Krispy Kreme Doughnuts 10-Q 2010
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Commission file number 001-16485
KRISPY KREME DOUGHNUTS, INC.
(Exact name of registrant as specified in its charter)
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 has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes o 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 Exchange Act). Yes o No þ
Number of shares of Common Stock, no par value, outstanding as of November 26, 2010: 67,514,159.
TABLE OF CONTENTS
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 and fiscal 2010 mean the fiscal years ended January 30, 2011 and January 31, 2010, respectively.
This quarterly report contains forward looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”) that relate to our plans, objectives, estimates and goals. Statements expressing expectations regarding our future and projections relating to products, sales, revenues, costs and earnings are typical of such statements, and are made under 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,” “could,” “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:
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 except as required by the federal securities laws.
PART I - FINANCIAL INFORMATION
Item 1. FINANCIAL STATEMENTS.
KRISPY KREME DOUGHNUTS, INC.
CONSOLIDATED STATEMENT OF OPERATIONS
The accompanying notes are an integral part of the financial statements.
KRISPY KREME DOUGHNUTS, INC.
CONSOLIDATED BALANCE SHEET
The accompanying notes are an integral part of the financial statements.
KRISPY KREME DOUGHNUTS, INC.
CONSOLIDATED STATEMENT OF CASH FLOWS
The accompanying notes are an integral part of the financial statements.
KRISPY KREME DOUGHNUTS, INC.
CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS' EQUITY
Total comprehensive income for the three months ended October 31, 2010 was $2.4 million and the total comprehensive loss for the three months ended November 1, 2009 was $2.2 million.
The accompanying notes are an integral part of the financial statements.
KRISPY KREME DOUGHNUTS, INC.
NOTES TO FINANCIAL STATEMENTS
Note 1 — Accounting Policies
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.
Significant Accounting Policies
BASIS OF PRESENTATION. The consolidated financial statements contained herein should be read in conjunction with the Company’s 2010 Form 10-K. 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 the 2010 Form 10-K, but have not been audited. In management’s opinion, the financial statements include all adjustments, which 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 January 31, 2010 were derived from the Company’s audited financial statements but do not include all disclosures required by GAAP.
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. In October 2009, the Company refranchised three stores in Northern California to a new franchisee. The Company did not report the refranchising as divestiture of the stores and continued to consolidate the stores’ financial statements for post-acquisition periods because the new franchisee was a variable interest entity of which the Company was the primary beneficiary. Effective February 1, 2010, the Company adopted new accounting standards under which the Company is no longer the primary beneficiary of the new franchisee, which required the Company to deconsolidate the franchisee and recognize a divestiture of the stores; see “Recent Accounting Pronouncements” below.
Investments in entities over which the Company has the ability to exercise significant influence but which the Company does not control, and whose financial statements are not otherwise required to be consolidated, are accounted for using the equity method. These entities typically are 25% 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. 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 warrants and the vesting of currently unvested shares of restricted stock and restricted stock units.
The following table sets forth amounts used in the computation of basic and diluted earnings per share:
The sum of the quarterly earnings per share amounts does not necessarily equal earnings per share for the year to date.
Stock options and warrants with respect to 7.3 million and 10.8 million shares, as well as 353,000 and 1.3 million unvested shares of restricted stock and unvested restricted stock units, have been excluded from the computation of the number of shares used to compute diluted earnings per share for the three months ended October 31, 2010 and November 1, 2009, respectively, because their inclusion would be antidilutive.
Stock options and warrants with respect to 8.2 million and 10.8 million shares, as well as 210,000 and 1.2 million unvested shares of restricted stock and unvested restricted stock units, have been excluded from the computation of the number of shares used to compute diluted earnings per share for the nine months ended October 31, 2010 and November 1, 2009, respectively, because their inclusion would be antidilutive.
Beginning in the first quarter of fiscal 2011, miscellaneous receivables previously classified as a component of other current assets were reclassified and combined with trade receivables, and the combined total has been captioned “Receivables” in the accompanying consolidated balance sheet. Amounts previously reported at January 31, 2010 have been reclassified to conform to the new presentation.
Beginning in the third quarter of fiscal 2011, the caption “Other operating income and expense, net” previously included in the consolidated statement of operations was eliminated. Amounts previously included in this caption have been reclassified to direct operating expenses and general and administrative expenses and amounts reported in this caption for earlier periods have been reclassified to conform to the new presentation. None of the reclassified amounts was material in any of the periods.
