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Connecting The Dots On Krispy Kreme

May 11, 2004 | Krispy Kreme is likely to go down as a classic example of style over substance and certainly a reminder of why liking a company's products doesn't necessarily mean you should like the stock.

Even with its exceptionally strong brand and customer loyalty, the doughnut maker's business model has had the skeptics scoffing for well over a year certainly enough time that investors coulda, woulda, shoulda seen Friday's pre-announcement coming. As I said Friday and I'll say again: It's hard to swallow Krispy Kreme's explanation that sales are falling because of the low-carb diet, especially when that's been the excuse du jour for almost every food-related company that has suffered unpleasant surprises over the past year.

One of the first signs that all wasn't well in doughnut land was the company's announcement in January of 2003 that it was buying Montana Mills, a bread bakery that Krispy Kreme (KKD) now says it's selling. Fast-growing companies don't usually stray from their core business unless growth is starting to slow a clear concern at the time.

But Krispy Kreme CEO Scott Livengood was quoted in a company press release when the deal was announced saying, "We will always try to prepare for any type of expansion well before we need the growth...for this concept, I think that time is now." Now he has the low-carb diets to blame for the bad timing of an acquisition of a company whose directors, it should be noted, include Krispy Kreme Chief Operating Officer John Tate.

Related party dealings, in fact, are among the dots investors could have connected that should have raised concern. (They still should.)

Dot one: Last June 30 Krispy Kreme paid $67 million to buy the Dallas and Shreveport, La. franchises, with a total of five stores and one commissary, from former directors Joseph McAleer and Steven Smith; McAleer is also a former chairman of the parent company. The question I raised at the time: Why would two former directors, who left their posts only three months earlier, want to sell? "We believe there is exceptional growth opportunity for additional stores and off-premises sales," Livengood said in a press release at the time.

Dot two: a question every investor should've been asking: How is it that the former insiders got so much money for five stores, especially when a few days later word leaked that the Southern California franchisee with no relations to the company wanted to sell its 22 store operation for at least $80 million? (The price apparently was based on a selling document the franchisee gave to prospective buyers.) It's been almost a year and so far, from what anybody can tell, there have been no takers. Even Krispy Kreme isn't nibbling, which itself is intriguing because in the same press release announcing the Dallas/Shreveport purchase, Livengood was quoted as saying that the company "will continue to pursue the acquisition of additional franchise markets when our franchisees indicate an interest to sell."

Dot three: The headline of the company's second quarter earnings release last August trumpeted how "Krispy Kreme Earnings Exceed Estimates." So what if it was by a measly penny? The company also pointed out in the same release that 2004 earnings would be "above consensus." As I pointed out at the time, when companies start playing the beat-the-Street game in their own press releases, investors should start paying closer attention to the quality of those earnings.

Dot four: On August 26 of last year Jubilee Investments, at the time Krispy Kreme's second largest investor, quietly started to sell its shares through what is known as a "forward contract" on 2.4 million of its 3.1 million share stake. Such transactions, which leave the company's stated holdings unchanged, are often used as a way to unload shares in a way that won't be detected. Jubilee's general partner is John McAleer, the brother of Joe, who co-owned the Dallas/Shreveport units.

Krispy Kreme disclosed the transaction on its website and said the purpose of the sale was to "diversify its investments and to help achieve the estate-planning objectives of its partners more efficiently." (Diversification, schmersification. You don't sell if you have conviction a stock is headed considerably higher.) As it so happens, the stock was just below its all time high of nearly $50, which it hit around a week earlier. It's unknown how many shares McAleer actually sold.

Dot five: A story in the Las Vegas Press in October noted that franchise holder Lincoln Spoor was opening his 15th Krispy Kreme store his first in Idaho. According to the story, revenues of $25 million to $30 million were "about even with 2001 numbers." Did he say even? Indeed he did. Even is another way of saying flat which is another way of saying, "Not growing."

Dot six: In late October Krispy Kreme filed a prospectus on behalf of Dough-Re-Mi, its Michigan franchisee, to sell all of the 443,917 shares Dough-Re-Mi received when Krispy Kreme bought 73% of its operations. As I wrote at the time, "Quite a vote of confidence from the people who supposedly know Krispy Kreme from inside out." (A bigger question: Why do so many franchisees want to sell?)

Dot seven: The fourth quarter, announced in March, included weaker than expected margins and falling average weekly sales two signs of deteriorating earnings quality.

Dot eight: As I reported two weeks ago, an inside peek at the sales of one store showed how dramatically sales can fall at a Krispy Kreme unit after the novelty wears off.

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