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Krispy Kreme Doughnuts 10-Q 2010

Documents found in this filing:

  1. 10-Q
  2. Ex-10.1
  3. Ex-31.1
  4. Ex-31.2
  5. Ex-32.1
  6. Ex-32.2
  7. Ex-32.2
krispykreme_10q.htm


UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
___________________ 
 
Form 10-Q
 
 
(Mark one)
  þ           QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
           For the quarterly period ended October 31, 2010
OR
  o   TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
      For the transition period from                                          to
 
Commission file number 001-16485
KRISPY KREME DOUGHNUTS, INC.
(Exact name of registrant as specified in its charter)
 
North Carolina 56-2169715
(State or other jurisdiction of incorporation or organization) (I.R.S. Employer Identification No.)
370 Knollwood Street, 27103
Winston-Salem, North Carolina (Zip Code)
(Address of principal executive offices)  

Registrant’s telephone number, including area code:
(336) 725-2981
 
     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  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):
 
Large accelerated filer  o               Accelerated filer  þ 
Non-accelerated filer  o    Smaller reporting company  o 
 
     Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes  No  þ
 
     Number of shares of Common Stock, no par value, outstanding as of November 26, 2010: 67,514,159.
 

 

TABLE OF CONTENTS
 
      Page
FORWARD-LOOKING STATEMENTS 3
   
PART I - FINANCIAL INFORMATION 4
   
Item 1.       FINANCIAL STATEMENTS 4
Item 2.   MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND  
           RESULTS OF OPERATIONS 24
Item 3.   QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK 56
Item 4.   CONTROLS AND PROCEDURES 56
   
PART II - OTHER INFORMATION 56
   
Item 1.   LEGAL PROCEEDINGS 56
Item 1A.   RISK FACTORS 56
Item 2.   UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS 57
Item 3.   DEFAULTS UPON SENIOR SECURITIES 57
Item 4.   (REMOVED AND RESERVED) 57
Item 5.   OTHER INFORMATION 57
Item 6.   EXHIBITS 57
       
    SIGNATURES 58

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 and fiscal 2010 mean the fiscal years ended January 30, 2011 and January 31, 2010, respectively.
 
FORWARD-LOOKING STATEMENTS
 
     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:
  • the quality of Company and franchise store operations;
     
  • our ability, and our dependence on the ability of our franchisees, to execute on our and their business plans;
     
  • our relationships with our franchisees;
     
  • our ability to implement our international growth strategy;
     
  • our ability to implement our new domestic operating model;
     
  • political, economic, currency and other risks associated with our international operations;
     
  • the price and availability of raw materials needed to produce doughnut mixes and other ingredients;
     
  • compliance with government regulations relating to food products and franchising;
     
  • our relationships with off-premises customers;
     
  • our ability to protect our trademarks and trade secrets;
     
  • restrictions on our operations and compliance with covenants contained in our secured credit facilities;
     
  • changes in customer preferences and perceptions;
     
  • risks associated with competition;
     
  • increased costs or other effects of new government regulations relating to healthcare benefits; and
     
  • other factors in Krispy Kreme’s periodic reports and other information filed with the Securities and Exchange Commission (the “SEC”), including under Part I, Item 1A, “Risk Factors,” in the Company’s Annual Report on Form 10-K for the fiscal year ended January 31, 2010 (the “2010 Form 10-K”).
     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.
 
3
 

 

PART I - FINANCIAL INFORMATION
 
Item 1. FINANCIAL STATEMENTS.
 
        Page
Index to Financial Statements    
Consolidated statement of operations for the three and nine months ended October 31, 2010 and November 1, 2009   5
Consolidated balance sheet as of October 31, 2010 and January 31, 2010   6
Consolidated statement of cash flows for the nine months ended October 31, 2010 and November 1, 2009   7
Consolidated statement of changes in shareholders’ equity for the nine months ended October 31, 2010 and November 1, 2009   8
Notes to financial statements   9

4
 

 

KRISPY KREME DOUGHNUTS, INC.
 
CONSOLIDATED STATEMENT OF OPERATIONS
(Unaudited)
 
    Three Months Ended   Nine Months Ended
    October 31,   November 1,   October 31,   November 1,
    2010   2009   2010   2009
    (In thousands, except per share amounts)
Revenues       $        90,228         $        83,600         $        270,277         $        259,750  
Operating expenses:                                
       Direct operating expenses (exclusive of depreciation and                                
              amortization shown below)   79,152       74,576       233,382       223,069  
       General and administrative expenses     4,784       6,128       15,509       17,259  
       Depreciation and amortization expense     1,818       2,154       5,619       6,146  
       Impairment charges and lease termination costs     399       109       1,482       3,922  
Operating income     4,075       633       14,285       9,354  
Interest income     42       10       164       38  
Interest expense     (1,585 )     (2,295 )     (5,023 )     (8,424 )
Equity in income (losses) of equity method franchisees     190       (393 )     371       (506 )
Other non-operating income and (expense), net     85       144       247       (356 )
Income (loss) before income taxes     2,807       (1,901 )     10,044       106  
Provision for income taxes     417       487       979       783  
Net income (loss)   $ 2,390     $ (2,388 )   $ 9,065     $ (677 )
                                 
Earnings (loss) per common share:                                
       Basic   $ 0.03     $ (0.04 )   $ 0.13     $ (0.01 )
       Diluted   $ 0.03     $ (0.04 )   $ 0.13     $ (0.01 )
                                 
The accompanying notes are an integral part of the financial statements.
 
5
 

 

KRISPY KREME DOUGHNUTS, INC.
 
