UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

Form 10-K

 

Commission file number 001-16485

 

KRISPY KREME DOUGHNUTS, INC.

(Exact name of registrant as specified in its charter)

 

 

Registrant’s telephone number, including area code:

(336) 725-2981

 

Securities registered pursuant to Section 12(b) of the Act:

 

 

Securities registered pursuant to Section 12(g) of the Act:

None

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes o     No þ

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  Yes o     No þ

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes o     No þ

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§ 229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer o     Accelerated filer þ     Non-accelerated filer o

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).  Yes o     No þ

 

The aggregate market value of voting and non-voting common equity of the registrant held by nonaffiliates of the registrant as of July 28, 2006 was $508.2 million.

 

Number of shares of Common Stock, no par value, outstanding as of September 29, 2006: 61,838,994.

 

DOCUMENTS INCORPORATED BY REFERENCE:

 

None.

 

 

TABLE OF CONTENTS

 

 

As used herein, unless the context otherwise requires, “Krispy Kreme,” the “Company,” “we,” “us” and “our” refer to Krispy Kreme Doughnuts, Inc. and its subsidiaries. References contained herein to fiscal 2002, fiscal 2003, fiscal 2004, fiscal 2005, fiscal 2006 and fiscal 2007 mean the fiscal years ended February 3, 2002, February 2, 2003, February 1, 2004, January 30, 2005, January 29, 2006 and January 28, 2007, respectively. Please note that fiscal 2002 contained 53 weeks. All references to share amounts and per share amounts in this Annual Report on Form 10-K, unless otherwise noted, have been adjusted to reflect stock splits.

 

The Company filed its Annual Report on Form 10-K for fiscal 2005 (the “2005 Form 10-K”) on April 28, 2006. As more fully described in Note 2 to the consolidated financial statements under Item 8, “Financial Statements and Supplementary Data” in the 2005 Form 10-K, the Company restated its consolidated balance sheet as of February 1, 2004 (the last day of fiscal 2004) and its consolidated statements of operations, of shareholders’ equity and of cash flows for fiscal 2004 and fiscal 2003. Certain restatement adjustments affected periods prior to fiscal 2003. The effect of those restatement adjustments on years prior to fiscal 2003 were reflected in the 2005 Form 10-K as an adjustment to the opening balance of retained earnings as of February 4, 2002, the first day of fiscal 2003.

 

In addition, as disclosed in the 2005 Form 10-K in Note 25 to the consolidated financial statements, certain restatement adjustments affected interim financial information for fiscal 2005 and fiscal 2004 previously filed on Form 10-Q (with respect to the first and second quarters of fiscal 2005 and the first three quarters of fiscal 2004) and on Form 8-K (with respect to the third quarter of fiscal 2005). Such restatement adjustments were reflected in the unaudited selected quarterly financial data appearing in the 2005 Form 10-K and, with respect to the third quarters of fiscal 2005 and fiscal 2004, will be reflected in the Company’s Quarterly Report on Form 10-Q for the third quarter of fiscal 2005.

 

Shortly after the filing of this Annual Report on Form 10-K, the Company expects to file its Quarterly Reports on Form 10-Q for the first, second and third quarters of fiscal 2006. However, the Company has not filed its Quarterly Reports on Form 10-Q for the third quarter of fiscal 2005 or for the first or second quarter of fiscal 2007. While the Company is working diligently to complete the filings referred to in the preceding sentence (focusing first on the fiscal 2007 reports and then on the third quarter fiscal 2005 report), there can be no assurance as to when the Company will be current in its reporting obligations.

 

The restatement adjustments corrected certain historical accounting policies to conform those policies to generally accepted accounting principles (“GAAP”) and to correct errors made in the application of GAAP. For a discussion of the significant restatement adjustments and the background leading to the adjustments, see Notes 2 and 25 to the consolidated financial statements in the 2005 Form 10-K.

 

The Company has not amended its Annual Reports on Form 10-K or its Quarterly Reports on Form 10-Q for periods affected by the restatement adjustments, and accordingly the financial statements and related financial information contained in such reports should not be relied upon.

 

All amounts in this Annual Report on Form 10-K affected by the restatement adjustments reflect such amounts as restated.

 

The financial statements included in this Annual Report on Form 10-K relate to periods and dates through January 29, 2006. For preliminary information regarding revenues and sales for the first and second quarters of fiscal 2007, see the Company’s Form 12b-25s filed on June 12, 2006 and September 12, 2006.

 

This Annual Report on Form 10-K contains statements about future events and expectations, including our business strategy, remediation plans with respect to internal controls and trends in or expectations regarding the Company’s operations, financing abilities and planned capital expenditures that constitute “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements are based on management’s beliefs, assumptions and expectations of our future economic performance, considering the information currently available to management. These statements are not statements of historical fact. Forward-looking statements involve risks and uncertainties that may cause our actual results, performance or financial condition to differ materially from the expectations of future results, performance or financial condition that we express or imply in any forward-looking statements. The words “believe,” “may,” “will,” “should,” “anticipate,” “estimate,” “expect,” “intend,” “objective,” “seek,” “strive” or similar words, or the negative of these words, identify forward-looking statements. Factors that could contribute to these differences include, but are not limited to:

 

 

 

All such factors are difficult to predict, contain uncertainties that may materially affect actual results and may be beyond our control. New factors emerge from time to time, and it is not possible for management to predict all such factors or to assess the impact of each such factor on the Company. Any forward-looking statement speaks only as of the date on which such statement is made, and we do not undertake any obligation to update any forward-looking statement to reflect events or circumstances after the date on which such statement is made.

 

We caution you that any forward-looking statements are not guarantees of future performance and involve known and unknown risks, uncertainties and other factors which may cause our actual results, performance or achievements to differ materially from the facts, results, performance or achievements we have anticipated in such forward-looking statements.

 

Overview

 

Krispy Kreme^® is a leading branded retailer and wholesaler of high-quality doughnuts. Our principal business, which began in 1937, is owning and franchising Krispy Kreme doughnut stores where over 20 varieties of doughnuts, including our Hot Original Glazed^tm, are made, sold and distributed and where a broad array of coffees and other beverages are offered.

 

As of January 29, 2006, there were 402 Krispy Kreme stores operated systemwide in 43 U.S. states, Australia, Canada, Mexico, South Korea and the United Kingdom, of which 133 were operated by us (including 15 operated by Glazed Investments, a consolidated franchisee until February 2006) and 269 were operated by other franchisees. Of the 402 total stores, there were 323 factory stores and 79 satellites. Of the 323 Krispy Kreme factory stores in operation at January 29, 2006, 293 were located in the United States.

 

Our factory stores (stores which contain a doughnut-making production line) typically support multiple sales channels to more fully utilize production capacity and reach additional consumer segments. These sales channels are comprised of on-premises sales (sales to customers visiting our stores) and off-premises sales (sales to supermarkets, convenience stores, mass merchants and other food service and institutional accounts) as described further under “Business Operations — Company Stores.” Satellite stores consist primarily of the fresh shop, kiosk and tunnel oven store formats. Tunnel oven stores contain doughnut heating technology that allows customers to have a hot doughnut experience throughout the day. Our fresh shops and our free-standing kiosk locations do not contain doughnut heating technology.

 

We generate revenues from three distinct sources: company stores, which we refer to as Company Stores; franchise fees and royalties from our franchise stores, which we refer to as Franchise; and a vertically integrated supply chain, which we refer to as Krispy Kreme Manufacturing and Distribution, or KKM&D. Company Stores, Franchise and KKM&D comprise our three reportable segments under GAAP.

 

Significant Events

 

Below is a summary of significant events that have occurred during the last two years.

 

Governmental Investigations/Litigation

 

 

Each of these investigations is ongoing. Developments relating to governmental investigations and responses to those investigations by us and by others will continue to create various risks and uncertainties that could have a material adverse effect on our business, results of operations and financial condition.

 

 

Special Committee Investigation

 

 

Restatement of Financial Statements

 

 

Management/Board of Directors Changes

 

 

 

 

 

 

 

 

Operations and Financing

 

 

Business Operations

 

We generate revenues from three distinct sources: company stores, which we refer to as Company Stores; franchise fees and royalties from our franchise stores, which we refer to as Franchise; and a vertically integrated supply chain, which we refer to as Krispy Kreme Manufacturing and Distribution, or KKM&D. Company Stores, Franchise and KKM&D comprise our three reportable segments under GAAP.

 

Company Stores.  The principal source of revenue for our stores is the production and distribution of doughnuts. Our factory stores are both retail outlets and wholesale producers of our doughnuts and, as a result, can sell their products through multiple channels.

 

These sales channels are designed to generate incremental sales, increase market penetration and brand awareness, increase consumer convenience and optimize utilization of our stores’ production capacity. We accomplish off-premises sales through our direct store delivery system, or DSD, through which we deliver fresh doughnuts, both packaged and unpackaged, to our retail customers. Our off-premises customers include Amerada Hess, Albertson’s, Exxon/Mobil, Food Lion, Kroger, Quick Trip, Sheetz, Speedway SuperAmerica and Wal-Mart. Our route drivers are capable of taking customer orders and delivering products directly to our customers’ retail locations, where they are typically merchandised from Krispy Kreme branded displays. We have also developed national account relationships and implemented electronic invoicing and payment systems with many large DSD customers.

 

Franchise.  Through our Franchise segment, we generate revenues through the collection of franchise fees and royalties. Franchisees sell their doughnuts and other products through the same channels discussed above under “— Company Stores” and, as a result, our royalty revenues are dependent on the on-premises and off-premises sales of our franchisees.

 

KKM&D.  KKM&D produces doughnut mixes and manufactures our doughnut-making equipment, which all factory stores are required to purchase. Additionally, KKM&D operates three distribution centers that provide Krispy Kreme stores with supplies for the critical areas of their business. KKM&D generates revenues on sales of our mixes, equipment and coffee to unconsolidated franchisees and supports both company and franchisee stores through product knowledge and technical skills, control of critical production and distribution processes and collective buying power.

 

The primary raw materials used in our products are flour, sugar, shortening and coffee beans. We routinely obtain ingredients under forward purchase agreements and in the commodity spot markets; market risks associated with our purchases of ingredients are discussed in Item 7A, “Quantitative and Qualitative Disclosures About Market Risks.” Although we own the recipe for our glaze flavoring — a key ingredient in many of our doughnuts — we are currently dependent on a sole source for our supply.

 

KKM&D has four business units:

 

 

 

 

 

 

Our line of doughnut-making machines includes machines that produce doughnuts at rates of approximately 65, 150, 270, 600 and 1,000 dozen doughnuts per hour. The largest of these machines (the 600 and 1,000 dozen per hour machines) are used primarily in a subset of our factory stores called commissaries, which are production facilities used principally to serve off-premises customers domestically and to supplement factory stores focused on on-premises sales internationally.

 

We also sell smaller machines, which we refer to as tunnel ovens, that are manufactured by others and that complete the final steps of the production process by preparing unglazed doughnuts for the glazing process. We also refurbish for resale used machines that we have as a result of store closings.

 

 

 

Krispy Kreme Brand Elements

 

Krispy Kreme has several important brand elements which we believe have created a bond with many of our customers. The key elements are:

 

 

Store Format and Development

 

Store Format.  We classify a store as either a factory store or a satellite store. Our traditional factory store has the capacity to produce from 4,000 dozen to over 10,000 dozen doughnuts daily. Commissaries, which are production facilities used principally to serve off-premises customers domestically and to supplement factory stores focused on on-premises sales internationally, have the highest production capabilities of our factory stores. As of January 29, 2006, there were 11 commissaries systemwide, five of which were owned by the Company. Our other factory stores generally engage in both on-premises and off-premises sales. We have begun introducing internationally, and on a test basis domestically, a store concept that will utilize doughnut-making technology scaled to accommodate principally on-premises sales in a store approximately one-half the size of a traditional factory store.

 

Satellite stores consist primarily of the fresh shop, kiosk and tunnel oven store formats. Tunnel oven stores contain doughnut heating technology that allows customers to have a hot doughnut experience throughout the day. Our fresh shops and our free-standing kiosk locations do not contain doughnut heating technology. In each of these formats, we typically sell fresh doughnuts, beverages and Krispy Kreme collectibles, and the doughnuts are supplied by nearby factory stores. Each of these formats requires less space than our traditional factory store. We began our tests of the fresh shop concept during fiscal 2004 and our tests of the tunnel oven store and kiosk formats in fiscal 2005. As of January 29, 2006, 33 fresh shops, 33 tunnel oven stores and 10 kiosks were open. We continue to view the fresh shop, tunnel oven store and kiosk formats as additional ways to achieve market penetration in a variety of market sizes and settings.

 

During fiscal 2002, we introduced a satellite store concept, the “doughnut and coffee shop,” or DCS, which featured first-generation doughnut heating technology. The majority of DCS stores that we opened were subsequently closed due to the financial performance of these stores and the development of the tunnel oven technology, and we do not expect to open any new stores using the DCS format. As of January 29, 2006, we had three DCS stores in operation.

 

Domestic Store Development.  As of January 29, 2006, there were a total of 334 domestic stores, of which 293 were factory stores and 41 were satellite stores. These store numbers reflect the opening in fiscal 2006 of 28 domestic stores and the closing of 90 domestic stores. Of the 28 stores opened in fiscal 2006, five

were company stores, including one operated by consolidated franchisees. Of the 90 stores closed in fiscal 2006, 47 were company stores, including 20 operated by consolidated franchisees. As we work to stabilize our operations and to refine our store format for new domestic stores, we do not expect that we or our franchisees will open a significant number of domestic factory stores in the near future. Since late 2004, our lack of current audited financial statements and other events have prevented us from offering franchises to new domestic franchisees. See “— Government Regulation” below.

 

International Store Development.  Markets outside the United States are a potential source of growth, and we are hiring additional personnel to assist in the development of international markets. As of January 29, 2006, there were a total of 68 Krispy Kreme stores operated internationally, which were located in Australia, Canada, Mexico, South Korea and the United Kingdom. In fiscal 2006, 39 new international stores were opened, and eight international stores were closed. Based upon our continued research and experience with our international stores, we are focusing additional international development efforts primarily on opportunities in potential markets in Asia, the Middle East and Western Europe. In the first half of fiscal 2007, we have awarded development rights in the Middle East, Hong Kong, Macau, Tokyo, the Philippines and Indonesia. The development and franchise agreements for these territories provide for the development of approximately 200 stores over the next five years. Our ability to expand in these or other international markets, however, will depend on a number of factors, including attracting experienced and well capitalized franchisees, demand for our product, our ability to supply or obtain the ingredients and equipment necessary to produce our products and local laws or policies of the particular countries.

 

Store Operations

 

General store operations.  We outline uniform specifications and designs for each Krispy Kreme store and require compliance with our standards regarding the operation of the store, including, but not limited to, varieties of products, product specifications, sales channels, packaging, sanitation and cleaning, signage, furniture and fixtures, image and use of logos and trademarks, training and marketing and advertising. We also require the use of a computer and cash register system with specified capabilities to ensure the collection of sales information necessary for effective store management. Our franchisees are required to provide us with weekly sales reports.

 

We generally assist our franchisees with issues such as operating procedures, advertising and marketing programs, public relations, store design, training and technical matters. We also provide an opening team to provide on-site training and assistance both for the week prior to and during the first week of operation for each initial store opened by a new franchisee. The number of opening team members providing this assistance is reduced with each subsequent store opening for an existing franchisee.

 

Our stores generally operate seven days a week, excluding some major holidays. Traditionally, our sales have been slower during the winter holiday season and the summer months.

 

Quality standards and customer service.  We encourage our employees to be courteous, helpful, knowledgeable and attentive. We emphasize the importance of performance by linking a portion of both a company store manager’s and an assistant store manager’s incentive compensation to profitability and customer service. We also encourage high levels of customer service and the maintenance of our quality standards by frequently monitoring our stores through a variety of methods, including periodic quality audits, “mystery shoppers” and a toll-free number. In addition, our customer experience department handles customer comments and conducts routine satisfaction surveys of our off-premises customers.

 

Management and staffing.  Our Executive Vice President of Operations, along with other corporate officers responsible for store operations, is responsible for corporate interaction with our store operations division directors and store management. Through our divisional directors, each of whom is responsible for a specific geographic region, we communicate frequently with all store managers and their staff using store audits, weekly communications by telephone or e-mail and both scheduled and surprise store visits.

 

We offer a comprehensive manager training program covering the critical skills required to operate a Krispy Kreme store and a training program for all positions in the store. The manager training program,

conducted both at our headquarters and at certified training stores, includes classroom instruction, computer-based training modules and in-store training.

 

Our staffing varies depending on a store’s size, volume of business and number of sales channels. Stores, depending on the sales channels they serve, have employees handling on-premises sales, processing, production, bookkeeping, sanitation and delivery. Hourly employees, along with delivery personnel, are trained by local store management through hands-on experience and training manuals.

 

Store Ownership

 

We divide our stores into three categories: company stores, associate stores and area developer stores. We refer to associates and area developers as franchisees, collectively. The store counts below include both factory stores and satellites.

 

Company stores.  As of January 29, 2006, Krispy Kreme operated 133 stores, including 15 which were operated by consolidated franchisees. Many of these stores were developed between 1937 and 1996 and are located predominantly in the Southeastern United States. These stores were designed as wholesale bakeries and generate a majority of their revenues through off-premises sales. Through acquisitions of associate and area developer franchisees’ market rights and related stores in recent years, as well as through new store construction, the number of company stores located outside the Southeast has increased. In fiscal 2005 and fiscal 2006, we examined the performance of each of our company stores and closed 78 underperforming stores, including 36 stores owned by consolidated franchisees. As of January 29, 2006, 15 company stores were owned by Glazed Investments, then a consolidated franchisee as described herein. As of January 29, 2006, we owned 97% of Glazed Investments. The Company ceased consolidating Glazed Investments subsequent to February 3, 2006, the date that Glazed Investments filed for bankruptcy protection. Subsequent to February 3, 2006, Glazed Investments closed three stores, and the 12 remaining stores operated by Glazed Investments were purchased by one of Krispy Kreme’s area developers, which continues to operate 11 of such stores.

