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Krispy Kreme Doughnuts 10-Q 2008 Table of Contents
UNITED STATES SECURITIES AND EXCHANGE
COMMISSION ________________ Form 10-Q
Commission file number
001-16485
Registrant’s telephone number,
including area code: Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes o No þ Number of shares of Common Stock, no par value, outstanding as of November 30, 2008: 67,528,429. TABLE OF CONTENTS
2 As used herein, unless the context otherwise requires, “Krispy Kreme,” the “Company,” “we,” “us” and “our” refer to Krispy Kreme Doughnuts, Inc. and its subsidiaries. References to fiscal 2011, 2010, 2009, 2008, 2007, 2006 and 2005 mean the fiscal years ended January 30, 2011, January 31, 2010, February 1, 2009, February 3, 2008, January 28, 2007, January 29, 2006 and January 30, 2005, respectively. FORWARD-LOOKING STATEMENTS This quarterly report contains statements about future events and expectations, including our business strategy and trends in or expectations regarding the Company’s operations, financing abilities and planned capital expenditures that constitute “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements are based on management’s beliefs, assumptions and expectations of our future economic performance, considering the information currently available to management. These statements are not statements of historical fact. Forward-looking statements involve risks and uncertainties that may cause our actual results, performance or financial condition to differ materially from the expectations of future results, performance or financial condition we express or imply in any forward-looking statements. The words “believe,” “may,” “will,” “should,” “anticipate,” “estimate,” “expect,” “intend,” “objective,” “seek,” “strive” or similar words, or the negative of these words, identify forward-looking statements. Factors that could contribute to these differences include, but are not limited to:
3
All such factors are difficult to predict, contain uncertainties that may materially affect actual results and may be beyond our control. New factors emerge from time to time, and it is not possible for management to predict all such factors or to assess the impact of each such factor on the Company. Any forward-looking statement speaks only as of the date on which such statement is made, and we do not undertake any obligation to update any forward-looking statement to reflect events or circumstances after the date on which such statement is made. We caution you that any forward-looking statements are not guarantees of future performance and involve known and unknown risks, uncertainties and other factors which may cause our actual results, performance or achievements to differ materially from the facts, results, performance or achievements we have anticipated in such forward-looking statements. 4 PART I – FINANCIAL INFORMATION Item 1. FINANCIAL STATEMENTS
5 KRISPY KREME DOUGHNUTS, INC. CONSOLIDATED BALANCE
SHEET
The accompanying notes are an integral part of the financial statements. 6 KRISPY KREME DOUGHNUTS, INC. CONSOLIDATED STATEMENT OF
OPERATIONS
The accompanying notes are an integral part of the financial statements. 7 KRISPY KREME DOUGHNUTS, INC. CONSOLIDATED STATEMENT OF CASH
FLOWS
The accompanying notes are an integral part of the financial statements. 8
KRISPY KREME DOUGHNUTS, INC. CONSOLIDATED STATEMENT OF CHANGES IN
SHAREHOLDERS’ EQUITY
The accompanying notes are an integral part of the financial statements. 9 KRISPY KREME DOUGHNUTS, INC. NOTES TO FINANCIAL
STATEMENTS Note 1 — Overview Significant Accounting Policies BASIS OF PRESENTATION. The consolidated financial statements contained herein should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended February 3, 2008. The accompanying interim consolidated financial statements are presented in accordance with the requirements of Article 10 of Regulation S-X and, accordingly, do not include all the disclosures required by generally accepted accounting principles (“GAAP”) with respect to annual financial statements. The interim consolidated financial statements have been prepared in accordance with the Company’s accounting practices described in such Annual Report, but have not been audited. In management’s opinion, the financial statements include all adjustments which, except as otherwise disclosed in this Quarterly Report on Form 10-Q, consist only of normal recurring adjustments, necessary for a fair statement of the Company’s results of operations for the periods presented. The consolidated balance sheet data as of February 3, 2008 were derived from the Company’s audited financial statements, but do not include all disclosures required by GAAP. NATURE OF BUSINESS. Krispy Kreme Doughnuts, Inc. (“KKDI”) and its subsidiaries (collectively, the “Company”) are engaged in the sale of doughnuts and related items through Company-owned stores. The Company also derives revenue from franchise and development fees and royalties from franchisees. Additionally, the Company sells doughnut mix, other ingredients and supplies and doughnut-making equipment to franchisees. BASIS OF CONSOLIDATION. The financial statements include the accounts of KKDI and its subsidiaries, the most significant of which is KKDI’s principal operating subsidiary, Krispy Kreme Doughnut Corporation. Investments in entities over which the Company has the ability to exercise significant influence, and whose financial statements are not required to be consolidated, are accounted for using the equity method. These entities typically are 20% to 35% owned and are hereinafter sometimes referred to as “Equity Method Franchisees.” EARNINGS PER SHARE. The computation of basic earnings per share is based on the weighted average number of common shares outstanding during the period (exclusive of shares of restricted stock which have been issued but have not yet vested). The computation of diluted earnings per share reflects the additional common shares that would have been outstanding if dilutive potential common shares had been issued, computed using the treasury stock method. Such potential common shares consist of shares issuable upon the exercise of stock options and the vesting of currently unvested shares of restricted stock. The following table sets forth amounts used in the computation of basic and diluted earnings per share:
All potentially dilutive securities have been excluded from the number of shares used in the computation of diluted earnings per share for the three months and nine months ended November 2, 2008 and October 28, 2007 because the Company incurred a net loss in these periods and their inclusion would be antidilutive. 10 Recent Accounting Pronouncements Effective February 4, 2008 (the first day of fiscal 2009), the Company adopted Financial Accounting Standards Board (“FASB”) Statement No. 157, “Fair Value Measurements” (“FAS 157”), as described in Note 11. FAS 157 addresses how companies should measure fair value when they are required to use a fair value measure for recognition or disclosure purposes under GAAP. As a result of FAS 157, there is now a common definition of fair value to be used throughout GAAP, which is expected to make the measurement of fair value more consistent and comparable. Adoption of FAS 157 had no material effect on the Company’s financial position or results of operations. See Note 11 for additional information regarding fair value measurement. Effective January 29, 2007 (the first day of fiscal 2008), the Company adopted the provisions of FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes,” (“FIN 48”). FIN 48 prescribes recognition thresholds that must be met before a tax position is recognized in the financial statements and provides guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. Under FIN 48, an entity may only recognize or continue to recognize tax positions that meet a "more likely than not" threshold. The Company recorded the cumulative effect of adopting FIN 48 as a $1.2 million credit to the opening balance of accumulated deficit as of January 29, 2007, the date of adoption. Principally as a result of the dissolution of one of the Company’s foreign subsidiaries and the resolution of related income tax uncertainties, the Company recorded a credit of approximately $1.7 million to the provision for income taxes during the first nine months of fiscal 2009 to reduce the Company’s accruals for uncertain tax positions. In February 2007, the FASB issued Statement No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities, including an amendment of FASB Statement No. 115” (“FAS 159”). FAS 159 permits entities to choose to measure many financial instruments and certain other items at fair value that are not currently required to be measured at fair value. Unrealized gains and losses on items for which the fair value option has been elected are reported in earnings. FAS 159 does not affect any existing accounting literature that requires certain assets and liabilities to be carried at fair value. The Company adopted FAS 159 as of February 4, 2008 (the first day of fiscal 2009) and did not elect any fair value measurement options permitted by FAS 159 and, accordingly, FAS 159 did not have any effect on the Company’s financial position or results of operations. In March 2008, the FASB issued FASB Statement No. 161, “Disclosures about Derivative Instruments and Hedging Activities” (“FAS 161”). FAS 161 is intended to improve financial reporting about derivative instruments and hedging activities by requiring enhanced disclosures to enable investors to better understand their effects on an entity’s financial position, financial performance and cash flows. FAS 161 is effective for the Company in fiscal 2010. Note 2 — Business Conditions, Uncertainties and Liquidity The Company experienced a decline in revenues and incurred net losses in each of the last three fiscal years. The revenue decline reflects fewer Company stores in operation, a decline in domestic royalty revenues and lower sales of mixes and other ingredients resulting from lower sales by the Company’s domestic franchisees. These declines were only partially offset by higher royalty revenues from international franchisees. Lower revenues have adversely affected operating margins because of the fixed or semi-fixed nature of many of the Company’s direct operating expenses. In addition, the Company has recorded significant asset impairment charges in each of the last three fiscal years. The Company generated net cash from operating activities of $10.8 million in the first nine months of fiscal 2009 and $8.1 million in the first nine months of fiscal 2008. Net cash provided by operating activities in the first nine months of fiscal 2008 reflects a cash outflow of approximately $4.1 million for a prepayment penalty on the refinancing of indebtedness. In the first nine months of fiscal 2009, the Company continued to experience declines in revenues in both its Company Stores and KK Supply Chain business segments. In addition, price increases in the Company Stores segment have not been sufficient to fully offset steep rises in agricultural commodity costs and gasoline prices in fiscal 2009 compared to fiscal 2008, although recent economic conditions have led to significant reductions in the market prices of these commodities and in the price of gasoline. Sales volumes and changes in the cost of major ingredients and fuel can have a material effect on the Company’s results of operations and cash flows. The Company’s 2007 Secured Credit Facilities described in Note 5 are the Company’s principal source of external financing. These facilities consist of a term loan having an outstanding principal balance of $74.7 million as of November 2, 2008 which matures in February 2014, and a $30 million revolving credit facility which matures in February 2013. 11 The 2007 Secured Credit Facilities contain significant financial covenants as described in Note 5, which become more stringent in the first quarter of fiscal 2010. It is likely the Company will need to seek amendments of its credit facilities to relax those financial covenants for fiscal 2010. The Company was in compliance with the financial covenants as of November 2, 2008, but also may need relief with respect to fiscal 2009 depending on its results for the fourth quarter. As a result of amendments in fiscal 2008 and 2009, the Company paid fees of approximately $835,000 and the interest rate on outstanding loans increased from LIBOR plus 2.75% to LIBOR plus 5.50% (with a LIBOR floor of 3.25%). Any future amendments or waivers could result in additional fees or rate increases. Failure to comply with the financial covenants contained in the 2007 Secured Credit Facilities, or the occurrence or failure to occur of certain events, would cause the Company to default under the facilities. In the absence of a waiver of, or forbearance with respect to, any such default, the Company’s lenders would be able to exercise their rights, under the credit agreement including, but not limited to, accelerating maturity of outstanding indebtedness and asserting their rights with respect to the collateral. In the event the Company were to fail to comply with one or more such covenants, the Company would attempt to negotiate waivers of any such noncompliance. There can be no assurance that the Company would be able to negotiate any such waivers, and the costs or conditions associated with any such waivers could be significant. Acceleration of the maturity of indebtedness under the 2007 Secured Credit Facilities could have a material adverse effect on the Company’s financial position, results of operations and cash flows. In the event that credit under the 2007 Secured Credit Facilities were not available to the Company, there can be no assurance that alternative sources of credit would be available to the Company or, if they are available, under what terms or at what cost. In addition to further declines in revenues, many other factors could also adversely affect the Company’s business. In particular, increases in the cost of raw materials and fuel and strengthening of the U.S. dollar relative to other currencies could adversely affect the Company’s operating results and cash flows. In addition, several franchisees have been experiencing financial pressures which, in certain instances, have become exacerbated in recent quarters. The Company has guaranteed certain obligations of franchisees in which it has an equity interest, as described in “Other Commitments and Contingencies” in Note 6. Franchisees opened 96 stores and closed 30 stores in the first nine months of fiscal 2009, including 37 and 19 stores, respectively, in the third quarter. The Company believes franchisees will close additional stores in the future, and the number of such closures may be significant. Royalty revenues and most of KK Supply Chain revenues are directly related to sales by franchise stores and, accordingly, the success of franchisees’ operations has a direct effect on the Company’s revenues, results of operations and cash flows. Note 3 — Receivables The components of receivables are as follows:
The allowances for doubtful accounts declined from an aggregate of $6.1 million at February 3, 2008 to $4.5 million at November 2, 2008 principally due to write-offs of receivables previously reserved. 12 Note 4 — Inventories The components of inventories are as follows:
Note 5 — Long Term Debt Long-term debt and capital lease obligations consist of the following:
In February 2007, the Company closed secured credit facilities totaling $160 million (the “2007 Secured Credit Facilities”). The facilities then consisted of a $50 million revolving credit facility maturing in February 2013 (the “2007 Revolver”) and a $110 million term loan maturing in February 2014 (the “2007 Term Loan”). The 2007 Secured Credit Facilities are secured by a first lien on substantially all of the assets of the Company and its domestic subsidiaries. At closing, the Company borrowed the full $110 million available under the 2007 Term Loan and used the proceeds to retire approximately $107 million of indebtedness outstanding under the Company’s former secured credit facilities (which were then terminated), to pay prepayment premiums under the former secured credit facilities and to pay fees and expenses associated with the 2007 Secured Credit Facilities. The Company recorded a pretax charge related to the refinancing of approximately $9.6 million in the first quarter of fiscal 2008, representing the approximately $4.1 million prepayment fee related to the former secured credit facilities and the write-off of approximately $5.5 million of unamortized deferred financing costs related to that facility. The 2007 Revolver contains provisions which permit the Company to obtain letters of credit. Issuance of letters of credit under these provisions constitutes usage of the lending commitments, and reduces the amount available for cash borrowings under the 2007 Revolver. The commitments under the 2007 Revolver were reduced to $30 million from $50 million in connection with the amendments to the 2007 Secured Credit Facilities executed in April 2008 (the “April Amendments”). Interest on borrowings under the 2007 Revolver and 2007 Term Loan is payable either at LIBOR or at the Alternate Base Rate (which is the greater of Fed funds rate plus 0.50% or the prime rate), in each case plus the Applicable Margin. As of November 2, 2008, the Applicable Margin for LIBOR-based loans and for Alternate Base Rate-based loans was 5.50% and 4.50%, respectively (3.50% and 2.50%, respectively, prior to the April Amendments and 2.75% and 1.75%, respectively, prior to amendments executed in January 2008 to permit the sale of certain real estate). In addition, the April Amendments provide that LIBOR-based loans shall be computed based upon the greater of the relevant LIBOR rate or 3.25%. The Company is required to pay a fee equal to the Applicable Margin for LIBOR-based loans on the outstanding amount of letters of credit issued under the 2007 Revolver, as well as a fronting fee of 0.25% of the amount of such letter of credit payable to the letter of credit issuer. There also is a fee on the unused portion of the 2007 Revolver lending commitment, which increased from 0.50% to 0.75% simultaneously with the reduction in the revolver lending commitments pursuant to the April Amendments. Borrowings under the 2007 Revolver (and issuances of letters of credit) are subject to the satisfaction of usual and customary conditions, including accuracy of representations and warranties and the absence of defaults. 13 The 2007 Term Loan is payable in quarterly installments of approximately $240,000 (after adjustment for the effects of certain principal prepayments) and a final installment equal to the remaining principal balance in February 2014. The 2007 Term Loan is required to be prepaid with some or all of the net proceeds of certain equity issuances, debt incurrences, asset sales and casualty events and with a percentage of excess cash flow (as defined in the agreement) on an annual basis. The 2007 Secured Credit Facilities require the Company to meet certain financial tests, including a maximum consolidated leverage ratio (expressed as a ratio of total debt to Consolidated EBITDA) and a minimum consolidated interest coverage ratio (expressed as a ratio of Consolidated EBITDA to net interest expense), computed based upon Consolidated EBITDA and net interest expense for the most recent four fiscal quarters and total debt as of the end of such four-quarter period. As of November 2, 2008, the consolidated leverage ratio was required to be not greater than 4.75 to 1.0 and the consolidated interest coverage ratio was required to be not less than 2.5 to 1.0. As of November 2, 2008, the Company’s consolidated leverage ratio was approximately 3.8 to 1.0 and the Company’s consolidated interest coverage ratio was approximately 3.0 to 1.0. The maximum consolidated leverage ratio declines during fiscal 2010 to 4.0 to 1.0 and declines thereafter until it reaches 2.75 to 1.0 in fiscal 2013. The minimum consolidated interest coverage ratio increases during fiscal 2010 to 3.0 to 1.0 and increases to 4.5 to 1.0 for fiscal 2011 and thereafter. “Consolidated EBITDA” is a non-GAAP measure and is defined in the 2007 Secured Credit Facilities to mean, generally, consolidated net income or loss, exclusive of unrealized gains and losses on hedging instruments, gains or losses on the early extinguishment of debt and provisions for payments on guarantees of franchisee obligations plus the sum of net interest expense, income taxes, depreciation and amortization, non-cash charges, store closure costs, costs associated with certain litigation and investigations, and extraordinary professional fees; and minus payments, if any, on guarantees of franchisee obligations in excess of $3 million in any rolling 12-month period and the sum of non-cash credits. In addition, the 2007 Secured Credit Facilities contain other covenants which, among other things, limit the incurrence of additional indebtedness (including guarantees), liens, investments (including investments in and advances to franchisees which own and operate Krispy Kreme stores), dividends, transactions with affiliates, asset sales, acquisitions, capital expenditures, mergers and consolidations, prepayments of other indebtedness and other activities customarily restricted in such agreements. The 2007 Secured Credit Facilities also prohibit the transfer of cash or other assets to KKDI from its subsidiaries, whether by dividend, loan or otherwise, but provide for exceptions to enable KKDI to pay taxes and operating expenses and certain judgment and settlement costs. The operation of the restrictive financial covenants described above may limit the amount the Company may borrow under the 2007 Revolver. In addition, the maximum amount which may be borrowed under the 2007 Revolver is reduced by the amount of outstanding letters of credit, which totaled approximately $16.0 million as of November 2, 2008. The maximum additional borrowing available to the Company as of November 2, 2008 was approximately $14.0 million. The 2007 Secured Credit Facilities also contain customary events of default, including, without limitation, payment defaults, breaches of representations and warranties, covenant defaults, cross-defaults to other indebtedness in excess of $5 million, certain events of bankruptcy and insolvency, judgment defaults in excess of $5 million and the occurrence of a change of control. In May 2007, the Company entered into interest rate derivative contracts having an aggregate notional principal amount of $60 million. The derivative contracts eliminate the Company’s exposure, with respect to such notional amount, to increases in three month LIBOR beyond 5.40% through April 2010, and eliminate the Company’s ability to benefit from a reduction in three month LIBOR below 4.48% for the same period. These derivatives were accounted for as cash flow hedges from their inception through April 8, 2008. Hedge accounting was discontinued on that date because the derivative contracts could no longer be shown to be effective (as defined in Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities”) in hedging interest rate risk as a result of the April Amendments, which provide that interest on LIBOR-based borrowings is payable at the greater of the LIBOR rate for the selected interest period or 3.25%. As a consequence of the discontinuance of hedge accounting, changes in the fair value of the derivative contracts subsequent to April 8, 2008 are reflected in earnings as they occur. Amounts included in accumulated other comprehensive income related to changes in the fair value of the derivative contracts for periods prior to April 9, 2008 are being charged to earnings in the periods in which the hedged forecasted transaction (interest on $60 million of the principal balance of the 2007 Term Loan) affects earnings. As of November 2, 2008, the fair value of the derivatives was a liability of approximately $1.6 million, which is included in accrued liabilities in the accompanying consolidated balance sheet. Accumulated other comprehensive income as of November 2, 2008 includes an accumulated loss related to these derivatives of approximately $1.0 million (net of income taxes of approximately $600,000). 14 Note 6 — Commitments and Contingencies Legal Proceedings Except as disclosed below, the Company is not a party to any material legal proceedings. Pending Litigation and Investigations The Company is subject to litigation and investigations, the outcome of which cannot presently be determined. The Company cannot predict the likelihood of an unfavorable outcome with respect to these matters, or the amount or range of potential loss with respect to, or the amount that might be paid in connection with any settlement of, any of these pending matters, and, accordingly, no provision for loss with respect to any of the following matters has been reflected in the consolidated financial statements. SEC Investigation On October 7, 2004, the staff of the SEC advised the Company that the SEC had entered a formal order of investigation concerning the Company. The Company is cooperating with the investigation. United States Attorney Investigation On February 24, 2005, the United States Attorney’s Office for the Southern District of New York advised the Company that it would seek to conduct interviews of certain current and former officers and employees of the Company. The Company is cooperating with the investigation. TAG Litigation In February 2008, the Company filed suit in the U.S. District Court for the Middle District of North Carolina against The Advantage Group Enterprise, Inc. (“TAG”), alleging that TAG failed to properly account for and pay the Company on sales of equipment that the Company consigned to TAG. Based on these allegations, the Company asserted various claims including breach of fiduciary duty and conversion, and it seeks an accounting and constructive trust. In addition, the Company seeks a declaration that it does not owe TAG approximately $1 million for storage fees and alleged lost profits. In March 2008, TAG answered the complaint, denying liability and asserting counterclaims against the Company. TAG alleges that the Company acted improperly by failing to execute a written contract between the companies and claims damages for breach of contract, services rendered, unjust enrichment, violation of the North Carolina Unfair Trade Practices Act and fraud in the inducement. TAG seeks approximately $1 million in actual damages as well as punitive and treble damages. The Company intends to vigorously prosecute its claims against TAG and to vigorously defend against the counterclaims, which the Company believes are without merit. Litigation Settled Federal Securities Class Actions and Settlement Thereof and Federal Court Shareholder Derivative Actions and Partial Settlement Thereof On May 12, 2004, a purported securities class action was filed on behalf of persons who purchased the Company’s publicly traded securities between August 21, 2003 and May 7, 2004 against the Company and certain of its former officers in the United States District Court for the Middle District of North Carolina, alleging violations of federal securities law in connection with various public statements made by the Company. Subsequently, 14 substantially identical purported class actions were filed in the same court. All the actions ultimately were consolidated. In addition to the purported securities class action, three shareholder derivative actions were filed in the United States District Court for the Middle District of North Carolina against certain current and former directors of the Company, certain former officers of the Company, including Scott Livengood (the Company’s former Chairman and Chief Executive Officer), as well as certain persons or entities that sold franchises to the Company. The complaints in these actions alleged that the defendants breached their fiduciary duties in connection with their management of the Company and the Company’s acquisitions of certain franchises. In October 2006, the Company entered into a Stipulation and Settlement Agreement (the “Stipulation”) with the lead plaintiffs in the securities class action, the derivative plaintiffs and all defendants named in the class action and derivative litigation, except for Mr. Livengood, providing for the settlement of the securities class action and a partial settlement of the derivative action. The Stipulation contained no admission of fault or wrongdoing by the Company or the other defendants. In February 2007, the Court entered final judgment dismissing all claims with respect to all defendants in the derivative action, except for claims that the Company may assert against Mr. Livengood, and entered final judgment dismissing all claims with respect to all defendants in the securities class action. 15 With respect to the securities class action, the settlement class received total consideration of approximately $76.0 million, consisting of a cash payment of approximately $35.0 million made by the Company’s directors’ and officers’ insurers, cash payments of $100,000 each made by each of a former Chief Operating Officer and former Chief Financial Officer of the Company, a cash payment of $4 million made by the Company’s independent registered public accounting firm, and common stock and warrants to purchase common stock issued by the Company having an estimated aggregate value of approximately $36.9 million as of their issuance on March 2, 2007. Claims against all defendants were dismissed with prejudice; however, claims that the Company may have against Mr. Livengood that may be asserted by the Company in the derivative action for contribution to the securities class action settlement or otherwise under applicable law are expressly preserved. The Stipulation also provided for the settlement and dismissal with prejudice of claims against all defendants in the derivative action, except for claims against Mr. Livengood. In addition to their contribution of $100,000 each to the settlement of the securities class action, the two former officers agreed to limit their claims for indemnity from the Company in connection with future proceedings before the SEC or by the United States Attorney for the Southern District of New York to specified amounts. The Company has been in negotiations with Mr. Livengood but has not reached agreement to resolve the derivative claims against him. Counsel for the derivative plaintiffs have deferred their application for fees until conclusion of the derivative actions against Mr. Livengood. See “Other Commitments and Contingencies” below. In the first quarter of fiscal 2008, the Company issued 1,833,828 shares of its common stock and warrants to purchase 4,296,523 shares of its common stock at a price of $12.21 per share in connection with the Stipulation, and provisions for the settlement recorded in fiscal 2007 were adjusted to reflect the ultimate fair value of the securities issued by the Company as of March 2, 2007, which resulted in a non-cash credit to earnings of $14.9 million. FACTA litigation On October 3, 2007, a purported nationwide class action (Peter Jackson v. Krispy Kreme Doughnut Corporation (Case No. CV07-06449 ABC (VBC)), United States District Court, Central District of California) was filed against the Company and ten fictitiously named defendants. Plaintiff asserted a single cause of action for alleged willful violation of the federal Fair and Accurate Credit Transactions Act (“FACTA”). Specifically, plaintiff alleged a violation concerning electronic printing of certain credit card and debit card receipts that were not in compliance with the applicable information truncation provisions of FACTA. On August 25, 2008, the Company entered into an agreement settling the case; such settlement had no material effect on the Company’s financial statements. Other matters The Company also is engaged in various legal proceedings arising in the normal course of business. The Company maintains customary insurance policies (which are subject to deductibles) against certain kinds of such claims and suits, including insurance policies for workers’ compensation and personal injury. Other Commitments and Contingencies The Company has guaranteed certain loans and leases from third-party financial institutions on behalf of Equity Method Franchisees, primarily to assist the franchisees in obtaining third-party financing. The loans are collateralized by certain assets of the franchisee, generally the Krispy Kreme store and related equipment. The Company’s contingent liabilities related to these guarantees totaled $9.4 million and $17.5 million at November 2 and February 3, 2008, respectively, and are summarized in Note 9. These guarantees require payment from the Company in the event of default on payment by the respective debtor and, if the debtor defaults, the Company may be required to pay amounts outstanding under the related agreements in addition to the principal amount guaranteed, including accrued interest and related fees. The aggregate recorded liability for these loan and lease guarantees totaled $2.7 million as of November 2, 2008. This amount represents the estimated amount of guarantee payments which the Company believes are probable and is included in accrued liabilities in the accompanying consolidated balance sheet. This liability was recorded in the fourth quarter of fiscal 2008 as more fully described in Note 9. The Company has made payments totaling approximately $650,000 related to these guarantees during fiscal 2009 as more fully described in Note 9. While there is no current demand on the Company to perform under any of the guarantees, there can be no assurance that the Company will not be required to perform and, if circumstances change from those prevailing at November 2, 2008, additional payments or provisions for guarantee payments could be required with respect to any of the guarantees, and such payments or provisions could be significant. 