CONSOLIDATED BALANCE SHEET
(Unaudited)
 
    October 31,   January 31,
    2010   2010
    (In thousands)
ASSETS
CURRENT ASSETS:                        
Cash and cash equivalents   $       21,756     $       20,215  
Receivables     21,329       17,839  
Receivables from equity method franchisees     576       524  
Inventories     15,137       14,321  
Other current assets     3,675       6,324  
       Total current assets     62,473       59,223  
Property and equipment     70,748       72,527  
Investments in equity method franchisees     1,401       781  
Goodwill and other intangible assets     23,816       23,816  
Other assets     10,211       8,929  
       Total assets   $ 168,649     $ 165,276  
 
LIABILITIES AND SHAREHOLDERS’ EQUITY
CURRENT LIABILITIES:                
Current maturities of long-term debt   $ 612     $ 762  
Accounts payable     8,287       6,708  
Accrued liabilities     28,404       30,203  
       Total current liabilities     37,303       37,673  
Long-term debt, less current maturities     34,773       42,685  
Other long-term obligations     20,477       22,151  
                 
Commitments and contingencies                
                 
SHAREHOLDERS’ EQUITY:                
Preferred stock, no par value     -       -  
Common stock, no par value     369,018       366,237  
Accumulated other comprehensive loss     (42 )     (180 )
Accumulated deficit     (292,880 )     (303,290 )
       Total shareholders’ equity     76,096       62,767  
              Total liabilities and shareholders’ equity   $ 168,649     $ 165,276  
                 
The accompanying notes are an integral part of the financial statements.
 
6
 

 

KRISPY KREME DOUGHNUTS, INC.
 
CONSOLIDATED STATEMENT OF CASH FLOWS
(Unaudited)
 
    Nine Months Ended
    October 31,   November 1,
    2010   2009
    (In thousands)
CASH FLOW FROM OPERATING ACTIVITIES:                        
Net income (loss)   $      9,065     $      (677 )
Adjustments to reconcile net income (loss) to net cash provided by operating activities:                
       Depreciation and amortization     5,619       6,146  
       Deferred income taxes     (90 )     (380 )
       Impairment charges     790       916  
       Accrued rent expense     (165 )     (569 )
       Loss on disposal of property and equipment     473       599  
       Impairment of investment in equity method franchisee     -       500  
       Unrealized loss on interest rate derivatives     -       537  
       Share-based compensation     3,197       3,448  
       Provision for doubtful accounts     (300 )     40  
       Amortization of deferred financing costs     560       636  
       Equity in (income) losses of equity method franchisees     (371 )     506  
       Other     (316 )     (137 )
       Change in assets and liabilities:                
              Receivables     (3,036 )     1,072  
              Inventories     (816 )     1,063  
              Other current and non-current assets     (1,948 )     (88 )
              Accounts payable and accrued liabilities     351       2,105  
              Other long-term obligations     (179 )     180  
                     Net cash provided by operating activities     12,834       15,897  
CASH FLOW FROM INVESTING ACTIVITIES:                
Purchase of property and equipment     (5,457 )     (6,160 )
Proceeds from disposals of property and equipment     2,688       156  
Other investing activities     6       209  
                     Net cash used for investing activities     (2,763 )     (5,795 )
CASH FLOW FROM FINANCING ACTIVITIES:                
Repayment of long-term debt     (8,114 )     (25,894 )
Deferred financing costs     -       (954 )
Proceeds from exercise of warrants     5       -  
Repurchase of common shares     (421 )     (249 )
                     Net cash used for financing activities     (8,530 )     (27,097 )
Net increase (decrease) in cash and cash equivalents     1,541       (16,995 )
Cash and cash equivalents at beginning of period     20,215       35,538  
Cash and cash equivalents at end of period   $ 21,756     $ 18,543  
                 
The accompanying notes are an integral part of the financial statements.
 
7
 

 

KRISPY KREME DOUGHNUTS, INC.
 
CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS' EQUITY
(Unaudited)
 
                  Accumulated                
    Common           Other                
    Shares   Common   Comprehensive   Accumulated        
        Outstanding       Stock       Income (Loss)       Deficit       Total
    (In thousands)
Balance at January 31, 2010           67,441     $      366,237     $            (180 )   $      (303,290 )   $      62,767  
Effect of adoption of new accounting standard                                      
       (Note 1)                           1,345       1,345  
Comprehensive income:                                      
       Net income for the nine months ended                                      
              October 31, 2010                           9,065       9,065  
       Foreign currency translation adjustment, net                                      
              of income taxes of $30                   46               46  
       Amortization of unrealized loss on interest                                      
              rate derivative, net of income taxes of $60                   92               92  
       Total comprehensive income                                   9,203  
Cancelation of restricted shares   (2 )     -                       -  
Exercise of warrants           5                       5  
Share-based compensation   148       3,197                       3,197  
Repurchase of common shares   (45 )     (421 )                     (421 )
Balance at October 31, 2010   67,542     $ 369,018     $ (42 )   $ (292,880 )   $ 76,096  
                                       
                                       
Balance at February 1, 2009   67,512     $ 361,801     $ (913 )   $ (303,133 )   $ 57,755  
Comprehensive income (loss):                                      
       Net loss for the nine months ended                                      
              November 1, 2009                           (677 )     (677 )
       Foreign currency translation adjustment, net                                      
              of income taxes of $8                   13               13  
       Amortization of unrealized loss on interest                                      
              rate derivative, net of income taxes of $372                   569               569  
       Total comprehensive loss                                   (95 )
Cancelation of restricted shares   (52 )     -                       -  
Share-based compensation   54       3,448                       3,448  
Repurchase of common shares   (47 )     (249 )                     (249 )
Balance at November 1, 2009   67,467     $ 365,000     $ (331 )   $ (303,810 )   $ 60,859  
                                       
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.
 