 

Franchisee stores.  Our franchisees consist of associates who operate under our original franchising program developed in the 1940s and area developers who operate under our franchising program developed in the mid-1990s. We prefer that franchisees have ownership and successful operating experience in multi-unit food operations within the territory they propose for development. To ensure a consistent high-quality product, we require each franchisee to purchase our proprietary mixes and doughnut-making equipment. We devote resources to providing our franchisees with assistance in site selection, store design, employee training and marketing. We expect that in the near term any franchisee growth will be primarily through international rather than domestic expansion.

 

Associates.  We had 19 associates who operated 57 stores as of January 29, 2006. Associate stores have attributes which are similar to those of company stores located in the Southeast and associates typically have many years of experience operating Krispy Kreme stores. This group generally concentrates on growing sales within the current base of stores rather than developing new stores or new territories. Generally, our associates are not obligated to develop additional stores within their territories. We cannot grant licenses to other franchisees within an associate’s territory during the term of the license agreement.

 

Associates are typically parties to 15-year licensing agreements that are renewed automatically for successive five-year periods, unless previously terminated by either party. These licensing agreements generally permit associates to operate stores using the Krispy Kreme system within a specific territory. Associates pay royalties of 3.0% of on-premises sales and 1.0% of all other sales. Some associates also contribute 1.0% of all sales to the company-administered public relations and advertising fund, which we refer to as the Brand Fund. Our associates who were shareholders prior to our initial public offering in April 2000 have license agreements which were extended for a period of 20 years following that offering. We do not plan to license any new Krispy Kreme franchisees under the terms of the associate license agreement.

 

Area developers.  Under our area developer franchise program, which we introduced in the mid-1990s to strategically expand into new territories in the United States and Canada, we licensed territories, usually

defined by metropolitan statistical areas, to area developers which we believed were capable of developing a prescribed number of stores within a specified time period. We have also used area developers through a modified franchise program to expand outside of the United States and Canada.

 

As of January 29, 2006, we had 24 area developers operating 212 stores, excluding Glazed Investments, then a consolidated franchisee as described herein. We had a minority equity interest in 12 of these area developers. We do not currently expect to own any equity interests in any area developers that may be formed in the future.

 

Many of our area developers are multi-unit food operators with knowledge about their local territory or territories. Our area developer program includes a royalty and fee structure that is more attractive to Krispy Kreme than that of our associate program.

 

Each of our domestic and Canadian area developers has been required to enter into two types of agreements: a development agreement, which establishes the number of stores to be developed in an area, and a franchise agreement for each store opened. With respect to our international area developers, most have entered into one agreement covering both store development and store operations for each store opened. Area developers typically pay development and franchise fees ranging from $20,000 to $50,000 for each store they develop. Domestic and international area developers pay royalties of 4.5% and 6.0%, respectively, of all sales.

 

Our current standard franchise agreement for domestic and Canadian area developers provides for a 15-year term. Upon expiration of the term, our area developer typically has the right to acquire a successor franchise on terms and conditions of the franchise agreement that we are then using and subject to certain conditions. The agreement can be terminated for a number of reasons, including the failure of the franchisee to comply with system standards or to make timely payments within applicable grace periods, subject to state law. Domestic area developers are required to contribute 1.0% of their sales to the Brand Fund. International area developers generally are required to contribute 0.25% of their sales to the Brand Fund.

 

In addition to a franchise agreement, all area developers have signed development agreements which require them to develop a specified number of stores on or before specific dates. Generally, these agreements expire upon the conclusion of the store development schedule stated in the agreement, which schedule varies among area developers. If area developers fail to develop their stores on schedule, we have the right to terminate the agreement and develop company stores or develop stores through other franchisees in their territories. Currently, we have several area developers which are not in compliance with their development schedules and, as part of our ongoing initiatives, we are seeking to address these failures to comply.

 

Where we are an equity investor in an area developer, we contribute equity or guarantee debt or lease commitments of the franchisee generally proportionate to our ownership interest. See Note 18 to our consolidated financial statements for additional information on our franchisee investments. In addition, for consolidated franchisees, we have from time to time provided loans to fund their operations and store development. We do not expect to provide any significant loans to franchisees in the future.

 

Restructuring Initiatives.  As a result of the underperformance by many of our area developers and disputes between us and some of our area developers, we have undertaken an analysis of each area developer in order to determine what, if any, restructuring initiatives should be taken. Although this analysis is ongoing, set forth below are the significant restructuring actions that have taken place. As a result of these restructurings, effective February 2006, we no longer had any operations at consolidated franchisees.

 

 

 

 

 

Products

 

Doughnuts and Related Products.  We currently make and sell over 20 varieties of high-quality doughnuts, including our Hot Original Glazed^tm. Generally a product is first tested in our company stores and then rolled out to our franchisee stores. We have recently introduced new doughnuts in non-traditional shapes and packaged doughnut snacks, as well as new packaging offerings including doughnut hole cups for distribution through convenience stores.

 

Beverages.  One of our focus areas has been on improving our beverage program to complement our doughnut offerings. We have implemented in the majority of our stores a complete beverage program, including drip coffees, a complete line of espresso-based coffees including flavors, both coffee-based and noncoffee-based frozen drinks and packaged and fountain beverages, and we continue to seek to improve our beverage program. These drinks are designed to complement our existing juices, sodas, milks and water.

 

Marketing

 

Krispy Kreme’s approach to marketing is a natural extension of our brand equity, brand attributes, relationship with our customers and our values. To build our brand and drive our sales in a manner aligned with our brand values, we have focused our marketing activities in the following areas:

 

Store Experience.  Our stores are where most customers first experience a Hot Original Glazed^tm.  Customers know that when our Hot Doughnuts Now^® sign in the store window is illuminated, they can see our doughnuts being made and enjoy a Hot Original Glazed^tm within seconds after it passes through the glaze waterfall. We believe this begins our relationship with our customers and forms the foundation of the Krispy Kreme experience.

 

Relationship Marketing.  Many of our brand-building activities are grassroots-based and focus on developing relationships with various constituencies, including consumers, local non-profit organizations, communities and businesses. Specific initiatives include:

 

 

Public Relations.  We utilize media relations, product placement and event marketing as vehicles to generate brand awareness and trial usage for our products. In the years following our initial public offering, there were numerous product placements and references to our products on leading television programs and films and favorable media mentions in print publications. In fiscal 2005 and 2006, there have been fewer such product placements, references and favorable media mentions.

 

Advertising and Sales Promotions.  Grass roots marketing has been central to building our brand awareness. Although our marketing strategy has not historically employed traditional advertising, we have occasionally utilized free-standing newspaper inserts, direct mail, radio, television and sales promotions to generate awareness and usage of our products.

 

Brand Fund.  We administer a public relations and advertising fund, which we refer to as the Brand Fund. We contribute 1.0% of sales from company stores to the Brand Fund. Domestic area developers are required to contribute 1.0% of their sales to the Brand Fund. International area developers generally are required to contribute 0.25% of their sales to the Brand Fund. Some associates contribute 1.0% of their sales to the Brand Fund. Proceeds from the Brand Fund are utilized to develop programs to increase sales and brand awareness and build brand affinity. Brand Fund proceeds are also utilized to measure consumer feedback and the performance of our products and stores. In fiscal 2006, we and our franchisees contributed approximately $5.8 million to the Brand Fund.

 

Management Information Systems

 

Krispy Kreme has a management information system that allows for communication among our corporate office, support operations, company stores, associates and area developers. Our franchisees and other affiliates connect to this system through our intranet and have access to e-mail and the ability to provide financial reporting.

 

An enterprise resource planning system supports major financial and operating functions within the corporation, including financial reporting and inventory control. A data warehouse system supports the financial and operating needs of our Company Stores and KKM&D.

 

All company stores have been retrofitted with a Windows-based point of sale, or POS, system. This POS system provides each store with the ability to manage on-premises sales. We retrieve the sales information from each store’s POS system, which gives us the ability to analyze data. Two-way electronic communication with our stores permits sales transactions to be uploaded and price changes to be downloaded to in-store POS servers.

 

Direct store delivery sales operations have access to an internally-developed route accounting system connected into the corporate network. Information from these systems is retrieved at multiple times weekly and aggregated into the corporate data warehouse.

 

The Company maintains business continuity plans for its locations to protect against business interruption in the event of a system failure resulting from a catastrophe, natural disaster, security breach, power loss, telecommunications failure or other similar event. These plans include daily system backup procedures and use of offsite data recovery centers.

 

Competition

 

Our competitors include retailers of doughnuts and snacks sold through supermarkets, convenience stores, restaurants and retail stores. We compete against Dunkin’ Donuts, which has the largest number of outlets in the doughnut retail industry, as well as against Tim Hortons and regionally and locally owned doughnut shops and distributors. Dunkin’ Donuts and Tim Hortons have substantially greater financial resources than we do and are expanding to other geographic regions within the United States, including areas where we have a significant store presence. We also compete against other retailers who sell sweet treats such as cookie stores and ice cream stores. We compete on elements such as food quality, concept, convenience, location, customer service and value. Customer service, including frequency of deliveries and maintenance of fully stocked shelves, is an important factor in successfully competing for grocery store and convenience store business. There is an industry trend moving towards expanded fresh product offerings at convenience stores during morning and evening drive times, and products are either sourced from a central commissary or brought in by local bakeries.

In the packaged doughnut market, an array of doughnuts is typically merchandised on a free-standing branded display. We compete primarily with other well-known producers of baked goods, such as Dolly Madison, Entenmann’s and Hostess, and some regional brands.

 

Within the in-store bakery market, grocery store operators are increasingly interested in products delivered to stores frozen, which are then thawed as needed to meet customer demand, and we are conducting product testing in this area. In the convenience store market, we are one of the few providers of fresh delivered snacks.

 

Trademarks and Trade Names

 

Our doughnut shops are operated under the Krispy Kreme name, and we use over 40 federally registered trademarks and service marks, including “Krispy Kreme” and “Hot Doughnuts Now” and the logos associated with these marks. We have also registered some of our trademarks in approximately 30 other countries. We generally license the use of these trademarks to our franchisees for the operation of their doughnut shops. We also license the use of certain trademarks to convenience stores and grocery stores in connection with the sale of some of our products at those locations.

 

Although we are not aware of anyone else using “Krispy Kreme” or “Hot Doughnuts Now” as a trademark or service mark, we are aware that some businesses are using “Krispy” or a phonetic equivalent, such as “Crispie Creme,” as part of a trademark or service mark associated with retail doughnut stores. There may be similar uses we are unaware of which could arise from prior users. When necessary, we aggressively pursue persons who unlawfully and without our consent use our trademarks.

 

Government Regulation

 

Local regulation.  Our stores, both those in the United States and those in international markets, are subject to licensing and regulation by a number of government authorities, which may include health, sanitation, safety, fire, building and other agencies in the states or municipalities in which the stores are located. Developing new doughnut stores in particular areas could be delayed by problems in obtaining the required licenses and approvals or by more stringent requirements of local government bodies with respect to zoning, land use and environmental factors. Our standard development and franchise agreements require our area developers and associates to comply with all applicable federal, state and local laws and regulations, and indemnify us for costs we may incur attributable to their failure to comply.

 

Food product regulation.  Our doughnut mixes are primarily produced at our manufacturing facilities in Winston-Salem, North Carolina and Effingham, Illinois. Additionally, production at and shipments from our Winston-Salem and Effingham facilities are subject to the applicable federal and state governmental rules and regulations. Similar state regulations may apply to products shipped from our doughnut stores to grocery or convenience stores. Many of our grocery and convenience store customers require us to guarantee our products’ compliance with applicable food regulations.

 

As is the case for other food producers, numerous other government regulations apply to our products. For example, the ingredient list, product weight and other aspects of our product labels are subject to state and federal regulation for accuracy and content. Most states will periodically check the product for compliance. The use of various product ingredients and packaging materials is regulated by the United States Department of Agriculture and the Federal Food and Drug Administration. Conceivably, one or more ingredients in our products could be banned, and substitute ingredients would then need to be found.

 

In connection with our international operations, we typically export our products, principally our doughnut mixes, to our franchisees in markets outside the United States. Numerous government regulations apply to both the export of food products from the United States as well as the import of food products into other countries. If one or more of the ingredients in our products are banned, alternative ingredients would need to be found. Although we intend to be proactive in addressing any product ingredient issues, such requirements may delay our ability to open stores in other countries in accordance with our desired schedule.

 

Franchise regulation.  We must comply with regulations adopted by the Federal Trade Commission (the “FTC”) and with several state and foreign laws that regulate the offer and sale of franchises. The FTC’s Trade

Regulation Rule on Franchising (“FTC Rule”) and certain state and foreign laws require that we furnish prospective franchisees with a franchise offering circular or disclosure document containing information prescribed by the FTC Rule and applicable state and foreign laws and regulations. Since late 2004, our lack of current audited financial statements and other events have prevented us from offering franchises to new franchisees, pursuant to an up-to-date registered Uniform Franchise Offering Circular (“UFOC”). Our lack of an updated registered UFOC will impede our ability to establish new franchises inside the United States and may impede our ability to establish franchises in certain countries outside the United States.

 

We also must comply with a number of state and foreign laws that regulate some substantive aspects of the franchisor-franchisee relationship. These laws may limit a franchisor’s ability to: terminate or not renew a franchise without good cause; interfere with the right of free association among franchisees; disapprove the transfer of a franchise; discriminate among franchisees with regard to charges, royalties and other fees; and place new stores near existing franchises.

 

Bills intended to regulate certain aspects of franchise relationships have been introduced into the United States Congress on several occasions during the last decade, but none has been enacted.

 

On June 15, 2005, the Commonwealth of Virginia, on behalf of itself, the FTC and eight other states, inquired into certain activities related to prior sales of franchises and the status of our financial statements. See Item 3, “Legal Proceedings — Governmental Investigations.”

 

Employment regulations.  We are subject to state and federal labor laws that govern our relationship with employees, such as minimum wage requirements, overtime and working conditions and citizenship requirements. Many of our on-premises and delivery personnel are paid at rates related to the federal minimum wage. Accordingly, further increases in the minimum wage could increase our labor costs. Furthermore, the work conditions at our facilities are regulated by the Occupational Safety and Health Administration and are subject to periodic inspections by this agency.

 

Other regulations.  We have several contracts to serve United States military bases, which require compliance with certain applicable regulations. The stores which serve these military bases are subject to health and cleanliness inspections by military authorities. We are also subject to federal and state environmental regulations, but we currently believe that these will not have a material effect on our operations.

 

Employees

 

As of January 29, 2006, we employed 5,025 people. Of these, 200 were employed in our administrative offices and 192 were employed in our manufacturing and distribution centers. In our Krispy Kreme stores, we had 4,633 employees. Of our total workforce, 4,251 were full-time employees, including 695 managers and administrators.

 

These numbers do not include individuals employed by Glazed Investments, our sole consolidated franchisee operating stores as of January 29, 2006.

 

We are not a party to any collective bargaining agreement although we have experienced occasional unionization initiatives. We believe our relationships with our employees are good.

 

Available Information

 

Krispy Kreme files annual reports, quarterly reports, proxy statements and other documents with the SEC under the Securities Exchange Act of 1934 (the “Exchange Act”). As of the date of this Annual Report on Form 10-K, we have not yet filed our Quarterly Reports on Form 10-Q for the quarters ended October 31, 2004, April 30, 2006 and July 30, 2006. The public may read and copy any materials that the Company files with the SEC at the SEC’s Public Reference Room at 100 F Street N.E., Washington, D.C. 20549 or obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. Additionally, the SEC maintains a website that contains reports, proxy statements, information statements and other information regarding issuers, including the Company, that file electronically with the SEC at: http://www.sec.gov.  

We make available free of charge through our website at: http://www.krispykreme.com our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and, if applicable, amendments to those reports filed or furnished pursuant to the Exchange Act as soon as reasonably practicable after we electronically file such material with, or provide it to, the SEC.

 

In addition, many of our corporate governance documents are available on our website. Specifically, our Governance Committee Charter is available at: http://www.krispykreme.com/gov_charter.pdf, our Compensation Committee Charter is available at: http://www.krispykreme.com/comp_charter.pdf, our Audit Committee Charter is available at: http://www.krispykreme.com/audit_charter.pdf, our Corporate Governance Guidelines are available at: http://www.krispykreme.com/corpgovernance.pdf, our Code of Business Conduct and Ethics is available at: http://www.krispykreme.com/code_of_ethics.pdf, our Code of Business Conduct and Ethics for Members of the Board of Directors is available at: http://www.krispykreme.com/board_directors_ethics.pdf, and our Code of Ethics for Chief Executive and Senior Financial Officers is available at: http://www.krispykreme.com/officers_ethics.pdf. Each of these documents is available in print to any shareholder who requests it by sending a written request to the Company’s Secretary, 370 Knollwood Street, Suite 500, Winston-Salem, NC 27103.

 

The content on our website is available for information purposes only and shall not be deemed to be a part of this report.

 

Our business, operations and financial condition are subject to various risks. Some of these risks are described below, and you should take such risks into account in evaluating us or any investment decision involving our Company. This section does not describe all risks that may be applicable to us, our industry or our business, and it is intended only as a summary of certain material risk factors. More detailed information concerning the risk factors described below is contained in other sections of this Annual Report on Form 10-K.

 

RISKS RELATING TO MATTERS UNDER INVESTIGATION

 

 

We and certain of our former and current executive officers, directors and other employees are currently subject to investigations by the SEC and the United States Attorney’s Office for the Southern District of New York. While we are cooperating with each of these investigations, adverse developments in connection with the investigations, including any expansion of the scope of the investigations, could negatively impact us and could divert the efforts and attention of our management team from our ordinary business operations. In connection with these investigations, it is possible that we will be required to pay criminal or civil fines, consent to injunctions on future conduct or suffer other penalties, any of which could have a material adverse effect on us. See Item 3, “Legal Proceedings” for a more detailed description of these investigations. Item 3 also describes a review by the DOL of the Krispy Kreme Doughnut Corporation Retirement Savings Plan and the Krispy Kreme Profit Sharing Stock Ownership Plan to determine whether any violations of Title I of ERISA have occurred.