16 In addition, accrued liabilities at November 2, 2008 includes approximately $200,000 recorded in the second quarter of fiscal 2009 in connection with the Company’s assignment of operating leases on three stores to two new franchisees who have acquired these stores from the Company. The Company is contingently liable to pay the rents on these stores to the landlords in the event the franchisees fail to perform under the leases they have assumed. The $200,000 charge represents the estimated fair value of the Company’s contingent obligation. The Company is subject to indemnification obligations to its directors and officers pursuant to indemnification provisions of North Carolina law, the Company’s bylaws and certain indemnification agreements. Several of the Company’s former directors, officers and employees are the subject of criminal, administrative and civil investigations and the unresolved components of the shareholder derivative litigation. The Company may have an obligation to indemnify these persons in relation to these matters, and currently is advancing certain legal costs incurred by certain of these potentially indemnified persons. Such advances of legal costs are being expensed as incurred. Some of these indemnification obligations would be covered by certain insurers under applicable directors’ and officers’ liability policies. In connection with the settlement of the securities class action and the partial settlement of the derivative litigation described above, however, the Company agreed with these insurers to limit its claims for reimbursement for legal fees and costs incurred in connection with those proceedings, and the related criminal and administrative investigations, to a specified reserve fund in the amount of $3.4 million (of which approximately $1.2 million remains as of November 2, 2008). Two of the Company’s former officers have agreed to limit their claims for indemnity from the Company in connection with future proceedings before the SEC or the United States District Court for the Southern District of New York to a portion of the amount deposited into the reserve fund. This portion is not available to the Company for its claims for reimbursement of the legal fees and costs described above. If the sums in this fund are not sufficient to provide for reimbursement to the Company or if the Company incurs significant uninsured indemnity obligations, such indemnity obligations could have a material adverse effect on the Company’s financial condition, results of operations and cash flows. In addition, counsel for the plaintiffs in the settled shareholder derivative actions have deferred their application for fees until conclusion of the derivative actions, and there can be no assurance as to the amount the Company will be required to pay to such counsel or that the remaining reserve fund at such time will be sufficient to reimburse the Company for such amount. One of the Company’s lenders had issued letters of credit on behalf of the Company totaling $16.0 million at November 2, 2008, the substantial majority of which secure the Company’s reimbursement obligations to insurers under the Company’s self-insurance arrangements. The Company is exposed to the effects of commodity price fluctuations on the cost of ingredients of its products, of which flour, sugar and shortening are the most significant. In order to secure adequate supplies of product and bring greater stability to the cost of ingredients, the Company routinely enters into forward purchase contracts with suppliers under which the Company commits to purchasing agreed-upon quantities of ingredients at agreed-upon prices at specified future dates. Typically, the aggregate outstanding purchase commitment at any point in time will range from one month’s to two years’ anticipated ingredients purchases, depending on the ingredient. In addition, from time to time the Company enters into contracts for the future delivery of equipment purchased for resale and components of doughnut-making equipment manufactured by the Company. While the Company has multiple suppliers for most of its ingredients, the termination of the Company’s relationships with vendors with whom the Company has forward purchase agreements, or those vendors’ inability to honor the purchase commitments, could adversely affect the Company’s results of operations and cash flows. In addition to entering into forward purchase contracts, the Company from time to time purchases exchange-traded commodity futures contracts or options on such contracts for raw materials which are ingredients of the Company’s products or which are components of such ingredients, including wheat and soybean oil. The Company typically assigns the futures contract to a supplier in connection with entering into a forward purchase contract for the related ingredient. The aggregate fair value of unassigned futures contracts as of November 2, 2008 was a liability of approximately $128,000. 17 Note 7 — Impairment Charges and Lease Termination Costs The components of impairment charges and lease termination costs are as follows:
When the Company concludes that the carrying value of long-lived assets is not recoverable (based on future projected undiscounted cash flows), the Company records impairment charges to reduce the carrying value of those assets to their estimated fair values. Impairment charges related to Company Stores long-lived assets were approximately $20.8 million for the nine months ended October 28, 2007. Such charge related to underperforming stores, including both stores closed or likely to be closed and stores management believed would not generate sufficient future cash flows to enable the Company to recover the carrying value of the stores’ assets, but which management had not yet decided to close. The impaired store assets included leasehold improvements, which are typically abandoned when the leased properties revert to the lessor (although the Company may recover a portion of the cost of the improvements if the Company is successful in assigning its leasehold interests to another tenant), and doughnut-making and other equipment. During the nine months ended October 28, 2007, the Company also recorded an impairment charge of approximately $11.0 million with respect to its KK Supply Chain manufacturing and distribution facility in Effingham, Illinois, based on management's revised expectations about the use and ultimate disposition of that facility. During the second quarter of fiscal 2008, the Company decided to divest the facility and determined that the projected cash flows from operation and ultimate sale of the facility were less than its carrying value; accordingly, the Company recorded an impairment charge to reduce the carrying value of the facility and related equipment to their estimated fair value. In the fourth quarter of fiscal 2008, the Company sold these assets for approximately $10.9 million cash (net of expenses), which approximated the Company’s earlier estimate of their disposal value. During the first nine months of fiscal 2008, the Company decided to close its KK Supply Chain coffee roasting operation and to sell the related assets, and recorded an impairment charge of approximately $1.5 million to reduce the carrying value of those assets to their estimated disposal value of $1.9 million. The Company sold these assets for approximately $1.9 million cash during the third quarter of fiscal 2008. The Company records impairment charges for reacquired franchise rights when such intangible assets are determined to be impaired as a result of store closing decisions or other developments. 18 Lease termination costs represent the net present value of remaining contractual lease payments related to closed stores, after reduction by estimated sublease rentals. The transactions reflected in the accrual for lease termination costs are as follows:
Note 8 — Segment Information The following table presents the results of operations of the Company’s operating segments for the three and nine months ended November 2, 2008 and October 28, 2007. Segment operating income is consolidated operating income before unallocated general and administrative expenses, impairment charges and lease termination costs and settlement of litigation.
Segment information for total assets and capital expenditures is not presented as such information is not used in measuring segment performance or allocating resources among segments. Note 9 — Investments in Franchisees As of November 2, 2008, the Company has investments in four franchisees. These investments have been made in the form of capital contributions and, in certain instances, loans evidenced by promissory notes. 19 The Company’s financial exposures related to franchisees in which the Company has an investment are summarized in the tables below. Current liabilities at November 2, 2008 include accruals for potential payments under the loan and lease guarantees of approximately $2.7 million related to Krispy Kreme of South Florida, LLC (“KKSF”). Current liabilities at February 3, 2008 include accruals for potential payments under loan and lease guarantees of approximately $3.0 million related to KKSF and $450,000 related to Priz Doughnuts, LP (“Priz”). There is no liability reflected for other guarantees of Equity Method Franchisee obligations because the Company does not believe it is probable that the Company will be required to perform under such other guarantees. The Company has a $900,000 note receivable from Kremeworks, LLC (“Kremeworks”) which is subordinate to certain Kremeworks bank indebtedness guaranteed, in part, by the Company. The note arose from cash advances made by the Company to Kremeworks in fiscal 2005 and earlier years. Kremeworks’ results of operations and operating cash flow have declined and, although Kremeworks has paid all amounts due under its bank indebtedness, it has failed to comply with certain financial covenants related to such indebtedness, a portion of which matures, by its terms, in January 2009. Kremeworks has requested that the lender waive the loan defaults resulting from the covenant violations and refinance the maturing indebtedness. In the event the lender is unwilling to do so and declares the entire indebtedness immediately due and payable, the Company could be required to perform under its guarantee, which totaled approximately $1.8 million as of November 2, 2008. Kremeworks could have insufficient cash flows from its business to service the indebtedness even if it is refinanced, which might require capital contributions to Kremeworks by the Company and the majority owner of Kremeworks (which has guarantees of the Kremeworks indebtedness proportionate to those of the Company) in order for Kremeworks to comply with the terms of the any new loan agreement. During the quarter ended November 2, 2008, the Company established a reserve equal to the entire $900,000 balance of its note receivable in recognition of the uncertainty surrounding its ultimate collection, the charge related to which is included in “Other non-operating income and expense, net” in the accompanying consolidated statement of operations. Kremeworks revenues, operating loss and net loss for the first nine months of fiscal 2009 were approximately $13.9 million, $1.0 million and $1.7 million, respectively.
The aggregate loan and lease guarantees at November 2, 2008 consist of $3.8 million of loan guarantees and $5.6 million of lease guarantees. The guaranteed amount for debt was determined based upon the principal amount outstanding under the related agreement and the guaranteed amount for leases was determined based upon the gross amount of remaining lease payments. In June 2008, the Company completed an agreement to dissolve Priz. In connection with this transaction, the Company conveyed the assets of one of the Priz stores to an existing franchisee and conveyed the other store to the other partner of Priz which is continuing to operate that store as a franchisee. In connection with the dissolution of Priz, the Company paid $400,000 to settle its loan guarantee related to Priz. 20 In April 2008, the Company completed an agreement with A-OK, LLC and KK-TX I, L.P. (which have common ownership and are collectively referred to as the “A-OK Parties”) pursuant to which, among other things, the Company conveyed to the owner of the A-OK Parties the Company’s equity interests in the A-OK Parties and compromised and settled certain disputed and past due amounts owed by the A-OK Parties to the Company. In connection with this agreement, the Company was released from its obligations under all of its partial guarantees of certain of the A-OK Parties’ indebtedness and lease obligations. The Company recorded a non-cash gain of $931,000 as a result of this transaction which is included in “Other non-operating income and expense, net” in the accompanying consolidated statement of operations for the nine months ended November 2, 2008. In December 2006, the Company entered into an agreement with KKSF (which has since expired) pursuant to which, among other things, the Company granted KKSF forbearance with respect to certain of KKSF’s financial obligations to the Company, and KKSF agreed to use its best efforts to cause the Company to be released from its obligations under its guarantees of certain KKSF indebtedness and lease obligations. The Company’s potential guarantee obligations have been reduced by approximately $10.9 million since December 2006, including the release of approximately $4.0 million of potential lease obligations during the third quarter of fiscal 2009 as described below. KKSF has sought additional forbearance and/or financial support from the Company, and has incurred defaults with respect to certain credit agreements with its lenders, including agreements related to KKSF indebtedness guaranteed, in part, by the Company. During the fourth quarter of fiscal 2008, the Company recorded a provision of $3.0 million for potential payments related to guarantees of KKSF loans and leases. In September 2008, the Company, KKSF and one of KKSF’s lenders entered into agreements pursuant to which, among other things, the Company paid approximately $250,000 to the lender to effect a cure of certain KKSF defaults with respect to certain of the indebtedness subject to the Company’s guarantee. Such agreements also provided for a reduction in the amount of the Company’s debt guarantee obligations of approximately $125,000, and for the Company’s release from KKSF lease guarantees for which the Company’s potential guarantee obligation was approximately $4.0 million. While there is no current demand on the Company to perform under any of the guarantees, there can be no assurance that the Company will not be required to perform and, if circumstances change from those prevailing at November 2, 2008, additional payments or provisions for guarantee payments could be required with respect to any of the guarantees, and such payments or provisions could be significant. Note 10 — Shareholders’ Equity Share-Based Compensation for Employees The Company accounts for share-based payment (“SBP”) awards under Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment,” which requires the measurement and recognition of compensation expense for share-based payment awards, including stock options. The aggregate cost of SBP awards charged to earnings for the three months and nine months ended November 2, 2008 and October 28, 2007 is set forth in the following table. The Company did not realize any excess tax benefits from the exercise of stock options or the vesting of restricted stock during any of these periods. 21
During the nine months ended November 2, 2008, the Company permitted holders of restricted stock awards to satisfy their obligations to reimburse the Company for the minimum required statutory withholding taxes arising from the vesting of such awards by surrendering vesting common shares in lieu of reimbursing the Company in cash. In addition, the terms of certain stock options granted under the Company’s 1998 Stock Option Plan which were exercised during the third quarter of fiscal 2009 provided that reimbursement of minimum required withholdings taxes and payment of the exercise price could, at the election of the optionee, be made by surrendering common shares acquired upon the exercise of such options. The aggregate fair value of common shares surrendered related to the vesting of restricted stock awards and the exercise of stock options was $300,000 and $1.8 million, respectively, for the nine months ended November 2, 2008. The aggregate fair value of $2.1 million has been reflected as a financing activity in the accompanying consolidated statement of cash flows and as a repurchase of common shares in the accompanying consolidated statement of changes in shareholders’ equity. Common Shares and Warrants Issued in Connection With Settlement of Litigation On March 2, 2007, the Company issued 1,833,828 shares of common stock and warrants to acquire 4,296,523 shares of common stock at a price of $12.21 per share in connection with the settlement of certain litigation as described in Note 6. As of that date, the aggregate fair value of the common shares was approximately $18.4 million and the aggregate fair value of the warrants was approximately $18.5 million. The estimated fair value of the warrants was computed using the Black-Scholes option pricing model with the following assumptions: an exercise price of $12.21 per share; a market price of common stock of $10.01 per share; an expected term of 5.0 years; a risk-free rate of 4.46%; a dividend yield of zero; and expected volatility of 50%. The common stock and warrants had a fair value as of January 28, 2007 of approximately $51.8 million which, together with the approximately $35.0 million cash paid to the settlement class by the Company’s insurers, was reflected in the consolidated balance sheet. The decrease in the estimated fair value of the common stock and warrants from January 28, 2007 to their issuance on March 2, 2007 of approximately $14.9 million was credited to earnings in the first quarter of fiscal 2008, at which time the aggregate fair value of the securities of approximately $36.9 million was reclassified from liabilities to common stock. Note 11 — Fair Value Measurements Except as described in the following paragraph, effective February 4, 2008, the Company adopted FAS 157, which defines fair value as the price that would be received for an asset or paid to transfer a liability in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants at the measurement date. FAS 157 is intended to establish a common definition of fair value to be used throughout GAAP, which is expected to make the measurement of fair value more consistent and comparable. FAS 157 was to be effective for years beginning after November 15, 2007. However, in February 2008, the FASB deferred the effective date of FAS 157 for one year for nonfinancial assets and nonfinancial liabilities that are recognized or disclosed at fair value in the financial statements on a nonrecurring basis. 22 FAS 157 establishes a three-level fair value hierarchy that prioritizes the inputs used to measure fair value. This hierarchy requires entities to maximize the use of observable inputs and minimize the use of unobservable inputs. The three levels of inputs used to measure fair value are as follows:
Adoption of FAS 157 had no material effect on the Company’s financial position or results of operations. The Company has no material financial assets or liabilities measured at fair value except for interest rate derivatives liabilities described in Note 5. Such liabilities had a fair value of approximately $1.6 million at November 2, 2008. The fair value of these over-the-counter derivatives was determined using a discounted cash flow model based on the terms of the contracts. The most significant input to this model is implied forward LIBOR rates. These inputs are classified within level 2 of the valuation hierarchy. 23 Item 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. Krispy Kreme is a leading branded retailer and wholesaler of high-quality doughnuts. The Company’s principal business, which began in 1937, is owning and franchising Krispy Kreme doughnut stores at which over 20 varieties of high-quality doughnuts, including the Company’s signature hot Original Glazed® doughnut, are made, sold and distributed together with complementary products, and where a broad array of coffees and other beverages are offered. As of November 2, 2008, there were 509 Krispy Kreme stores operated systemwide in the United States, Australia, Bahrain, Canada, Indonesia, Japan, Kuwait, Lebanon, Mexico, the Philippines, Puerto Rico, Qatar, Saudi Arabia, South Korea, the United Arab Emirates and the United Kingdom, of which 97 were owned by the Company and 412 were owned by franchisees. Of the 509 stores, 284 were factory stores and 225 were satellites; 228 stores were located in the United States and 281 were located in other countries. Factory stores (stores which contain a doughnut-making production line) typically support multiple sales channels to more fully utilize production capacity and reach various consumer segments. These sales channels are comprised of on-premises sales (principally sales to customers visiting stores) and off-premises sales (sales to convenience stores, grocery stores/mass merchants and other food service and institutional accounts). Satellite stores consist primarily of the hot shop, fresh shop and kiosk formats. Hot shops contain doughnut heating technology that allows customers to have a hot doughnut experience throughout the day. Fresh shops and free-standing kiosk locations do not contain doughnut heating technology. The Company generates revenues from three distinct sources: stores operated by the Company, referred to as Company Stores; franchise fees and royalties from franchise stores, referred to as Franchise; and a vertically integrated supply chain, referred to as KK Supply Chain. On May 13, 2008, the Company entered into an agreement with BakeMark USA LLC of Pico Rivera, California pursuant to which BakeMark distributes doughnut mix, other ingredients and supplies to substantially all Company and franchise stores located west of the Mississippi River. The Company did not renew the lease for its California distribution center, which had been distributing mix, ingredients and supplies to the majority of these locations, and exited the California facility in August 2008. Several franchisees have been experiencing financial pressures which, in certain instances, have become exacerbated in recent quarters. The Company has guaranteed certain obligations of franchisees in which it has an equity interest, as described in “Other Commitments and Contingencies” in Note 6 and in Note 9 to the consolidated financial statements appearing elsewhere herein. Such guarantees totaled $9.4 million as of November 2, 2008, and the aggregate recorded liability for estimated payments under such guarantees was $2.7 million at that date. During fiscal 2008, two of the Company’s domestic franchisees filed for reorganization under Chapter 11 of the United States Bankruptcy Code. One of these bankruptcy cases was substantially concluded in February 2008 upon the sale of the franchisee’s assets to, and assumption of most of its franchise agreements by, a successor franchisee; the other franchise operation is continuing to operate under court supervision. In the third quarter of fiscal 2009, the Company’s franchisee in Hong Kong commenced liquidation proceedings, and has since closed the nine stores it operated. Franchisees opened 96 stores and closed 30 stores (of which seven were in Hong Kong) in the first nine months of fiscal 2009, including 37 and 19 stores, respectively, in the third quarter. The Company believes franchisees will close additional stores in the future, and the number of such closures may be significant. Royalty revenues and most of KK Supply Chain revenues are directly related to sales by franchise stores and, accordingly, the success of franchisees’ operations has a direct effect on the Company’s revenues, results of operations and cash flows. The following discussion of the Company’s financial condition and results of operations should be read together with the Company’s consolidated financial statements and notes thereto appearing elsewhere herein. 24 RESULTS OF OPERATIONS The following table presents the Company’s operating results for the three months and nine months ended November 2, 2008 and October 28, 2007, expressed as a percentage of total revenues (percentage amounts may not add to totals due to rounding).
Data on the number of factory stores (including commissaries) appear in the table below.
25 Data on the number of satellite stores appear in the table below.
Data on the aggregate number of factory and satellite stores as of November 2, 2008 appear in the table below.
26 Franchisees closed 30 stores in the first nine months of fiscal 2009, including 19 in the third quarter. The Company believes franchisees will close additional stores in the future, and the number of such closures may be significant. Systemwide sales, a non-GAAP financial measure, include the sales by both Company and franchise stores. The Company believes systemwide sales data are useful in assessing the overall performance of the Krispy Kreme brand and, ultimately, the performance of the Company. The Company’s consolidated financial statements appearing elsewhere herein include sales by Company stores, sales to franchisees by the KK Supply Chain business segment, and royalties and fees received from franchisees, but exclude sales by franchise stores to their customers. The table below presents average weekly sales per store (which represents, on a Company and systemwide basis, total sales of all stores divided by the number of operating weeks for both factory and satellite stores). Operating weeks represents, on a Company and systemwide basis, the aggregate number of weeks in a period that both factory and satellite stores were in operation.
(1) Excludes intersystem sales between Company and franchise stores. THREE MONTHS ENDED NOVEMBER 2, 2008 COMPARED TO THREE MONTHS ENDED OCTOBER 28, 2007 Overview Systemwide sales for the third quarter of fiscal 2009 decreased approximately 1.0% compared to the third quarter of fiscal 2008, reflecting an 19.0% decrease in average weekly sales per store, partially offset by a 22.1% increase in store operating weeks. The systemwide sales decrease reflects an 11.1% decrease in Company Stores sales from the prior year quarter, partially offset by a 5.5% increase in franchise store sales. The total number of factory stores at the end of the third quarter of fiscal 2009 was 284, consisting of 86 Company stores and 198 franchise stores. Satellite stores made up 44% of the total systemwide store count as of November 2, 2008, compared to 31% at October 28, 2007. Systemwide average weekly sales per store are lower than Company average weekly sales per store principally because satellite stores, which generally have lower average weekly sales than factory stores, are operated almost exclusively by franchisees. In addition, the increasing percentage of total stores which are satellite stores has the effect of reducing the overall systemwide average weekly sales per store. On a same store basis (as described below), systemwide on-premises sales decreased 11.8% in the third quarter of fiscal 2009 compared to the third quarter of fiscal 2008. Revenues Total revenues decreased 8.7% to $94.3 million for the three months ended November 2, 2008 from $103.4 million for the three months ended October 28, 2007. This decrease was comprised of an 11.1% decrease in Company Stores revenues to $64.7 million, a 12.6% increase in Franchise revenues to $6.4 million, and a 6.6% decrease in KK Supply Chain revenues to $23.2 million. 27 Revenues by business segment (expressed in dollars and as a percentage of total revenues) are set forth in the table below (percentage amounts may not add to totals due to rounding).
Company Stores Revenues. Company Stores revenues decreased 11.1% to $64.7 million in the third quarter of fiscal 2009 from $72.8 million in the third quarter of fiscal 2008. The decrease reflects a 6.3% decline in store operating weeks and a 5.7% decrease in average weekly sales per store. The decrease in store operating weeks reflects the sale or closure of 11 Company factory stores and three Company satellite stores since the beginning of the third quarter of fiscal 2008. The Company continuously reviews the performance of its stores and may decide to close additional locations, and the number of such closures may be significant. On-premises sales (which include fundraising sales) comprised approximately 45% and 43% of total Company Stores revenues in the third quarter of fiscal 2009 and 2008, respectively, with the balance comprised of off-premises sales. The following table sets forth statistical data with respect to on- and off-premises sales by Company stores. The change in “same store sales” is computed by dividing the aggregate on-premises sales (including fundraising sales) during the current year period for all stores which had been open for more than 56 consecutive weeks (but only to the extent such sales occurred in the 57th or later week of each store’s operation) by the aggregate on-premises sales of such stores for the comparable weeks in the preceding year period. Once a store has been open for at least 57 consecutive weeks, its sales are included in the computation of same stores sales for all subsequent periods. In the event a store is closed temporarily (for example, for remodeling) and has no sales during one or more weeks, such store’s sales for the comparable weeks during the earlier or subsequent period are excluded from the same store sales computation. For off-premises sales, “average weekly number of doors” represents the average number of customer locations to which product deliveries are made during a week, and “average weekly sales per door” represents the average weekly sales to each such location.
On-premises same stores sales decreased in the third quarter of fiscal 2009 compared to the third quarter of fiscal 2008, generally reflecting a decrease in customer traffic partially offset by an increase in the average guest check. In the off-premises distribution channel, the decrease in the average weekly number of doors represents a decrease in both the grocery/mass merchant channel and in the convenience store channel. The average weekly sales per door also fell in both channels. A decrease in average weekly sales per door generally adversely affects profitability because of the increased significance of delivery costs in relation to sales. Sales in the off-premises distribution channel have been declining and are expected to continue to decline in the near term. However, the Company is designing and implementing strategies designed to increase average per door sales and reduce costs in the off-premises channel. The Company has increased selling prices in both on-premises and off-premises distribution channels in order to cover rising costs, particularly the increased cost of doughnut mixes and shortening due to rising agricultural commodity prices. The Company believes the selling price increases have adversely affected sales volumes, particularly in the off-premises channel. 28 Franchise Revenues. Franchise revenues consist principally of royalties payable to the Company by franchisees based upon the franchisees’ sales and initial franchise fees earned by the Company in connection with new store openings by franchisees. The components of Franchise revenues are as follows:
Royalty revenues rose to $5.5 million in the third quarter of fiscal 2009 from $4.9 million in the third quarter last year. Sales by franchise stores, as reported by the franchisees, were approximately $122 million in the third quarter of fiscal 2009 and $116 million in the third quarter of fiscal 2008. All of the growth in franchisee sales in the third quarter of fiscal 2009 was attributable to an increase in the number of franchise stores outside the United States. Domestic franchisee sales fell in the third quarter of fiscal 2009 compared to the third quarter of fiscal 2008, principally due to store closings. The Company did not recognize as revenue approximately $150,000 and $450,000 of uncollected royalties which accrued during the third quarter of fiscal 2009 and 2008, respectively, because the Company did not believe collection of these royalties was reasonably assured. The unrecorded revenue in fiscal 2009 relates principally to international franchisees, while the unrecorded revenue in fiscal 2008 related principally to domestic franchisees. Development and franchise fees increased $118,000 in the third quarter of fiscal 2009 compared to the third quarter of fiscal 2008 due to an increase in store openings by franchisees. Although royalties and fees from international franchisees are payable to the Company in U.S. dollars, changes in the rate of exchange between the U.S. dollar and the foreign currencies used in the countries in which the international franchisees operate affect the Company’s revenues. The Company historically has not hedged these exchange rate risks. Recently, the U.S. dollar has strengthened relative to many other currencies; strengthening of the U.S. dollar relative to the currencies of international franchisees adversely affects Franchise revenue. Franchisees opened 96 stores and closed 30 stores in the first nine months of fiscal 2009, including 37 and 19 stores, respectively, in the third quarter. The Company believes franchisees will close additional stores in the future, and the number of such closures may be significant. Royalty revenues are directly related to sales by franchise stores and, accordingly, franchise store closures have an adverse effect on Franchise revenues. KK Supply Chain Revenues. KK Supply Chain revenues decreased 6.6% to $23.2 million in the third quarter of fiscal 2009 from $24.9 million in the third quarter of fiscal 2008. The most significant reason for the decrease in revenues was lower unit sales of mixes, ingredients and supplies by KK Supply Chain. An increasing percentage of franchisee sales is attributable to sales by franchisees outside North America. Many of the ingredients and supplies used by international franchisees are acquired locally instead of from KK Supply Chain. The decline in the KK Supply Chain revenue due to lower unit volume was partially offset by an increase in revenue resulting from price increases for mixes and certain other ingredients instituted by KK Supply Chain in fiscal 2009 in order to offset increases in materials costs. The KK Supply Chain revenue decrease was also attributable to a decrease in sales of equipment and equipment services in the third quarter of fiscal 2009 compared to the third quarter of fiscal 2008. Franchisee expansion in the third quarter of fiscal 2009 was comprised principally of satellite stores, which require less equipment than do factory stores. Sales of equipment and related services (including signage, beverage equipment, furniture, fixtures and similar items sold through the KK Supply Chain distribution center) represented approximately 7.9% and 14.6% of KK Supply Chain revenues in the third quarter of fiscal 2009 and 2008, respectively. Franchisees opened 96 stores and closed 30 stores in the first nine months of fiscal 2009, including 37 and 19 stores, respectively, in the third quarter. The Company believes franchisees will close additional stores in the future, and the number of such closures may be significant. A significant majority of KK Supply Chain’s revenues are directly related to sales by franchise stores and, accordingly, franchise store closures have an adverse effect on KK Supply Chain revenues. 29 Direct Operating Expenses Direct operating expenses, which exclude depreciation and amortization expense, were 92.4% of revenues in the third quarter of fiscal 2009 compared to 88.0% of revenues in the third quarter of fiscal 2008. Direct operating expenses by business segment (expressed in dollars and as a percentage of applicable segment revenues) are set forth in the table below. Such operating expenses are consistent with the segment operating income data set forth in Note 8 to the consolidated financial statements appearing elsewhere herein.