8
 

 

KRISPY KREME DOUGHNUTS, INC.
 
NOTES TO FINANCIAL STATEMENTS
(Unaudited
)
 
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.
 
9
 

 

     The following table sets forth amounts used in the computation of basic and diluted earnings per share:
 
    Three Months Ended   Nine Months Ended
    October 31,   November 1,   October 31,   November 1,
        2010       2009       2010       2009
    (In thousands)
Numerator: net income (loss)   $       2,390   $       (2,388 )   $       9,065   $       (677 )
Denominator:                            
       Basic earnings per share - weighted average shares                            
              outstanding     68,407     67,612       68,232     67,354  
       Effect of dilutive securities:                            
              Stock options     1,101     -       809     -  
              Restricted stock and restricted stock units     515     -       486     -  
       Diluted earnings per share - weighted average shares                            
              outstanding plus dilutive potential common shares     70,023     67,612       69,527     67,354  
                             
     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.
 
Reclassification
 
     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.
 
10
 

 

Note 2 — Receivables
 
     The components of receivables are as follows:
 
        October 31,       January 31,
    2010   2010
    (In thousands)
Receivables:                
       Off-premises customers   $       9,972     $       9,010  
       Unaffiliated franchisees     10,705       8,974  
       Other receivables     1,581       1,130  
       Current portion of notes receivable     174       68  
      22,432       19,182  
       Less — allowance for doubtful accounts:                
              Off-premises customers     (313 )     (307 )
              Unaffiliated franchisees     (790 )     (1,036 )
      (1,103 )     (1,343 )
    $ 21,329     $ 17,839  
                 
Receivables from Equity Method Franchisees (Note 7):                
       Trade   $ 576     $ 1,263  
       Notes receivable     887       -  
      1,463       1,263  
       Less — allowance for doubtful accounts:                
              Trade     -       (739 )
              Notes receivable     (887 )     -  
      (887 )     (739 )
    $ 576     $ 524  
                 
Note 3 — Inventories
 
     The components of inventories are as follows:
 
        October 31,       January 31,
    2010   2010
    (In thousands)
Raw materials   $      5,009   $      5,253
Work in progress     67     4
Finished goods     3,542     3,688
Purchased merchandise     6,400     5,268
Manufacturing supplies     119     108
    $ 15,137   $ 14,321
             
11
 

 

Note 4 — Long Term Debt
 
      Long-term debt and capital lease obligations consist of the following:
 
    October 31,   January 31,
    2010   2010
        (In thousands)
Secured Credit Facilities   $       35,102         $       43,054  
Capital lease obligations     283       393  
      35,385       43,447  
Less: current maturities     (612 )     (762 )
    $ 34,773     $ 42,685  
                 
     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:
 
        Maximum
Period   Leverage Ratio
Third Quarter of Fiscal 2011   3.25 to 1.00
Fourth Quarter of Fiscal 2011   3.00 to 1.00
Fiscal 2012   2.50 to 1.00
Fiscal 2013 and thereafter   2.00 to 1.00

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             Minimum Interest
Period   Coverage Ratio
Third Quarter of Fiscal 2011          2.95 to 1.00
Fourth Quarter of Fiscal 2011   3.15 to 1.00
Fiscal 2012   3.75 to 1.00
Fiscal 2013 and thereafter   4.50 to 1.00

    “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:
 
  Three Months Ended   Nine Months Ended
  October 31,       November 1,       October 31,       November 1,
  2010   2009   2010   2009
  (In thousands)
Impairment of long-lived assets:                            
    Current period charges $       -   $       178     $       899     $       1,398  
    Recovery from bankruptcy estate of former subsidiary   -     (482 )     -       (482 )
    Adjustments to previously recorded estimates   81     -       (109 )     -  
       Total impairment of long-lived assets   81     (304 )     790       916  
Lease termination costs:                            
    Provision for termination costs   318     631       1,336       3,964  
    Less — reversal of previously recorded accrued rent                            
       expense   -     (218 )     (644 )     (958 )
       Net provision   318     413       692       3,006  
  $ 399   $ 109     $ 1,482     $ 3,922  
                             
    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.
 
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    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:
 
  Three Months Ended   Nine Months Ended
  October 31,       November 1,       October 31,       November 1,
  2010   2009   2010   2009
  (In thousands)
Balance at beginning of period $       2,100     $       2,428     $       1,679     $       1,880  
    Provision for lease termination costs:                              
       Provisions associated with store closings, net of estimated                              
          sublease rentals   -       212       394       2,427  
       Adjustments to previously recorded provisions resulting                              
          from settlements with lessors and adjustments of previous                              
          estimates   266       372       795       1,395  
       Accretion of discount   52       47       147       142  
          Total provision   318       631       1,336       3,964  
    Proceeds from assignment of leases   -       62       -       62  
    Payments on unexpired leases, including settlements with                              
       lessors   (374 )     (1,344 )     (971 )     (4,129 )
          Total reductions   (374 )     (1,282 )     (971 )     (4,067 )
Balance at end of period $ 2,044     $ 1,777     $ 2,044     $ 1,777  
                               
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.
 
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    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.
 