 

 

We and certain of our former and current executive officers, directors and other employees are defendants in several lawsuits, including a federal securities class action, several shareholder derivative actions and an ERISA class action. We have reached a proposed settlement with respect to the federal securities class action, a proposed partial settlement with respect to the shareholder derivative actions and a proposed settlement with respect to the ERISA class action. Under the terms of these proposed settlements, we would be required to issue shares of common stock and warrants to purchase shares of common stock having an aggregate value of approximately $35.8 million based on the current market price of the Company’s common stock. These settlements are still subject to the approval of the relevant courts and no assurance can be given that these settlements will be approved. If any of these settlements are not approved, we cannot provide assurance that the legal and other costs associated with the defense of all of these actions, the amount of time required to be spent by management and the Board of Directors on these matters and the ultimate outcome of these actions will not have a material adverse effect on our business, financial condition and results of operations. In addition, counsel for the derivative plaintiffs are deferring their application for fees until conclusion of the derivative actions and there can be no assurance as to the amount the Company will be required to pay to such counsel. See Item 3, “Legal Proceedings” for a more detailed description of these proceedings.

 

 

As discussed elsewhere herein, several of our current and former directors, officers and employees are the subject of criminal, administrative and civil investigations and lawsuits. Under North Carolina law, our bylaws and certain indemnification agreements, we may have an obligation to indemnify our current and former officers and directors in relation to these matters. Some of these indemnification obligations would be covered by certain insurers under applicable directors’ and officers’ liability policies. In connection with the settlement of the securities class action and the partial settlement of the derivative litigation described below under Item 3, “Legal Proceedings”; however, we have agreed with these insurers to limit our claims for reimbursement to a specified reserve fund. If the sums provided for in this fund are not sufficient, if the proposed settlement is not

ultimately consummated, or if the Company incurs significant uninsured indemnity obligations, our indemnity obligations could have a material adverse effect on our business, results of operations and financial condition.

 

 

We have numerous material weaknesses in our internal control over financial reporting.

 

As required by Section 404 of the Sarbanes-Oxley Act of 2002 (the “Sarbanes-Oxley Act”), management has conducted an assessment of our internal control over financial reporting. We identified numerous material weaknesses in our internal control over financial reporting and concluded that our internal control over financial reporting was not effective as of January 29, 2006. For a detailed description of these material weaknesses, see Item 9A, “Controls and Procedures.” Each of our material weaknesses results in more than a remote likelihood that a material misstatement will not be prevented or detected. As a result, we must perform extensive additional work to obtain reasonable assurance regarding the reliability of our financial statements. Even with this additional work, given the numerous material weaknesses identified, there is a risk of additional errors not being prevented or detected which could result in additional restatements. Moreover, it is reasonably possible that other material weaknesses may be identified.

 

We have extensive work remaining to remedy the material weaknesses in our internal control over financial reporting.

 

We have extensive work remaining to remedy our material weaknesses in internal control over financial reporting. We are in the process of developing and implementing a full work plan for remedying all of the identified material weaknesses, and this work will continue during fiscal 2007 and beyond. There can be no assurance as to when the remediation plan will be fully developed and when it will be implemented. Until our remedial efforts are completed, management will continue to devote significant time and attention to these efforts, and we will continue to incur the expenses associated with the manual procedures and resources required to prepare our consolidated financial statements. There will also continue to be an increased risk that we will be unable to timely file future periodic reports with the SEC, that a default under our debt agreements could occur as a result of further delays and that our future financial statements could contain errors that will be undetected.

 

 

As a result of its investigation, the Special Committee has directed the Company to implement a number of significant remedial measures to improve our processes and procedures. These include a substantial bolstering of resources in the areas of accounting, financial reporting and internal audit, remediation of the material weaknesses and other control deficiencies discussed above, a comprehensive review of the Company’s compliance and internal audit programs, clarification and reinforcement of the role of General Counsel and enhancement of the Company’s disclosure process generally. These remedial measures may take time and be costly to implement.

 

 

As a result of the matters investigated by the Special Committee and other matters discussed herein, we have been the subject of continuing negative publicity. This negative publicity may have an effect on the terms under which some customers, suppliers and franchisees are willing to continue to do business with us and could affect our financial performance or financial condition. We also believe that many of our employees and franchisees are operating under stressful conditions, which reduce morale and could consequently adversely affect our business. In addition, many of our franchisees have experienced reduced access to financing, in part as a result of this negative publicity. Continuing negative publicity could have a material adverse effect on our business.

 

We are not current in our periodic reporting obligations under the Exchange Act, and until we are, we will be precluded from registering any securities with the SEC. In addition, our failure to comply with these obligations could subject us to penalties.

 

RISKS RELATING TO OUR BUSINESS

 

 

After Mr. Livengood’s departure from the Company on January 17, 2005, the positions of Chief Executive Officer, President and Chief Operating Officer were filled on an interim basis by executives of KZC. On March 6, 2006, a new President and Chief Executive Officer joined the Company. Both our Chief Accounting Officer and Executive Vice President of Operations joined Krispy Kreme in fiscal 2005. Our former General Counsel resigned effective December 1, 2005, and that position was not filled until September 11, 2006, when our new General Counsel joined Krispy Kreme on an interim basis. In fiscal 2006, we had four different individuals serve as the principal officer overseeing company store operations. Our new senior management team may require a period of time to become familiar with each other and our business. The efforts of the current senior management team and Board of Directors to manage the Company’s business have been hindered at times by a lack of institutional knowledge and their need to spend significant time and effort to resolve issues related to matters under investigation. To the extent the senior management team and the Board of Directors will be required to devote significant attention to these matters in the future, this may have, at least in the near term, an adverse effect on operations. In addition to changes at the senior management level, directed, in part, by the Special Committee, we have also experienced changes at other levels of management, including accounting.

 

 

In fiscal 2006, systemwide and Company average weekly sales per factory store (which includes sales through satellites) decreased approximately 15.4% and 16.7%, respectively, compared to fiscal 2005. Fiscal 2005 systemwide and Company average weekly sales per factory store decreased approximately 14.0% and 19.7%, respectively, compared to fiscal 2004. We are in the process of reevaluating our business and have taken steps to improve our sales. There can be no assurance, however, that these steps will produce the desired results. Each company store has significant fixed and semi-fixed costs, which prevents us from reducing our operating expenses in proportion with declining sales. Thus, our earnings will be negatively impacted if average weekly sales continue to decline.

 

A number of factors have historically affected, and will continue to affect, our average weekly sales results, including, among other factors:

 

 

Changes in our average weekly sales results could cause the price of our common stock to fluctuate substantially.

 

Area developers and associates, which are all independent contractors and not Krispy Kreme employees, generated approximately 27% of our total revenues in fiscal 2006. We rely in part on these area developers and associates and the manner in which they operate their locations to develop and promote our business. We occasionally have disputes with franchisees and have recently settled litigation with two area developers. Future disputes could materially adversely affect our business, financial condition and results of operations. We provide training and support to area developers and associates, but the quality of franchised store operations may be diminished by any number of factors beyond our control. The failure of our area developers and associates to operate franchises successfully could have a material adverse effect on us, our reputation and our brands and could materially adversely affect our business, financial condition and results of operations. As a result of the underperformance by many of our area developers and disputes between us and some of our area developers, we have undertaken an analysis of each area developer in order to determine what, if any, restructuring initiatives should be taken. No assurance can be given as to the success of our restructuring activities.

 

Reduced access to financing by our franchisees on reasonable terms could adversely affect our future operations by leading to additional store closures by our franchisees, which may in turn reduce our franchise revenues and KKM&D revenues. Most area development agreements specify a schedule for opening stores in the territory covered by the agreement. These schedules form the basis for our expectations regarding the number and timing of new Krispy Kreme store openings. In the past, Krispy Kreme has agreed to extend or modify development schedules for certain area developers and may do so in the future.

 

 

As we work to stabilize our operations and to refine our store format for new domestic stores, we do not expect that we or our franchisees will open a significant number of domestic factory stores in the near future. Our growth strategy, therefore, depends on the opening of new Krispy Kreme stores internationally. Our ability to expand our store base internationally is influenced by factors beyond our and our franchisees’ control, which may slow store development and impair our strategy. The success of these new stores will be dependent in part on a number of factors, which neither we nor our franchisees can control.

 

 

As of January 29, 2006, there were 68 Krispy Kreme stores operated outside of the United States. Such operations are transacted in the respective local currency. Amounts payable to us by our international franchisees are based on a conversion of the royalties and other fees to U.S. dollars using the prevailing exchange rate. In particular, the royalties are based on a percentage of net sales generated by our foreign franchisees’ operations. Our revenues from international franchisees are exposed to the potentially adverse effects of our franchisees’ operations, currency exchange rates, local economic conditions, political instability and other risks associated with doing business in foreign countries. To the extent that the portion of our revenues generated from international operations increases in the future, our exposure to changes in foreign economic conditions and currency fluctuations will increase.

 

In connection with our international operations, we typically export our products, principally our doughnut mixes, to our franchisees in markets outside the United States. Numerous government regulations apply to both the export of food products from the United States as well as the import of food products into other countries. If one or more of the ingredients in our products are banned, alternative ingredients would need to be found. Although we intend to be proactive in addressing any product ingredient issues, such requirements may delay our ability to open stores in other countries in accordance with our desired schedule.

 

We are the exclusive supplier of doughnut mixes and other key ingredients and flavors to all domestic company stores and most domestic franchised stores. We supply the doughnut mixes and other key ingredients and flavors principally out of our two mix manufacturing facilities, which are located in Winston-Salem, North Carolina and Effingham, Illinois. Although we have a backup source to manufacture our doughnut mixes in the event of the loss of our Winston-Salem and Effingham plants, these backup facilities do not regularly produce our doughnut mixes. Any interruption of existing or planned production capacity at our manufacturing plants could impede our ability or that of our franchisees to make doughnuts. In addition, in the event that any of our supplier relationships terminate unexpectedly, even where we have multiple suppliers for the same ingredient, we may not be able to obtain adequate quantities of the same high-quality ingredient at competitive prices. Certain of our major suppliers tightened credit terms since early 2005. Further changes to credit terms offered to us by our suppliers could adversely affect our liquidity.

 

Although we utilize forward purchase contracts and futures contracts to mitigate the risks related to commodity price fluctuations, such contracts do not fully mitigate commodity price risk. Adverse changes in commodity prices could adversely affect our profitability and liquidity.

 

 

We manufacture our custom doughnut-making equipment in one facility in Winston-Salem, North Carolina. Although we have limited backup sources for the production of our equipment, obtaining new equipment quickly in the event of the loss of our Winston-Salem plant would be difficult and would jeopardize our ability to supply equipment to new stores or new parts for the maintenance of existing equipment in established stores on a timely basis.

 

 

We are dependent on a sole supplier for our glaze flavoring. Any interruption in the distribution from our current supplier could affect our ability to produce our signature Hot Original Glazed^tm.

 

 

We, as a franchisor, are subject to both regulation by the FTC and state laws regulating the offer and sale of franchises. Our failure to obtain or maintain approvals to sell franchises would cause us to lose franchise revenues and KKM&D revenues. In addition, state laws that regulate substantive aspects of our relationships with franchisees may limit our ability to terminate or otherwise resolve conflicts with our franchisees. Because we plan to grow primarily through franchising, any impairment of our ability to develop new franchised stores will negatively affect us and our growth strategy more than if we planned to develop additional company stores. Since late 2004, our lack of current audited financial statements and other events have prevented us from offering franchises pursuant to an up-to-date registered UFOC. Our lack of an updated registered UFOC will impede our ability to establish new franchises inside the United States and may impede our ability to establish franchises in certain countries outside the United States.

 

The Company operates a fleet network to support off-premises sales. Declines in off-premises sales without a commensurate reduction in operating expenses, as well as rising fuel costs, may adversely affect our business.

 

We have several large wholesale customers. Our top two such customers accounted for approximately 10.3% of total company store sales during fiscal 2006, excluding consolidated franchisee sales. The loss of one of our large national wholesale customers could adversely affect our results of operations across all business segments. These customers do not enter into long-term contracts; instead, they make purchase decisions based on a combination of price, product quality, consumer demand and customer service performance. They may in the future use more of their shelf space, including space currently used for our products, for other products, including private label products. If our sales to one or more of these customers are reduced, this reduction may adversely affect our business.

 

 

We own certain common law trademark rights in the United States, as well as numerous trademark and service mark registrations in the United States and in other jurisdictions. We believe that our trademarks and other intellectual property rights are important to our success and our competitive position. We therefore devote appropriate resources to the protection of our trademarks and proprietary rights and aggressively pursue persons who unlawfully and without our consent use or register our trademarks. The protective actions that we take, however, may not be sufficient, in some jurisdictions, to secure our trademark rights for some of the goods and services that we offer and/or to prevent imitation by others, which could adversely affect the value of our trademarks and service marks.

 

With regard to the United States, although we are not aware of anyone else who is using “Krispy Kreme” or “Hot Doughnuts Now” as a trademark or service mark, we are aware that some businesses are using “Krispy” or a phonetic equivalent, such as “Crispie Creme,” as part of a trademark or service mark in connection with retail doughnut stores. In jurisdictions outside the United States, specifically Costa Rica, Guatemala, Indonesia, Nigeria, Peru, the Philippines, Thailand and Venezuela, we are aware that some businesses have registered, used and/or may be using the “Krispy Kreme” trademark (or its phonetic equivalent) in connection with doughnut-related goods and services. There may be similar such uses or registrations of which we are unaware and which could perhaps arise from prior users. These uses and/or registrations could limit our operations and possibly cause us to incur litigation costs, or pay damages or licensing fees to a prior user or registrant of similar intellectual property.

 

 

Our indebtedness for borrowed money as of July 30, 2006 was approximately $120.6 million, including $118.8 million under our senior secured credit facilities. Our debt service obligations with respect to this increased indebtedness could have an adverse impact on our earnings and cash flow for as long as the indebtedness is outstanding.

 

Our substantial level of indebtedness could have important consequences, including the following:

 

 

 

If our cash flows and capital resources are insufficient to fund our debt service obligations, we may be forced to reduce or delay capital expenditures, sell assets, seek additional capital or restructure or refinance our indebtedness. These alternative measures may not be successful and may not permit us to meet our scheduled debt service obligations. In the absence of such operating results and resources, we could face substantial liquidity problems and might be required to dispose of material assets to meet our debt service payments.

 

  Our senior secured credit facilities impose restrictions and obligations upon us that significantly limit our ability to operate our business, and in the past we have sought and received waivers relating to these restrictions and obligations.

 

Our senior secured credit facilities impose financial and other restrictive covenants that limit our ability to plan for and respond to changes in our business. Under our senior secured credit facilities, we are required to meet certain financial tests, including a maximum leverage ratio and a minimum interest coverage ratio. The financial covenants are based upon the Company’s fiscal 2007 operating plan and preliminary plans for fiscal 2008, which include, among other things, anticipated sales of certain assets and reductions in the amount of indebtedness and other obligations of franchisees guaranteed by the Company. In addition, we must comply with covenants which, among other things, limit the incurrence of additional indebtedness, liens, investments, dividends, transactions with affiliates, asset sales, acquisitions, capital expenditures, mergers and consolidations, prepayments of other indebtedness and other matters customarily restricted in such agreements. Any failure to comply with these covenants could result in an event of default under our senior secured credit facilities.

 

We have sought and received waivers of defaults and amendments to covenants from the lenders under our senior secured credit facilities. While we were able to obtain these waivers and amendments, in some cases at a significant additional cost, there is no assurance that we will not have further defaults or that any future defaults will be waived. Such defaults could result in acceleration of all or substantially all of our indebtedness and the loss of earning assets securing our indebtedness.

 

 

We currently rely on numerous professional advisors to provide us with services. Fees to these professional advisors incurred since May 2004 have been very significant and, depending on the governmental investigations and the progress of ongoing litigation, may remain significant in the future. Our ability to make payments to our professional advisors will depend on our ability to generate cash in the future. Our ability to generate cash depends on many factors beyond our control. We cannot assure you that our business will generate sufficient cash flow from operations to enable us to retain all of our professional advisors and to fund our operations. If we are not able to retain all of our professional advisors, we may not be able to obtain the services that we currently rely on to operate our business and represent us in the governmental investigations and litigation to which we are subject.

 

RISKS RELATING TO THE FOOD SERVICE INDUSTRY

 

 

Food service businesses are often affected by changes in consumer tastes, national, regional and local economic conditions and demographic trends. Individual store performance may be adversely affected by traffic patterns, the cost and availability of labor, purchasing power, availability of products and the type,

number and location of competing stores. Our sales have been and may continue to be affected by changing consumer tastes, such as health or dietary preferences, including the reduction of consumption of food products containing high levels of carbohydrates or trans fats, that cause consumers to avoid doughnuts in favor of foods that are perceived as more healthy. Moreover, because we are primarily dependent on a single product, if consumer demand for doughnuts should decrease, our business would suffer more than if we had a more diversified menu.

 

 

Food service businesses can be adversely affected by litigation, by regulation and by complaints from customers or government authorities resulting from food quality, illness, injury or other health concerns or operating issues stemming from one store or a limited number of stores, including stores operated by our franchisees. In addition, class action lawsuits have been filed and may continue to be filed against various food service businesses (including quick service restaurants) alleging, among other things, that food service businesses have failed to disclose the health risks associated with high-fat foods and that certain food service business marketing practices have encouraged obesity. Adverse publicity about these allegations may negatively affect us and our franchisees, regardless of whether the allegations are true, by discouraging customers from buying our products. In addition, the New York City Health Department recently proposed an amendment to the New York City Health Code that would partially phase out artificial trans fat (which we currently use in our doughnuts) in all New York City restaurants and other food service establishments. Additional cities or states may propose or adopt similar regulations. Although we could produce our doughnuts without using any trans fat, the taste of our doughnuts may be affected. Because one of our competitive strengths is the taste and quality of our doughnuts, adverse publicity or such regulations relating to food quality or other similar concerns affects us more than it would food service businesses that compete primarily on other factors. We could also incur significant liabilities if such a lawsuit or claim results in a decision against us or as a result of litigation costs regardless of the result.