Recent Accounting Pronouncements
In the first quarter of fiscal 2011, the Company adopted amended accounting standards related to the consolidation of variable-interest entities. The amended standards require an enterprise to qualitatively assess the determination of the primary beneficiary of a variable interest entity (“VIE”) based on whether the enterprise has the power to direct matters that most significantly impact the activities of the VIE and has the obligation to absorb losses of, or the right to receive benefits from, the VIE that could potentially be significant to the VIE. Adoption of the new standards resulted in the Company recognizing a divestiture of three stores sold by the Company in the October 2009 refranchising transaction described under “Basis of Consolidation,” above. The cumulative effect of adoption of the new standards has been reflected as a $1.3 million credit to the opening balance of retained earnings as of February 1, 2010, the first day of fiscal 2011. Adoption of the standards had no material effect on the Company’s financial position, results of operations or cash flows.
Note 2 — Receivables
The components of receivables are as follows:
Note 3 — Inventories
The components of inventories are as follows:
Note 4 — 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 “Secured Credit Facilities”) then consisting of a $50 million revolving credit facility maturing in February 2013 (the “Revolver”) and a $110 million term loan maturing in February 2014 (the “Term Loan”). The Secured Credit Facilities are secured by a first lien on substantially all of the assets of the Company and its subsidiaries.
The 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 Revolver. The commitments under the Revolver were reduced from $50 million to $30 million in April 2008, and further reduced to $25 million in connection with amendments to the facilities in April 2009 (the “April 2009 Amendments”). In connection with the April 2009 Amendments, the Company prepaid $20 million of the principal balance outstanding under the Term Loan. The Company has made other payments of Term Loan principal since February 2007, consisting of $26.6 million representing the proceeds of asset sales, $25.0 million representing discretionary prepayments and $3.3 million representing scheduled amortization which, together with the $20.0 million prepayment in April 2009 have reduced the principal balance of the Term Loan to $ 35.1 million as of October 31, 2010.
Interest on borrowings under the Revolver and Term Loan is payable either (a) at the greater of LIBOR or 3.25% or (b) 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. After giving effect to the April 2009 Amendments, the Applicable Margin for LIBOR-based loans and for Alternate Base Rate-based loans was 7.50% and 6.50%, respectively (5.50% and 4.50%, respectively, prior to the April 2009 Amendments).
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 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 Revolver lending commitment, which increased from 0.75% to 1.00% in connection with the April 2009 Amendments.
Borrowings under the Revolver (and issuances of letters of credit) are subject to the satisfaction of usual and customary conditions, including the accuracy of representations and warranties and the absence of defaults.
The Term Loan is payable in quarterly installments of approximately $116,000 (as adjusted to give effect to prepayments of principal under the Term Loan) and a final installment equal to the remaining principal balance in February 2014. The Term Loan is required to be prepaid with some or all of the net proceeds of certain equity issuances, debt issuances, asset sales and casualty events and with a percentage of excess cash flow (as defined in the agreement) on an annual basis.
The 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 October 31, 2010, the consolidated leverage ratio was required to be not greater than 3.25 to 1.0 and the consolidated interest coverage ratio was required to be not less than 2.95 to 1.0. As of October 31, 2010, the Company’s consolidated leverage ratio was approximately 1.5 to 1.0 and the Company’s consolidated interest coverage ratio was approximately 5.5 to 1.0. In the future, the maximum consolidated leverage ratio declines, and the minimum consolidated interest coverage ratio increases, as set forth in the following tables:
“Consolidated EBITDA” is a non-GAAP measure and is defined in the 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 interest expense (net of interest income), 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 four-quarter period and the sum of non-cash credits. In addition, the 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 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 Revolver. In addition, the maximum amount which may be borrowed under the Revolver is reduced by the amount of outstanding letters of credit, which totaled approximately $13 million as of October 31, 2010, the substantial majority of which secure the Company’s reimbursement obligations to insurers under the Company’s self-insurance arrangements. The restrictive covenants did not limit the Company’s ability to borrow the full $12 million of unused credit under the Revolver at October 31, 2010.
The 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.
