Krispy Kreme Doughnuts Inc. (KKD) investors have plenty to chew on these days, and it's giving them indigestion rather than a pleasant sugar surge. Since the company warned in May of disappointing profits and then announced in July that the Securities & Exchange Commission was conducting an informal inquiry into its accounting, the once-hot stock has been in the doldrums. It trades at around $15 a share, down from nearly $50 last August.
More nasty surprises could be in store for shareholders in the Winston-Salem (N.C.) chain as the SEC probe gets going. Consider the way Krispy Kreme accounts for the franchises it buys back, on which it has spent nearly $150 million over the past year. Because much of the outlay pays for property, plant, and equipment, most food chains amortize this cost over several years. Krispy Kreme doesn't. Company documents show it has been booking most of the spending as so-called intangible assets, which don't have to be amortized. The result: Krispy Kreme's reported earnings are higher than they would have been had it written them off. "Krispy Kreme's accounting for franchise acquisitions is the most aggressive we've found," says Robert Miceli, analyst at Scottsdale (Ariz.) Camelback Research Alliance.
The company has stated that it has done nothing wrong. A spokeswoman said executives could not speak with BusinessWeek because of the SEC probe. But in a July 29 press release, Scott A. Livengood, chairman, chief executive, and president, said: "Krispy Kreme has no higher priority than the confidence of our shareholders, customers, and employees. We are confident in our practices."
The accounting treatment isn't the only potential problem with the acquisitions. Krispy Kreme didn't disclose that one of the owners of a Northern California franchise it bought earlier this year was Livengood's ex-wife. Nor did it identify two of the owners of the Dallas and Shreveport, La., franchises acquired last year as the brother and cousin of a senior executive. Krispy Kreme has said it believes it wasn't required to under SEC rules. But, says Sanjai Bhajat, a professor of finance and corporate governance at the University of Colorado: "These kinds of relationships should be disclosed."
The prices paid for some of the company's acquisitions have also raised eyebrows. Krispy Kreme shelled out $67 million in cash for the Dallas and Shreveport franchises, a total of six stores. That's more than $11 million a store. Just months before, Krispy Kreme was paying an average of $6.5 million a store.
Questions about accounting started to hit Krispy Kreme as its growth appeared to stall. Sales for stores open more than a year grew just 4% in the first quarter ended May 2, a fraction of the 20% growth rate of three years ago. When the company gave its first-ever profits warning in May, it blamed the low-carb craze for hurting sales. The explanation doesn't ring true to all observers, who note that other doughnut chains haven't been hit.
Krispy Kreme has been fighting back. In a July 14 presentation to investors, Chief Financial Officer Michael C. Phalen said the chain still had tremendous potential for growth. It has just $3.28 a year in revenue for each U.S. resident, half to a third of the per-capita revenue at Dunkin' Donuts (AED) and International Dairy Queen Inc. (BRK) Chief Operating Officer John Tate outlined a string of new products to be introduced over the next year such as frozen beverages, coffee beans, and mini- and sugar-free doughnuts. Tate said Krispy Kreme also plans to expand to Europe, Japan, South Korea, and China.
Largely because of all the franchise acquisitions, Krispy Kreme's debt has shot up from $22 million to $135 million in the past four years. Fixing its business back home -- and not borrowing to expand -- may be the wisest move if Krispy Kreme wants to reassure its nervous investors.
By Christopher Palmeri in Los Angeles, with Amy Borrus in Washington