 

 

We compete with many well-established food service companies. At the retail level, we compete with other doughnut retailers and bakeries, specialty coffee retailers, bagel shops, fast-food restaurants, delicatessens, take-out food service companies, supermarkets and convenience stores. At the wholesale level, we compete primarily with grocery store bakeries, packaged snack foods and vending machine dispensers of snack foods. Aggressive pricing by our competitors or the entrance of new competitors into our markets could reduce our sales and profit margins. Moreover, many of our competitors offer consumers a wider range of products. Many of our competitors or potential competitors have substantially greater financial and other resources than we do which may allow them to react to changes in pricing, marketing and the quick service restaurant industry better than we can. As competitors expand their operations, we expect competition to intensify. In addition, the start-up costs associated with retail doughnut and similar food service establishments are not a significant impediment to entry into the retail doughnut business. We also compete with other employers in our markets for hourly workers and may be subject to higher labor costs.

 

RISKS RELATING TO OWNERSHIP OF OUR COMMON STOCK

 

 

The market price of our common stock has been volatile and may continue to be volatile. This volatility may cause wide fluctuations in the price of our common stock, which is listed on the NYSE. The market price may fluctuate in response to many factors including:

 

 

 

 

Our articles of incorporation, bylaws and shareholder rights agreement contain several provisions that may make it more difficult for a third party to acquire control of us without the approval of our board of directors. These provisions may make it more difficult or expensive for a third party to acquire a majority of our outstanding voting common stock. They may also delay, prevent or deter a merger, acquisition, tender offer, proxy contest or other transaction that might otherwise result in our shareholders’ receiving a premium over the market price for their common stock.

 

None.

 

Stores.  As of January 29, 2006, there were 323 Krispy Kreme factory stores systemwide, of which 128 were company stores (including 15 which were operated by consolidated franchisees), 148 were operated by area developers (including 49 in which we had a minority interest) and 47 were operated by associates. Of the 323 Krispy Kreme factory stores in operation at January 29, 2006, 293 were located in 43 states in the continental United States, six were located in Australia, seven were located in Canada, four were located in Mexico, six were located in South Korea and seven were located in the United Kingdom.

 

 

As of January 29, 2006, there were 79 Krispy Kreme satellite stores systemwide, of which five were operated by the Company.

Set forth below is a table containing certain store information as of the end of fiscal 2006, fiscal 2005 and fiscal 2004. As of January 29, 2006, consolidated franchisees consisted of Glazed Investments, which the Company ceased consolidating subsequent to February 3, 2006, the date that Glazed Investments filed for bankruptcy protection. As of January 30, 2005, consolidated franchisees consisted of New England Dough, KremeKo, Freedom Rings and Glazed Investments. As of February 1, 2004, consolidated franchisees consisted of Freedom Rings and Glazed Investments.

 

KKM&D facilities.  We own a 143,000 square foot mix manufacturing plant and distribution center in Winston-Salem, North Carolina. Our coffee roasting operation is also located at this facility. We also own a 190,000 square foot mix manufacturing and distribution facility in Effingham, Illinois. We lease a 105,000 square foot facility near Los Angeles, California, which is used as a distribution center, under a lease that expires on May 31, 2008. Additionally, we own a 100,000 square foot facility in Winston-Salem, which we use primarily as our equipment manufacturing facility and training facility.

 

Other properties.  Our corporate headquarters is located in Winston-Salem, North Carolina. We occupy approximately 59,000 square feet of this multi-tenant facility under a lease that expires on September 30, 2012, with one five-year renewal option.

 

From time to time we are subject to claims and suits arising in the course of our business. We maintain customary insurance policies against claims and suits which arise in the course of our business, including insurance policies for workers’ compensation and personal injury, some of which provide for relatively large deductible amounts.

 

Except as disclosed below, we are currently not aware of any legal proceedings or claims that we believe could have, individually or in the aggregate, a material adverse effect on our business, financial condition or results of operations.

 

Governmental Investigations

 

SEC Investigation.  On October 7, 2004, the staff of the SEC advised us that it had entered a formal order of investigation concerning the Company. The Company is cooperating with the investigation.

 

United States Attorney Investigation.  On February 24, 2005, the United States Attorney’s Office for the Southern District of New York advised us that it would seek to conduct interviews of certain current and former officers and employees of the Company. The Company is cooperating with the investigation.

 

Department of Labor Review.  On March 9, 2005, and March 21, 2005, the DOL informed the Company that it was commencing a “review” of the Krispy Kreme Doughnut Corporation Retirement Savings Plan and the Krispy Kreme Profit Sharing Stock Ownership Plan, respectively, to determine whether any violations of Title I of ERISA have occurred. The DOL investigation is ongoing and the DOL has not yet indicated whether it believes any violations of ERISA have occurred. The Company is cooperating with the DOL.

 

State Franchise/FTC Inquiry.  On June 15, 2005, the Commonwealth of Virginia, on behalf of itself, the FTC and eight other states, inquired into certain activities related to prior sales of franchises and the status of our financial statements and requested that we provide them with certain documents. The inquiry related to potential violations for failures to file certain amendments to franchise registrations and the failure to deliver accurate financial statements to prospective franchisees. Fourteen states (the “Registration States”) and the FTC regulate the sale of franchises. The Registration States specify forms of disclosure documents that must be provided to franchisees and filed with the state. In the non-registration states, according to FTC rules, documents must be provided to franchisees but are not filed. Earlier in 2005, we had chosen not to renew our disclosure document in the Registration States because we realized that our financial statements would need to be restated and because we had stopped selling domestic franchises. We are fully cooperating with the inquiry and have delivered the requested documents. Since June 15, 2005, Virginia has indicated that it and a majority of the remaining states would withdraw from the inquiry. We have not received any additional information from the FTC or any other state that one or more of them intend to pursue or abandon the inquiry.

 

Litigation

 

Federal Securities Class Actions and Settlement Thereof and Federal Court Shareholder Derivative Actions and Partial Settlement Thereof.  On May 12, 2004, a purported securities class action was filed on behalf of persons who purchased the Company’s publicly traded securities between August 21, 2003 and May 7, 2004 against the Company and certain of its current and former officers in the United States District Court for the Middle District of North Carolina. Plaintiff alleged that defendants violated Sections 10(b) and 20(a) of the Exchange Act and Rule 10b-5 promulgated thereunder in connection with various public statements made by the Company. Plaintiff sought damages in an unspecified amount. Thereafter, 14 substantially identical purported class actions were filed in the same court. On November 8, 2004, all of these cases were consolidated into one action. The court appointed lead plaintiffs in the consolidated action, who filed a second amended complaint on May 23, 2005, alleging claims under Sections 10(b) and 20(a) of the Exchange Act on behalf of persons who purchased the Company’s publicly-traded securities between March 8, 2001 and April 18, 2005. The Company filed a motion to dismiss the second amended complaint on October 14, 2005 that is currently pending.

Three shareholder derivative actions have been filed in the United States District Court for the Middle District of North Carolina: Wright v. Krispy Kreme Doughnuts, Inc., et al., filed September 14, 2004; Blackwell v. Krispy Kreme Doughnuts, Inc., et al., filed May 23, 2005; and Andrews v. Krispy Kreme Doughnuts, Inc., et al., filed May 24, 2005.

 

The defendants in one or more of these actions include all current and certain former directors of the Company (other than members of the Special Committee and Messrs. Brewster and Schindler), certain current and former officers of the Company, including Scott Livengood (the Company’s former Chairman and Chief Executive Officer), John Tate (the Company’s former Chief Operating Officer) and Randy Casstevens (the Company’s former Chief Financial Officer), and certain persons or entities that sold franchises to the Company. The complaints in these actions allege that the defendants breached their fiduciary duties in connection with their management of the Company and the Company’s acquisitions of certain franchises. The complaints sought damages, rescission of the franchise acquisitions, disgorgement of the proceeds from these acquisitions and other unspecified relief.

 

In orders dated November 5, 2004, November 24, 2004, April 4, 2005 and June 1, 2005, the court stayed the Wright action pending completion of the investigation of the Special Committee.

 

On June 3, 2005, the plaintiffs in the Wright, Blackwell and Andrews actions filed a motion to consolidate the three actions and to name lead plaintiffs in the consolidated action. On June 27, 2005, Trudy Nomm, who, like the plaintiffs in the Wright, Blackwell and Andrews actions, identified herself as a Krispy Kreme shareholder, filed a motion to intervene in these derivative actions and to be named lead plaintiff. On July 12, 2005, the court consolidated the Wright, Blackwell and Andrews shareholder derivative actions under the heading Wright v. Krispy Kreme Doughnuts, Inc., et al.  and ordered the plaintiffs to file a consolidated complaint on or before the later of 45 days after the plaintiffs receive the report of the Special Committee or 30 days after the court appoints lead counsel. A consolidated complaint has not yet been filed.

 

On August 10, 2005, the Company announced that the Special Committee had completed its investigation. The Special Committee concluded that it was in the best interest of the Company to reject the demands by shareholders that the Company commence litigation against the current and former directors and officers of the Company named in the derivative actions and to seek dismissal of the shareholder litigation against the outside directors, the sellers of certain franchises and current and former officers, except for Messrs. Livengood, Tate and Casstevens, as to whom the Special Committee concluded that it would not seek dismissal of the shareholder derivative litigation.

 

On October 21, 2005, the court granted Ms. Nomm’s motion to intervene. On October 28, 2005, the court appointed the plaintiffs in the Wright action, Judy Woodall and William Douglas Wright, as co-lead plaintiffs in the consolidated action.

 

On October 31, 2006, the Company and the Special Committee entered into a Stipulation and Settlement Agreement (the “Stipulation”) with the lead plaintiffs in the securities class action, the derivative plaintiffs and all defendants named in the class action and derivative litigation, except for Mr. Livengood, providing for the settlement of the securities class action and a partial settlement of the derivative action, on the terms described below.

 

With respect to the securities class action, the Stipulation provides for the certification of a class consisting of all persons who purchased the Company’s publicly-traded securities between March 8, 2001 and April 18, 2005, inclusive. The settlement class will receive total consideration of approximately $75 million, consisting of a cash payment of $34,967,000 to be made by the Company’s directors’ and officers’ insurers, a cash payment of $100,000 to be made by Mr. Tate, a cash payment of $100,000 to be made by Mr. Casstevens, a cash payment of $4,000,000 to be made by the Company’s independent registered public accounting firm and common stock and warrants to purchase common stock to be issued by the Company having an aggregate value of $35,833,000 (based on the current market price of the Company’s common stock). All claims against defendants will be dismissed with prejudice; however, claims that the Company may have against Mr. Livengood that may be asserted by the Company in the derivative action for contribution to the securities class action settlement or otherwise under applicable law are expressly preserved. The Stipulation contains no

admission of fault or wrongdoing by the Company or the other defendants. The settlement is subject to preliminary and final approval of the court.

 

With respect to the derivative litigation, the Stipulation provides for the settlement and dismissal with prejudice of all claims against defendants except for claims against Mr. Livengood. The Company, acting through its Special Committee, settled claims against Mr. Tate and Mr. Casstevens for the following consideration: Messrs. Tate and Casstevens each agreed to contribute $100,000 in cash to the settlement of the securities class action; Mr. Tate agreed to cancel his interest in 6,000 shares of the Company’s common stock; and Messrs. Tate and Casstevens agreed to limit their claims for indemnity from the Company in connection with future proceedings before the SEC or the United States Attorney for the Southern District of New York to specified amounts. The Company, acting through its Special Committee, has been in negotiations with Mr. Livengood but has not reached agreement to resolve the derivative claims against him and counsel for the derivative plaintiffs are deferring their application for fees until conclusion of the derivative actions against Mr. Livengood. All other claims against defendants named in the derivative actions will be dismissed with prejudice without paying any consideration, consistent with the findings and conclusions of the Special Committee in its report of August 2005.

 

The Company estimates that, based on the current market price of its common stock, it will issue approximately 1,875,000 shares of its common stock and warrants to purchase approximately 4,400,000 shares of its common stock in connection with the Stipulation. The exercise price of the warrants will be equal to 125% of the average of the closing prices of the Company’s common stock for the 10-day period surrounding the filing of this Annual Report on Form 10-K.

 

The Company has recorded a non-cash charge to earnings in fiscal 2006 of $35,833,000, representing the estimated fair value of the common stock and warrants to be issued by the Company. The Company has recorded a related receivable from its insurers in the amount of $34,967,000, as well as a liability in the amount of $70,800,000 representing the aggregate value of the securities to be issued by the Company and the cash to be paid by the insurers. The settlement is conditioned upon the Company’s insurers and the other contributors paying their share of the settlement. The provision for settlement costs will be adjusted to reflect changes in the fair value of the securities until they are issued following final court approval of the Stipulation, which the Company anticipates will occur in late calendar 2006 or early calendar 2007.

 

State Court Shareholder Derivative Actions.  Two shareholder derivative actions have been filed in the Superior Court of North Carolina, Forsyth County: Andrews v. Krispy Kreme Doughnuts, Inc., et al., filed November 12, 2004, and Lockwood v. Krispy Kreme Doughnuts, Inc., et al., filed January 21, 2005. On April 26, 2005, those actions were assigned to the North Carolina Business Court. On May 26, 2005, the plaintiffs in these actions voluntarily dismissed these actions in favor of a federal court action they filed on May 25, 2005 (the Andrews action discussed above).

 

State Court Books and Records Action.  On February 21, 2005, a lawsuit was filed against the Company in the Superior Court of North Carolina, Wake County, Nomm v. Krispy Kreme, Inc., seeking an order requiring the Company to permit the plaintiff to inspect and copy the books and records of the Company. On March 29, 2005, the action was transferred to the Superior Court of North Carolina for Forsyth County. On May 20, 2005, the case was assigned to the North Carolina Business Court. On June 27, 2005, plaintiff filed a motion to intervene and be named lead plaintiff in the federal court derivative actions described above. On August 2, 2005, the North Carolina Business Court stayed this action pending a decision on Ms. Nomm’s motion to intervene and to serve as lead plaintiff in the federal court actions. On October 21, 2005, the court in the federal court actions granted Ms. Nomm’s motion to intervene and, on October 28, 2005, denied Ms. Nomm’s motion to be named lead plaintiff.

 

ERISA Class Action.  On March 16, 2005, our wholly-owned subsidiary, KKDC, was served with a purported class action lawsuit filed in the United States District Court for the Middle District of North Carolina that asserted claims for breach of fiduciary duty under ERISA against KKDC and certain of its current and former officers and employees. Plaintiffs purported to represent a class of persons who were participants in or beneficiaries of KKDC’s retirement savings plan or profit sharing stock ownership plan between January 1, 2003 and the date of filing and whose accounts included investments in our common

stock. Plaintiffs contended that defendants failed to manage prudently and loyally the assets of the plans by continuing to offer our common stock as an investment option and to hold large percentages of the plans’ assets in our common stock; failed to provide complete and accurate information about the risks of our common stock; failed to monitor the performance of fiduciary appointees; and breached duties and responsibilities as co-fiduciaries. On May 15, 2006 we announced that a proposed settlement had been reached with respect to this matter. The settlement would include a one-time cash payment to be made to the settlement class by our insurer in the amount of $4,750,000. The Company and the individual defendants deny any and all wrongdoing and would pay no money in the settlement. Several contingent events must be satisfied before the settlement becomes final, including final approval by the United States District Court where the matter is pending. It is anticipated that if the United States District Court gives final approval to the proposed settlement, this matter will be resolved finally by the end of calendar 2007.

 

Franchisee Litigation.

 

Lone Star.  On May 19, 2005, KKDC was sued by one of our area developers, Lone Star Doughnuts, Ltd., in the District Court for Harris County, Texas. The trial court entered a temporary injunction requiring KKDC to continue shipments of supplies to Lone Star on normalized rather than cash-before-delivery terms, and referred the matter to the American Arbitration Association for arbitration in Winston-Salem, North Carolina. The issues between the parties included KKDC’s claims against Lone Star for past due amounts for royalties, the Brand Fund, and equipment and supplies furnished to Lone Star. Lone Star’s claims against KKDC included breach of contract, fraud, negligent misrepresentation, breach of warranties, and violation of North Carolina’s Unfair and Deceptive Trade Practices Act. On February 9, 2006, we reached an agreement with Lone Star to settle all outstanding disputes and claims, including the dismissal of this lawsuit. The settlement agreement includes a complete separation of the relationship between Lone Star Doughnuts, Ltd. and KKDC, the return of certain proprietary equipment and a de-identification of all former Krispy Kreme locations.

 

Sweet Traditions.  On July 19, 2005, KKDC was sued by one of our area developers, Sweet Traditions, LLC, and its Illinois corporate entity Sweet Traditions of Illinois, LLC, in the Circuit Court for St. Clair County, Illinois seeking specific performance, declaratory judgment and injunctive relief, as well as moving for a temporary restraining order and preliminary injunction. Sweet Traditions sought to compel KKDC to continue to supply product to its franchisee stores without payment. On July 22, 2005, the case was removed to the United States District Court for the Southern District of Illinois. On July 27, 2005, the District Court entered an order denying Plaintiffs’ Motion for Preliminary Injunction on the basis that their claims had no reasonable likelihood of success on the merits. A settlement was reached between the parties and on August 25, 2006 a joint stipulation for dismissal of the litigation with prejudice was filed with the court. The court dismissed the case on August 28, 2006.

 

Great Circle.  On September 29, 2005, KKDI, KKDC, certain former officers and directors of KKDI and KKDC and various other defendants were sued in California Superior Court for Los Angeles County, by Richard Reinis and Roger E. Glickman. Messrs. Reinis and Glickman are the principals and managing members of the Company’s Southern California developer and franchisee, Great Circle Family Foods, LLC, and the guarantors of Great Circle’s monetary obligations to KKDC. The complaint, which sought unspecified damages and injunctive relief, purported to assert various claims on behalf of Great Circle, as well as certain individual claims by the plaintiffs that arose out of and related to Great Circle’s franchise relationship with the Company. On July 28, 2006, KKDI and KKDC announced that they reached agreements with Great Circle on an integrated transaction involving the settlement of all pending litigation between the parties and the court dismissed the case on August 31, 2006. As part of the transaction, which closed on August 31, 2006, Southern Doughnuts, LLC, a wholly owned subsidiary of KKDC, acquired three of Great Circle’s stores located in Burbank, Ontario and Orange, California, together with the related franchise rights. Southern Doughnuts paid Great Circle $2.9 million for the acquired stores and related assets. Pursuant to the agreements, Great Circle has the right to repurchase the three stores and related assets from the Company for $2.9 million plus interest at 8% per annum to the date of repurchase. Such repurchase right terminates under certain conditions, but in

no event later than May 29, 2007. Under the agreements, Krispy Kreme, Great Circle and related parties exchanged mutual releases and dismissals regarding the pending litigation.