Note 5 — Impairment Charges and Lease Termination Costs
The components of impairment charges and lease termination costs are as follows:
The Company tests long-lived assets for impairment when events or changes in circumstances indicate that their carrying value may not be recoverable. These events and changes in circumstances include store closing and refranchising decisions, the effects of changing costs on current results of operations, observed trends in operating results, and evidence of changed circumstances observed as a part of periodic reforecasts of future operating results and as part of the Company’s annual budgeting process. 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. During the three months ended November 1, 2009, the Company received $482,000 of cash proceeds from the bankruptcy estate of Freedom Rings, LLC (“Freedom Rings”), a former subsidiary which filed for bankruptcy in the third quarter of fiscal 2006. During fiscal 2006, the Company recorded impairment provisions related to long-lived assets of Freedom Rings under the assumption that there would be no recovery from the Freedom Rings bankruptcy estate. Had any such recovery been assumed, the impairment charges would have been reduced by the amount of the assumed recovery. Accordingly, the amount recovered in the third quarter of fiscal 2010 has been reported as a credit to impairment charges in the accompanying consolidated statement of operations.
Lease termination costs represent the estimated fair value of liabilities related to unexpired leases, after reduction by the amount of accrued rent expense, if any, related to the leases, and are recorded when the lease contracts are terminated or, if earlier, the date on which the Company ceases use of the leased property. The fair value of these liabilities were estimated as the excess, if any, of the contractual payments required under the unexpired leases over the current market lease rates for the properties, discounted at a credit-adjusted risk-free rate over the remaining term of the leases.
The transactions reflected in the accrual for lease termination costs are summarized as follows:
Note 6 — Segment Information
The Company’s reportable segments are Company Stores, Domestic Franchise, International Franchise and KK Supply Chain. The Company Stores segment is comprised of the stores operated by the Company. These stores sell doughnuts and complementary products through both on-premises and off-premises sales channels, although some stores serve only one of these distribution channels. The Domestic Franchise and International Franchise segments consist of the Company’s franchise operations. Under the terms of franchise agreements, domestic and international franchisees pay royalties and fees to the Company in return for the use of the Krispy Kreme name and ongoing brand and operational support. Expenses for these segments include costs to recruit new franchisees, to assist in store openings, to support franchisee operations and marketing efforts, as well as allocated corporate costs. The majority of the ingredients and materials used by Company stores are purchased from the KK Supply Chain segment, which supplies doughnut mix, other ingredients and supplies and doughnut making equipment to both Company and franchisee-owned stores.
All intercompany sales by the KK Supply Chain segment to the Company Stores segment are at prices intended to reflect an arms-length transfer price and are eliminated in consolidation. Operating income for the Company Stores segment does not include any profit earned by the KK Supply Chain segment on sales of doughnut mix and other items to the Company Stores segment; such profit is included in KK Supply Chain operating income.
The following table presents the results of operations of the Company’s operating segments for the three and nine months ended October 31, 2010 and November 1, 2009. Segment operating income is consolidated operating income before unallocated general and administrative expenses and impairment charges and lease termination costs.
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 7 — Investments in Franchisees
As of October 31, 2010, the Company had investments in four franchisees. These investments have been made in the form of capital contributions and, in certain instances, loans evidenced by promissory notes. These investments are reflected as “Investments in equity method franchisees” in the consolidated balance sheet.
The Company’s financial exposures related to franchisees in which the Company has an investment are summarized in the tables below.
The loan guarantee amounts represent the portion of the principal amount outstanding under the related loan that is subject to the Company’s guarantee.
Current liabilities at October 31, 2010 and January 31, 2010 include accruals for potential payments under loan guarantees of approximately $2.2 million and $2.5 million, respectively, related to Krispy Kreme of South Florida, LLC (“KKSF”). The underlying indebtedness related to approximately $1.6 million of the Company’s KKSF guarantee exposure matured by its terms in October 2009. Such maturity has been extended on a month-to-month basis pursuant to an informal agreement between KKSF and the lender.
There was no liability reflected in the financial statements for other guarantees of franchisee obligations because the Company did not believe it was probable that the Company would be required to perform under such other guarantees.