  Three Months Ended   Nine Months Ended
  October 31,       November 1,       October 31,       November 1,
  2010   2009   2010   2009
  (In thousands)
Revenues:                              
    Company Stores $       61,565     $       60,020     $       184,069     $       185,730  
    Domestic Franchise   2,040       1,945       6,314       5,798  
    International Franchise   4,389       3,583       13,158       11,267  
    KK Supply Chain:                              
       Total revenues 45,001       39,314       135,798       121,926  
       Less – intersegment sales elimination (22,767 )     (21,262 )     (69,062 )     (64,971 )
          External KK Supply Chain revenues 22,234       18,052       66,736       56,955  
             Total revenues $ 90,228     $ 83,600     $ 270,277     $ 259,750  
  
Operating income (loss):                              
    Company Stores $ (1,449 )   $ (1,380 )   $ (3,214 )   $ 2,951  
    Domestic Franchise   499       811       2,694       2,425  
    International Franchise   3,018       2,117       9,004       6,495  
    KK Supply Chain   7,342       5,549       23,361       19,375  
       Total segment operating income   9,410       7,097       31,845       31,246  
    Unallocated general and administrative expenses (4,936 )     (6,355 )     (16,078 )     (17,970 )
    Impairment charges and lease termination costs   (399 )     (109 )     (1,482 )     (3,922 )
       Consolidated operating income $ 4,075     $ 633     $ 14,285     $ 9,354  
 
Depreciation and amortization expense:                              
    Company Stores $ 1,410     $ 1,694     $ 4,264     $ 4,709  
    Domestic Franchise   56       14       166       57  
    International Franchise   2       -       5       -  
    KK Supply Chain   198       219       615       669  
    Corporate administration   152       227       569       711  
       Total depreciation and amortization expense $ 1,818     $ 2,154     $ 5,619     $ 6,146  
                               
    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.
 
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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.
 
  October 31, 2010
  Company       Investment                                  
  Ownership   and           Notes   Loan
  Percentage   Advances   Receivables   Receivable   Guarantees
  (Dollars in thousands)
Kremeworks, LLC 25.0%   $        900     $        353     $        -     $        1,064
Kremeworks Canada, LP 24.5%     -       26       -       -
Krispy Kreme of South Florida, LLC 35.3%     -       161       -       2,245
Krispy Kreme Mexico, S. de R.L. de C.V. 30.0%     1,401       36       887       -
        2,301       576       887     $ 3,309
Less: reserves and allowances       (900 )     -       (887 )      
      $ 1,401     $ 576     $ -        
  
  January 31, 2010
  Company   Investment                      
  Ownership   and           Notes     Loan
  Percentage   Advances   Receivables   Receivable     Guarantees
  (Dollars in thousands)
Kremeworks, LLC 25.0%   $ 900     $ 327     $ -     $ 1,241
Kremeworks Canada, LP 24.5%     -       16       -       -
Krispy Kreme of South Florida, LLC 35.3%     -       138       -       2,489
Krispy Kreme Mexico, S. de R.L. de C.V. 30.0%     781       782       -       -
        1,681       1,263       -     $ 3,730
Less: reserves and allowances       (900 )     (739 )     -        
      $ 781     $ 524     $ -        
                                 
    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.
 
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    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.
 
  Three Months Ended   Nine Months Ended
  October 31,       November 1,       October 31,       November 1,
  2010   2009   2010   2009
  (In thousands)
Revenues $        4,124     $        3,933     $        12,831     $        13,015  
Operating loss   (519 )     (681 )     (1,151 )     (1,506 )
Net loss   (597 )     (785 )     (1,382 )     (1,832 )

    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.
 
  Three Months Ended   Nine Months Ended
  October 31,       November 1,       October 31,       November 1,
  2010   2009   2010   2009
  (In thousands)
Revenues $        4,573   $        3,110     $        12,816   $        8,849  
Operating income (loss)   913     (470 )     1,938     (553 )
Net income (loss)   872     (487 )     1,813     (606 )

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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.
 
  Three Months Ended   Nine Months Ended
  October 31,       November 1,       October 31,       November 1,
  2010   2009   2010   2009
  (In thousands)
Costs charged to earnings related to:                      
    Stock options $       141   $       378   $       645   $       844
    Restricted stock and restricted stock units   1,122     1,000     2,552     2,604
       Total costs $ 1,263   $ 1,378   $ 3,197   $ 3,448
 
Costs included in:                      
    Direct operating expenses $ 722   $ 524   $ 1,510   $ 1,246
    General and administrative expenses   541     854     1,687     2,202
       Total costs $ 1,263   $ 1,378   $ 3,197   $ 3,448
                       
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:
  • Level 1 - Quoted prices in active markets that are accessible at the measurement date for identical assets or liabilities.
     
  • Level 2 - Observable inputs other than quoted prices included within Level 1, such as quoted prices for similar assets and liabilities in active markets; quoted prices for identical or similar assets and liabilities in markets that are not active; or other inputs that are observable or can be corroborated by observable market data.
     
  • Level 3 - Unobservable inputs that are supported by little or no market activity and that are significant to the fair value measurement of the assets or liabilities. These include certain pricing models, discounted cash flow methodologies and similar techniques that use significant unobservable inputs.
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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.
 
  October 31, 2010
  Level 1       Level 2       Level 3
  (In thousands)
Assets:                
    401(k) mirror plan assets $       728   $       -   $       -
    Commodity futures contracts   30     -     -
    Total assets $ 758   $ -   $ -
 
  January 31, 2010
  Level 1   Level 2   Level 3
  (In thousands)
Assets:                
    401(k) mirror plan assets $ 455   $ -   $ -
Liabilities:                
    Interest rate derivatives $ -   $ 641   $ -
    Commodity futures contracts   92     -     -
    Total liabilities $ 92   $ 641   $ -
                  
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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. 
 