 

In addition, on or about April 14, 2006, Great Circle initiated an arbitration before the American Arbitration Association (“AAA”) against KKDI, KKDC and various other respondents, seeking in excess of $20 million in alleged damages, contract rescission, indemnification, injunctive and declaratory relief, and other relief. The claims asserted in the arbitration demand arise out of and relate to Great Circle’s franchise relationship with the Company and largely mirror the claims asserted by Messrs. Reinis and Glickman in the litigation described above. On June 7, 2006, Krispy Kreme and certain co-defendants filed their response to the demand. Also on that date, Krispy Kreme filed a counterclaim/cross-claim against Great Circle and Messrs. Reinis and Glickman, asserting thirteen causes of action relating to breaches of Great Circle’s development agreement and franchise agreements with Krispy Kreme. A settlement agreement was reached between the parties and on August 31, 2006 the parties jointly requested that the AAA dismiss the arbitration with prejudice.

 

KremeKo.  On January 11, 2006, KKDI, KKDC, two of their former officers and PricewaterhouseCoopers LLP were sued in California Superior Court for Los Angeles County by Robert C. Fisher. Mr. Fisher is a shareholder of KKDC’s former Canadian developer and franchisee, KremeKo, Inc., and a guarantor of KremeKo’s monetary obligations to KKDC. The complaint purports to assert claims for fraud, constructive fraud, breach of fiduciary duty, rescission, negligent misrepresentation and declaratory relief and seeks unspecified damages based on defendants’ alleged misstatements regarding KKDI’s operations and financial performance and KKDC’s acquisition of KremeKo. On June 30, 2006, the parties entered into a settlement agreement which settled all claims in this matter. The settlement amounts involved were not material.

 

No matters were submitted to a vote of security holders during the fourth quarter of fiscal 2006.

 

Market Information

 

Our common stock is listed on the NYSE under the symbol “KKD.” The following table sets forth the high and low sales prices for our common stock as reported by the NYSE for the fiscal periods shown.

 

 

Holders

 

As of September 29, 2006, there were 14,076 shareholders of record of our common stock.

 

Dividends

 

We did not pay any dividends in fiscal 2004, 2005 or 2006 or the first half of fiscal 2007. We intend to retain any earnings to finance our business and do not anticipate paying cash dividends in the foreseeable future. Furthermore, the terms of our senior secured credit facilities prohibit the payment of dividends on our common stock.

 

Securities Authorized for Issuance Under Equity Compensation Plans

 

The information required by Item 201(d) of Regulation S-K is provided under Item 12, “Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters,” which is incorporated herein by reference.

 

Recent Sales of Unregistered Securities

 

On July 31, 2005, Krispy Kreme and KZC agreed to the terms of the success fee under the Services Agreement, described below in Item 11, “Execution Compensation — Employment Contracts and Termination of Employment and Change-In-Control Arrangements — KZC Services Agreement,” pursuant to which KZC provided management services to the Company. The success fee is in the form of a warrant issued to KZC. The warrant entitles KZC to purchase 1,200,000 shares of the Company’s common stock at a cash exercise price of $7.75 per share. The number of shares issuable upon exercise and the exercise price are subject to adjustment pursuant to customary anti-dilution adjustment provisions. The warrant, which is currently exercisable, expires on January 31, 2013. The warrant is not transferable except to certain related persons. Shares issuable upon exercise of the warrant will be subject to customary demand and piggyback registration rights. The warrant was issued under a transaction exempted under Section 4(2) of the Securities Act of 1933, (the “Securities Act”) as a transaction by an issuer not involving a public offering.

 

Purchases of Equity Securities

 

No purchases were made by or on behalf of the Company of its equity securities in fiscal 2005 or fiscal 2006.

 

The following selected financial data should be read in conjunction with Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and the Company’s consolidated financial statements appearing elsewhere herein. Fiscal 2002 contained 53 weeks.

 

 

 

 

The following discussion of the Company’s financial condition and results of operations should be read together with the consolidated financial statements and notes thereto appearing elsewhere herein.

 

During fiscal 2005, the Company experienced first a slowing in the rate of growth in sales in its Company Stores segment and, later in the year, declines in sales compared to the comparable periods of fiscal 2004. These sales declines continued in fiscal 2006. Systemwide and Company average weekly sales per factory store (which includes sales through satellites) decreased approximately 14.0% and 19.7%, respectively, in fiscal 2005 compared to fiscal 2004 and decreased approximately 15.4% and 16.7%, respectively, in fiscal 2006 compared to fiscal 2005. The lower Company average weekly sales per factory store had a disproportionately higher adverse impact on Company Store profitability due to the significant fixed or semi-fixed costs inherent in operating the Company’s stores. In response to the declining sales, the Company closed 14 factory stores in fiscal 2005 and 47 stores in fiscal 2006. Lower sales in stores operated by franchisees resulted in reduced sales of mixes, icings and fillings, sugar, shortening, coffee and supplies by KKM&D, and resulted in lower royalty revenues in the Franchise segment. Certain franchisees have experienced financial difficulties and, as a result, the Company recorded bad debt provisions of approximately $10.8 million in fiscal 2005 and $5.2 million in fiscal 2006 related to its receivables from franchisees. The Company also recorded impairment charges and lease termination costs in income from continuing operations of $161.8 million in fiscal 2005 and $55.1 million in fiscal 2006. The Company was also significantly affected by the substantial costs associated with the legal and regulatory matters discussed in Item 1, “Business,” and Item 3, “Legal Proceedings,” of this Annual Report on Form 10-K.

 

Company Overview and Industry Outlook

 

The Company’s principal business, which began in 1937, is owning and franchising Krispy Kreme doughnut stores which make and sell over 20 varieties of high-quality doughnuts, including the Company’s Hot Original Glazed^tm. Each of the Company’s traditional factory stores has a doughnut-making production line and the capacity to produce from 4,000 dozen to over 10,000 dozen doughnuts daily. Consequently, each factory store has significant fixed or semi-fixed costs, and margins and profitability are significantly affected by doughnut production volume and sales. Factory stores are versatile in that most can support multiple sales channels to more fully utilize production capacity. These sales channels are comprised of:

 

 

The Company is vertically integrated to help maintain the consistency and quality of products throughout the Krispy Kreme system. In addition, through vertical integration, the Company utilizes volume-buying power, which the Company believes helps lower the cost of supplies to stores and enhances profitability. The Krispy Kreme Manufacturing and Distribution business unit, KKM&D, produces doughnut mixes and coffee and manufactures doughnut-making equipment, which all factory stores are required to purchase. Additionally, this business unit operates three distribution centers that are capable of supplying domestic stores and certain international stores with key supplies. This business unit is volume-driven, and its economics are enhanced by the opening of new stores and the growth of sales by existing stores.

 

One of the Company’s focus areas has been improving its beverage program to complement the Company’s doughnut offerings. The Company has implemented in the majority of its stores a complete

beverage program, including drip coffees, a complete line of espresso-based coffees including flavors and both coffee-based and noncoffee-based frozen drinks.

 

The Company’s stores include factory stores and satellite stores. Traditional factory stores have the capacity to produce from 4,000 dozen to over 10,000 dozen doughnuts daily. Commissaries, which are production facilities used principally to serve off-premises customers domestically and to supplement factory stores focused on on-premises sales internationally, have the highest production capacities of factory stores. As of January 29, 2006, there were 11 commissaries systemwide, five of which were operated by the Company. Other factory stores often engage in both on-premises and off-premises sales, with the allocation between such channels dependent on the particular capacity of the store. The Company has begun introducing internationally, and on a test basis domestically, a store concept that will utilize doughnut-making technology scaled to accommodate principally on-premises sales in a store approximately one-half the size of a traditional factory store.

 

Satellite stores consist primarily of the fresh shop, kiosk and tunnel oven store formats. Tunnel oven stores contain doughnut heating technology that allows customers to have a hot doughnut experience throughout the day. Fresh shops and free-standing kiosks are locations that do not contain doughnut heating technology. In each of these formats, the Company typically sells fresh doughnuts, beverages and Krispy Kreme collectibles, with the doughnuts supplied by nearby factory stores. Each of these formats requires less space than a traditional factory store. The Company began tests of the fresh shop concept during fiscal 2004 and tests of the tunnel oven store and kiosk formats in fiscal 2005. As of January 29, 2006, 33 fresh shops, 33 tunnel oven stores and 10 kiosks were open. The Company views the fresh shop, tunnel oven store and kiosk formats as additional ways to achieve market penetration in a variety of market sizes and settings.

 

As of January 29, 2006, there were 323 Krispy Kreme factory stores, consisting of 128 company stores (including 15 owned by Glazed Investments, a consolidated franchisee until February 2006), 148 Area Developer franchise stores (including 49 owned by franchisees in which the Company had a minority equity interest) and 47 Associate franchise stores. The Company is working to stabilize its operations and to refine its store format for new domestic factory stores, and does not expect that the Company or its franchisees will open a significant number of domestic stores in the near future. It is likely that the Company will close some additional domestic factory stores.

 

The Company is hiring personnel to assist in the development of international markets. As of January 29, 2006, there were a total of 68 Krispy Kreme stores operated internationally, located in Australia, Canada, Mexico, South Korea and the United Kingdom. As of January 29, 2006, the Company owned six stores in Canada and had an equity interest in the franchisees operating the stores in Mexico and the United Kingdom and one store in Canada. The Company currently does not expect to own equity interests in any international area developers formed in the future. Based on continued research and experience with international stores, the Company is focusing international development efforts primarily on opportunities in potential markets in Asia, the Middle East and Western Europe. Subsequent to January 29, 2006, the Company signed agreements awarding development rights to franchisees in the Middle East, Hong Kong, Macau, Tokyo, the Philippines and Indonesia. The development and franchise agreements for these territories provide for the development of approximately 200 stores over the next five years.

 

As the Company expands its business, management expects to incur infrastructure costs in the form of additional personnel to support the expansion and additional facilities costs to provide mixes, equipment and other items necessary to operate new stores. In the course of building this infrastructure, the Company may incur unplanned costs which could negatively impact the Company’s operating results.

 

The domestic doughnut market is comprised of several sales channels including retail, grocery store packaged, in-store bakeries within grocery stores, convenience stores, business and institutional, fundraising and vending. Comprehensive, reliable doughnut industry statistics are not readily available; however, with regard to specific sales channels within the industry, data is available. Information Resources, Inc. data indicate that, during calendar 2005, packaged and in-store bakery doughnut sales through domestic grocery stores decreased and through domestic convenience stores increased.

The Company has three reportable segments as defined in Statement of Financial Accounting Standards No. 131, “Disclosures about Segments of an Enterprise and Related Information,” as described below.

 

 

Results of Operations

 

The following table presents the Company’s operating results for fiscal 2006, 2005 and 2004 expressed as a percentage of total revenues (amounts may not add to totals due to rounding).

 

To facilitate an understanding of the Company’s operating results, data on the number of factory stores appears in the table below. The factory store counts include commissaries but exclude satellite stores. Transferred stores represent stores sold between the Company and franchisees and, in fiscal 2005, stores operated by New England Dough and KremeKo, the financial statements of each of which were consolidated with those of the Company effective May 2, 2004 (the end of the first quarter of fiscal 2005).

 

 

 

 

Company factory stores include factory stores operated by consolidated franchisees. As of January 29, 2006, the only consolidated franchisee was Glazed Investments, which operated 15 factory stores. Glazed Investments filed for bankruptcy protection subsequent to fiscal 2006, and the Company thereafter ceased consolidation of Glazed Investments’ financial statements.

The table below presents average weekly sales per factory store (which represents, on a company and systemwide basis, total sales of all stores divided by the number of operating weeks for factory stores) and average weekly sales per store (which represents, on a company or systemwide basis, total sales of all stores divided by the number of operating weeks for both factory stores and satellites). Operating weeks represents the aggregate number of weeks in the fiscal year that factory stores or systemwide stores were in operation.

 

Systemwide sales, a non-GAAP financial measure, include the sales by both Company and franchise stores. The Company believes systemwide sales data is useful in assessing the overall performance of the Krispy Kreme brand and, ultimately, the performance of the Company. The Company’s consolidated financial statements appearing elsewhere herein include sales by Company Stores, including the sales by consolidated franchisees’ stores, sales to non-consolidated franchisees by the KKM&D business segment, and royalties and fees received from franchisees, but exclude the sales by franchise stores to their customers.

 

 

 

 

FISCAL 2006 COMPARED TO FISCAL 2005

 

Overview

 

Systemwide sales for fiscal 2006 decreased 16.6% compared to fiscal 2005, reflecting an 18.0% decrease in average weekly sales per store, slightly offset by a 1.7% increase in store operating weeks. The systemwide sales decrease reflects a 21.6% decrease in Company Stores sales and a 12.6% decrease in franchise store sales. During fiscal 2006, three new company factory stores and 13 new franchise factory stores were opened and 47 company factory stores and 42 franchise factory stores were closed, for a net decrease of 73 factory stores. As a result, the total number of factory stores at the end of fiscal 2006 was 323, consisting of 128 company stores (including 15 owned by Glazed Investments), 148 Area Developer franchise stores (including 49 owned by franchisees in which the Company has a minority equity interest) and 47 Associate franchise stores.

 

Total revenues decreased 23.2% to $543.4 million in fiscal 2006 from $707.8 million in fiscal 2005. This decrease was comprised of a 21.6% decrease in Company Stores revenues to $398.5 million, a 25.6% decrease in Franchise revenues to $18.4 million and a 27.7% decrease in KKM&D revenues to $126.5 million.

Revenues

 

Revenues by business segment (expressed in dollars and as a percentage of total revenues) are set forth in the table below. KKM&D revenues exclude intersegment sales eliminated in consolidation.

 

 

Company Stores Revenues.  Company Stores revenues decreased 21.6% to $398.5 million in fiscal 2006 from $508.1 million in fiscal 2005. The decrease in revenues reflects a 13.4% decrease in average weekly sales per store and a 9.2% decrease in store operating weeks. The decrease in average weekly sales per store is attributable principally to lower volumes, and reflects relatively greater weakness in sales through off-premises sales channels than in on-premises sales. Off-premises sales were affected by price reductions on certain products. The number of operating weeks declined due to the closure of relatively poorly performing locations.

 

Franchise Revenues.  Franchise revenues, consisting principally of franchise fees and royalties, decreased 25.6% to $18.4 million in fiscal 2006 from $24.7 million in fiscal 2005. The decline in franchise revenues reflects a decrease in royalty revenues resulting from lower sales by franchises in fiscal 2006 compared to fiscal 2005 and, to a lesser extent, reduced initial franchise fees due to fewer store openings in fiscal 2006 compared to the prior year. In addition, the Company did not recognize as revenue approximately $3.7 million of uncollected royalties which accrued during fiscal 2006 because the Company did not believe collection of these royalties was reasonably assured. Sales by franchise stores, as reported by the franchisees, were approximately $490.5 million in fiscal 2006 compared to approximately $561.3 million in fiscal 2005.

 

KKM&D Revenues.  KKM&D sales to franchise stores decreased 27.7% to $126.5 million in fiscal 2006 from $174.9 million in fiscal 2005. Lower sales at franchise stores resulted in decreased sales of mixes, icings and fillings, sugar, shortening, coffee and supplies by KKM&D. In addition, reduced store expansion by franchisees in fiscal 2006 compared to the prior year resulted in lower equipment sales. Franchisees opened 13 new factory stores in fiscal 2006 compared to 36 in fiscal 2005.

 

Direct Operating Expenses

 

Direct operating expenses, which exclude depreciation and amortization expense, were 87.3% of revenues in fiscal 2006 compared to 84.5% of revenues in fiscal 2005. Direct operating expenses by business segment (expressed in dollars and as a percentage of applicable segment revenues) are set forth in the table below. The estimated profit earned by the KKM&D segment on sales to the Company Stores segment has been deducted from Company Stores direct operating expenses in the table below to illustrate the effects of the Company’s vertical integration on the overall profit earned on Company Stores revenues. However, the profit earned by KKM&D on sales to Company Stores is included in KKM&D operating income in the segment information in Note 17 to the consolidated financial statements appearing elsewhere herein.

 

 

Company Stores Direct Operating Expenses.  Company Stores direct operating expenses as a percentage of Company Stores revenues increased to 90.7% in fiscal 2006 from 88.3% in fiscal 2005, due primarily to operating inefficiencies generated by lower average weekly sales per store.

 

Franchise Direct Operating Expenses.  Franchise direct operating expenses include costs to recruit new franchisees, costs to open, monitor and aid in the performance of franchise stores and direct general and administrative expenses. Franchise direct operating expenses as a percentage of Franchise revenues decreased to 27.3% in fiscal 2006 from 32.4% in fiscal 2005, primarily due to reduced provisions for uncollectible receivables and a reduction in corporate cost allocations arising from cost reductions in certain categories which are allocated, in part, to the franchise segment.

 

KKM&D Direct Operating Expenses.  KKM&D direct operating expenses as a percentage of KKM&D revenues were 85.6% in fiscal 2006 compared with 80.9% in fiscal 2005. KKM&D direct operating expenses include bad debt provisions related to certain franchisee receivables of approximately $4.8 million in fiscal 2006 and approximately $10.0 million in fiscal 2005. KKM&D direct operating expenses as a percentage of revenues increased principally due to the effects of fixed or semi-fixed operating costs on a reduced revenue base.

 

General and Administrative Expenses

 

General and administrative expenses were $67.7 million, or 12.5% of total revenues, in fiscal 2006 compared to $55.3 million, or 7.8% of total revenues, in fiscal 2005. General and administrative expenses include fees paid to the interim management firm engaged by the Company in January 2005 and professional fees related to the internal and external investigations and litigation described in Notes 2 and 12 to the consolidated financial statements appearing elsewhere herein, totaling approximately $31.8 million (net of estimated insurance recoveries of approximately $14.4 million) in fiscal 2006 and approximately $8.8 million (net of estimated insurance recoveries of approximately $3.4 million) in fiscal 2005. In addition, general and administrative expenses in fiscal 2006 include approximately $4.0 million of out-of-period costs related to stock-based compensation. The Company erroneously failed to record these costs in prior years, but concluded that such error was not material to the consolidated financial statements of the affected periods or to the fiscal 2006 consolidated financial statements. Accordingly, the Company recorded the costs in fiscal 2006 rather than restating prior periods’ financial statements, as more fully described in Note 1 to the consolidated financial statements appearing elsewhere herein. Exclusive of these costs, general and administrative expenses were approximately 5.9% of total revenues in fiscal 2006 and 6.6% of total revenues in fiscal 2005. Among the more significant reductions in general and administrative expenses in fiscal 2006 compared to the preceding year were reductions of approximately $1.8 million in executive compensation, benefits and travel, and approximately $3.5 million in the cost of corporate aircraft.

Depreciation and Amortization Expense

 

Depreciation and amortization expense decreased to $28.9 million, or 5.3% of total revenues, in fiscal 2006 from $31.9 million, or 4.5% of total revenues, in fiscal 2005. The decrease in depreciation and amortization expense relates almost entirely to the Company Stores segment, in which depreciation and amortization expense declined principally due to store closures. Depreciation and amortization expense as a percentage of total revenues rose primarily because revenues declined disproportionately to the decline in the number of stores in operation in fiscal 2006 compared to fiscal 2005.

 

Impairment Charges and Lease Termination Costs

 

Impairment and lease termination costs were $55.1 million in fiscal 2006 compared to $161.8 million in fiscal 2005, including $3.5 million and $131.6 million, respectively, of goodwill impairment charges. The goodwill impairment charges reflect reductions in the Company’s forecasted sales and earnings in the reporting units comprising the Company Stores segment. The fair values of those reporting units are estimated using the present value of expected future cash flows. The decline in goodwill impairment charges was partially offset by an increase in impairment charges related principally to long-lived assets, which rose to $49.7 million in fiscal 2006 from $26.0 million in fiscal 2005, principally due to an increased number of store closing and other disposal decisions in fiscal 2006 compared to fiscal 2005.

 

Settlement of Litigation

 

On October 31, 2006, the Company agreed to settle a federal securities class action and to settle, in part, certain shareholder derivative actions, as more fully described in Item 3, “Legal Proceedings,” and Note 12 to the consolidated financial statements appearing elsewhere herein. As part of the settlement, the Company agreed to issue to the plaintiffs an estimated 1,875,000 shares of the Company’s common stock and warrants to acquire an estimated 4,400,000 shares of common stock. The Company has charged a provision for the settlement of $35.8 million against fiscal 2006 earnings, representing the estimated fair value of the common stock and warrants to be issued by the Company. The provision for settlement costs will be adjusted to reflect changes in the fair value of the securities until they are issued following final court approval of the settlement, which the Company anticipates will occur in late calendar 2006 or early calendar 2007.

 

Interest Income

 

Interest income was $1.1 million in fiscal 2006 compared to $775,000 in fiscal 2005. The increase principally reflects higher interest rates earned on invested balances in fiscal 2006 compared to fiscal 2005.

 

Interest Expense

 

Interest expense increased to $20.2 million in fiscal 2006 from $6.9 million in fiscal 2005. The aggregate costs, including interest, fees and amortization of deferred debt issuance costs, associated with the Company’s primary credit facilities (the Secured Credit Facilities and, prior to April 1, 2005, a bank credit facility which was retired using proceeds of the Secured Credit Facilities) increased approximately $12.2 million in fiscal 2006 compared to fiscal 2005. Of the $12.2 million increase, approximately $11.0 million reflects higher outstanding debt balances, interest rates, lender margin and transaction costs in fiscal 2006 compared to fiscal 2005; the remainder of the increase consists principally of one-time fees and expenses associated with the bank credit facility prior to its retirement using proceeds of the Secured Credit Facility. In addition, interest expense in fiscal 2006 includes the write-off of approximately $840,000 of unamortized financing costs associated with the retired bank financing and approximately $640,000 charged to earnings upon termination of an interest rate hedge related to the retired bank financing. Interest expense associated with Consolidated Franchisees declined approximately $560,000 in fiscal 2006 compared to fiscal 2005, primarily due to the deconsolidation of KremeKo. Fiscal 2006 included approximately four months of KremeKo’s results of operations, while fiscal 2005 included nine months of KremeKo’s results.

Equity in Losses of Equity Method Franchisees

 

The Company’s share of the losses incurred by equity method franchisees totaled $4.3 million in fiscal 2006 compared to $1.6 million in fiscal 2005. This caption represents the Company’s share of operating results of unconsolidated franchisees which develop and operate Krispy Kreme stores. The largest component of the fiscal 2006 losses is approximately $2.4 million of losses related to KremeKo. The fiscal 2005 losses include approximately $2.1 million of losses related to franchisees in the United Kingdom and Australia, approximately $400,000 of losses related to KremeKo, and approximately $700,000 of income related to KK South Florida which did not recur in fiscal 2006 because of declining financial performance at the franchisee.

 

Minority Interests in Results of Consolidated Franchisees

 

The minority interest in the results of operations of consolidated franchisees represents the portion of the income or loss of consolidated franchisees allocable to other investors’ interest in those franchisees. In fiscal 2006, minority investors absorbed a total of $4.2 million of losses incurred by consolidated franchisees, consisting of approximately $3.7 million related to New England Dough and approximately $500,000 related to Glazed Investments; the interests of minority investors in KremeKo and Freedom Rings had been reduced to zero in fiscal 2005 and, accordingly, no portion of these entities’ losses was absorbed by minority interests in fiscal 2006. In fiscal 2005, minority investors shared in $6.2 million of aggregate net losses incurred by consolidated franchisees, the substantial majority of which related to KremeKo.

 

Provision for Income Taxes

 

The provision for income taxes on continuing operations was a benefit of $776,000 in fiscal 2006. The provision includes adjustments to the valuation allowance for deferred income tax assets to maintain such allowance at an amount sufficient to reduce the Company’s aggregate net deferred income tax assets to zero, as well as a provision for taxes estimated to be payable currently. Since the third quarter of fiscal 2005, the valuation allowance has been maintained in an amount sufficient to reduce the Company’s net deferred income tax asset to zero because management is unable to conclude, in light of the cumulative losses realized by the Company, that realization of the net deferred income tax asset is more likely than not. The provision for income taxes for fiscal 2006 also includes an out-of-period credit of approximately $1.5 million. This credit corrects an overstatement of the valuation allowance for deferred income tax assets recorded by a charge to earnings in fiscal 2005. The Company concluded that this error was not material to the consolidated financial statements of the affected periods or to the fiscal 2006 consolidated financial statements. Accordingly, the Company recorded the credit in fiscal 2006 rather than restating prior periods’ financial statements, as more fully described in Note 1 to the consolidated financial statements appearing elsewhere herein.

 

The provision for income taxes on continuing operations was approximately $9.7 million in fiscal 2005. The provision includes a valuation allowance of $7.9 million, equal to the Company’s net deferred income tax assets related to continuing operations as of the beginning of fiscal 2005, as well as taxes estimated to be payable currently. The significant losses incurred by the Company caused the Company to be unable to conclude, as of the end of the third quarter of fiscal 2005, that realization of the Company’s net deferred income tax assets was more likely than not, and the Company established an allowance against deferred income tax assets equal to the amount of the deferred income tax assets, net of deferred income tax liabilities.

 

Income (Loss) From Continuing Operations

 

The Company incurred a loss from continuing operations of $135.8 million in fiscal 2006, compared to a loss from continuing operations of $157.1 million in fiscal 2005.

 

FISCAL 2005 COMPARED TO FISCAL 2004

 

Overview

 

Systemwide sales for fiscal 2005 increased 8.5% compared to fiscal 2004. This increase was primarily attributable to a 10.9% increase in systemwide factory stores to 396 at the end of fiscal 2005 from 357 at the

end of fiscal 2004 and the full year impact of factory stores opened in fiscal 2004. The systemwide sales increase reflects a 15.0% increase in Company Store sales and a 3.3% increase in franchise store sales. During fiscal 2005, 24 new company factory stores and 36 new franchise factory stores were opened and 14 company factory stores and seven franchise factory stores were closed, for a net increase of 39 factory stores. Additionally, 24 Area Developer franchise stores became company stores as a result of the consolidation of KremeKo and New England Dough pursuant to FIN 46(R) as explained more fully in Note 1 to the consolidated financial statements appearing elsewhere herein. As a result, the total number of factory stores at the end of fiscal 2005 was 396, consisting of 175 company stores (including 51 which are owned by consolidated franchisees), 167 Area Developer franchise stores (including 60 owned by franchisees in which the Company has an equity interest) and 54 Associate franchise stores.

 

Total revenues increased 9.0% to $707.8 million in fiscal 2005 from $649.3 million in fiscal 2004. This increase was comprised of a 15.0% increase in Company Stores revenues to $508.1 million and a 5.2% increase in Franchise revenues to $24.7 million partially offset by a 5.0% decrease in KKM&D revenues to $174.9 million.

 

Revenues

 

Revenues by business segment (expressed in dollars and as a percentage of total revenues) are set forth in the table below. KKM&D revenues exclude intersegment sales eliminated in consolidation.

 

 

Company Stores Revenues.  Company Stores revenues increased 15.0% to $508.1 million in fiscal 2005 from $441.7 million in fiscal 2004. The revenue growth was primarily due to the consolidation of KremeKo and New England Dough pursuant to adoption of FIN 46(R) and the full year impact of sales related to the stores acquired in fiscal 2004 from franchisees in the Texas, Louisiana and Michigan markets. Revenues also increased principally as a result of the net opening of 10 new company factory stores (24 openings less 14 closures) during fiscal 2005 as well as the full year impact of sales related to factory stores opened during fiscal 2004, offset by lower average weekly sales per factory store at existing stores. Within the off-premises sales channel, the Company served a greater number of wholesale customers’ locations, but sales per customer location declined. On-premises sales increased due to the higher number of factory stores in fiscal 2005 compared to fiscal 2004, offset by lower average weekly sales per factory store.

 

Franchise Revenues.  Franchise revenues, consisting of franchise fees and royalties, increased 5.2% to $24.7 million in fiscal 2005 from $23.5 million in fiscal 2004. The growth in revenue was primarily due to the franchise fees and royalties associated with 36 new franchise factory stores opened in fiscal 2005 and royalties associated with the full year impact of the 58 new franchise stores opened in fiscal 2004, partially offset by the impact of seven franchise factory store closings, the transfer of 24 factory stores from Franchise to Company Stores as a result of the adoption of FIN 46(R) and lower average weekly sales per store in fiscal

2005. Sales of franchised stores, as reported by our franchisees, were $561.3 million in fiscal 2005 and $543.2 million in fiscal 2004.

 

KKM&D Revenues.  KKM&D sales to franchise stores decreased 5.0% to $174.9 million in fiscal 2005 from $184.1 million in fiscal 2004. The primary reason for the decrease in revenues was the opening of fewer franchise factory stores in fiscal 2005 versus fiscal 2004, which resulted in lower equipment sales. In fiscal 2005, franchisees opened 36 new factory stores compared to 58 in fiscal 2004. Lower sales per franchise store, principally through the on-premises sales channel, also resulted in decreased revenues for KKM&D from sales of mixes, sugar, shortening, coffee and other supplies.

 

Direct Operating Expenses

 

Direct operating expenses, which exclude depreciation and amortization expense, were 84.5% of revenues in fiscal 2005 compared to 76.0% of revenues in fiscal 2004. Direct operating expenses by business segment (expressed in dollars and as a percentage of applicable segment revenues) are set forth in the table below. The estimated profit earned by the KKM&D segment on sales to the Company Stores segment has been deducted from Company Stores direct operating expenses in the table below to illustrate the effects of the Company’s vertical integration on the overall profit earned on Company Stores revenues. However, the profit earned by KKM&D on sales to Company Stores is included in KKM&D operating income in the segment information which appears in Note 17 to the consolidated financial statements appearing elsewhere herein.

 

 

Company Stores Direct Operating Expenses.  Company Stores direct operating expenses as a percentage of Company Stores revenues increased to 88.3% in fiscal 2005 from 80.5% in fiscal 2004, due primarily to operating inefficiencies generated by lower average weekly sales per store, as well as the consolidation of KremeKo and New England Dough, which generated lower margins than the Company’s other operations.

 

Franchise Direct Operating Expenses.  Franchise direct operating expenses include costs to recruit new franchisees, costs to open, monitor and aid in the performance of franchise stores and direct general and administrative expenses. Franchise direct operating expenses as a percentage of Franchise revenues increased to 32.4% in fiscal 2005 from 19.7% in fiscal 2004, primarily due to increased employee-related and other corporate expenses allocated to the segment in fiscal 2005.

 

KKM&D Direct Operating Expenses.  KKM&D direct operating expenses as a percentage of KKM&D revenues were 80.9% in fiscal 2005 compared with 72.4% in fiscal 2004. The increase in KKM&D direct operating expenses as a percentage of revenues reflects approximately $10.0 million of bad debt provisions related to certain franchisee receivables recorded in fiscal 2005 (of which approximately $7.7 million was recorded in the fourth quarter), as well as the effects of the fixed or semi-fixed nature of many operating costs on a reduced revenue base.

General and Administrative Expenses

 

General and administrative expenses increased to $55.3 million, or 7.8% of total revenues, in fiscal 2005 from $45.2 million, or 7.0% of total revenues, in fiscal 2004. General and administrative expenses in fiscal 2005 include professional fees related to the internal and external investigations and litigation described in Notes 2 and 12 to the consolidated financial statements appearing elsewhere herein, totaling approximately $8.8 million (net of estimated insurance recoveries of approximately $3.4 million). Exclusive of these charges, general and administrative expenses for fiscal 2005 were 6.6% of revenues in fiscal 2005. The fiscal 2004 amount includes $4.4 million of compensation paid to former owners of acquired franchises in the fourth quarter related to those former owners’ employment with the Company, and $1.9 million of expense recorded in the fourth quarter related to payments to another former owner of an acquired franchise. Exclusive of these charges, general and administrative expenses for fiscal 2004 were 6.0% of total revenues.

 

Depreciation and Amortization Expense

 

Depreciation and amortization expense increased to $31.9 million, or 4.5% of total revenues, in fiscal 2005 from $22.3 million, or 3.4% of total revenues, in fiscal 2004. The growth in depreciation and amortization expense is due primarily to depreciation expense associated with increased capital asset additions, primarily related to the opening of new company stores, including those opened by consolidated franchisees. The increase also was attributable to the full year effect of stores acquired from area developer and associate franchisees in fiscal 2004 and the consolidation of KremeKo and New England Dough pursuant to FIN 46(R) beginning May 2, 2004.

 

Impairment Charges and Lease Termination Costs

 

As discussed further in Notes 1 and 13 to the consolidated financial statements, the Company recorded impairment charges and lease termination costs of $161.8 million in fiscal 2005. The fiscal 2005 charges included the impairment of goodwill of $131.6 million. In fiscal 2005, the Company also incurred asset impairment and lease termination costs primarily related to the closure of 14 factory stores and 11 satellites during the year.

 

Settlement of Litigation

 

As discussed further in Note 12 to the consolidated financial statements appearing elsewhere herein, in fiscal 2003 the Company recorded a charge of $9.1 million as a result of an arbitration panel’s ruling against the Company in a lawsuit. The Company settled the award for $8.6 million and reversed the remaining $525,000 accrual in the first quarter of fiscal 2004.

 

Interest Income

 

Interest income was $775,000 in fiscal 2005 compared with $906,000 in fiscal 2004. This decrease results from generally lower average invested balances and a reduction in rates of interest earned on excess cash invested during fiscal 2005.

 

Interest Expense

 

Interest expense increased to $6.9 million in fiscal 2005 from $4.5 million in fiscal 2004. This increase was primarily attributable to higher average debt balances during fiscal 2005, partially offset by lower average rates.

 

Equity in Losses of Equity Method Franchisees

 

Equity in losses of equity method franchisees decreased to $1.6 million in fiscal 2005 from $2.2 million in fiscal 2004. This item represents the Company’s share of operating results associated with investments in unconsolidated franchisees which develop and operate Krispy Kreme stores. This decrease was primarily attributable to the consolidation of KremeKo effective as of the end of the first quarter of fiscal 2005. At January 30, 2005, there were 60 factory stores operated by equity method franchisees, compared to 66 factory stores at February 1, 2004.

Minority Interests in Results of Consolidated Franchisees

 

The net minority interest in the earnings of consolidated franchisees decreased to $(6.2) million in fiscal 2005 from $1.9 million in fiscal 2004. For fiscal 2004, this caption includes the minority owners’ share of the results of operations of Freedom Rings, Glazed Investments and Golden Gate Doughnuts, LLC (“Golden Gate”). As of the end of fiscal 2004, the Company acquired the remaining minority interest in Golden Gate and, thus, there is no minority interest related to Golden Gate included in the fiscal 2005 results. In addition, as a result of the Company’s consolidation, effective as of the end of the first quarter of fiscal 2005, of KremeKo and New England Dough, this caption also reflects the minority owners’ share of the results of operations of KremeKo and New England Dough for periods subsequent to the Company’s consolidation.

 

Provision for Income Taxes

 

The provision for income taxes on continuing operations was approximately $9.7 million in fiscal 2005. The provision includes a valuation allowance of $7.9 million, equal to the Company’s net deferred income tax assets related to continuing operations as of the beginning of fiscal 2005, as well as taxes estimated to be payable currently. The significant losses incurred by the Company caused the Company to be unable to conclude, as of the end of the third quarter of fiscal 2005, that realization of the Company’s net deferred income tax assets was more likely than not, and the Company established an allowance against deferred income tax assets equal to the amount of the deferred income tax assets, net of deferred income tax liabilities. The provision for income taxes on continuing operations in fiscal 2004 approximated 40% of pretax income from continuing operations, which exceeds the statutory federal income tax rate principally due to the effects of state income taxes and foreign losses for which no income tax benefit has been recorded.

 

Income (Loss) From Continuing Operations

 

The Company incurred a loss from continuing operations of $157.1 million in fiscal 2005 compared to income from continuing operations of $49.8 million in fiscal 2004.

 

Liquidity and Capital Resources

 

The following table summarizes the Company’s cash flows from operating, investing and financing activities:

 

 

Cash Flows from Operating Activities

 

Net cash provided by operating activities was $1.9 million in fiscal 2006, $84.9 million in fiscal 2005 and $82.7 million in fiscal 2004.

 

Cash provided by operating activities in fiscal 2006 was adversely affected by reduced operating margins resulting from lower sales, as described in “— Business Conditions, Uncertainties and Liquidity” below. In addition, fees paid to the interim management firm engaged by the Company in January 2005 and professional fees related to the internal and external investigations and litigation described in Notes 2 and 12 to the consolidated financial statements appearing elsewhere herein reduced operating cash flows by approximately $26.9 million in fiscal 2006.

In fiscal 2005, cash flow from operating activities was affected by sales trends and lower operating margins, and by improved working capital management. In fiscal 2005, cash flows from operating activities primarily consisted of a significant net loss offset by non-cash items, including impairment charges, depreciation and deferred income taxes and provision for doubtful accounts.

 

In fiscal 2004, operating cash flow was affected principally by net income, the tax benefit from the exercise of nonqualified stock options, and non-cash items such as depreciation, partially offset by additional investments in working capital, primarily receivables and inventories. The tax benefit from the exercise of non-qualified stock options provided $35.8 million in fiscal 2004.

 

Cash Flows from Investing Activities

 

Net cash used for investing activities was $11.7 million in fiscal 2006, $47.6 million in fiscal 2005 and $169.9 million in fiscal 2004.

 

Cash used for investing activities in fiscal 2006 included approximately $10.4 million of capital expenditures, substantially less than the level of capital expenditures in fiscal 2005 and 2004 because the Company substantially eliminated store expansion in fiscal 2006. During fiscal 2006, the Company realized approximately $7.3 million of proceeds from disposals of assets, the majority of which represented the proceeds from sales of closed stores. During fiscal 2006, the Company advanced approximately $12.2 million to franchisees in which the Company had an ownership interest, including approximately $9.3 million paid to settle the Company’s obligations under certain guarantees of indebtedness of KremeKo, as more fully described in Note 18 to the consolidated financial statements included elsewhere herein.

 

In fiscal 2005, cash flows from investing activities primarily consisted of capital expenditures for property and equipment, the proceeds from a sale-leaseback transaction, payment of $3.6 million to acquire an additional 11% interest in Glazed Investments, and proceeds from other sales of property and equipment.

 

In fiscal 2004, investing cash outflows primarily related to acquisitions of franchisees and capital expenditures for property and equipment were partially offset by proceeds sales of investments in marketable securities. In fiscal 2004, the Company paid $112.5 million (net of cash acquired), and issued approximately 1.7 million shares of common stock for the acquisition of Associate and Area Developer franchise markets in Kansas, Missouri, Michigan, Texas and Louisiana; the acquisition of the remaining minority interest in Golden Gate, the consolidated franchisee which had the rights to develop stores in Northern California; and Montana Mills. See Note 19 to the notes to the consolidated financial statements appearing elsewhere herein.

 

Cash Flows from Financing Activities

 

Net cash provided by financing activities was $0.1 million in fiscal 2006 and $76.1 million in fiscal 2004. Net cash used for financing activities was $34.2 million in fiscal 2005.

 

In fiscal 2006, the Company closed the Secured Credit Facilities described below and in Note 10 to the consolidated financial statements appearing elsewhere herein. The Company borrowed $120 million under these facilities at closing, and used approximately $88 million to repay borrowing outstanding under the 2003 Credit Facility described below (which was terminated). The Company paid approximately $9.5 million of fees, costs and expenses associated with the new facility. Other retirements of long-term debt in fiscal 2006 included approximately $16.2 million related to consolidated franchisees and payments on capital lease obligations. Cash inflows from financing activities in fiscal 2006 included a $7.7 million capital contribution to a consolidated franchisee by the minority investors in that franchisee.

 

In fiscal 2005, financing activities were comprised primarily of repayment of long-term debt related to the Company’s 2003 Credit Facility and debt at Glazed Investments using proceeds of the sale-leaseback transaction, partially offset by issuance of long-term debt by consolidated franchisees. The Company paid approximately $29.5 million to reduce borrowings under the 2003 Credit Facility. At Glazed Investments, proceeds from a sale-leaseback transaction were used to reduce borrowings by approximately $10.5 million. Consolidated franchisees borrowed approximately $11.5 million of long-term debt during fiscal 2005.

 

Financing activities in fiscal 2004 consisted primarily of borrowings and repayment of debt and the proceeds from stock option exercises. On October 31, 2003, the Company entered into a $150 million unsecured bank credit facility (the “2003 Credit Facility”), which was composed of a $119.3 million revolving

credit facility and a $30.7 million term loan. Proceeds of borrowings under revolving portion of the 2003 Credit Facility were used to pay the outstanding amounts under a $55 million short-term promissory note entered into to finance, in part, the acquisition of franchises in Texas and Louisiana, to repay outstanding bank borrowings of two consolidated franchisees, and to fund, in part, the acquisition of the minority interest in another consolidated franchisee. The proceeds of the term loan under the 2003 Credit Facility were used to repay an existing term loan with similar terms.

 

Business Conditions, Uncertainties and Liquidity

 

The Company incurred a net loss of $198.3 million in fiscal 2005 and $135.8 million in fiscal 2006; such losses include non-cash impairment charges of $194.1 million in fiscal 2005 and $53.7 million in fiscal 2006. In addition, fiscal 2006 results include a charge of $35.8 million related to the settlement of certain litigation. Cash provided by operating activities declined from $84.9 million in fiscal 2005 to $1.9 million in fiscal 2006.

 

During fiscal 2005, the Company experienced first a slowing in the rate of growth in sales in its Company Stores segment and, later in the year, declines in sales compared to the comparable periods of fiscal 2004. The Company’s Franchise and KKM&D segments experienced revenue trends similar to those experienced in the Company Stores segment. These sales declines continued in fiscal 2006, during which the Company’s revenues declined to $543.4 million from $707.8 million in fiscal 2005, reflecting, among other things, lower revenues at KKM&D, store closures (including closures by Consolidated Franchisees) and lower revenues at remaining stores. These trends adversely affected operating margins because of the fixed or semi-fixed nature of many of the Company’s direct operating expenses. In addition, litigation has been commenced against the Company and certain current and former officers and directors, and investigations of the Company have been initiated by the Securities and Exchange Commission (the “Commission”) and the United States Attorney for the Southern District of New York, as described in Note 12 to the consolidated financial statements appearing elsewhere herein. In October 2004, the Company’s Board of Directors appointed a Special Committee to conduct an independent investigation of certain matters, including accounting matters. In August 2005, the Company’s Board of Directors received the report of the Special Committee, a summary of which was filed as an exhibit to a Current Report on Form 8-K dated August 9, 2005.

 

The loss incurred in fiscal 2005 reflects impairment charges of approximately $159.0 million related to goodwill, other intangible assets and property and equipment associated with the Company Stores business segment, and approximately $35.1 million related to the Company’s discontinued Montana Mills segment (see Note 22 to the consolidated financial statements appearing elsewhere herein). The loss for fiscal 2006 reflects a net provision of $35.8 million for anticipated settlement of certain litigation, impairment charges and lease termination costs of $55.1 million, of which $51.0 million relates to long-lived assets and leases principally associated with closed or disposed stores, and $4.1 million relates to intangible assets. In addition, the Company has incurred substantial expenses to defend the Company and its officers and directors in connection with pending litigation, to cooperate with the investigations of the Special Committee, the Commission and the United States Attorney, to undertake the Company’s internal investigation of accounting matters, and to indemnify certain current and former officers and directors for certain legal and other expenses incurred by them. These expenses were significantly greater in fiscal 2006 than in fiscal 2005, are continuing in fiscal 2007 and could be substantial.

 

In January 2005, the Company’s Chairman, President and Chief Executive Officer retired, and the Board of Directors engaged KZC, a corporate recovery and advisory firm, to provide interim executive management services to the Company. Since that time, the Company has undertaken a number of initiatives designed to improve the Company’s operating results and financial position. Such initiatives include closing a substantial number of underperforming stores, reducing corporate overhead and other costs to bring them more in line with the Company’s current level of operations, recruiting new management personnel for certain positions, obtaining the Secured Credit Facilities described below under “— Capital Resources, Contractual Obligations and Off-Balance Sheet Arrangements,” restructuring certain financial arrangements associated with franchisees in which the Company has an ownership interest and with respect to which the Company has financial guarantee obligations and selling certain non-strategic assets.

 

In addition to the foregoing, a committee of the Company’s board of directors conducted a search for a new chief executive officer to lead the Company on a permanent basis. On March 7, 2006, the Company

announced the appointment, effective immediately, of a new chief executive officer having over 20 years experience in the food industry and with particular experience in consumer packaged goods.

 

While the Company believes that these actions have enhanced the likelihood that the Company will be able to improve its business, the Company remains subject to a number of risks, many of which are not within the control of the Company. Among the more significant of those risks are pending litigation and governmental investigations, the outcome of which cannot be predicted, the costs of defending such litigation and cooperating with such investigations, and the magnitude of indemnification expenses which the Company will incur under indemnification provisions of North Carolina law, the Company’s bylaws and certain indemnification agreements. Any of these risks could cause the Company’s operations to fail to improve or to continue to erode.

 

In order to fund its business and potential indemnification obligations, including the payment of legal expenses, the Company is dependent upon its ability to generate cash from operations and continued access to external financing.

 

The Company’s principal source of external financing is its Secured Credit Facilities. These facilities contain significant financial and other covenants, as described below under “— Capital Resources, Contractual Obligations and Off-Balance Sheet Arrangements.” Failure to generate sufficient earnings to comply with these financial covenants, or the occurrence or failure to occur of certain events, would cause the Company to default under the Secured Credit Facilities. In the absence of a waiver of, or forbearance with respect to, any such default from the Company’s lenders, the Company could be obligated to repay outstanding indebtedness under the facilities, and the Company’s ability to access additional borrowings under the facilities would be restricted. The facilities contain covenants which limit the total indebtedness of the Company and limit the Company’s ability to obtain borrowings under the facilities, as described below under “— Capital Resources, Contractual Obligations and Off-Balance Sheet Arrangements.”

 

The Company believes that it will have sufficient access to credit under the Secured Credit Facilities to continue the restructuring of the Company’s business, and that it will be able to comply with the covenants contained in such facilities. The financial covenants contained in such facilities are based upon the Company’s fiscal 2007 operating plan and preliminary plans for fiscal 2008, which include, among other things, anticipated sales of certain assets and reductions in the amount of indebtedness and other obligations of franchisees guaranteed by the Company. There can be no assurance that the Company will be able to comply with the financial and other covenants in these facilities. In the event the Company were to fail to comply with one or more such covenants, the Company would attempt to negotiate waivers of any such noncompliance. There can be no assurance that the Company will be able to negotiate any such waivers, and the costs or conditions associated with any such waivers could be significant.

 

In the event that credit under the Secured Credit Facilities were not available to the Company, there can be no assurance that alternative sources of credit will be available to the Company or, if they are available, under what terms or at what cost. Until such time as the Company is current in filing with the Commission all periodic reports required to be filed by the Company under the Exchange Act, the Company will not be able to obtain capital by issuing any security whose registration would be required under the Securities Act. Shortly after the filing of this Annual Report on Form 10-K, the Company expects to file its Quarterly Reports on Form 10-Q for the first, second and third quarters of fiscal 2006. However, the Company has not filed its Quarterly Reports on Form 10-Q for the third quarter of fiscal 2005 or for the first or second quarter of fiscal 2007. While the Company is working diligently to complete the filings referred to in the preceding sentence (focusing first on the fiscal 2007 reports and then on the third quarter fiscal 2005 report), there can be no assurance as to when the Company will be current in its reporting obligations.

 

Capital Resources, Contractual Obligations and Off-Balance Sheet Arrangements

 

In addition to cash flow generated from operations, the Company utilizes other capital resources and financing arrangements to fund the expansion of the Krispy Kreme concept. These other resources and arrangements have assumed increased importance in light of the substantially reduced cash flows provided by operations. A discussion of these capital resources and financing techniques is included below.

Debt

 

The Company continuously monitors its funding requirements for general working capital purposes and other financing and investing activities. In fiscal 2005, the Company also provided financing to consolidated franchisees. In fiscal 2006, management focused on reducing or eliminating our investments in franchisees and the related guarantees of franchisee’s obligations, and on restructuring the Company’s borrowing arrangements to make additional credit available to the Company to facilitate accomplishing the Company’s business restructuring initiatives.

 

On April 1, 2005, the Company closed new secured credit facilities totaling $225 million (collectively, the “Secured Credit Facilities”). KKDC is the borrower under each of the Secured Credit Facilities, and KKDI and certain of its domestic subsidiaries are guarantors. The facilities consist of a $75 million revolving credit facility maturing April 1, 2008, secured by a first lien on substantially all of the assets of KKDC and the guarantors (the “First Lien Revolver”), and a $150 million credit facility maturing April 1, 2010, secured by a second lien on those assets (the “Second Lien Facility”). The Second Lien Facility consists of a $120 million term loan (the “Term Loan”) and a $30 million revolving credit facility (the “Second Lien Revolver”). At closing, the Company borrowed the full $120 million available under the Term Loan, and used the proceeds to retire approximately $88 million of indebtedness outstanding under the 2003 Credit Facility (which was then terminated) and to pay fees and expenses associated with the Secured Credit Facilities. The balance of the term loan proceeds were retained for general corporate purposes.

 

Both the First Lien Revolver and the Second Lien Revolver contain provisions which permit the Company to obtain letters of credit. Issuance of letters of credit under these provisions constitutes usage of the lending commitments, and the amount of such letters of credit reduces the amount available for cash borrowings under the related revolver. On the closing date, the Company obtained approximately $9.2 million of letters of credit (the “Backstop LCs”) under the Second Lien Revolver, which were issued to secure the Company’s reimbursement obligations relating to letters of credit issued under the 2003 Credit Facility, and a new letter of credit of $6.0 million to secure obligations to one of the Company’s banks. The letters of credit issued under the 2003 Credit Facility (the majority of which secured the Company’s obligations under self-insured worker’s compensation insurance policies) subsequently were replaced with new letters of credit issued under the Second Lien Revolver, and the corresponding Backstop LCs were terminated.

 

The description of the Secured Credit Facilities contained herein reflects post-closing amendments, the most recent of which was effective October 30, 2006.

 

Interest on borrowings under the First Lien Revolver is payable either at LIBOR or at the Alternate Base Rate (which is the greater of Fed funds rate plus 0.50% or the prime rate), in each case plus the Applicable Margin. The Applicable Margin for LIBOR-based loans is 2.75% and for Alternate Base Rate- based loans is 1.75% (3.25% and 2.25%, respectively, from December 12, 2005 through January 28, 2007). In addition, the Company is required to pay a fee equal to the Applicable Margin for LIBOR-based loans on the outstanding amount of letters of credit issued under the First Lien Revolver, as well as a 0.25% fronting fee. There also is a fee of 0.50% (0.75% from December 12, 2005 through January 28, 2007) on the unused portion of the First Lien Revolver lending commitment.

 

The Company pays fees aggregating 5.975% (7.35% from December 12, 2005 through January 28, 2007) on the entire $30 million Second Lien Revolver commitment. In addition, interest accrues on outstanding borrowings at either the Fed funds rate or LIBOR, and the outstanding amount of letters of credit issued under the Second Lien Revolver incurs a fronting fee of 0.25%.

 

Interest on the outstanding balance of the Term Loan accrues either at LIBOR or at the Fed funds rate plus, in each case, the Applicable Margin. The Applicable Margin for LIBOR-based loans is 5.875% and for Fed funds-based loans is 4.875% (7.25% and 6.25%, respectively, from December 12, 2005 through January 28, 2007).

 

As required by the Secured Credit Facilities, the Company has entered into an interest rate derivative contract having a notional principal amount of $75 million. The derivative contract eliminates the Company’s exposure, with respect to such notional amount, to increases in three month LIBOR beyond 4.0% through

April 2006, 4.50% from May 2006 through April 2007 and 5.0% from May 2007 through March 2008. This derivative is being accounted for as a cash flow hedge from its inception in fiscal 2006.

 

Borrowings under the First Lien Revolver are limited to 150% of the Consolidated EBITDA of the Financial Test Group, minus the amount of outstanding letters of credit issued under the First Lien Revolver. The operation of this restriction, and the restrictive financial covenants described below, may limit the amount the Company may borrow under the First Lien Revolver to less than $75 million. As defined in the agreement, “Consolidated EBITDA,” a non-GAAP measure, means, generally, net income or loss, exclusive of unrealized gains and losses on hedging instruments and gains or losses on the early extinguishment of debt, plus the sum of net interest expense, income taxes, depreciation and amortization, non-cash charges, store closure costs, costs associated with certain litigation and investigations described in Item 3, “Legal Proceedings” (including, but not limited to, the purported securities class action litigation and the shareholder derivative actions) the costs and expenses paid to KZC and other extraordinary professional fees; and minus the sum of non-cash credits and the unremitted earnings of Equity Method Franchisees. The “Financial Test Group” consists of the Company and its subsidiaries, exclusive of the Consolidated Franchisees.

 

Borrowings under the First Lien Revolver and the Second Lien Revolver (and issuances of letters of credit) are subject to the satisfaction of usual and customary conditions, including accuracy of representations and warranties and the absence of defaults and, in the case of the First Lien Revolver, the existence of minimum Net Liquidity (as defined in the First Lien Revolver) of at least $10 million.

 

The Term Loan is payable in equal quarterly installments of $300,000 beginning July 31, 2005 and a final installment equal to the remaining principal balance on April 1, 2010.

 

The Secured Credit Facilities are required to be repaid with the net proceeds of certain equity issuances, debt incurrences, asset sales and casualty events. In addition, the First Lien Revolver is required to be repaid on a daily basis to the extent the Company’s Net Liquidity (as defined in the First Lien Revolver) is below $20.0 million. Mandatory repayments under the First Lien Revolver do not reduce commitments under the First Lien Revolver. Net proceeds are generally required to be first applied to repay amounts outstanding under the First Lien Revolver and then (without giving effect to the amount repaid under the First Lien Revolver) to be offered to the holders of the Term Loan. To the extent application of these mandatory prepayment provisions results in prepayment of amounts outstanding under the Term Loan, such prepaid amounts cannot be reborrowed, and any such prepayments are not subject to the prepayment fees described in the following paragraph.

 

The Company may permanently reduce the commitments under both the First Lien Revolver and the Second Lien Revolver. The Company must pay a fee of 1% of the amount of any such reduction of the commitments under the First Lien Revolver which occurs before August 1, 2006. The Company may not reduce the commitments under the Second Lien Revolver until August 1, 2006. The Company must pay a fee of 3% of the amount of any such reduction which occurs on or before August 1, 2007; such fee declines to 2% on August 2, 2007, to 1% on August 2, 2008 and to zero on August 2, 2009. The Company has not reduced the commitments under either the First Lien Revolver or the Second Lien Revolver. The Company may prepay the Term Loan on or after August 1, 2006; prepayment fees equal to the commitment termination fees for the Second Lien Revolver apply to any such Term Loan prepayments.

 

The Secured Credit Facilities require the Company to meet certain financial tests, including a maximum leverage ratio (expressed as a multiple of earnings before interest, taxes and depreciation (“EBITDA”)) and a minimum interest coverage ratio (expressed as a ratio of EBITDA to net interest expense), computed based upon EBITDA and net interest expense for the most recent four fiscal quarters. As of January 29, 2006, these tests were set at 4.5 to 1.0, in the case of the maximum leverage ratio, and 2.5 to 1.0, in the case of the minimum interest coverage ratio. As of January 29, 2006, the Company’s leverage ratio was approximately 3.9 to 1.0 and the Company’s interest coverage ratio was approximately 3.9 to 1.0. After giving effect to the October 30, 2006 amendments to the Secured Credit Facilities, the maximum leverage ratio for years after fiscal 2006 ranges from 5.4 to 1.0 to 3.7 to 1.0, and the minimum interest coverage ratio ranges from 2.05 to 1.0 to 3.4 to 1.0. In addition, the Secured Credit Facilities contain other covenants which, among other things, limit the incurrence of additional indebtedness (including guarantees), liens, investments (including investments in and advances to franchisees which own and operate Krispy Kreme stores), dividends, transactions with

affiliates, asset sales, acquisitions, capital expenditures, mergers and consolidations, prepayments of other indebtedness and other matters customarily restricted in such agreements. The Secured Credit Facilities also prohibit the transfer of cash or other assets to KKDI from its subsidiaries, whether by dividend, loan or otherwise, but provide for exceptions to enable KKDI to pay taxes and operating expenses and certain judgment and settlement costs.

 

As of January 29, 2006, the maximum additional borrowings available to the Company under the Secured Credit Facilities were approximately $29 million. Such amount reflects the effects of application of the restrictive financial covenants described in the preceding paragraph.

 

The Secured Credit Facilities also contain customary events of default, including without limitation, payment defaults, breaches of representations and warranties, covenant defaults, cross-defaults to other indebtedness in excess of $1 million, certain events of bankruptcy and insolvency, judgment defaults in excess of $1 million and the occurrence of a change of control.

 

Leases

 

The Company conducts some of its operations from leased facilities and leases certain equipment. Generally, these leases have initial terms of three to twenty years and contain provisions for renewal options of five to ten years. In determining whether to enter into a lease for an asset, the Company evaluates the nature of the asset and the associated lease terms to determine if leasing is an effective financing tool.

 

Off-Balance Sheet Arrangements

 

The Company’s only off-balance sheet arrangements, as defined by Item 303(a)(4) of SEC Regulation S-K, consist of the Company’s guarantees of indebtedness and lease obligations of certain franchisees, as discussed in Notes 12 and 18 to the consolidated financial statements appearing elsewhere herein, and certain advancement and potential indemnification obligations also discussed in Note 12.

 

Contractual Cash Obligations at January 29, 2006

 

The Company’s contractual cash obligations as of January 29, 2006 are as follows:

 

 

 

 

Capital Requirements

 

In the next five years, the Company plans to use cash primarily for the following activities:

 

 

The Company’s capital requirements for the items outlined above may be significant. These capital requirements will depend on many factors including the Company’s overall performance, the pace of store expansion and Company store remodels and infrastructure needs for both personnel and facilities.

 

Inflation

 

The Company does not believe that inflation has had a material impact on its results of operations in recent years. The Company cannot predict, however, what effect inflation may have on its results of operations in the future.

 

Critical Accounting Policies

 

The Company’s discussion and analysis of its financial condition and results of operations is based upon its financial statements that have been prepared in accordance with GAAP. The preparation of financial statements in accordance with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosures, including disclosures of contingencies and uncertainties. GAAP provides the framework from which to make these estimates, assumptions and disclosures. The Company chooses accounting policies within GAAP that management believes are appropriate to accurately and fairly report the Company’s operating results and financial position in a consistent manner. Management regularly assesses these policies in light of changes in facts and circumstances and discusses the selection of accounting policies and significant accounting judgments with the audit committee of the Board of Directors. The Company believes that application of the following accounting policies involves judgments and estimates that are among the more significant used in the preparation of the financial statements, and that an understanding of these policies is important to understanding the Company’s financial condition and results of operations.

 

Basis of Consolidation

 

The consolidated financial statements include the accounts of KKDI and all subsidiaries where voting control rests with the Company, as well as the accounts of certain franchisees that are variable interest entities and with respect to which the Company has determined that variable interests owned by the Company absorb a majority of each entity’s expected losses, expected residual returns, or both, as each of these terms is defined in Financial Accounting Interpretation No. 46 (Revised), “Consolidation of Variable Interest Entities” (“FIN 46(R)”). Investments in franchisees over which the Company has the ability to exercise significant influence over operating and financial policies, and whose financial statements are not required to be consolidated under FIN 46(R), are accounted for using the equity method of accounting. Management’s judgments regarding the Company’s level of influence or control over each franchisee in which it has an investment and the extent to which variable interests owned by the Company absorb a majority of the franchisee’s expected losses or expected residual returns affect management’s decisions about which investments are consolidated and which are accounted for using the equity method.

Allowance for Doubtful Accounts

 

Accounts receivable arise primarily from royalties earned on sales by the Company’s franchisees, sales by KKM&D to our franchisees of equipment, mix, coffee and other supplies necessary to operate a Krispy Kreme store, as well as from off-premises sales by company stores to convenience and grocery stores and other customers. During fiscal 2005 and 2006, some of the Company’s franchisees experienced financial difficulties or for other reasons did not comply with the normal payment terms for settlement of amounts due to the Company. The Company has recorded provisions for doubtful accounts related to its accounts receivable, including receivables from franchisees, in amounts which management believes are sufficient to provide for losses estimated to be sustained on realization of these receivables. Such estimates inherently involve uncertainties and assessments of the outcome of future events, and changes in facts and circumstances may result in adjustments to the provision for doubtful accounts.

 

Goodwill and Identifiable Intangible Assets

 

FAS 142, “Goodwill and Other Intangible Assets” (“FAS 142”), addresses the accounting and reporting of goodwill and other intangible assets subsequent to their acquisition. FAS 142 requires intangible assets with definite lives to be amortized over their estimated useful lives, while those with indefinite lives and goodwill are not subject to amortization but must be tested annually for impairment, or more frequently if events and circumstances indicate potential impairment.

 

Goodwill arose principally from acquisitions of franchisees and from the acquisition of Montana Mills in fiscal 2004. Identifiable intangible assets include the value assigned to recipes and reacquired franchise rights recorded in connection with franchise acquisitions. Reacquired franchise rights were determined to have indefinite lives based upon the long operating history of the Company’s brand and its franchise model, and the Company’s ability to enfranchise these markets. All of the intangibles associated with Montana Mills were written off in fiscal 2005 when the Company decided to discontinue the Montana Mills operation.

 

For intangible assets with indefinite lives, the Company performs the annual test for impairment as of December 31. The impairment test involves determining the fair values of the reporting units to which goodwill is assigned and comparing those fair values to the reporting units’ carrying values, including goodwill. To determine fair value for each reporting unit, the Company uses the fair value of the cash flows that the reporting unit can be expected to generate in the future. This valuation method requires management to project revenues, operating expenses, working capital investment, capital spending and cash flows for the reporting units over a multiyear period, as well as determine the weighted average cost of capital to be used as a discount rate. Significant management judgment is involved in preparing these estimates. Changes in projections or estimates could significantly change the estimated fair value of reporting units and affect the recorded balances of goodwill. In addition, if management uses different assumptions or estimates in the future or if conditions exist in future periods that are different than those anticipated, future operating results and the balances of goodwill in the future could be affected by impairment charges. Impairment analyses of goodwill in fiscal 2006 and 2005 resulted in impairment charges of approximately $3.5 million and $131.6 million, respectively. As of January 29, 2006, the remaining goodwill had a carrying value of $29.2 million.

 

Asset Impairment

 

When an asset group (typically a store) is identified as underperforming or when a decision is made to abandon an asset group or to close a store, the Company makes an assessment of the potential impairment of the related assets. The assessment is based upon a comparison of the carrying amount of the assets, primarily property and equipment, to the estimated undiscounted cash flows expected to be generated from those assets. To estimate cash flows, management projects the net cash flows anticipated from continuing operation of the asset group or store until its closing or abandonment, as well as cash flows, if any, anticipated from disposal of the related assets. If the carrying amount of the assets exceeds the sum of the undiscounted cash flows, the Company records an impairment charge in an amount equal to the excess of the carrying value of the assets over their estimated fair value.

 

Determining undiscounted cash flows and the fair value of an asset group involves estimating future cash flows, revenues, operating expenses and disposal values. The projections of these amounts represent management’s best estimates at the time of the review. If different cash flows had been estimated, property and

equipment balances and related impairment charges could have been affected. Further, if management uses different assumptions or estimates in the future or if conditions exist in future periods that are different than those anticipated, future operating results could be affected. In fiscal 2006 and 2005, the Company recorded impairment charges related to long-lived assets totaling approximately $49.7 and $26.0 million, respectively. The Company anticipates that additional impairment charges will be reflected in fiscal 2007 related to store closure decisions made during fiscal 2007.

 

Insurance

 

The Company is subject to workers’ compensation, vehicle and general liability claims. The Company is self-insured for the cost of all workers’ compensation, vehicle and general liability claims up to the amount of stop- loss insurance coverage purchased by the Company from commercial insurance carriers. The Company maintains accruals for these self-insurance costs, the amounts of which are determined using actuarial methods which evaluate open claims and take into consideration estimated ongoing loss development exposure. Many estimates and assumptions are involved in estimating future claims, and differences between future events and prior estimates and assumptions could affect future operating results and result in adjustments to these liabilities.

 

Income Taxes

 

The Company recognizes deferred tax assets and liabilities based upon management’s expectation of the future tax consequences of temporary differences between the income tax and financial reporting bases of assets and liabilities. Deferred tax liabilities generally represent tax expense recognized for which payment has been deferred, or expenses which already have been deducted in the Company’s tax return but which have not yet recognized as an expense in the consolidated financial statements. Deferred tax assets generally represent tax deductions or credits that will be reflected in future tax returns for which the Company has already recorded a tax benefit in its consolidated financial statements. The Company establishes valuation allowances for deferred income tax assets as required under FAS 109, “Accounting for Income Taxes.” At January 29, 2006, the Company has recorded a valuation allowance against deferred income tax assets of $116.0 million, representing the total amount of such assets in excess of the Company’s deferred income tax liabilities. The valuation allowance was recorded because management was unable to conclude, in light of the cumulative losses realized by the Company that realization of the net deferred income tax asset was more likely than not. The determination of income tax expense and the related balance sheet accounts, including valuation allowances for deferred income tax assets, requires management to make estimates and assumptions regarding future events, including future operating results and the outcome of tax-related contingencies. If future events are different from those assumed or anticipated, the amount of income tax assets and liabilities, including valuation allowances for deferred income tax assets, could be materially affected.

 

Guarantee Liabilities

 

The Company has guaranteed a portion of loan and lease obligations of certain franchisees in which the Company owns an interest. To the extent such guarantees relate to franchisees whose financial statements are consolidated with those of the Company, the guaranteed indebtedness is included in the Company’s consolidated balance sheet and the guaranteed lease obligations are included in the disclosure of the Company’s lease obligations. For guarantees related to franchisees accounted for using the equity method, the Company assesses the likelihood of making any payments under the guarantees and records liabilities for the present value of any anticipated payments. No liability for the guarantees related to equity method franchisees was recorded at the time they were issued because the Company believed the value of the guarantees was immaterial, and there are no liabilities recorded for any such guarantee payments as of January 29, 2006 or January 30, 2005. Assessing the probability of future guarantee payments involves estimates and assumptions regarding future events, including the future operating results of the franchisees. If future events are different from those assumed or anticipated, the amounts estimated to be paid pursuant to such guarantees could change, and provisions to record such liabilities could be required.

 

Investments in Franchisees

 

The Company has investments in certain unconsolidated franchisees. While the Company believes that the recorded amounts of such investments are realizable, these franchisees typically are startup businesses

without a history of successful operations, and the value of the Company’s investments in the franchisees cannot be verified by reference to quoted market prices. The Company’s assessment of the realizability of these investments involves assumptions concerning future events, including the future operating results of the franchisees. If future events are different from those assumed or anticipated by the Company, the assessment of realizability of the recorded investments in these entities could change, and impairment provisions related to these investments could be required. As of January 29, 2006, the Company’s investment in unconsolidated franchisees was approximately $8.6 million.

 

For further information concerning accounting policies, refer to Note 1, “Nature of Business and Significant Accounting Policies,” to the consolidated financial statements appearing elsewhere herein.

 

Recent Accounting Pronouncements

 

In September 2006, the Financial Accounting Standards Board (“FASB”) issued Statement No. 157, “Fair Value Measurements” (“FAS 157”), which addresses how companies should measure fair value when they are required to use a fair value measure for recognition or disclosure purposes under GAAP. As a result of FAS 157, there is now a common definition of fair value to be used throughout GAAP, which is expected to make the measurement of fair value more consistent and comparable. The Company must adopt FAS 157 in fiscal 2009, but has not yet begun to evaluate the effects, if any, of adoption on its consolidated financial statements.

 

In July 2006, the FASB released FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109” (“FIN 48”). FIN 48 prescribes a comprehensive model for the financial statement recognition, measurement, presentation and disclosure of income tax uncertainties with respect to positions taken or expected to be taken in income tax returns. The Company must adopt FIN 48 in fiscal 2008, and management currently is evaluating the effect of adoption on the Company’s financial statements.

 

In December 2004, the FASB issued Statement No. 123 (revised 2004), Share-Based Payment (“FAS 123(R)”), which requires the measurement and recognition of compensation expense for all share-based payment (“SBP”) awards. The new standard supersedes the Company’s current accounting under APB 25 and will require the Company to recognize compensation expense for all SBP awards based on fair value. In March 2005, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 107 relating to the adoption of FAS 123(R). Beginning in the first quarter of fiscal 2007, the Company will adopt the provisions of FAS 123(R), and expects to use a modified prospective transition method and the Black-Scholes option pricing model. Under the new standard, the Company’s estimate of the fair value of SBP awards, and therefore compensation expense, will require a number of complex and subjective assumptions, including the Company’s stock price volatility, employee exercise patterns influencing the expected life of the options, future forfeitures and related tax effects. The Company currently expects to recognize SBP compensation expense for awards on a straight-line basis over the vesting period of the award. Pro forma net income and earnings per share amounts for fiscal 2006, 2005 and 2004, computed as if the Company had used a fair-value based method similar to the methods required under FAS 123(R) to measure compensation expense for employee stock-based compensation awards, are set forth under “Stock-based compensation” in Note 1 to the consolidated financial statements appearing elsewhere herein.

 

In November 2004, the FASB issued Statement No. 151, “Inventory Costs” (“FAS 151”), which amends the guidance in Accounting Research Bulletin No. 43, “Inventory Pricing,” to clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs and wasted material (spoilage). FAS 151 requires that those items be recognized as current period charges and that the allocation of fixed production overheads to the cost of converting work in process to finished goods be based on the normal capacity of the production facilities. The Company will adopt this statement in fiscal 2007. Adoption will not have a material effect on the Company’s consolidated financial statements.

 

In February 2005, the Emerging Issues Task Force reached a consensus in Issue No. 03-13, “Applying the Conditions in Paragraph 42 of FASB Statement No. 144 in Determining Whether to Report Discontinued Operations” (“EITF 03-13”). The Company considered the guidance in EITF 03-13 in evaluating whether the operations and cash flows of components disposed of in fiscal 2006 had been or will be eliminated from ongoing operations, and the types of continuing involvement that constitute significant continuing involvement

in the operations of the disposed component. These evaluations affect the determination of whether the results of operations of a disposed component are reported as discontinued operations. The Company concluded that none of the components disposed of in fiscal 2006 should be reported as discontinued operations.

 

In May 2005, the FASB issued Statement No. 154, “Accounting Changes and Error Corrections” (“FAS 154”) to replace Accounting Principles Board Opinion No. 20, “Accounting Changes” (“APB 20”) and FAS 3, “Reporting Accounting Changes in Interim Periods.” FAS 154 provides guidance on the accounting for and reporting of accounting changes and error corrections, and establishes retrospective application as the required method for reporting a change in accounting principle. FAS 154 provides guidance for determining whether retrospective application of a change in accounting principle is impracticable, and for reporting a change when retrospective application is determined to be impracticable. FAS 154 also addresses the reporting of a correction of an error by restating previously issued financial statements. FAS 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. The Company will adopt this pronouncement in fiscal 2007.