The Company has a 25% interest in Kremeworks, LLC (“Kremeworks”), and has guaranteed 20% of the outstanding principal balance of certain of Kremeworks’ bank indebtedness, which originally matured in January 2009 and subsequently was refinanced with the lender through July 2010. During the third quarter of fiscal 2010, Kremeworks completed an amendment to its debt agreement which, among other things, waived certain defaults related to the failure to comply with the financial covenants and extended the maturity of the indebtedness until July 2010. In connection with that amendment, during fiscal 2010, the Company and the majority owner of Kremeworks (which also is a guarantor of the indebtedness) made capital contributions to Kremeworks in the aggregate amount of $1 million (of which the Company’s contribution was $250,000), the proceeds of which were used to prepay a portion of the indebtedness as required by the amendment. In the second quarter of fiscal 2011, Kremeworks’ lender granted a one-month extension of the maturity of the bank indebtedness to August 31, 2010 in connection with an expected refinancing by the lender. During the third quarter of fiscal 2011, Kremeworks refinanced its debt agreement which extended the maturity of the indebtedness until October 2011. The aggregate amount of such indebtedness was approximately $5.3 million at October 31, 2010.
Kremeworks’ unaudited revenues, operating loss and net loss for the three and nine months ended October 31, 2010 and November 1, 2009, based upon information provided by the franchisee, are set forth in the following table.
The Company has a 30% interest in Krispy Kreme Mexico, S. de R.L. de C.V. (“KK Mexico”). In the first half of fiscal 2010, KK Mexico was adversely affected by economic weakness in that country as well as by a significant decline in the value of the country’s currency relative to the U.S. dollar, which made the cost of goods imported from the U.S. more expensive, and which increased the amount of cash required to service the portion of the franchisee’s debt that is denominated in U.S. dollars. In the second quarter of fiscal 2010, management concluded that the decline in the value of the investment was other than temporary and, accordingly, the Company recorded a charge of approximately $500,000 in the quarter then ended to reduce the carrying value of the investment in KK Mexico to its then estimated fair value of $700,000. Such charge was included in “Other non-operating income and expense, net” in the accompanying consolidated statement of operations. In addition, during the nine months ended November 1, 2009, the Company increased its bad debt reserve related to KK Mexico by approximately $500,000, of which approximately $120,000 and $380,000 was included in KK Supply Chain and International Franchise direct operating expenses, respectively. KK Mexico’s operations have improved in recent quarters, and in the second quarter of fiscal 2011, the Company converted its past due receivables from the franchisee to a note in the amount of $967,000 payable in installments, together with interest. The Company has maintained reserves equal to substantially all amounts due from KK Mexico, including the balance of the note. KK Mexico’s unaudited revenues, operating income and net income for the three and nine months ended October 31, 2010 and November 1, 2009, based upon information provided by the franchisee, are set forth in the following table.
Note 8 — Shareholders’ Equity
The Company measures and recognizes compensation expense for share-based payment (“SBP”) awards based on their fair values. The fair value of SBP awards for which employees render the requisite service necessary for the award to vest is recognized over the related vesting period.
The aggregate cost of SBP awards charged to earnings for the three and nine months ended October 31, 2010 and November 1, 2009 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 or restricted stock units during any of the periods.
Note 9 — Fair Value Measurements
The accounting standards for fair value measurements define 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.
The accounting standards for fair value measurements establish 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:
Assets and Liabilities Measured at Fair Value on a Recurring Basis
The following table presents the Company’s assets and liabilities that are measured at fair value on a recurring basis at October 31, 2010 and January 31, 2010.
Assets and Liabilities Measured at Fair Value on a Non-Recurring Basis
The following tables present the nonrecurring fair value measurements recorded during the three and nine months ended October 31, 2010 and November 1, 2009.
During the nine months ended October 31, 2010, long-lived assets with an aggregate carrying value of $4.5 million were written down to their estimated fair values of $3.6 million, resulting in recorded impairment charges of $899,000. During the three and nine months ended November 1, 2009, long-lived assets having an aggregate carrying value of $3.0 million and $7.2 million, respectively, were written down to their estimated fair values of $2.8 million and $5.8 million, respectively, resulting in recorded impairment charges of $178,000 and $1.4 million, respectively. Substantially all of such long-lived assets were real properties, the fair values of which were estimated based on independent appraisals or, in the case of properties which the Company was negotiating to sell, based on the Company’s negotiations with unrelated third-party buyers. These inputs are classified as Level 2 within the valuation hierarchy.