  Three Months Ended October 31, 2010
  Level 1       Level 2       Level 3       Total gain (loss)
  (In thousands)
Long-lived assets $       -   $       -   $       -   $             -  
Lease termination liabilities $ -   $ -   $ -   $ -  
 
  Nine Months Ended October 31, 2010
  Level 1   Level 2   Level 3   Total gain (loss)
  (In thousands)
Long-lived assets $ -   $ 3,638   $ -   $ (899 )
Lease termination liabilities $ -   $ 394   $ -   $ 250  
 
  Three Months Ended November 1, 2009
  Level 1   Level 2   Level 3   Total gain (loss)
  (In thousands)
Long-lived assets $ -   $ 2,838   $ -   $ (178 )
Lease termination liabilities $ -   $ 212   $ -   $ 6  
 
  Nine Months Ended November 1, 2009
  Level 1   Level 2   Level 3   Total gain (loss)
  (In thousands)
Long-lived assets $ -   $ 5,768   $ -   $ (1,398 )
Investment in Equity Method Franchisee $ -   $ -   $ 700   $ (500 )
Lease termination liabilities $ -   $ 2,427   $ -   $ (1,469 )

   Long-Lived Assets
 
    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.
 
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   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:
 
  October 31, 2010   January 31, 2010
  Carrying       Fair       Carrying       Fair
  Value   Value   Value   Value
  (In thousands)
Assets:                      
    Cash and cash equivalents $       21,756   $       21,756   $       20,215   $       20,215
    Receivables   21,329     21,329     17,839     17,839
    Receivables from Equity Method Franchisees   576     576     524     524
    Commodity futures contracts   30     30     -     -
  
Liabilities:                      
    Accounts payable   8,287     8,287     6,708     6,708
    Interest rate derivatives   -     -     641     641
    Commodity futures contracts   -     -     92     92
    Long-term debt (including current maturities)   35,385     35,385     43,447     41,872

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.
 
21
 

 

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.
 
22
 

 

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:
 
        Asset Derivatives
        Fair Value
                October 31,       January 31,
Derivatives Not Designated as Hedging Instruments   Balance Sheet Location   2010   2010
        (In thousands)
Commodity futures contracts   Other current assets   $       30   $       -
 
        Liability Derivatives
        Fair Value
        October 31,   January 31,
Derivatives Not Designated as Hedging Instruments   Balance Sheet Location   2010   2010
        (In thousands)
Interest rate contracts   Accrued liabilities   $ -   $ 641
Commodity futures contracts   Accrued liabilities     -     92
        $ -   $ 733
                 
    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:
 
                Amount of Derivative Gain or (Loss) Recognized in Income
        Three Months Ended   Nine Months Ended
Derivatives Not Designated as   Location of Derivative Gain or   October 31,       November 1,       October 31,       November 1,
Hedging Instruments   (Loss) Recognized in Income   2010   2009   2010   2009
        (In thousands)
Interest rate contracts   Interest expense   $         -     $         (118 )   $         -   $         (537 )
Agricultural commodity                                  
    futures contracts   Direct operating expenses     (77 )     (256 )     164     (796 )
Gasoline commodity                                  
    futures contracts   Direct operating expenses     5       (22 )     135     120  
       Total       $ (72 )   $ (396 )   $ 299   $ (1,213 )
                                   
23
 

 

Item 2.   MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

    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.
 
24
 

 

  Three Months Ended   Nine Months Ended
  October 31,   November 1,   October 31,   November 1,
  2010       2009       2010       2009
Change in Same Store Sales (on-premises sales only):                              
       Company stores   5.0 %     5.1 %     4.6 %     4.2 %
       Domestic Franchise stores   5.7       1.0       4.4       1.4  
       International Franchise stores   (8.6 )     (15.6 )     (9.2 )     (28.8 )
       International Franchise stores, in constant dollars(1)   (12.3 )     (16.8 )     (14.8 )     (21.9 )
                               
Change in Same Store Customer Count - Company stores   2.5 %     N/A       3.1 %     N/A  
                               
Off-Premises Metrics (Company stores only):                              
       Average weekly number of doors served:                              
              Grocers/mass merchants   5,731       5,619       5,642       5,692  
              Convenience stores   5,152       5,230       5,114       5,373  
                               
       Average weekly sales per door:                              
              Grocers/mass merchants $      251     $      241     $      259     $      241  
              Convenience stores   207       210       207       210  
                               
Systemwide Sales (in thousands):(2)                              
       Company stores $ 61,146     $ 59,738     $ 182,936     $ 185,008  
       Domestic Franchise stores   58,185       52,918       179,460       164,968  
       International Franchise stores   84,039       65,192       235,850       189,415  
       International Franchise stores, in constant dollars(3)   84,039       67,719       235,850       200,529  
                               
Average Weekly Sales Per Store (in thousands):(4)(5)                              
       Company stores:                              
              Factory stores:                              
                     Commissaries — off-premises $ 176.6     $ 149.5     $ 173.1     $ 156.7  
                     Dual-channel stores:                              
                            On-premises   30.2       27.7       29.9       27.8  
                            Off-premises   39.3       37.2       39.7       36.8  
                                   Total   69.5       64.9       69.6       64.6  
                     On-premises only stores   31.4       31.8       31.7       32.4  
                     All factory stores   64.6       61.3       64.4       62.2  
              Satellite stores   17.9       18.1       18.1       18.1  
              All stores   55.9       54.9       56.5       56.2  
                               
       Domestic Franchise stores:                              
              Factory stores $ 39.5     $ 35.8     $ 40.4     $ 37.4  
              Satellite stores   11.6       13.7       12.4       15.4  
                               
       International Franchise stores:                              
              Factory stores $ 41.3     $ 35.7     $ 40.9     $ 35.7  
              Satellite stores   9.0       9.0       8.9       9.0  

(1)        Represents the change in International Franchise same store sales computed by reconverting franchise store sales in each foreign currency to U.S. dollars at a constant rate of exchange for each period.
 
(2) Excludes sales among Company and franchise stores.
 
(3) Represents International Franchise store sales computed by reconverting International Franchise store sales for the three and nine months ended November 1, 2009 to U.S. dollars based upon the weighted average of the exchange rates prevailing in the three and nine months ended October 31, 2010.
 
