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Case analysis krispy kreme-1

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  • 1. Case Analysis Krispy Kreme Doughnuts, Inc. Thadavillil (Nathan) Jithendranathan Professor of Finance Opus College of Business University of St. Thomas St. Paul, Minnesota, U.S.A.
  • 2. Context This case considers the sudden and very large drop in the market value of equity for Krispy Kreme Doughnuts, Inc., associated with a series of announcements made in 2004. Those announcements caused investors to revise their expectations about the future growth of Krispy Kreme, which had been one of the most rapidly growing American corporations in the new millennium.
  • 3. Objective • To gradually gain back analysts’, investors’ and lenders’ confidence in the company in the succeeding months. • To increase sales and profitability in terms of its core business, which is selling doughnuts. • To increase stock price to the previous levels and thereby increase shareholder value.
  • 4. Objectives (continued) • To correct inaccurate entries in the financial statements and to present a clean and unbiased report. • To extend further reach to consumers strategically to achieve significant growth in the next five years. • To implement extensive marketing measures for its brand and products and investment strategy for both on and off premise operations.
  • 5. Background • Fortune magazine had dubbed Krispy Kreme Doughnut, Inc. “the hottest brand in America,” with ambitious plans to open 500 doughnut shops over the first half of the decade. • The company generated revenues through four primary sources: on-premise retail sales at company owned stores (27% of revenues), off-premises sales to grocery and convenience stores (40%); manufacturing and distribution of product mix and machinery (29%); and franchise royalties and fees (4%). • Roughly 60% of sales at a Krispy Kreme store were derived from the company’s signature product, the glazed doughnut.
  • 6. Background (continued) • On May 7, 2004, Krispy Kreme announced adverse results. The company told investors to expect earnings to be 10% lower than anticipated, claiming that the recent low-carbohydrate diet trend in the United States had hurt wholesale and retail sales. • The company also said it planned to divest Montana Mills and would take a charge of $35million to $40 million. • According to the Wall Street Journal, the company recorded the interest paid by the franchisees as interest income and, thus, as immediate profit; however, the company booked the purchase cost of the franchise as an intangible asset which the company did not amortize. • Only 25% of the analysts were recommending the company as a buy; 50% had downgraded to a hold.
  • 7. Analysis Growth • Rapid growth in revenues and earnings over the past five years. • Significant asset growth in the past five years. • The bulk of this growth, however, has occurred in accounts receivables from affiliates and from reacquired franchise rights.
  • 8. DuPont Analysis 2000 2001 2002 2003 2004 Return on equity 12.47% 11.72% 14.06% 12.25% 12.62% Profit margin 2.70% 4.90% 6.69% 6.81% 8.58% Asset turnover 2.10x 1.75x 1.54x 1.20x 1.01x Equity multiplier 2.20x 1.36x 1.36x 1.50x 1.46x Asset turnover 5.67% 8.59% 10.33% 8.16% 8.64%
  • 9. Liquidity, Leverage, and Profitability • The firm’s liquidity ratios are strong and continued to improve over the five-year period. • The leverage ratios show that the firm has been increasing its proportion of debt, but the balance sheet also indicates that the firm’s level of equity has been increasing as well. • Times interest earned has dropped dramatically (from 124 in 2002 to 23 in 2004) as a result of a material increase in debt. • The stagnant returns on equity, relative to the improving profit margins, appear to be a significant issue.
  • 10. Peer Comparisons • Krispy Kreme is significantly more liquid, turns its receivables and inventory more slowly, and has less financial leverage than its peers. • Krispy Kreme has significantly more receivables and intangibles, higher operating expenses, but better profit margins than its peers. • Krispy Kreme is growing aggressively, extending substantial credit to its affiliates, amassing large unamortized assets on its balance sheet in the form of reacquired franchise rights, and yet remaining profitable and competitive with its peers.
  • 11. Causes for concern • Investors are concerned about the future earning capacity of the firm. • There is evidence of weak management, which led to lack of internal controls. • CEO’s salary is 20 percent higher than the median of companies of similar size. • The turnover in senior management.
  • 12. Strategies for gaining investor confidence • Reduce the number of new store openings. This will reduce the saturation of the market, which will reduce the profitability. • Stop pushing debt to franchises, which will reduce the conflict of interest between the management and the franchises. • Revert back to more conservative accounting practices.