Investment in Equity Method Franchisee
During the nine months ended November 1, 2009, the Company concluded that a decline in the value of an Equity Method Franchisee was other than temporary and, accordingly, recorded a writedown of $500,000 to reduce the carrying value of the investment to its estimated fair value of $700,000 as described in Note 7. The fair value of the investment was estimated based upon a multiple of the investee’s current normalized trailing earnings before interest, income taxes and depreciation and amortization. These inputs are classified as Level 3 within the valuation hierarchy.
Lease Termination Liabilities
During the nine months ended October 31, 2010 and the three and nine months ended November 1, 2009, the Company recorded provisions for lease termination costs related to closed stores based upon the estimated fair values of the liabilities under unexpired leases as described in Note 5; such provisions were reduced by previously recorded accrued rent expense related to those stores. The fair value of these liabilities was computed as the excess, if any, of the contractual payments required under the unexpired leases over the current market lease rates for the properties, discounted at a credit-adjusted risk-free rate over the remaining term of the leases. These inputs are classified as Level 2 within the valuation hierarchy. For the nine months ended October 31, 2010, $644,000 of previously recorded accrued rent expense related to a store closure and a store relocation exceeded the $394,000 fair value of lease termination liabilities related to such stores, and such excess has been reflected as a credit to lease termination costs during the period. For the three months ended November 1, 2009, $218,000 of previously recorded accrued rent expense related to closed stores exceeded the $212,000 fair value of lease termination liabilities related to such stores, and such excess was reflected as a credit to lease termination costs during the period. For the nine months ended November 1, 2009, the fair value of lease termination liabilities related to closed stores of $2.4 million exceeded the $958,000 of previously recorded accrued rent expense related to such stores, and such excess was reflected as a charge to lease termination costs during the period.
Fair Values of Financial Instruments at the Balance Sheet Dates
The carrying values and approximate fair values of certain financial instruments as of October 31, 2010 and January 31, 2010 were as follows:
Note 10 — Derivative Instruments
The Company is exposed to certain risks relating to its ongoing business operations. The primary risks managed by using derivative instruments are commodity price risk and interest rate risk. The Company does not hold or issue derivative instruments for trading purposes.
The Company was exposed to credit-related losses in the event of non-performance by the counterparties to its derivative instruments which expired in April 2010. The Company mitigated this risk of nonperformance by dealing with highly rated counterparties.
Additional disclosure about the fair value of derivative instruments is included in Note 9.
Commodity Price Risk
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 bring greater stability to the cost of ingredients, the Company purchases, from time to time, 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 is also exposed to the effects of commodity price fluctuations in the cost of gasoline used by its delivery vehicles. To mitigate the risk of fluctuations in the price of its gasoline purchases, the Company may purchase exchange-traded commodity futures contracts and options on such contracts. The difference between the cost, if any, and the fair value of commodity derivatives is reflected in earnings because the Company has not designated any of these instruments as hedges. Gains and losses on these contracts are intended to offset losses and gains on the hedged transactions in an effort to reduce the earnings volatility resulting from fluctuating commodity prices. The settlement of commodity derivative contracts is reported in the consolidated statement of cash flows as cash flow from operating activities. At October 31, 2010, the Company had commodity derivatives with an aggregate contract volume of 5,000 bushels of wheat and 294,000 gallons of gasoline. Other than the requirement to meet minimum margin requirements with respect to the commodity derivatives, there are no collateral requirements related to such contracts.
Interest Rate Risk
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, with LIBOR subject to a floor of 3.25%. The interest cost of the Company’s debt may be affected by changes in these short-term interest rates and increases in those rates may adversely affect the Company’s results of operations. On May 16, 2007, the Company entered into interest rate derivative contracts having an aggregate notional principal amount of $60 million. The derivative contracts entitled the Company to receive from the counterparties the excess, if any, of three-month LIBOR over 5.40%, and required the Company to pay to the counterparties the excess, if any, of 4.48% over three-month LIBOR, in each case multiplied by the notional amount of the contracts. The contracts expired in April 2010. Settlements under these derivative contracts are reported as cash flow from operating activities in the consolidated statement of cash flows.
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 in hedging interest rate risk as a result of amendments to the Company’s Secured Credit Facilities, which provided that interest on LIBOR-based borrowings is payable based upon 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 were reflected in earnings as they occurred. 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 were charged to earnings in the periods in which the hedged forecasted transaction (interest on $60 million of the principal balance of the Term Loan) affected earnings, or earlier upon a determination that some or all of the forecasted transaction would not occur. The derivative contracts expired in April 2010; accordingly, there were no such charges during the three months ended October 31, 2010. Such charges totaled approximately $152,000 for the nine months ended October 31, 2010, and $275,000 and $941,000 for the three and nine months ended November 1, 2009, respectively.