Company Stores Direct Operating Expenses. Company Stores direct operating expenses as a percentage of Company Stores revenues increased to 104.2% in the third quarter of fiscal 2009 compared to 99.0% in the third quarter of fiscal 2008. Higher costs for materials resulting from price increases instituted by KK Supply Chain in fiscal 2009 in order to offset higher raw materials costs, higher fuel costs and the adverse effects on delivery efficiency of lower average weekly sales per door more than offset selling price increases and the closure of underperforming stores. Recent economic conditions have led to significant reductions in the market prices of agricultural commodities and fuel. The Company has been experiencing a decline in the average weekly sales per door in the off-premises distribution channel. A decrease in average weekly sales per door generally adversely affects profitability because of the increased significance of delivery costs in relation to sales. Franchise Direct Operating Expenses. Franchise direct operating expenses include costs to recruit new franchisees, to assist in store openings, and to monitor and aid in the performance of franchise stores, as well as direct general and administrative expenses and allocated corporate costs. Higher spending related to the development and support of international franchisees in the third quarter of fiscal 2009 compared to the third quarter of fiscal 2008 was partially offset by lower allocated corporate costs resulting from cost reduction efforts. In addition, Franchise direct operating expenses increased in the third quarter of fiscal 2009 compared to the third quarter of fiscal 2008 due to a bad debt provision of approximately $240,000 principally related to credit exposure on international franchisees. KK Supply Chain Direct Operating Expenses. KK Supply Chain direct operating expenses as a percentage of KK Supply Chain revenues before intersegment eliminations increased to 88.0% in the third quarter of fiscal 2009 from 84.0% in the third quarter of 2008. The cost of raw materials used in the production of doughnut mix and of other goods sold to Company and franchise stores was higher in the third quarter of fiscal 2009 than in the third quarter of fiscal 2008. In particular, the prices of flour and shortening and the products from which they are made were significantly higher in the third quarter of fiscal 2009 compared to the third quarter of fiscal 2008. In fiscal 2009, KK Supply Chain increased the prices charged to Company and franchise stores for doughnut mix, shortening and other goods in order to mitigate increases in the cost of certain raw materials, particularly flour and shortening. However, KK Supply Chain margins were adversely affected because, while the Company increased prices to cover higher costs, the Company did not raise prices to earn a proportionate gross profit on all of its higher costs. 30 KK Supply Chain direct operating expenses include a charge of approximately $100,000 to the bad debt provision in the third quarter of fiscal 2009 compared to a net credit of approximately $400,000 in the third quarter of fiscal 2008. The net credit in the third quarter of fiscal 2008 reflects a reduction in the allowance for doubtful accounts resulting principally from a decrease in receivable balances with respect to certain franchisees, partially offset by bad debt provisions recorded with respect to other franchise receivables. As of November 2, 2008, the Company’s allowance for doubtful accounts from franchisees totaled approximately $4.2 million. General and Administrative Expenses General and administrative expenses increased to $5.8 million, or 6.2% of total revenues, in the third quarter of fiscal 2009 from $5.7 million, or 5.5% of total revenues, in the third quarter of fiscal 2008. The increase in general and administrative expenses as a percentage of total revenues principally reflects the fixed nature of many of these expenses on a lower revenue base. General and administrative expenses include professional fees and expenses related to the investigations and securities litigation described in Note 6 to the consolidated financial statements included elsewhere herein, totaling approximately $160,000 in the third quarter of both fiscal 2009 and fiscal 2008. Such professional fees and expenses include amounts advanced to certain former officers of the Company pursuant to the indemnification obligations described in Note 6. Depreciation and Amortization Expense Depreciation and amortization expense decreased to $2.1 million, or 2.2% of total revenues, in the third quarter of fiscal 2009 from $4.9 million, or 4.7% of total revenues, in the third quarter of fiscal 2008. The decline in depreciation and amortization expense is attributable to the reduction in the number of Company factory stores operating in the third quarter of fiscal 2009 compared to the third quarter of fiscal 2008 and to a lower depreciable base of property and equipment resulting from asset dispositions and impairment writedowns. Additionally, depreciation and amortization expense decreased in the third quarter of fiscal 2009 compared to the third quarter of fiscal 2008 as a result of the Company’s divestiture in January 2008 of its manufacturing and distribution facility in Effingham, Illinois as described in Note 7 to the consolidated financial statements appearing elsewhere herein. Impairment Charges and Lease Termination Costs The Company recorded a charge of $345,000 in the third quarter of fiscal 2009 compared to a net credit to impairment charges and lease termination costs of $268,000 in the third quarter of fiscal 2008. Impairment charges related to long-lived assets were $547,000 in the third quarter of fiscal 2008. The Company records impairment charges associated with stores in the accounting period in which a store closing decision is made or in which the carrying value of the store is otherwise determined to be nonrecoverable. Lease termination costs represent the net present value of remaining contractual lease payments related to closed stores, after reduction by estimated sublease rentals, and are recorded when the lease contract is terminated or, if earlier, the date on which the Company ceases use of the leased property. The Company recorded a charge to lease termination costs of approximately $306,000 in the third quarter of fiscal 2009 compared to a net credit of approximately $815,000 in the third quarter of fiscal 2008. In the third quarter of fiscal 2008, the aggregate reversals of previously recorded deferred rent expense associated with certain closed stores exceeded the lease termination charges related to stores closed during the third quarter of fiscal 2008, resulting in an aggregate net credit in the provision for lease termination costs. The Company also received $841,000 in the third quarter of fiscal 2008 in connection with its assignment of lease related to a closed store. The credit to earnings from this assignment was partially offset by lease termination charges related to other closed stores. The Company plans to refranchise certain geographic markets, expected to consist principally of, but not necessarily limited to, markets outside the Company’s traditional base in the Southeastern United States. The franchise rights and other assets in many of these markets were acquired by the Company in business combinations in prior years. In the first quarter of fiscal 2009, the Company refranchised one idled store acquired by the Company from a failed franchisee and refranchised two operating stores to a new franchisee in the second quarter of fiscal 2009. The Company received no proceeds in connection with these refranchising transactions. The Company cannot predict the likelihood of refranchising any additional stores or markets or the amount of proceeds, if any, which might be received therefrom, including the amounts which might be realized from the sale of store assets and the execution of any related franchise agreements. Refranchising could result in the recognition of impairment losses on the related assets. 31 Interest Income Interest income decreased to $65,000 in the third quarter of fiscal 2009 from $379,000 in the third quarter of fiscal 2008 primarily due to lower short-term interest rates. Interest Expense Interest expense increased to $3.0 million in the third quarter of fiscal 2009 from $2.3 million in the third quarter of fiscal 2008. Interest accruing on outstanding indebtedness was lower in the third quarter of fiscal 2009 than in the third quarter of fiscal 2008 principally resulting from the reduction in outstanding debt since the third quarter of fiscal 2008. This lower interest on outstanding indebtedness was largely offset by higher lender margin resulting from the amendments to the Company’s 2007 Secured Credit Facilities described in Note 5 to the consolidated financial statements appearing elsewhere herein. Interest expense for the third quarter of fiscal 2009 reflects a non-cash charge of $582,000 resulting from marking to market the Company’s liabilities related to interest rate derivatives. As more fully described in Note 5 to the consolidated financial statements appearing elsewhere herein, effective April 9, 2008 the Company discontinued hedge accounting for these derivatives as a result of amendments to its credit facilities. As a consequence of the discontinuance of hedge accounting, changes in the fair value of the derivative contracts subsequent to April 8, 2008 are reflected in earnings as they occur. Amounts included in accumulated other comprehensive income related to changes in the fair value of the derivative contracts for periods prior to April 9, 2008 are being charged to earnings through April 2010 when the underlying hedged transactions (interest expense on long-term debt) affect earnings. As of November 2, 2008, the fair value of the derivative liability was approximately $1.6 million, which is included in accrued liabilities in the accompanying consolidated balance sheet. Accumulated other comprehensive income as of November 2, 2008 includes an accumulated loss related to these derivatives of approximately $1.0 million (net of income taxes of approximately $600,000). Interest expense for the three months ended November 2, 2008 includes approximately $320,000 of amortization of this accumulated loss. Equity in Losses of Equity Method Franchisees The Company’s share of the losses incurred by equity method franchisees totaled $335,000 in the third quarter of fiscal 2009 compared to $216,000 in the third quarter of fiscal 2008. This caption represents the Company’s share of operating results of unconsolidated franchisees which develop and operate Krispy Kreme stores. Other Non-Operating Income and Expense, Net Other non-operating income and expense for the three months ended November 2, 2008 includes a charge of $900,000 to establish a reserve for collectability risk on a note receivable from an Equity Method Franchisee as described in Note 9 to the consolidated financial statements appearing elsewhere herein. Other non-operating income and expense for the three months ended October 28, 2007 includes an impairment charge of approximately $550,000 to reduce the carrying value of the Company’s investment in an Equity Method Franchisee to its estimated fair value, as well as a gain of approximately $260,000 resulting from the receipt of additional proceeds from the prior sale of another Equity Method Franchisee. Provision for Income Taxes The provision for income taxes was $404,000 in the third quarter of fiscal 2009 compared to $376,000 in the third quarter of fiscal 2008. Each of these amounts includes adjustments to the valuation allowance for deferred income tax assets to maintain such allowance at an amount sufficient to reduce the Company’s aggregate net deferred income tax assets to zero, as well as a provision for income taxes estimated to be payable currently. Net Loss The Company reported a net loss of $5.9 million for the three months ended November 2, 2008 compared to a net loss of $798,000 for the three months ended October 28, 2007. 32 NINE MONTHS ENDED NOVEMBER 2, 2008 COMPARED TO NINE MONTHS ENDED OCTOBER 28, 2007 Overview Systemwide sales for the first nine months of fiscal 2009 increased approximately 1.8% compared to the first nine months of fiscal 2008, reflecting a 17.5% increase in store operating weeks, partially offset by a 13.5% decrease in average weekly sales per store. The systemwide sales increase reflects a 10.6% increase in franchise store sales, partially offset by an 11.6% decrease in Company Stores sales from the first nine months of the prior year. The total number of factory stores at the end of the first nine months of fiscal 2009 was 284, consisting of 86 Company stores and 198 franchise stores. Satellite stores made up 44% of the total systemwide store count as of November 2, 2008, compared to 31% at October 28, 2007. On a same store basis, systemwide on-premises sales decreased 8.3% in the first nine months of fiscal 2009 compared to the first nine months of fiscal 2008. Revenues Total revenues decreased 8.2% to $292.2 million for the nine months ended November 2, 2008 from $318.4 million for the nine months ended October 28, 2007. This decrease was comprised of an 11.6% decrease in Company Stores revenues to $202.0 million, a 23.8% increase in Franchise revenues to $19.5 million, and a 4.5% decrease in KK Supply Chain revenues to $70.7 million. Revenues by business segment (expressed in dollars and as a percentage of total revenues) are set forth in the table below (percentage amounts may not add to totals due to rounding).
Company Stores Revenues. Company Stores revenues decreased 11.6% to $202.0 million in the first nine months of fiscal 2009 from $228.5 million in the first nine months of fiscal 2008. The decrease reflects a 7.9% decline in store operating weeks and a 4.5% decrease in average weekly sales per store. The decrease in store operating weeks reflects the sale or closure of 14 Company factory stores and three Company satellite stores since the end of fiscal 2007. The Company continuously reviews the performance of its stores and may decide to close additional locations, and the number of such closures may be significant. On-premises sales (which include fundraising sales) comprised approximately 45% and 42% of total Company Stores revenues in the first nine months of fiscal 2009 and 2008, respectively, with the balance comprised of off-premises sales. The following table sets forth statistical data with respect to on- and off-premises sales by Company stores.
33 On-premises same stores sales decreased in the first nine months of fiscal 2009 compared to the first nine months of fiscal 2008, generally reflecting a decrease in customer traffic partially offset by an increase in the average guest check. In the off-premises distribution channel, the decrease in the average weekly number of doors represents a decrease in both the grocery/mass merchant channel and in the convenience store channel. The average weekly sales per door also fell in both channels. A decrease in average weekly sales per door generally adversely affects profitability because of the increased significance of delivery costs in relation to sales. Sales in the off-premises distribution channel have been declining and are expected to continue to decline in the near term. However, the Company is designing and implementing strategies designed to increase average per door sales and reduce costs in the off-premises channel. The Company has increased selling prices in both on-premises and off-premises distribution channels in order to cover rising costs, particularly increased costs of doughnut mixes and shortening due to rising agricultural commodity prices. The Company believes the selling price increases have adversely affected sales volumes particularly in the off-premises channel. Franchise Revenues. Franchise revenues consist principally of royalties payable to the Company by franchisees based upon the franchisees’ sales and initial franchise fees earned by the Company in connection with new store openings by franchisees. The components of Franchise revenues are as follows:
Royalty revenues rose to $17.3 million in the first nine months of fiscal 2009 from $14.0 million in the first nine months of fiscal 2008. Sales by franchise stores, as reported by the franchisees, were approximately $386 million in the first nine months of fiscal 2009 and $349 million in the first nine months of fiscal 2008. All of the growth in franchisee sales in the first nine months of fiscal 2009 was attributable to an increase in the number of franchise stores outside the United States. Domestic franchisee sales fell in the first nine months of fiscal 2009 compared to the first nine months of fiscal 2008, principally due to store closings. The Company did not recognize as revenue approximately $760,000 and $2.3 million of uncollected royalties which accrued during the first nine months of fiscal 2009 and 2008, respectively, because the Company did not believe collection of these royalties was reasonably assured. The unrecorded revenue in fiscal 2009 relates principally to international franchisees, while the unrecorded revenue in fiscal 2008 related principally to domestic franchisees. Development and franchise fees increased to $2.0 million in the first nine months of fiscal 2009 from $1.5 million in the first nine months of fiscal 2008 due to an increase in store openings by international franchisees. Franchisees opened 96 stores and closed 30 stores in the first nine months of fiscal 2009, including 37 and 19 stores, respectively, in the third quarter. The Company believes franchisees will close additional stores in the future, and the number of such closures may be significant. Royalty revenues are directly related to sales by franchise stores and, accordingly, franchise store closures have an adverse effect on Franchise revenues. KK Supply Chain Revenues. KK Supply Chain revenues decreased 4.5% to $70.7 million in the first nine months of fiscal 2009 from $74.1 million in the first nine months of fiscal 2008. The most significant reason for the decrease in revenues was lower unit sales of mixes, ingredients and supplies by KK Supply Chain. An increasing percentage of franchisee sales is attributable to sales by franchisees outside North America. Many of the ingredients and supplies used by international franchisees are acquired locally instead of from KK Supply Chain. The decline in the KK Supply Chain revenue due to lower unit volume was partially offset by an increase in revenue resulting from price increases for mixes and certain other ingredients instituted by KK Supply Chain in fiscal 2009 in order to offset increases in materials costs. The KK Supply Chain revenue decrease was also attributable to a decrease in sales of equipment and equipment services in the first nine months of fiscal 2009 compared to the first nine months of fiscal 2008. Franchisee expansion in the first nine months of fiscal 2009 was comprised principally of satellite stores, which require less equipment than do factory stores. Sales of equipment and related services (including signage, beverage equipment, furniture, fixtures and similar items sold through the KK Supply Chain distribution centers) represented approximately 7.4% and 12.0% of KK Supply Chain revenues in the first nine months of fiscal 2009 and 2008, respectively. 34 Franchisees opened 96 stores and closed 30 stores in the first nine months of fiscal 2009, including 37 and 19 stores, respectively, in the third quarter. The Company believes franchisees will close additional stores in the future, and the number of such closures may be significant. A significant majority of KK Supply Chain’s revenues are directly related to sales by franchise stores and, accordingly, franchise store closures have an adverse effect on KK Supply Chain revenues. Direct Operating Expenses Direct operating expenses, which exclude depreciation and amortization expense, were 90.7% of revenues in the first nine months of fiscal 2009 compared to 89.0% of revenues in the first nine months of fiscal 2008. Direct operating expenses by business segment (expressed in dollars and as a percentage of applicable segment revenues) are set forth in the table below. Such operating expenses are consistent with the segment operating income data set forth in Note 8 to the consolidated financial statements appearing elsewhere herein.
Company Stores Direct Operating Expenses. Company Stores direct operating expenses as a percentage of Company Stores revenues increased to 101.8% for the first nine months of fiscal 2009 compared to 99.4% in the first nine months of fiscal 2008. Higher costs for materials resulting from price increases instituted by KK Supply Chain in fiscal 2009 in order to offset higher raw materials costs, higher fuel costs and the adverse effects on delivery efficiency of lower average weekly sales per door more than offset selling price increases and the closure of underperforming stores. Recent economic conditions have led to significant reductions in the market prices of agricultural commodities and fuel. The Company has been experiencing a decline in the average weekly sales per door in the off-premises distribution channel. A decrease in average weekly sales per door generally adversely affects profitability because of the increased significance of delivery costs in relation to sales. Franchise Direct Operating Expenses. Franchise direct operating expenses include costs to recruit new franchisees, to assist in store openings, and to monitor and aid in the performance of franchise stores, as well as direct general and administrative expenses and allocated corporate costs. Franchise direct operating expenses increased in the first nine months of fiscal 2009 compared to the first nine months of fiscal 2008 due to a bad debt provision of approximately $1.3 million principally related to credit exposure on international franchisees, partially offset by lower allocated corporate costs resulting from cost reduction efforts and lower store opening support expenses. Costs to support franchise store openings decline as individual franchisees gain experience opening stores and develop internal resources to assist in store openings. 35 KK Supply Chain Direct Operating Expenses. KK Supply Chain direct operating expenses as a percentage of KK Supply Chain revenues before intersegment eliminations increased to 87.5% in the first nine months of fiscal 2009 from 84.2% in the first nine months of 2008. A significant component of the increase was a charge of approximately $1.7 million (approximately 1.2% of KK Supply Chain revenues before intersegment eliminations) related to the Company’s former third-party freight consolidator. For many years, the Company utilized a third-party freight consolidator to review and pay freight bills on behalf of the Company. During the second quarter of fiscal 2009, the Company made routine payments to the third-party freight consolidator which were improperly not remitted to the freight carriers. The actions of the third-party freight consolidator, which has since filed for bankruptcy protection, resulted in a loss to the Company which the Company currently does not expect to recover. The Company has since changed its procedures to pay freight carriers directly and taken other actions to mitigate this and similar risks. The cost of raw materials used in the production of doughnut mix and of other goods sold to Company and franchise stores was higher in the first nine months of fiscal 2009 than in the first nine months of fiscal 2008. In particular, the prices of flour and shortening and the products from which they are made were significantly higher in the first nine months of fiscal 2009 compared to the first nine months of fiscal 2008. During the first nine months of fiscal 2009, KK Supply Chain increased the prices charged to Company and franchise stores for doughnut mixes, shortening and other goods in order to mitigate increases in the cost of certain raw materials, particularly flour and shortening. However, KK Supply Chain margins were adversely affected because, while the Company increased prices to cover higher costs, the Company did not raise prices to earn a proportionate gross profit on all of its higher costs. KK Supply Chain direct operating expenses include a net credit of approximately $730,000 to the bad debt provision in the first nine months of fiscal 2009 compared to a charge of approximately $770,000 in the first nine months of fiscal 2008. The net credit in the first nine months of fiscal 2009 reflects a reduction in the allowance for doubtful accounts resulting principally from a decrease in receivable balances with respect to certain franchisees and a recovery of certain receivables previously reserved, partially offset by bad debt provisions recorded with respect to other franchise receivables. As of November 2, 2008, the Company’s allowance for doubtful accounts from franchisees totaled approximately $4.2 million. General and Administrative Expenses General and administrative expenses decreased to $17.4 million, or 6.0% of total revenues, in the first nine months of fiscal 2009 from $19.4 million, or 6.1% of total revenues, in the first nine months of fiscal 2008. The decrease in general and administrative expenses reflects a decrease in share-based compensation expense of approximately $1.4 million due principally to executive officer turnover resulting in the forfeiture of stock and option awards, and an out of period credit of approximately $600,000 recorded in the second quarter of fiscal 2009 related to the Company’s self-insured worker’s compensation program. In addition, the decrease in general and administrative expenses reflects a net decrease in professional fees of approximately $1.2 million. The decrease in professional fees reflects the remediation of material weaknesses in internal control over financial reporting and the resulting reduction in consulting fees, reduced use of consultants generally, and lower outside legal fees. The net reduction in professional fees reflects an increase in professional fees and expenses related to the investigations and securities litigation described in Note 6 to the consolidated financial statements included elsewhere herein, which totaled approximately $1.1 million in the first nine months of fiscal 2009 compared to $1.0 million in the first nine months of fiscal 2008. Such professional fees and expenses include amounts advanced to certain former officers of the Company pursuant to the indemnification obligations described in Note 6. These decreases in general and administrative expenses were partially offset by a charge of approximately $600,000 for vacation and other time off pay resulting from policy changes to enhance these employee benefits. Depreciation and Amortization Expense Depreciation and amortization expense decreased to $6.6 million, or 2.3% of total revenues, for the first nine months of fiscal 2009 from $13.6 million, or 4.3% of total revenues, for the first nine months of fiscal 2008. The decline in depreciation and amortization expense is attributable principally to the reduction in the number of Company factory stores operating in the first nine months of fiscal 2009 compared to the first nine months of fiscal 2008 and to a lower depreciable base of property and equipment resulting from asset dispositions and impairment writedowns. Additionally, depreciation and amortization expense decreased in the first nine months of fiscal 2009 as a result of the Company’s divestiture in January 2008 of its manufacturing and distribution facility in Effingham, Illinois as described in Note 7 to the consolidated financial statements appearing elsewhere herein. Impairment Charges and Lease Termination Costs The Company recorded a net credit to impairment charges and lease termination costs of $648,000 in the first nine months of fiscal 2009 compared to a charge of $34.5 million in the first nine months of fiscal 2008. 36 Impairment charges related to long-lived assets were $33.3 million in the first nine months of fiscal 2008, of which approximately $20.8 million related to underperforming stores. The Company records impairment charges associated with stores in the accounting period in which a store closing decision is made or in which the carrying value of the store is otherwise determined to be nonrecoverable. In addition, in the first nine months of fiscal 2008, the Company also recorded an impairment charge of approximately $11.0 million with respect to its KK Supply Chain manufacturing and distribution facility in Effingham, Illinois, based on management's revised expectations about the use and ultimate disposition of that facility. During the second quarter of fiscal 2008, the Company decided to divest the facility and determined that the projected cash flows from operation and ultimate sale of the facility were less than its carrying value; accordingly, the Company recorded an impairment charge to reduce the carrying value of the facility and related equipment to their estimated fair value. In the fourth quarter of fiscal 2008, the Company sold these assets for approximately $10.9 million cash (net of expenses), which approximated the Company’s earlier estimate of their disposal value. During the first nine months of fiscal 2008, the Company decided to close its KK Supply Chain coffee roasting operation and to sell the related assets, and recorded an impairment charge of approximately $1.5 million to reduce the carrying value of those assets to their estimated disposal value of $1.9 million. The Company sold these assets for approximately $1.9 million cash during the third quarter of fiscal 2008. Lease termination costs represent the net present value of remaining contractual lease payments related to closed stores, after reduction by estimated sublease rentals, and are recorded when the lease contract is terminated or, if earlier, the date on which the Company ceases use of the leased property. In the first nine months of fiscal 2009, changes in estimated sublease rentals on a closed store and the realization of proceeds on an assignment of another closed store lease resulted in $1.2 million of credits to the provision for lease termination costs. This credit, in combination with the reversal of approximately $800,000 of previously recorded deferred rent expense related to stores closed during the period and approximately $1.4 million of charges related to other closed store leases, resulted in a net credit in the net provision for lease termination costs of $539,000 in the first nine months of fiscal 2009. In the first nine months of fiscal 2008, the Company received proceeds of $966,000 on the assignment of leases related to closed stores, reversed approximately $1.5 million of previously recorded deferred rent expense related to stores closed during the period and recorded approximately $1.6 million of charges related to other closed store leases, resulting in a net provision for lease termination costs of $833,000 in the first nine months of fiscal 2008. The Company plans to refranchise certain geographic markets, expected to consist principally of, but not necessarily limited to, markets outside the Company’s traditional base in the Southeastern United States. The franchise rights and other assets in many of these markets were acquired by the Company in business combinations in prior years. In the first quarter of fiscal 2009, the Company refranchised one idled store acquired by the Company from a failed franchisee and refranchised two operating stores to a new franchisee in the second quarter of fiscal 2009. The Company received no proceeds in connection with these refranchising transactions. The Company cannot predict the likelihood of refranchising any additional stores or markets or the amount of proceeds, if any, which might be received therefrom, including the amounts which might be realized from the sale of store assets and the execution of any related franchise agreements. Refranchising could result in the recognition of impairment losses on the related assets. Settlement of Litigation In October 2006, the Company agreed to settle a federal securities class action and to settle, in part, certain shareholder derivative actions, as more fully described in Note 6 to the consolidated financial statements appearing elsewhere herein. As part of the settlement, in the first quarter of fiscal 2008 the Company issued to the plaintiffs 1,833,828 shares of the Company’s common stock and warrants to acquire 4,296,523 shares of common stock, and provisions for the settlement recorded in fiscal 2007 were adjusted to reflect the ultimate fair value of the securities issued by the Company on March 2, 2007, which resulted in a non-cash credit to earnings of $14.9 million. Interest Income Interest income decreased to $287,000 in the first nine months of fiscal 2009 from $1.2 million in the first nine months of fiscal 2008 primarily due to lower short term interest rates. Interest Expense Interest expense decreased to $7.3 million in the first nine months of fiscal 2009 from $7.4 million in the first nine months of fiscal 2008. Interest accruing on outstanding indebtedness was lower in the first nine months of fiscal 2009 than in the first nine months of fiscal 2008 principally because of the reduction in outstanding debt since the first quarter of fiscal 2008. This lower interest on outstanding indebtedness was largely offset by higher lender margin on fees resulting from the amendments to the Company’s 2007 Secured Credit Facilities described in Note 5 to the consolidated financial statements appearing elsewhere herein. 37 As more fully described in Note 5 to the consolidated financial statements appearing elsewhere herein, effective April 9, 2008 the Company discontinued hedge accounting for certain interest rate derivatives as a result of amendments to its credit facilities. As a consequence of the discontinuance of hedge accounting, changes in the fair value of the derivative contracts subsequent to April 8, 2008 are reflected in earnings as they occur. Amounts included in accumulated other comprehensive income related to changes in the fair value of the derivative contracts for periods prior to April 9, 2008 are being charged to earnings through April 2010 when the underlying hedged transactions (interest expense on long-term debt) affect earnings. As of November 2, 2008, the fair value of the derivative liability was approximately $1.6 million, which is included in accrued liabilities in the accompanying consolidated balance sheet. Accumulated other comprehensive income as of November 2, 2008 includes an accumulated loss related to these derivatives of approximately $1.0 million (net of income taxes of approximately $600,000). Interest expense for the nine months ended November 2, 2008 includes approximately $660,000 of amortization of this accumulated loss. In the first nine months of fiscal 2009, the Company charged to interest expense approximately $260,000 of fees and expenses associated with the amendments to the Company’s credit facilities, and wrote off to interest expense approximately $290,000 of unamortized debt issuance costs associated with the reduction in the size of the Company’s revolving credit facility from $50 million to $30 million. Loss on Extinguishment of Debt During the first nine months of fiscal 2008, the Company closed the 2007 Secured Credit Facilities and used the proceeds to retire other indebtedness, as more fully described in Note 5 to the consolidated financial statements appearing elsewhere herein. The Company recorded a loss on extinguishment of debt of approximately $9.6 million, consisting of a $4.1 million prepayment fee related to the other indebtedness and a $5.5 million write-off of unamortized deferred financing costs related to that debt. Equity in Losses of Equity Method Franchisees Equity in losses of equity method franchisees totaled $685,000 in the first nine months of fiscal 2009 compared to $695,000 for the first nine months of fiscal 2008. This caption represents the Company’s share of operating results of unconsolidated franchisees which develop and operate Krispy Kreme stores. Other Non-Operating Income and Expense, Net Other non-operating income and expense in the first nine months of fiscal 2009 includes a non-cash gain of $931,000 on the disposal of an investment in an Equity Method Franchisee, largely offset by a $900,000 charge for collectability risk on a note receivable from another Equity Method Franchisee, as described in Note 9 to the consolidated financial statements appearing elsewhere herein. Other non-operating income and expense for the first nine months of fiscal 2008 includes an impairment charge of approximately $550,000 to reduce the carrying value of the Company’s investment in an Equity Method Franchisee to its estimated fair value, partially offset by a gain of approximately $260,000 resulting from the receipt of additional proceeds from the prior sale of another Equity Method Franchisee. Provision for Income Taxes The provision for income taxes was a benefit of $613,000 for the first nine months of fiscal 2009 and a charge of $1.0 million for the first nine months of fiscal 2008. Each of these amounts includes adjustments to the valuation allowance for deferred income tax assets to maintain such allowance at an amount sufficient to reduce the Company’s aggregate net deferred income tax assets to zero, as well as a provision for income taxes estimated to be payable currently. In addition, principally as a result of the dissolution of one of the Company’s foreign subsidiaries and the resolution of related income tax uncertainties during the first nine months of fiscal 2009, the Company recorded a credit of approximately $1.7 million to the provision for income taxes to reduce the Company’s accruals for uncertain tax positions. Net Loss The Company reported a net loss of $3.8 million for the nine months ended November 2, 2008 compared to a net loss of $35.2 million for the nine months ended October 28, 2007. LIQUIDITY AND CAPITAL RESOURCES The following table presents a summary of the Company’s cash flows from operating, investing and financing activities for the first nine months of fiscal 2009 and 2008. 38
Cash Flows from Operating Activities Net cash provided by operating activities was $10.8 million and $8.1 million in the first nine months of fiscal 2009 and 2008, respectively. Cash provided by operating activities in the first nine months of fiscal 2008 reflects a cash outflow of approximately $4.1 million for the prepayment fee associated with the refinancing of the Company’s credit facilities described under “Cash Flows from Financing Activities” below and in Note 5 to the consolidated financial statements appearing elsewhere herein. Cash provided by operating activities in the first nine months of fiscal 2009 and fiscal 2008 was affected by professional and other fees related to the investigations and securities litigation described in Note 6 to the consolidated financial statements appearing elsewhere herein. These fees and expenses reduced operating cash flows by approximately $950,000 in the first nine months of fiscal 2009 compared to $3.6 million for the first nine months of fiscal 2008. Cash Flows from Investing Activities Net cash used for investing activities was approximately $2.2 million in the first nine months of fiscal 2009 compared to net cash provided by investing activities of $1.8 million in the first nine months of fiscal 2008. Cash used for capital expenditures decreased to approximately $2.6 million in the first nine months of fiscal 2009 from $4.9 million in first nine months of fiscal 2008. Additionally, in the first nine months of fiscal 2009, the Company realized proceeds from the sale of property and equipment of $427,000 compared to $6.8 million in the first nine months of fiscal 2008. The fiscal 2008 proceeds resulted principally from the sale of closed stores. Cash Flows from Financing Activities Net cash used by financing activities was $1.1 million in the first nine months of fiscal 2009, compared to $22.8 million in the first nine months of fiscal 2008. During the first nine months of fiscal 2009, the Company repaid approximately $1.7 million of outstanding term loan and capitalized lease indebtedness, consisting of approximately $920,000 of scheduled amortization and a prepayment of approximately $750,000 from the proceeds of the assignment of a lease related to a closed store. Additionally, the Company paid approximately $695,000 in fees to its lenders in the first nine months of fiscal 2009 to amend its credit facilities as described below and in Note 5 to the consolidated financial statements appearing elsewhere herein. In the first nine months of fiscal 2009, the Company received $3.1 million in proceeds from the exercise of stock options. During the same period, present and former employees surrendered common shares having an aggregate fair value of $2.1 million to pay the exercise price of options exercised and to reimburse the Company for the minimum statutory withholding taxes paid by the Company on behalf of present and former employees arising from such exercise and from the vesting of restricted stock awards. During the first nine months of fiscal 2008, the Company closed new secured credit facilities totaling $160 million. At closing, the Company borrowed the full $110 million available under the 2007 Term Loan, and used the proceeds to retire approximately $107 million of indebtedness outstanding under its former secured credit facilities (which were terminated) and to pay prepayment fees under the former secured credit facilities and fees and expenses associated with the 2007 Secured Credit Facilities. In the first nine months of fiscal 2008, the Company prepaid approximately $21.9 million of the 2007 Term Loan, of which $6.9 million was from the proceeds of sales of certain property and equipment and $15.0 million represented discretionary prepayments. Business Conditions, Uncertainties and Liquidity The Company experienced a decline in revenues and incurred net losses in each of the last three fiscal years. The revenue decline reflects fewer Company stores in operation, a decline in domestic royalty revenues and lower sales of mixes and other ingredients resulting from lower sales by the Company’s domestic franchisees. These declines were only partially offset by higher royalty revenues from international franchisees. Lower revenues have adversely affected operating margins because of the fixed or semi-fixed nature of many of the Company’s direct operating expenses. In addition, the Company has recorded significant asset impairment charges in each of the last three fiscal years. 39 The Company generated net cash from operating activities of $10.8 million in the first nine months of fiscal 2009 and $8.1 million in the first nine months of fiscal 2008. Net cash provided by operating activities in the first nine months of fiscal 2008 reflects a cash outflow of approximately $4.1 million for a prepayment penalty on the refinancing of indebtedness. In the first nine months of fiscal 2009, the Company continued to experience declines in revenues in both its Company Stores and KK Supply Chain business segments. In addition, price increases in the Company Stores segment have not been sufficient to fully offset steep rises in agricultural commodity costs and gasoline prices in fiscal 2009 compared to fiscal 2008, although recent economic conditions have led to significant reductions in the market prices of these commodities and in the price of gasoline. Sales volumes and changes in the cost of major ingredients and fuel can have a material effect on the Company’s results of operations and cash flows. The Company’s 2007 Secured Credit Facilities described in Note 5 to the consolidated financial statements appearing elsewhere herein are the Company’s principal source of external financing. These facilities consist of a term loan having an outstanding principal balance of $74.7 million as of November 2, 2008 which matures in February 2014, and a $30 million revolving credit facility which matures in February 2013. The 2007 Secured Credit Facilities contain significant financial covenants as described in Note 5 to the consolidated financial statements appearing elsewhere herein, which become more stringent in the first quarter of fiscal 2010. It is likely the Company will need to seek amendments of its credit facilities to relax those financial covenants for fiscal 2010. The Company was in compliance with the financial covenants as of November 2, 2008, but also may need relief with respect to fiscal 2009 depending on its results for the fourth quarter. As a result of amendments in fiscal 2008 and 2009, the Company paid fees of approximately $835,000 and the interest rate on outstanding loans increased from LIBOR plus 2.75% to LIBOR plus 5.50% (with a LIBOR floor of 3.25%). Any future amendments or waivers could result in additional fees or rate increases. Failure to comply with the financial covenants contained in the 2007 Secured Credit Facilities, or the occurrence or failure to occur of certain events, would cause the Company to default under the facilities. In the absence of a waiver of, or forbearance with respect to, any such default, the Company’s lenders would be able to exercise their rights, under the credit agreement including, but not limited to, accelerating maturity of outstanding indebtedness and asserting their rights with respect to the collateral. In the event the Company were to fail to comply with one or more such covenants, the Company would attempt to negotiate waivers of any such noncompliance. There can be no assurance that the Company would be able to negotiate any such waivers, and the costs or conditions associated with any such waivers could be significant. Acceleration of the maturity of indebtedness under the 2007 Secured Credit Facilities could have a material adverse effect on the Company’s financial position, results of operations and cash flows. In the event that credit under the 2007 Secured Credit Facilities were not available to the Company, there can be no assurance that alternative sources of credit would be available to the Company or, if they are available, under what terms or at what cost. In addition to further declines in revenues, many other factors could also adversely affect the Company’s business. In particular, increases in the cost of raw materials and fuel and strengthening of the U.S. dollar relative to other currencies, could adversely affect the Company’s operating results and cash flows. In addition, several franchisees have been experiencing financial pressures which, in certain instances, have become exacerbated in recent quarters. The Company has guaranteed certain obligations of franchisees in which it has an equity interest, as described in “Other Commitments and Contingencies” in Note 6 to the consolidated financial statements appearing elsewhere herein. Franchisees opened 96 stores and closed 30 stores in the first nine months of fiscal 2009, including 37 and 19 stores, respectively, in the third quarter. The Company believes franchisees will close additional stores in the future, and the number of such closures may be significant. Royalty revenues and most of KK Supply Chain revenues are directly related to sales by franchise stores and, accordingly, the success of franchisees’ operations has a direct effect on the Company’s revenues, results of operations and cash flows. Recent Accounting Pronouncements Effective February 4, 2008 (the first day of fiscal 2009), the Company adopted Financial Accounting Standards Board (“FASB”) Statement No. 157, “Fair Value Measurements” (“FAS 157”), as described in Note 11 to the consolidated financial statements appearing elsewhere herein. FAS 157 addresses how companies should measure fair value when they are required to use a fair value measure for recognition or disclosure purposes under GAAP. As a result of FAS 157, there is now a common definition of fair value to be used throughout GAAP, which is expected to make the measurement of fair value more consistent and comparable. Adoption of FAS 157 had no material effect on the Company’s financial position or results of operations. See Note 11 for additional information regarding fair value measurement. 40 Effective January 29, 2007 (the first day of fiscal 2008), the Company adopted the provisions of FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes,” (“FIN 48”). FIN 48 prescribes recognition thresholds that must be met before a tax position is recognized in the financial statements and provides guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. Under FIN 48, an entity may only recognize or continue to recognize tax positions that meet a "more likely than not" threshold. The Company recorded the cumulative effect of adopting FIN 48 as a $1.2 million credit to the opening balance of accumulated deficit as of January 29, 2007, the date of adoption. Principally as a result of the dissolution of one of the Company’s foreign subsidiaries and the resolution of related income tax uncertainties during the first nine months of fiscal 2009, the Company recorded credit of approximately $1.7 million to the provision for income taxes to reduce the Company’s accruals for uncertain tax positions. In February 2007, the FASB issued Statement No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities, including an amendment of FASB Statement No. 115” (“FAS 159”). FAS 159 permits entities to choose to measure many financial instruments and certain other items at fair value that are not currently required to be measured at fair value. Unrealized gains and losses on items for which the fair value option has been elected are reported in earnings. FAS 159 does not affect any existing accounting literature that requires certain assets and liabilities to be carried at fair value. The Company adopted FAS 159 as of February 4, 2008 (the first day of fiscal 2009) and did not elect any fair value measurement options permitted by FAS 159 and, accordingly, FAS 159 did not have any effect on the Company’s financial position or results of operations. In March 2008, the FASB issued FASB Statement No. 161, “Disclosures about Derivative Instruments and Hedging Activities” (“FAS 161”). FAS 161 is intended to improve financial reporting about derivative instruments and hedging activities by requiring enhanced disclosures to enable investors to better understand their effects on an entity’s financial position, financial performance and cash flows. FAS 161 is effective for the Company in fiscal 2010. Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK. The Company is exposed to market risk from increases in interest rates on its outstanding debt. All of the borrowings under the Company’s secured credit facilities bear interest at variable rates based upon either the Fed funds rate or LIBOR. The interest cost of the Company’s debt is affected by changes in these short-term interest rates. On May 16, 2007, the Company entered into interest rate derivative contracts having an aggregate notional principal amount of $60 million. The derivative contracts eliminate the Company’s exposure, with respect to such notional amount, to increases in three month LIBOR beyond 5.40% through April 2010, and eliminate the Company’s ability to benefit from a reduction in three month LIBOR below 4.48% for the same period. As of November 2, 2008, the Company had approximately $75.2 million in borrowings outstanding. A hypothetical increase of 100 basis points in short-term interest rates would have no significant effect on the Company’s annual interest expense. The increase would reduce amounts payable by the Company on the $60 million outstanding notional balance of interest rate derivatives, while only a portion of the hypothetical rate increase would result in higher interest expense on the Company’s term debt due to the operation of an interest rate floor provision in the Company’s credit agreement. The Company’s credit facilities and the related interest rate derivatives are described in Note 5 to the consolidated financial statements appearing elsewhere herein. The substantial majority of the Company’s revenue, expense and capital purchasing activities are transacted in United States dollars. The Company’s investment in its franchisee operating in Mexico and the Company’s operations in Canada expose the Company to exchange rate risk. In addition, although royalties from international franchisees are payable to the Company in United States dollars, changes in the rate of exchange between the United States dollar and the foreign currencies used in the countries in which the international franchisees operate affect the Company’s royalty revenues. Recently, the U.S. dollar has strengthened relative to many other currencies; strengthening of the U.S. dollar relative to the currencies of international franchisees adversely affects Franchise revenue. The Company historically has not hedged these exchange rate risks. The Company is exposed to the effects of commodity price fluctuations in the cost of ingredients of its products, of which flour, sugar and shortening are the most significant. In order to secure adequate supplies of materials and bring greater stability to the cost of ingredients, the Company routinely enters into forward purchase contracts and other purchase arrangements with suppliers. Under the forward purchase contracts, the Company commits to purchasing agreed-upon quantities of ingredients at agreed-upon prices at specified future dates. The outstanding purchase commitment for these commodities at any point in time typically ranges from one month’s to two years’ anticipated requirements, depending on the ingredient. Other purchase arrangements typically are contractual arrangements with vendors (for example, with respect to certain beverages and ingredients) under which the Company is not required to purchase any minimum quantity of goods, but must purchase minimum percentages of its requirements for such goods from these vendors with whom it has executed these contracts. 41 In addition to entering into forward purchase contracts, from time to time the Company purchases exchange-traded commodity futures contracts, and options on such contracts, for raw materials which are ingredients of its products or which are components of such ingredients, including wheat and soybean oil. The Company typically assigns the futures contract to a supplier in connection with entering into a forward purchase contract for the related ingredient. Quantitative information about the Company’s unassigned commodity futures contracts as of November 2, 2008, all of which mature in fiscal 2010, is set forth in the table below.
Although the Company utilizes forward purchase contracts and futures contracts and options on such contracts to mitigate the risks related to commodity price fluctuations, such contracts do not fully mitigate commodity price risk. In addition, the portion of the Company’s anticipated future commodity requirements that is subject to such contracts varies from time to time. Prices for agricultural commodities have been volatile in recent quarters and have traded at record high prices during this period, although recent economic conditions have led to significant reductions in the market prices of agricultural and other commodities, including wheat and soybean oil. Adverse changes in commodity prices could adversely affect the Company’s profitability and liquidity. The following table illustrates the potential effect on the Company’s costs resulting from hypothetical changes in the cost of the Company’s three most significant ingredients.
The range of prices paid for fiscal 2008 set forth in the table above reflect the effects of any forward purchase contracts entered into at various times prior to delivery of the goods and, accordingly, do not necessarily reflect the range of prices of these ingredients prevailing in the market during the fiscal year. Item 4. CONTROLS AND PROCEDURES. Evaluation of Disclosure Controls and Procedures As of November 2, 2008, the end of the period covered by this Quarterly Report on Form 10-Q, management performed, under the supervision and with the participation of the Company’s chief executive officer and chief financial officer, an evaluation of the effectiveness of the Company’s disclosure controls and procedures as defined in Rules 13a-15(e) and 15d-15(e) of the Exchange Act. The Company’s disclosure controls and procedures are designed to ensure that information required to be disclosed in the reports the Company files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to management, including the Company’s chief executive officer and chief financial officer, to allow timely decisions regarding required disclosures. Based on this evaluation, the Company’s chief executive officer and chief financial officer have concluded that, as of November 2, 2008, the Company’s disclosure controls and procedures were effective. Changes in Internal Control Over Financial Reporting During the quarter ended November 2, 2008, there were no changes in the Company’s internal control over financial reporting that materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting. 42 PART II – OTHER INFORMATION Item 1. LEGAL PROCEEDINGS. From time to time we are subject to claims and suits arising in the course of our business. We maintain customary insurance policies against certain kinds of claims and suits which arise in the course of our business, including insurance policies for workers’ compensation and personal injury, some of which provide for relatively large deductible amounts. Except as disclosed below, we are currently not a party to any material legal proceedings. Governmental Investigations SEC Investigation On October 7, 2004, the staff of the SEC advised us that the SEC had entered a formal order of investigation concerning the Company. The Company is cooperating with the investigation. United States Attorney Investigation On February 24, 2005, the United States Attorney’s Office for the Southern District of New York advised us that it would seek to conduct interviews of certain current and former officers and employees of the Company. The Company is cooperating with the investigation. Litigation Federal Securities Class Actions and Settlement Thereof and Federal Court Shareholder Derivative Actions and Partial Settlement Thereof On May 12, 2004, a purported securities class action was filed on behalf of persons who purchased the Company’s publicly traded securities between August 21, 2003 and May 7, 2004 against the Company and certain of its former officers in the United States District Court for the Middle District of North Carolina, alleging violations of federal securities law in connection with various public statements made by the Company. Subsequently, 14 substantially identical purported class actions were filed in the same court. All the actions ultimately were consolidated. In addition to the purported securities class action, three shareholder derivative actions were filed in the United States District Court for the Middle District of North Carolina against certain current and former directors of the Company, certain former officers of the Company, including Scott Livengood (the Company’s former Chairman and Chief Executive Officer), as well as certain persons or entities that sold franchises to the Company. The complaints in these actions alleged that the defendants breached their fiduciary duties in connection with their management of the Company and the Company’s acquisitions of certain franchises. In October 2006, the Company entered into a Stipulation and Settlement Agreement (the “Stipulation”) with the lead plaintiffs in the securities class action, the derivative plaintiffs and all defendants named in the class action and derivative litigation, except for Mr. Livengood, providing for the settlement of the securities class action and a partial settlement of the derivative action. The Stipulation contained no admission of fault or wrongdoing by the Company or the other defendants. In February 2007, the Court entered final judgment dismissing all claims with respect to all defendants in the derivative action, except for claims that the Company may assert against Mr. Livengood, and entered final judgment dismissing all claims with respect to all defendants in the securities class action. With respect to the securities class action, the settlement class received total consideration of approximately $76.0 million, consisting of a cash payment of approximately $35.0 million made by the Company’s directors’ and officers’ insurers, cash payments of $100,000 each made by each of a former Chief Operating Officer and former Chief Financial Officer of the Company, a cash payment of $4 million made by the Company’s independent registered public accounting firm and common stock and warrants to purchase common stock issued by the Company having an estimated aggregate value of approximately $36.9 million as of their issuance on March 2, 2007. Claims against all defendants were dismissed with prejudice; however, claims that the Company may have against Mr. Livengood that may be asserted by the Company in the derivative action for contribution to the securities class action settlement or otherwise under applicable law are expressly preserved. 43 The Stipulation also provided for the settlement and dismissal with prejudice of claims against all defendants in the derivative action, except for claims against Mr. Livengood. In addition to their contribution of $100,000 each to the settlement of the securities class action, the two former officers agreed to limit their claims for indemnity from the Company in connection with future proceedings before the SEC or by the United States Attorney for the Southern District of New York to specified amounts. The Company has been in negotiations with Mr. Livengood but has not reached agreement to resolve the derivative claims against him. Counsel for the derivative plaintiffs have deferred their application for fees until conclusion of the derivative actions against Mr. Livengood. See “Other Commitments and Contingencies” in Note 6 to the consolidated financial statements appearing elsewhere herein. In the first quarter of fiscal 2008, the Company issued 1,833,828 shares of its common stock and warrants to purchase 4,296,523 shares of its common stock at a price of $12.21 per share in connection with the Stipulation, and provisions for the settlement recorded in fiscal 2007 were adjusted to reflect the ultimate fair value of the securities issued by the Company as of March 2, 2007, which resulted in a non-cash credit to earnings of $14.9 million. FACTA litigation On October 3, 2007, a purported nationwide class action (Peter Jackson v. Krispy Kreme Doughnut Corporation (Case No. CV07-06449 ABC (VBC)), United States District Court, Central District of California) was filed against the Company and ten fictitiously named defendants. Plaintiff asserted a single cause of action for alleged willful violation of the federal Fair and Accurate Credit Transactions Act (“FACTA”). Specifically, plaintiff alleged a violation concerning electronic printing of certain credit card and debit card receipts that were not in compliance with the applicable information truncation provisions of FACTA. On August 25, 2008, the Company entered into an agreement settling the case; such settlement had no material effect on the Company’s financial statements. TAG Litigation In February 2008, the Company filed suit in the U.S. District Court for the Middle District of North Carolina against The Advantage Group Enterprise, Inc. (“TAG”), alleging that TAG failed to properly account for and pay the Company on sales of equipment that the Company consigned to TAG. Based on these allegations, the Company asserted various claims including breach of fiduciary duty and conversion, and it seeks an accounting and constructive trust. In addition, the Company seeks a declaration that it does not owe TAG approximately $1 million for storage fees and alleged lost profits. In March 2008, TAG answered the complaint, denying liability and asserting counterclaims against the Company. TAG alleges that the Company acted improperly by failing to execute a written contract between the companies and claims damages for breach of contract, services rendered, unjust enrichment, violation of the North Carolina Unfair Trade Practices Act and fraud in the inducement. TAG seeks approximately $1 million in actual damages as well as punitive and treble damages. The Company intends to vigorously prosecute its claims against TAG and to vigorously defend against the counterclaims, which the Company believes are without merit. Item 1A. RISK FACTORS. There have been no material changes from the risk factors disclosed in Part I, Item 1A, “Risk Factors,” in the 2008 Form 10-K. Item 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS. None. Item 3. DEFAULTS UPON SENIOR SECURITIES. None. Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. None. 44 Item 5. OTHER INFORMATION. None. Item 6. EXHIBITS.
45 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
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