Krispy Kreme Doughnuts, Inc. Essay

Krispy Kreme Doughnuts, as discussed in Darden Business Publishing Case UVA-F-1479, appears to be at a crossroads. After years of astronomical growth, the company find its share price plummeting in the midst of discoveries about faulty accounting practices. The following paper examines several issues behind the sudden decline First, the historical income statements and balance sheets are examined to determine the financial health and current condition of the company. This is followed by an analysis of key financial ratios across time and versus industry standards. Next, the paper addresses if Krispy Kreme is financially healthy at year-end 2003 and, if so, what accounts for the firm’s recent share price decline. The paper concludes with a discussion of the intrinsic investment value in the company. Income Statement and Balance Sheets Close review of the income statement leads to some noteworthy conclusions. The first quarterly column of the 2004 income statement shows that the company gained thirty-four million dollars in discontinued operations from the sale of the Montana Mills venture. In the same quarter the firm lost approximately twenty-four million dollars. It is likely that this maneuver was made to deflect attention from or make up for the company’s poor performance and mounting losses. Generally, this is not a sign of a healthy company but rather signals an alarm since the loss in that quarter was closer to fifty-eight million dollars when not considering the sale. Krispy Kreme may have been struggling to make ends meet through its operations, and perhaps the company hoped to make up lost income through the sale of a venture. Furthermore, operating expenses were increasing while net income was decreasing. In May 2004, the company had seven million dollars in closing costs and still showed losses. An aggressive expansion strategy did not result in enough income to cover these costs. Additionally, quarterly comps decreased dramatically. From May 2003 to May 2004, operating income dropped from $23,702 million to $18,636 million. This decrease is even more pronounced when examining the quarters ending in August. Krispy Kreme’s balance sheet is no less indicative of poor financial health, particularly with a substantial increase in year over year long-term liability figures. The two major contributors to this increase in long-term liabilities include Krispy Kreme’s revolving lines of credit and its long-term debt. First, the revolving lines of credit greatly increased from nothing in fiscal year 2002 to eighty-seven million dollars in fiscal year 2004, demonstrating a burgeoning dependence by Krispy Kreme on outside finance to support operations. Second, long-term debt increased from 3,912 million in 2002 to 48,056 million in 2004. This anomalous and significant increase in long term debt could mean that Krispy Kreme is having trouble paying off its debt. After analyzing both the income statement and balance sheet an initial assumption can me made that Krispy Kreme does not appear to be financially healthy. The next step of understanding this case is to determine how financial ratios extend our understanding of the abovel statements. Financial Ratios The following financial ratios were analyzed: quick ratio, current ratio, return on assets, return on equity, net profit margin, receivables turnover, inventory turnover, asset turnover, cash turnover, debt-to-equity, and times interest earned. These ratios are included in a time series (Case Exhibit 7) raise and in a cross-sectional chart of quick-service restaurants (Case Exhibit 8). To begin, the time series ratios are detailed in Figure 1. Starting with the liquidity ratios we noticed some significance in the changes of the current ratio. The increases in the current ratio in 2003 and 2004 signal that Krispy Kreme is borrowing over the long term, not the short term, resulting in an increase of cash affecting assets. The current liabilities would not be affected by this increase in cash or long term. This corroborates the balance sheet, as with the current ratio rise we see a gain in cash and cash equivalents plus a gain in long term debt. Figure 1. Krispy Kreme Analytical Financial Ratios The debt-to-equity ratio in 2003 and 2004 imply the company is also using more long-term debt from shareholder equity to run the company. In 2004, the balance sheet shows a jump in the number of share of common stock. The selling of more stock to pay for long term debt is not usually a good signal to investors. It may mean a corporation wants more cash to finance activities, which in conjunction with other figures could mean it is trying to offset some losses. A lower times interest earned ratio may also mean fewer earnings are available to meet interest payments and that the business is more vulnerable to increases in interest rates. This ratio has declined dramatically since 2002. Negative findings of the company are apparent when looking at the activity ratios. The receivables turnover ratio has been declining since 2001. This decline in receivables turnover implies that company is not being as efficient in the collection of accounts owed as it should be. Not collecting the credit in a timely manner means that they are not gaining interest for the firm, but potentially giving others a free loan for the time being. Furthermore, the asset turnover ratio for Krispy Kreme has been declining since the company went public in 2000. As seen in Figure 1, the ratio was at a high in 2000 at 2.10 and is not at 1.01 in 2004. This lower asset turnover ratio signals that the company is not doing well in using its assets to generate sales. The final subcategory in the time series ratio analysis are the profitability ratios, which show some positive signs for Krispy Kreme. The return on assets ratio is relatively stable at 8.64% in 2004. Krispy Kreme is still doing relatively well by using current assets to generate income. Unfortunately, the return on assets has come down from a high of 10.33% in 2002, a signal to investors that Krispy Kreme is not ameliorating its use of assets to create income. However, the operating profit margin ratio displayed a steady increase for the company, resulting in more operating income for every dollar of sales. The increasing net profit margin also shows Krispy Kreme is generating more profit for every dollar of sales. The change from 6.81% to 8.58% in 2004 shows that Krispy Kreme is now making another 1.7 cents per dollar of sales. Examination of the financial ratios between Krispy Kreme and its peers in the quick-service restaurant industry reveals a few key facts about the company’s financial state. Foremost is the relatively high liquidity index of the corporation as measured by both the quick and the current ratios. Compared to a respective mean of 0.80 and 1.17 for each aforementioned ratio, Krispy Kreme weighs in at 2.72 for the former and 3.25 for the latter – approximately three times the average. As these figures measure a firm’s ability to pay bills in the short term without stress, it may not be farfetched to suggest Krispy Kreme has liquefied many of its assets to satisfy the doubts of short-term creditors. This band-aid solution may be short-lived, however, since current assets and liabilities are never a dependable tool for forecasting. Exorbitant liquidity also suggests an ineffective use of cash and other short-term assets and a lack of borrowing power. The other noteworthy aspect of these industry ratios is the low level of turnover on both receivables and inventory. Krispy Kreme’s receivables turnover ratio of 9.70 is about four times smaller than the mean of 37.51 for most quick-service restaurants. This is possibly an indication of the firm’s inability to collect on its due bills. Inventory turnover for the corporation is at a ratio of 17.76 versus the industry mean of 64.70, also about four times less than standard. Low inventory turnover can signify a poor management of said inventory. Combined with poor cash management, this spells trouble for investors. Nevertheless, there is a redeeming factor for the corporation, although given the looming sale of several stores, it may not be one that lasts very long. The profitability ratios of Krispy Kreme are comparable to those within the industry, and a good set of such ratios is a reflection of how efficiently a firm uses its assets and how well it manages its operations. In order for Krispy Kreme to make good on these numbers, it will need to convince creditors of its long-term solvency and improve its turnover. At the end of fiscal year 2003, the financial health of Krispy Kreme is neither stellar nor abysmal. The company has several indications of future tribulations that it needs to sort out, but from a financial standpoint it is relatively in good standing and could be said to pass the litmus test of profitability. Some symptoms it needs to examine include its acutely high short-term solvency. Does the firm find itself liquefying at an excessive rate to satisfy short-term creditors? If so, the company needs to reduce the scale of its operations and cut costs until longer-term loans are able to be secured. At that point, it may be able to grow again without the burden of investor and media hype. Furthermore, the firm needs to apply pressure to its debtors and try to improve its receivable turnover ratio. In this way, Krispy Kreme may be able to raise more capital and manage its assets more effectively. Finally, with the increased scrutiny and speculation concerning the company’s financial reporting, it should seriously address these concerns and restore investor confidence before stock prices continued to decline. Stock Price Evaluation Given Krispy Kreme’s mixed financial health, what accounts for sharp decline in it’s share price? On May 27, 2004 Krispy Kreme announced poor results for the first time in its history as a public company. Earnings were down 10% due to the trend toward low carbohydrate diets, or at least as reported by the company . Krispy Kreme decided to divest Montana Mills for $40 million in stock and also planned to close three of its new Hot Doughnut and Coffee shops. The Wall Street Journal published a negative story on the accounting principles that Krispy Kreme used for franchise acquisitions. The company also had to pay Michigan franchise’s top executive $5 million as part of a severance package. On July 29th, U.S. Securities and Exchange Commision (SEC) launched an informal investigation on â€Å"franchise reacquisition’s and the company’s previously announced reduction in earnings guidance.† In September 2004, Krispy Kreme announced that it would reduce number of new stores from 120 to around 60. In the beginning of 2005, the company announced previously issued financial statements for fiscal year ended 2004 would be restated to correct certain errors. Krispy Kreme then delayed the filing of its financial reports until the SEC’s investigation had been resolved. Numerous problems, both salient and hidden, tarnished once-optimistic forecasts for Krispy Kreme, changing it from a solid company to a risk. Investors have now lost confidence and the share price has steadily dropped. Although the company’s actual financial health may have been more benign, public perception has been sullied nearly irreparably. Intrinsic Investment Value Barring incisive and insightful financial analysis, there must be a source of intrinsic investment value in the company which can be gleaned from financial statements. The perceived quality and expectations of the investors hass a strong influence on this innate value. If the investors feel that a company will be profitable the intrinsic value will likely increase and vice versa. Intrinsic value also has much to do with brand image, as in Krispy Kreme’s distinctive green and red vintage logo, it’s â€Å"Hot Doughnuts Now† neon sign and the perceived quality of the doughnuts. These accoutrements drive traffic and sales, two key indicators of a food service company’s health. Furthermore, the central Krispy Kreme retail concept, The Factory Store, is a prime contributor to intrinsic value. Krispy Kreme creation of â€Å"a doughnut theatre† illustrated by custom machinery and doughnut viewing areas is a significant point of distinction from its competitors by offering more than just a product but a complete experience. These subtle differences add to the Krispy Kreme mystique, which adds a level of perceived quality. Conclusion The brief history of Krispy Kreme since its IPO in 2000, reveals a company that has already seen its ups and downs. These undulations characterize the growth of many such firms. Several conclusions on the state of Krispy Kreme Doughnuts can be drawn from the Darden School case. First, Krispy Kreme is a company that is moderately healthy, but seems to be turning for the worse. Second, a time series profitability ratios suggest good health, but peer-to-peer current and quick ratios show a startling scramble to meet short-term obligations. Third, in an era of high-profile accounting scandals, clandestine reporting practices scare off investors, leading to Krispy Kreme’s decline in share price. Finally, Krispy Kreme may be able to trade on its brand equity to leverage poor financial practices.