Quantitative Summary of Derivative Positions and Their Effect on Results of Operations
The following table presents the fair values of derivative instruments included in the consolidated balance sheet as of October 31, 2010 and January 31, 2010:
The effect of derivative instruments on the consolidated statement of operations for the three and nine months ended October 31, 2010 and November 1, 2009, was as follows:
The following discussion of the Company’s financial condition and results of operations should be read in conjunction with the consolidated financial statements and notes thereto appearing elsewhere herein.
Results of Operations
The following table sets forth operating metrics for the three and nine months ended October 31, 2010 and November 1, 2009.
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 during the current year (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. Once a store has been open for at least 57 consecutive weeks, its sales are included in the computation of same store 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. The change in same store customer count is similarly computed, but is based upon the number of retail transactions reported in the Company’s point-of-sale system.
For off-premises sales, “average weekly number of doors” represents the average number of customer locations to which product deliveries were made during a week, and “average weekly sales per door” represents the average weekly sales to each such location.
Systemwide sales, a non-GAAP financial measure, include 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 franchise stores based on their sales, but exclude sales by franchise stores to their customers.
The following table sets forth data about the number of systemwide stores as of October 31, 2010 and November 1, 2009.
The following table sets forth data about the number of store operating weeks for the three and nine months ended October 31, 2010 and November 1, 2009.
The following table sets forth the types and locations of Company stores as of October 31, 2010.
Changes in the number of Company stores during the three and nine months ended October 31, 2010 and November 1, 2009 are summarized in the table below.
The following table sets forth the types and locations of domestic franchise stores as of October 31, 2010.
Changes in the number of domestic franchise stores during the three and nine months ended October 31, 2010 and November 1, 2009 are summarized in the table below.
The types and locations of international franchise stores as of October 31, 2010 are summarized in the table below.
Changes in the number of international franchise stores during the three and nine months ended October 31, 2010 and November 1, 2009 are summarized in the table below.
Three months ended October 31, 2010 compared to three months ended November 1, 2009
Total revenues rose by 7.9% for the three months ended October 31, 2010 compared to the three months ended November 1, 2009. The Company refranchised three stores in Northern California and one store in South Carolina in fiscal 2010. Those refranchisings had the effect of reducing consolidated revenues because the sales of these refranchised stores (which are no longer reported as revenues by the Company) exceed the royalties and KK Supply Chain sales recorded by the Company subsequent to the refranchisings. Excluding the Company’s revenues related to the refranchised stores in both periods, total revenues rose 9.6% in the three months ended October 31, 2010 compared to the three months ended November 1, 2009.
A reconciliation of total revenues as reported to adjusted total revenues exclusive of the effects of refranchising follows:
The Company believes that adjusted total revenues exclusive of the effects of refranchising, a non-GAAP measure, is a useful measure because it enables comparisons of the Company’s revenues that are unaffected by the Company’s decisions to sell operating Krispy Kreme stores to franchisees instead of continuing to operate the stores as Company locations. In addition, this comparison is one of the performance metrics adopted by the compensation committee of the Company’s board of directors to determine the amount of incentive compensation potentially payable to the Company’s executive officers for fiscal 2011.
Consolidated operating income increased from $633,000 in the three months ended November 1, 2009 to $4.1 million in the three months ended October 31, 2010. Consolidated net income was $2.4 million in the three months ended October 31, 2010 compared to a net loss of $2.4 million in the three months ended November 1, 2009.
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).
A discussion of the revenues and operating results of each of the Company’s four business segments follows, together with a discussion of income statement line items not associated with specific segments.
Company Stores >
The components of Company Stores revenues and expenses (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).
A reconciliation of Company Store segment sales from the third quarter of fiscal 2010 to the third quarter of fiscal 2011 follows:
Sales at Company Stores increased 2.6% in the third quarter of fiscal 2011 from the third quarter of fiscal 2010 due to an increase in sales from existing stores and stores opened in fiscal 2010 and fiscal 2011, partially offset by store closings and refranchisings. Excluding the effects of refranchising, Company Stores sales increased 5.9%.
The following table presents sales metrics for Company stores: