-premise and off-premise purchases of its doughnuts.
 You should press the class for their ideas as to how to recreate the excitement that
prevailed in 2002-2003 and regain sales momentum. One of the main teaching/learning
points of this case is spur strategic thinking about how to restore the market luster of a
good product that for whatever reason has lost its “magic.” In Krispy Kreme’s case, we
think that the circumstances surrounding the drop off in sales can be best countered by
introducing a “better-for-you” line of doughnuts. We don’t see that just advertising the
product or engaging in price discounting have much appeal for restoring sustained
profitability. We believe KKD’s best chances for sustained increases in doughnut sales
revolve around a “better-for-you” doughnut that makes people feel good about eating the
company’s product rather than provoking guilt feelings.
But there’s ample opportunity here for students to debate the pros and cons of the various
options KKD has for rejuvenating its sales and gaining market momentum. Unless
management comes up with something workable, the company’s glory days are surely
over and the company’s survival might well be in doubt.
10. Do you think KKD’s turnaround potential is bright enough to justify
purchasing shares at the roughly $6 per share price prevailing in early
2005? Why or why not?
Plainly, students can take either side here. Some may say yes, because they believe there are
good chances of KKD making a market comeback. Some may say no, because they are
skeptical about a successful turnaround and think the Krispy Kreme craze of 2000-2004 was
a “fad” whose time has passed.
The important thing here is to press students to justify their position with analysis-based
answers rather than seat-of-the-pants opinions.

Epilogue
As of April 2005, there was little to report about the turnaround efforts at Krispy Kreme. On
December 28, 2004, Krispy Kreme’s Board of Directors determined that indeed accounting errors
had been made in reporting the company’s fiscal 2004 results and that adjustments totaling
between $6.2 million and $8.1 million should be made to reduce pre-tax income for fiscal 2004.
However, the special committee’s investigative efforts were still ongoing, and additional
adjustments might be called for.
Management successfully negotiated a $225 million loan to be repaid in 3 years that gave it some
breathing room in resolving its financial problems and getting the company back on track. And
the stock price had bounced back to trading in the $8-$9 range.
In March 2005, Krispy Kreme was operating approximately 400 stores in 45 U.S. states,
Australia, Canada, Mexico, the Republic of South Korea and the United Kingdom.
You can also check Krispy Kreme’s Web site (www.krispykreme.com) for the company’s latest
financial and operating results and for recent press releases pertaining to the company’s strategy.