Equity cash flow and notes analysis

Krispy Kreme: The Unsweetened, Unglazed Truth of Its Equity, Cash Flow, And Notes

To the Managers of Krispy Kreme, Inc.:

As well you all surely know, although it does bear repeating for the sake of company pride, the publicly traded firm Krispy Kreme began as a small, independent business and is now a large, publicly traded firm with franchises extending all over the country, as well as the potential of gaining numerous acquisitions of great value and potential into its fold. For a long time, the firm has stood proud, weathering the low-carb craze to hang on as one of the darlings of Wall Street investors and analysts. Krispy Kreme was 'proof' that a small, relatively concentrated product that originated as a regional specialty in the American South could come to dominate bigger conglomerates such as Dunkin' Doughnuts.

However, recent adjustments in the form of statements of changes to the company's Annual Report mean that Krispy Kreme's financial future may be in jeopardy.

In recording its financial data regarding its statement of owner's equity, or "the company's total assets minus total liabilities of an individual or company" the company reported an initial profit that was better than initially expected, a welcome improvement from its previous year's reneging on projected profits. ("Owners' Equity," Investor Words, 2004) The company recorded that it had made a profit for its shareholders of 3.8 million dollars from its product sales, new acquisitions and revenue from its franchise agreements. For a company, owner's equity, which is also called net worth or shareholders' equity or net assets, is generally considered a leading measure or indicator of a company's overall financial health and desirability as a place to invest or to purchase a franchise from. ("Annual Report, 2004, p.25-29) However, this statement of health of Krispy Kreme has now been called into question -- things are not as sweet as they seem.

Krispy Kreme also released a relatively salutary report on its cash flow. A company's cash flow equals "cash receipts minus cash payments over a given period of time; or equivalently, net profit plus amounts charged off for depreciation, depletion, and amortization." ("Cash flow," Investor Words, 2004) Initially, the company was also given a fairly healthy report regarding its cash flow despite the subtracted depreciation of goods. It had trimmed the 'fat' from under performing franchises, and in an addendum to better flesh out the financial data as a note to shareholders, the Krispy Kreme Company stated that it had completed the acquisition of Montana Mills Bread Co., Inc. (otherwise known as "Montana Mills"), an owner and operator of upscale "village bread stores" in the Northeastern United States. Montana Mills' stores produce and sell a variety of breads and baked goods prepared in an open-view format. "In addition to providing operating synergies," the acquisition of Montana Mills was expected to provide the Krispy Kreme Company with the ability to leverage its existing capabilities, such as its distribution chain, off-premises sales and coffee-roasting expertise, in order to expand Montana Mills' business." (Annual Report, 2004, p.51) The acquisition was supposed to be another potential source of profitability for the company, extending well into its projected future.

But now, one recent report noted that "Krispy Kreme's" reports of renewed health have taken, to use the BBC's sickeningly memorable phrase, a "dunking," because of recently discovered accounting errors in the original report. The Annual Report of course included notes to the stockholders to explain the financial accounting procedures that are used. "To estimate cash flows, management projects the net cash flows anticipated from continuing operation of the store until its closing as well as cash flows anticipated from disposal of the related assets, if any. If the carrying amount of the assets exceeds the sum of the undiscounted cash flows," the Krispy Kreme Company "records an impairment charge measured as the excess of the carrying value over the fair value of the assets. The resulting net book value of the assets, less estimated net realizable value at disposition, is depreciated over the remaining term that the store will continue in operation." (Annual Report, 2004, p. 32) Not only is there a contention that Krispy Kreme overextended itself into under performing franchises, but that these franchises have failed upon their loan agreements, and that the company has diluted its name by purveying its goods to supermarkets and convenience stores.

A readjustment of accounting errors regarding depreciation and defaulting of franchises on loans, in the recalculation of cash flow, amongst other factors means the company must cut its stated profits by $3.8m to $4.9m, or between 6.6% and 8.6%. "The revelation comes just a month" after the firm warned owner's equity, that is investor earnings, "would be cut by as much as 7.6%" as a result of other accounting errors." (BBC, 2005) According to another addendum to its most recent financial statements, "Krispy Kreme said the latest adjustments involved the way it accounted for the repurchase of three franchise restaurants. Some of its franchise owners were not in compliance with their loan agreements." (BBC, 2005) But the initial cut in profit and expected growth expectations was simple underperformance, hidden by a lack of deductions of depreciations of currently existing firms.

All of these irregularities mean that the company "might need to borrow extra money if it was required to honor agreements on franchisee debts or operating leases." (BBC, 2004) Now, as a result of the disclosure of these accounting irregularities regarding the over reporting of profits and the underreporting of defaulted franchise loans, the company has "lost 80% of its stock value." (BBC News, 2004) Of course, this is not the first time the company has weathered adversity. As noted in the Annual report, "on March 9, 2000, a lawsuit was filed against the Company, management and Golden Gate in Superior Court in the State of California. The lawsuit was filed as a result of joint venture discussions between the Company and the plaintiffs to develop the Northern California market. On April 7, 2003, this lawsuit was finally settled." (Annual Report, 2004, p.50-51) Lawsuits pending against the company, of course, must always be included in notes to shareholders, to better flesh out the picture painted of the company for current and potential investors, to facilitate full disclosure.