(4) Includes sales between Company and franchise stores.
   
(5) Metrics for the three and nine months ended October 31, 2010 include only stores open at October 31, 2010 and metrics for the three and nine months ended November 1, 2009 include only stores open at January 31, 2010.
 
25
 

 

     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.
 
  October 31,   November 1,
  2010       2009
Number of Stores Open At Period End:      
       Company stores:      
              Factory:      
                     Commissaries 6   6
                     Dual-channel stores 37   40
                     On-premises only stores 26   25
              Satellite stores 16   13
                            Total Company stores 85   84
       
       Domestic Franchise stores:      
              Factory stores 101   101
              Satellite stores 42   37
                     Total Domestic Franchise stores 143   138
       
       International Franchise stores:      
              Factory stores 106   93
              Satellite stores 315   248
                     Total International Franchise stores 421   341
       
                            Total systemwide stores 649   563
       
     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.
 
26
 

 

  Three Months Ended   Nine Months Ended
  October 31,   November 1,   October 31,   November 1,
  2010       2009       2010       2009
Store Operating Weeks:              
       Company stores:              
              Factory stores:              
                     Commissaries 78   78   238   234
                     Dual-channel stores 481   606   1,443   1,991
                     On-premises only stores 338   307   1014   918
              Satellite stores 205   153   569   410
               
       Domestic Franchise stores:(1)              
              Factory stores 1,326   1,322   3,978   3,947
              Satellite stores 517   391   1452   1,037
               
       International Franchise stores:(1)              
              Factory stores 1,154   1,075   3,241   3,209
              Satellite stores 4,009   2,915   11,476   8,025

(1)        Metrics for the three and nine months ended October 31, 2010 include only stores open at October 31, 2010 and metrics for the three and nine months ended November 1, 2009 include only stores open at January 31, 2010.
 
     The following table sets forth the types and locations of Company stores as of October 31, 2010.
 
    Number of Company Stores
    Factory            
State       Stores       Hot Shops       Fresh Shops       Total
Alabama   3   -   -   3
District of Columbia   -   1   -   1
Florida   4   -   -   4
Georgia   6   4   -   10
Indiana   3   1   -   4
Kansas   3   -   -   3
Kentucky   3   1   -   4
Louisiana   1   -   -   1
Maryland   2   -   -   2
Michigan   3   -   -   3
Missouri   4   -   -   4
Mississippi   1   -   -   1
North Carolina   11   3   1   15
Ohio   6   -   -   6
South Carolina   2   1   -   3
Tennessee   7   4   -   11
Texas   3   -   -   3
Virginia   6   -   -   6
West Virginia   1   -   -   1
Total        69        15        1        85
                 
     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.
 
27
 

 

    Number of Company Stores
    Factory                  
        Stores       Hot Shops       Fresh Shops       Total
Three months ended October 31, 2010                        
August 1, 2010   69     13     2     84  
Opened   -     1     -     1  
Changed store type   -     1     (1 )   -  
October 31, 2010   69     15     1     85  
                         
Nine months ended October 31, 2010                        
January 31, 2010   69     12     2     83  
Opened   -     3     -     3  
Closed   -     (1 )   -     (1 )
Changed store type   -     1     (1 )   -  
October 31, 2010   69     15     1     85  
                         
Three months ended November 1, 2009                        
August 2, 2009   77     11     1     89  
Opened   -     1     1     2  
Closed   (3 )   (1 )   -     (4 )
Transferred   (3 )   -     -     (3 )
November 1, 2009   71     11     2     84  
                         
Nine months ended November 1, 2009                        
February 1, 2009   83     10     -     93  
Opened   1     2     2     5  
Closed   (9 )   (2 )   -     (11 )
Change in store type   (1 )   1     -     -  
Transferred   (3 )   -     -     (3 )
November 1, 2009        71               11                    2          84  
                         
     The following table sets forth the types and locations of domestic franchise stores as of October 31, 2010.
 
28
 

 

    Number of Domestic Franchise Stores
    Factory                
State       Stores       Hot Shops       Fresh Shops   Total
Alabama   5   2   -   7
Arkansas   2   -   -   2
Arizona   2   -   9   11
California   11   -   3   14
Connecticut   1   -   3   4
Colorado   2   -   -   2
Florida   11   5   1   17
Georgia   7   4   -   11
Hawaii   1   -   -   1
Iowa   1   -   -   1
Idaho   1   -   -   1
Illinois   4   -   -   4
Louisiana   3   -   -   3
Missouri   2   1   -   3
Mississippi   2   -   -   2
North Carolina   6   1   -   7
Nebraska   1   -   1   2
New Mexico   1   -   1   2
Nevada   3   1   3   7
Oklahoma   3   -   1   4
Oregon   2   -   -   2
Pennsylvania   4   1   1   6
South Carolina   6   1   2   9
Tennessee   1   -   -   1
Texas   8   -   1   9
Utah   2   -   -   2
Wisconsin   1   -   -   1
Washington   8   -   -   8
Total        101        16        26        143
                 
     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.
 
29
 

 

    Number of Domestic Franchise Stores
    Factory                
        Stores       Hot Shops       Fresh Shops       Total
Three months ended October 31, 2010                      
August 1, 2010   102     15   23     140  
Opened   -     -   3     3  
Closed   -     -   -     -  
Change in store type   (1 )   1   -     -  
October 31, 2010   101     16   26     143  
                       
Nine months ended October 31, 2010                      
January 31, 2010   104     14   23     141  
Opened   -     1   4     5  
Closed   (2 )   -   (1 )   (3 )
Change in store type   (1 )   1   -     -  
October 31, 2010   101     16   26     143  
                       
Three months ended November 1, 2009                      
August 2, 2009   100     12   21     133  
Opened   -     -   2     2  
Closed   -     -   -     -  
Change in store type   (2 )   2   -     -  
Transferred   3     -   -     3  
November 1, 2009   101     14   23     138  
                       
Nine months ended November 1, 2009                      
February 1, 2009   104     13   15     132  
Opened   -     -   7     7  
Closed   (3 )   -   (1 )   (4 )
Change in store type   (3 )   1   2     -  
Transferred   3     -   -     3  
November 1, 2009        101          14                23          138  
                       
     The types and locations of international franchise stores as of October 31, 2010 are summarized in the table below.
 
30
 

 

    Number of International Franchise Stores
        Factory                                
Country   Stores   Hot Shops   Fresh Shops   Kiosks   Total
Australia   6   3   24   20   53
Bahrain   2   -   2   5   9
Canada   4   -   -   -   4
China   1   -   -   -   1
Dominican Republic   1   -   -   -   1
Indonesia   2   -   2   3   7
Japan   12   -   7   -   19
Kuwait   3   -   23   2   28
Lebanon   2   -   6   3   11
Malaysia   2   1   1   1   5
Mexico   5   1   22   21   49
Philippines   4   3   12   1   20
The Commonwealth of Puerto Rico   4   -   -   -   4
Qatar   2   -   3   1   6
The Republic of Korea   31   1   8   -   40
The Kingdom of Saudi Arabia   9   -   63   9   81
The Kingdom of Thailand   2   -   -   -   2
Turkey   1   -   10   2   13
The United Arab Emirates   2   -   16   4   22
The United Kingdom   11   4   23   8   46
Total        106        13        222        80        421
                     
     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.
 
31
 

 

  Number of International Franchise Stores
  Factory                                        
  Stores   Hot Shops   Fresh Shops   Kiosks   Total
Three months ended October 31, 2010                            
August 1, 2010 103     14     214     78     409  
Opened 6     -     8     2     16  
Closed (3 )   (1 )   -     -     (4 )
October 31, 2010 106     13     222     80     421  
                             
Nine Months Ended October 31, 2010                            
January 31, 2010 95     14     180     69     358  
Opened 17     -     46     12     75  
Closed (6 )   (1 )   (4 )   (1 )   (12 )
October 31, 2010 106     13     222     80     421  
                             
Three months ended November 1, 2009                            
August 2, 2009 93     26     154     53     326  
Opened 2     -     10     8     20  
Closed (2 )   -     (2 )   (1 )   (5 )
Change in store type -     -     (4 )   4     -  
November 1, 2009 93     26     158     64     341  
                             
Nine Months Ended November 1, 2009                            
February 1, 2009 94     26     126     52     298  
Opened 5     2     39     13     59  
Closed (6 )   -     (5 )   (5 )   (16 )
Change in store type -     (2 )   (2 )   4     -  
November 1, 2009      93               26                158          64          341  
                              
Three months ended October 31, 2010 compared to three months ended November 1, 2009
 
   Overview
 
     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:
 
  Three Months Ended
  October 31,   November 1,
  2010       2009
  (In thousands)
Total revenues as reported $ 90,228     $ 83,600  
Sales by refranchised stores(1)   -       (1,904 )
Royalties from refranchised stores(1)   (78 )     (7 )
KK Supply Chain sales to refranchised stores(1)   (657 )     -  
       Adjusted total revenues exclusive of the effects of refranchising $      89,493     $      81,689  
               
(1)        Adjustments reflect amounts only for stores refranchised in fiscal 2010 because earlier refranchisings do no affect comparability between the periods presented.

32
 

 

     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).
 
  Three Months Ended
  October 31,   November 1,
  2010       2009
  (Dollars in thousands)
Revenues by business segment:              
       Company Stores $      61,565     $      60,020  
       Domestic Franchise   2,040       1,945  
       International Franchise   4,389       3,583  
       KK Supply Chain:              
              Total revenues   45,001       39,314  
              Less - intersegment sales elimination   (22,767 )     (21,262 )
                     External KK Supply Chain revenues   22,234       18,052  
                            Total revenues $ 90,228     $ 83,600  
               
Segment revenues as a percentage of total revenues:              
       Company Stores   68.2 %     71.8 %
       Domestic Franchise   2.3       2.3  
       International Franchise   4.9       4.3  
       KK Supply Chain (external sales)   24.6       21.6  
    100.0 %     100.0 %
               
Operating income (loss):              
       Company Stores $ (1,449 )   $ (1,380 )
       Domestic Franchise   499       811  
       International Franchise   3,018       2,117  
       KK Supply Chain   7,342       5,549  
              Total segment operating income   9,410       7,097  
       Unallocated general and administrative expenses   (4,936 )     (6,355 )
       Impairment charges and lease termination costs   (399 )     (109 )
              Consolidated operating income $ 4,075     $ 633  
               
     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).
 
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                  Percentage of Total Revenue
  Three Months Ended   Three Months Ended
  October 31,   November 1,   October 31,   November 1,
  2010       2009       2010       2009
  (In thousands)            
Revenues:                          
       On-premises sales:                          
              Retail sales $ 24,886     $ 24,682     40.4 %   41.1 %
              Fundraising sales   4,058       3,753     6.6     6.3  
                     Total on-premises sales   28,944       28,435     47.0     47.4  
       Off-premises sales:                          
              Grocers/mass merchants   18,564       17,413     30.2     29.0  
              Convenience stores   13,334       13,555     21.7     22.6  
              Other off-premises   723       617     1.2     1.0  
                     Total off-premises sales   32,621       31,585     53.0     52.6  
                            Total revenues   61,565       60,020     100.0     100.0  
                           
Operating expenses:                          
       Cost of sales:                          
              Food, beverage and packaging   22,694       20,910     36.9     34.8  
              Shop labor   12,278       11,938     19.9     19.9  
              Delivery labor   5,228       5,211     8.5     8.7  
              Employee benefits   4,409       5,259     7.2     8.8  
                     Total cost of sales   44,609       43,318     72.5     72.2  
              Vehicle costs(1)   3,726       3,081     6.1     5.1  
              Occupancy(2)   2,165       2,366     3.5     3.9  
              Utilities expense   1,475       1,451     2.4     2.4  
              Depreciation expense   1,410       1,694     2.3     2.8  
              Settlement of litigation   -       750     -     1.2  
              Other operating expenses   4,830       4,603     7.8     7.7  
                     Total store level costs   58,215       57,263     94.6     95.4  
       Store operating income   3,350       2,757     5.4     4.6  
       Other segment operating costs (3)   3,674       2,560     6.0     4.3  
       Allocated corporate overhead   1,125       1,577     1.8     2.6  
Segment operating income (loss) $      (1,449 )   $      (1,380 )        (2.4 )%        (2.3 )%
                           
(1)        Includes fuel, maintenance and repairs, rent, taxes and other costs of operating the delivery fleet, exclusive of depreciation.
 
(2) Includes rent, property taxes, common area maintenance charges, insurance, building maintenance and other occupancy costs, exclusive of utilities and depreciation.
 
(3) Includes marketing costs not charged to stores, segment management costs, off-premises selling expenses and support functions.
 
     A reconciliation of Company Store segment sales from the third quarter of fiscal 2010 to the third quarter of fiscal 2011 follows:
 
  On-Premises       Off-Premises       Total
  (In thousands)
Sales for the three months ended November 1, 2009 $      28,435     $      31,585     $      60,020  
Fiscal 2010 sales at refranchised stores   (1,250 )     (654 )     (1,904 )
Fiscal 2010 sales at closed stores   (577 )     (74 )     (651 )
Increase in sales at mature stores (open stores only)   1,395       1,764       3,159  
Increase in sales at stores opened in fiscal 2010   180       -       180  
Sales at stores opened in fiscal 2011   761       -       761  
Sales for the three months ended October 31, 2010 $ 28,944     $ 32,621     $ 61,565  
                       
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     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:
 
  Three Months Ended
  October 31,   November 1,
  2010       2009
On-premises:          
              Change in same store sales 5.0 %   5.1 %
              Change in same store customer count 2.5 %   N/A  
Off-premises:          
       Grocers/mass merchants:          
              Change in average weekly number of doors 2.0 %   (10.4 )%
              Change in average weekly sales per door 4.1 %   14.2 %
       Convenience stores:          
              Change in average weekly number of doors (1.5 )%        (12.0 )%
              Change in average weekly sales per door      (1.4 )%   (1.9 )%

   On-premises sales
 
     Same store sales at Company stores rose 5.0% in the third quarter of fiscal 2011 over the third quarter of fiscal 2010, of which the Company estimates approximately 3.4 percentage points is attributable to price increases. Additionally, the same store sales increase in the third quarter of fiscal 2011 reflects increased customer traffic partially offset by a decrease in the average guest check.
 
     The Company is implementing programs intended to improve on-premises sales, including increased focus on local store marketing efforts, improved employee training, store refurbishment efforts and the introduction of new products.
 
   Off-premises sales
 
     Sales to grocers and mass merchants increased to $18.6 million, with a 4.1% increase in average weekly sales per door and a 2.0% increase in the average number of doors served. Convenience store sales fell due to both a decline in the average number of doors served and in the average weekly sales per door. Among other reasons, sales to convenience stores declined in the third quarter of fiscal 2011 as a result of a large customer implementing an in-house doughnut program in fiscal 2010 to replace the Company’s products; the loss of doors associated with this customer accounted for approximately 1.2 percentage points of the 1.5% decline in the average number of convenience store doors served for the three months ended October 31, 2010. Declines in the average weekly sales per door adversely affect profitability because of the increased significance of delivery costs in relation to sales.
 
     The Company started implementing price increases for some products offered in the off-premises channel late in the first quarter of fiscal 2011, and substantially completed implementing the increases during the second quarter. Those price increases affect products comprising approximately 30% of off-premises sales. The average price increase on those products was approximately 8%.
 
     The Company is implementing steps intended to increase sales, increase average per door sales and reduce costs in the off-premises channel. These steps include improved route management and route consolidation (including elimination of or reduction in the number of stops at relatively low volume doors), new sales incentives and performance-based pay programs, increased emphasis on relatively longer shelf-life products and the development of order management systems to more closely match merchandised quantities and assortments with consumer demand.
 
   Costs and expenses
 
     Cost of sales as a percentage of revenues rose by 0.3 percentage points from the third quarter of fiscal 2010 to 72.5% of revenues in the third quarter of fiscal 2011, due to increases in the cost of food, beverage and packaging. The cost of sugar rose approximately 27% from the third quarter of fiscal 2010 as a result of price increases implemented by KK Supply Chain to reflect the expiration of a favorable sugar supply contract. The cost of shortening also rose year over year. In addition to higher ingredient costs, an increase in product returns in the off-premises channel also increased product costs as a percentage of revenues.
 
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     Prices of agricultural commodities have been volatile in recent quarters, and that volatility continued in the third quarter of fiscal 2011. Notwithstanding that volatility, the trend in the Company’s costs for doughnut mix, shortening and sugar has been upward in recent years. In particular, the Company’s cost of sugar has been dramatically higher in fiscal 2011 as a result of the expiration earlier this year of a favorable KK Supply Chain sugar supply contract.