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Krispy Kreme Doughnuts 10-Q 2011 UNITED STATES SECURITIES AND EXCHANGE
COMMISSION
Washington, D.C. 20549 ___________________ Form 10-Q
Commission file number
001-16485
KRISPY KREME DOUGHNUTS, INC. (Exact name of registrant as specified in its charter)
Registrant’s telephone number, including area code: (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 þ No o
Indicate by check mark whether the
registrant is a large accelerated filer, an accelerated filer, a non-accelerated
filer, or a smaller reporting company. See definitions of “large accelerated
filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the
Exchange Act. (Check one):
Indicate by check mark whether the
registrant is a shell company (as defined in Rule 12b-2 of the Exchange
Act). Yes o No þ
Number of shares of Common Stock, no
par value, outstanding as of November 25, 2011: 68,084,290.
TABLE OF CONTENTS
2 As used herein, unless the context otherwise requires, “Krispy Kreme,” the “Company,” “we,” “us” and “our” refer to Krispy Kreme Doughnuts, Inc. and its subsidiaries. References to fiscal 2012 and fiscal 2011 mean the fiscal years ended January 29, 2012 and January 30, 2011, 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, expenditures, 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,” “would,” “anticipate,” “estimate,” “expect,” “intend,” “objective,” “seek,” “strive” or similar words, or the negative of these words, identify forward-looking statements. Factors that could contribute to these differences include, but are not limited to:
All such factors are difficult to predict, contain uncertainties that may materially affect actual results and may be beyond our control. New factors emerge from time to time, and it is not possible for management to predict all such factors or to assess the impact of each such factor on the Company. Any forward-looking statement speaks only as of the date on which such statement is made, and we do not undertake any obligation to update any forward-looking statement to reflect events or circumstances after the date on which such statement is made. We caution you that any forward-looking statements are not guarantees of future performance and involve known and unknown risks, uncertainties and other factors which may cause our actual results, performance or achievements to differ materially from the facts, results, performance or achievements we have anticipated in such forward-looking statements except as required by the federal securities laws. 3 PART I - FINANCIAL INFORMATION Item 1. FINANCIAL STATEMENTS.
4 KRISPY KREME DOUGHNUTS, INC. CONSOLIDATED STATEMENT OF OPERATIONS
The accompanying notes are an integral part of the financial statements. 5 KRISPY KREME DOUGHNUTS, INC. CONSOLIDATED BALANCE SHEET
The accompanying notes are an integral part of the financial statements. 6 KRISPY KREME DOUGHNUTS, INC. CONSOLIDATED STATEMENT OF CASH FLOWS
The accompanying notes are an integral part of the financial statements. 7 KRISPY KREME DOUGHNUTS, INC. CONSOLIDATED STATEMENT OF CHANGES IN
SHAREHOLDERS' EQUITY
Total comprehensive income for the three months ended October 30, 2011 and October 31, 2010 was $4.7 million and $2.4 million, respectively. The accompanying notes are an integral part of the financial statements. 8 KRISPY KREME DOUGHNUTS, INC. NOTES TO FINANCIAL STATEMENTS
Note 1 — Accounting Policies Krispy Kreme Doughnuts, Inc. (“KKDI”) and its subsidiaries (collectively, the “Company”) are engaged in the sale of doughnuts and complimentary products 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 2011 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 2011 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 30, 2011 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. Investments in entities over which the Company has the ability to exercise significant influence but which the Company does not control, and whose financial statements are not otherwise required to be consolidated, are accounted for using the equity method. These entities typically are 25% to 35% owned and are hereinafter sometimes referred to as “Equity Method Franchisees.” EARNINGS PER SHARE. The computation of basic earnings per share is based on the weighted average number of common shares outstanding during the period. The computation of diluted earnings per share reflects the additional common shares that would have been outstanding if dilutive potential common shares had been issued, computed using the treasury stock method. Such potential common shares consist of shares issuable upon the exercise of stock options and warrants and the vesting of currently unvested shares of restricted stock and restricted stock units. The following table sets forth amounts used in the computation of basic and diluted earnings per share:
The sum of the quarterly earnings per share amounts does not necessarily equal earnings per share for the year to date. 9 Stock options and warrants with respect to 7.4 million and 7.3 million shares, as well as 340,000 and 353,000 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 30, 2011 and October 31, 2010, respectively, because their inclusion would be antidilutive. Stock options and warrants with respect to 7.4 million and 8.2 million shares, as well as 158,000 and 210,000 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 30, 2011 and October 31, 2010, respectively, because their inclusion would be antidilutive. INCOME TAXES. The Company recognizes deferred tax assets and liabilities based upon management’s expectation of the future tax consequences of temporary differences between the income tax and financial reporting bases of assets and liabilities. Deferred tax liabilities generally represent tax expense recognized for which payment has been deferred, or expenses which have been deducted in the Company’s tax return but which have not yet been recognized as an expense in the consolidated financial statements. Deferred tax assets generally represent tax deductions or credits that will be reflected in future tax returns for which the Company has already recorded a tax benefit in its consolidated financial statements. The Company establishes valuation allowances for deferred tax assets in accordance with GAAP, which provides that such valuation allowances shall be established unless realization of the income tax benefits is more likely than not. Realization of deferred income taxes is dependent upon the Company’s generation of taxable income in future years. As of January 30, 2011, the Company had a valuation allowance against deferred tax assets of $159 million, representing the total amount of such assets in excess of the Company’s deferred income tax liabilities. The Company has maintained an allowance equal to 100% of such excess since fiscal 2005, principally because the substantial losses incurred by the Company indicated that it was more likely than not that the Company’s deferred tax assets would not be realized. The Company generated a cumulative profit over its three most recent fiscal years, although substantially all of that profit was earned in fiscal 2011, the most recently completed year. The assessment of the amount of the Company’s deferred tax assets that is more likely than not to be realized, and therefore the amount of the valuation allowance that is appropriate, is a matter that requires significant management judgment. This judgment is largely dependent upon management’s estimate of the amount of taxable income the Company will generate in future periods. The Company incurred significant losses in each of fiscal 2005 through 2009, and did not generate a significant profit until fiscal 2011. As previously disclosed, management believes that it is appropriate that, among other things, the Company achieve at least two full years of significant pretax earnings before concluding that future profitability is sustainable. As it does at each reporting period, the Company conducted an assessment of the recoverability of its deferred tax assets as of October 30, 2011, and was unable to conclude that recoverability of those assets was more likely than not. The Company will again conduct an assessment of the recoverability of its deferred tax assets in the fourth quarter of fiscal 2012, and will consider the Company’s operating results and other evidence relevant to the conclusion as to the likelihood of realization of the deferred tax assets. Such assessment could result in a conclusion that reversal of all, or a substantial portion, of the valuation allowance on deferred tax assets is appropriate. Any reversal will have no effect on the Company’s cash flows. Recent Accounting Pronouncements Effective February 1, 2010, the first day of fiscal 2011, the Company was required to adopt new accounting standards related to the consolidation of variable interest entities (“VIEs”). Those standards require an enterprise to qualitatively assess whether it is the primary beneficiary of a 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. An enterprise must consolidate the financial statements of VIEs of which it is the primary beneficiary. Under the new accounting standards, the Company was no longer the primary beneficiary of its franchisee in northern California, which required the Company to deconsolidate the franchisee and recognize a divestiture of the three stores the Company sold to the franchisee in the third quarter of fiscal 2010. 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. Adoption of the standards had no material effect on the Company’s financial position, results of operations or cash flows. In May 2011, the Financial Accounting Standards Board (the “FASB”) issued an Accounting Standards Update (“ASU”) related to fair value measurements. The ASU clarifies some existing concepts, eliminates wording differences between GAAP and International Financial Reporting Standards (“IFRS”), and in some limited cases, changes some principles to achieve convergence between GAAP and IFRS. The ASU also expands the disclosures for fair value measurements that are estimated using significant unobservable (Level 3) inputs. The ASU is effective for the Company in fiscal 2013. The Company does not expect the adoption of the new accounting standards to have a material effect on the Company’s financial condition or results of operations. 10 In June 2011, the FASB issued new accounting standards which require an entity to present the total of comprehensive income, the components of net income, and the components of other comprehensive income either in a single continuous statement of comprehensive income, or in two separate but consecutive statements. The new accounting rules eliminate the option to present components of other comprehensive income as part of the statement of changes in shareholders’ equity. The new accounting rules will be effective for the Company in fiscal 2013. The Company does not expect the adoption of the new accounting rules to have a material effect on the Company’s financial condition or results of operations. In September 2011, the FASB amended the guidance on the annual testing of goodwill for impairment. The amended guidance will allow companies to assess qualitative factors to determine if it is more likely than not that goodwill might be impaired and whether it is necessary to perform the two-step goodwill impairment test required under current accounting standards. This guidance is effective for the Company in fiscal 2013, with early adoption permitted. The Company does not expect that this new guidance will have a material impact on its consolidated financial statements. Note 2 — Receivables The components of receivables are as follows:
11 The Company also has notes receivable from franchisees which are summarized in the following table. These balances are included in “Other assets” in the accompanying consolidated balance sheet.
In addition to the foregoing notes receivable, the Company had promissory notes totaling approximately $3.3 million and $3.7 million at October 30, 2011 and January 30, 2011, respectively, representing payment obligations related to royalties and fees due to the Company which, as a result of doubt about their collection, the Company had not yet recorded as revenues. No payments were required to be made currently on any of the October 30, 2011 amount. During the quarter ended May 1, 2011, the Company recognized approximately $375,000 of previously unrecognized revenues related to KK Mexico which were received on May 5, 2011 in connection with the Company’s sale of its 30% equity interest in the franchisee, as more fully described in Note 8. During the quarter ended May 1, 2011, the Company also reversed an allowance for doubtful notes receivable of approximately $391,000 related to KK Mexico; such note also was paid in full on May 5, 2011. Note 3 — Inventories The components of inventories are as follows:
12 Note 4 — Long Term Debt Long-term debt and capital lease obligations consist of the following:
On January 28, 2011, the Company closed new secured credit facilities (the “2011 Secured Credit Facilities”), consisting of a $25 million revolving credit line (the “2011 Revolver”) and a $35 million term loan (the “2011 Term Loan”), each of which mature in January 2016. The 2011 Secured Credit Facilities are secured by a first lien on substantially all of the assets of the Company and its domestic subsidiaries. The Company used the proceeds of the 2011 Term Loan to repay the outstanding borrowings under the Company’s prior secured credit facilities (the “2007 Secured Credit Facilities”). The 2007 Secured Credit Facilities, which consisted of a $25 million revolving credit facility (the “2007 Revolver”) and a term loan maturing in February 2014, which had an outstanding balance of approximately $35.1 million (the “2007 Term Loan”), were then terminated. Interest on borrowings under the 2011 Secured Credit Facilities is payable either at LIBOR or the Base Rate (which is the greatest of the prime rate, the Fed funds rate plus 0.50%, or the one-month LIBOR rate plus 1.00%), in each case plus the Applicable Percentage. The Applicable Percentage for LIBOR loans ranges from 2.25% to 3.00%, and for Base Rate loans ranges from 1.25% to 2.00%, in each case depending on the Company’s leverage ratio. As of October 30, 2011, all outstanding borrowings under the 2011 Secured Credit Facilities were based on LIBOR, and the Applicable Percentage was 2.25%. The Company also pays fees on outstanding letters of credit issued under the 2011 Revolver equal to the Applicable Percentage for LIBOR loans plus 0.125%. Such letters of credit totaled $10.2 million as of October 30, 2011. Interest on borrowings under the 2007 Revolver and 2007 Term Loan was payable either (a) at the greater of LIBOR or 3.25% or (b) at the Alternate Base Rate (which was the greater of Fed funds rate plus 0.50% or the prime rate), in each case plus the Applicable Margin. The Applicable Margin for LIBOR-based loans and for Alternate Base Rate-based loans was 7.50% and 6.50%, respectively. The Company also paid fees on outstanding letters of credit issued under the 2007 Revolver equal to the Applicable Margin for LIBOR loans plus 0.25%. The 2011 Term Loan is payable in quarterly installments of approximately $470,000, as adjusted to give effect to principal prepayments, and a final installment equal to the remaining principal balance in January 2016. The 2011 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. On the closing date, the Company deposited into escrow $200,000 with respect to each of nine properties ($1.8 million in the aggregate) with respect to which the Company agreed to furnish to the lenders certain documentation on or before January 31, 2012, with amounts to be released from escrow upon the Company’s furnishing such documentation. If the Company does not furnish the documentation by January 31, 2012, then the amount remaining in escrow on that date will be used to make a prepayment of principal on the 2011 Term Loan. During the nine months ended October 30, 2011, $1.6 million of the escrowed amount was returned to the Company; amounts remaining in escrow are included in “Other current assets” in the accompanying consolidated balance sheet. The 2011 Secured Credit Facilities require the Company to meet certain financial tests, including a maximum leverage ratio and a minimum fixed charge coverage ratio. The leverage ratio is required to be not greater than 2.75 to 1.0 in fiscal 2012, and declines to 2.5 to 1.0 thereafter. The fixed charge coverage ratio is required to be not less than 1.05 to 1.0 in fiscal 2012, increasing to a minimum of 1.1 to 1.0 in fiscal 2013 and to 1.2 to 1.0 thereafter. As of October 30, 2011, the Company’s leverage ratio was 0.9 to 1.0, and the fixed charge coverage ratio for the rolling four-quarter period then ended was 2.8 to 1.0. In accordance with the terms of the 2011 Secured Credit Facilities, interest and fees related to these facilities is reflected in the computation of the fixed charge coverage ratio by annualizing amounts incurred under those facilities subsequent to the closing date. The operation of the restrictive financial covenants described above may limit the amount the Company may borrow under the 2011 Revolver. The restrictive covenants did not limit the Company’s ability to borrow the full $14.8 million of unused credit under the 2011 Revolver at October 30, 2011. 13 Note 5 — Commitments and Contingencies Except as disclosed below, the Company currently is not a party to any material legal proceedings. Pending Litigation On April 7, 2009, a Cayman Islands corporation, K2 Asia Ventures, and its owners filed a lawsuit in Forsyth County, North Carolina Superior Court against the Company, its franchisee in the Philippines, and other persons associated with the franchisee. The suit alleges that the Company and the other defendants conspired to deprive the plaintiffs of claimed “exclusive rights” to negotiate franchise and development agreements with prospective franchisees in the Philippines, and seeks unspecified damages. The Company believes that these allegations are false and intends to vigorously defend against the lawsuit. Other Legal Matters The Company also is engaged in various legal proceedings arising in the normal course of business. The Company maintains customary insurance policies against certain kinds of such claims and suits, including insurance policies for workers’ compensation and personal injury, some of which provide for relatively large deductible amounts. Other Commitments and Contingencies The Company has guaranteed certain loans from third-party financial institutions on behalf of Equity Method Franchisees primarily to assist the franchisees in obtaining third-party financing. The loans are collateralized by certain assets of the franchisee, generally the Krispy Kreme store and related equipment. The Company’s contingent liabilities related to these guarantees totaled approximately $2.7 million at October 30, 2011, and are summarized in Note 8. These guarantees require payment from the Company in the event of default on payment by the respective debtor and, if the debtor defaults, the Company may be required to pay amounts outstanding under the related agreements in addition to the principal amount guaranteed, including accrued interest and related fees. The aggregate recorded liability for these loan guarantees totaled $1.9 million as of October 30, 2011, which is included in accrued liabilities in the accompanying consolidated balance sheet. These liabilities represent the estimated amount of guarantee payments which the Company believed to be probable. While there is no current demand on the Company to perform under any of the guarantees, there can be no assurance that the Company will not be required to perform and, if circumstances change from those prevailing at October 30, 2011, additional guarantee payments or provisions for guarantee payments could be required with respect to any of the guarantees. In addition, accrued liabilities at October 30, 2011, includes approximately $990,000 related to the Company’s assignment of operating leases on refranchised stores. The Company is contingently liable to pay the rents on these stores to the landlords in the event the assignees fail to perform under the leases they have assumed. During the second quarter of fiscal 2012, the Company recorded a provision of $820,000 for payments the Company expects to make under a lease guarantee related to a franchisee whose franchise rights the Company terminated during the second quarter. During the third quarter of fiscal 2012, the Company reversed a previously recorded lease guarantee accrual of $110,000 as a result of the Company receiving a release from the related guarantee. The aggregate gross guarantee exposure under all such lease guarantees, without reduction for any potential sublease rentals or any other mitigation, was approximately $4.2 million as of October 30, 2011. One of the Company’s lenders had issued letters of credit on behalf of the Company totaling $10.2 million at October 30, 2011, all of which secure the Company’s reimbursement obligations to insurers under the Company’s self-insurance arrangements. In addition to entering into forward purchase contracts, the Company from time to time purchases exchange-traded commodity futures contracts or options on such contracts for raw materials which are ingredients of the Company’s products or which are components of such ingredients, including wheat and soybean oil. The Company typically assigns the futures contract to a supplier in connection with entering into a forward purchase contract for the related ingredient. The Company may also purchase futures, options on futures or enter into other hedging contracts to hedge its exposure to rising gasoline prices. See Note 11 for additional information about these derivatives. 14 Note 6 — Impairment Charges and Lease Termination Costs The components of impairment charges and lease termination costs are as follows:
The Company tests long-lived assets for impairment when events or changes in circumstances indicate that their carrying value may not be recoverable. These events and changes in circumstances include store closing and refranchising decisions, the effects of changing costs on current results of operations, observed trends in operating results, and evidence of changed circumstances observed as a part of periodic reforecasts of future operating results and as part of the Company’s annual budgeting process. When the Company concludes that the carrying value of long-lived assets is not recoverable (based on future projected undiscounted cash flows), the Company records impairment charges to reduce the carrying value of those assets to their estimated fair values. 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 are 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 provision for lease termination costs also includes adjustments to liabilities recorded in prior periods arising from changes in estimated sublease rentals and from settlements with landlords. The transactions reflected in the accrual for lease termination costs are summarized as follows:
15 Note 7 — Segment Information The Company’s reportable segments are Company Stores, Domestic Franchise, International Franchise and KK Supply Chain. The Company Stores segment is comprised of the stores operated by the Company. These stores sell doughnuts and complementary products through both on-premises and off-premises sales channels, although some stores serve only one of these distribution channels. The Domestic Franchise and International Franchise segments consist of the Company’s franchise operations. Under the terms of franchise agreements, domestic and international franchisees pay royalties and fees to the Company in return for the use of the Krispy Kreme name and ongoing brand and operational support. Expenses for these segments include costs to recruit new franchisees, to assist in store openings, to support franchisee operations and marketing efforts, as well as allocated corporate costs. The majority of the ingredients and materials used by Company stores are purchased from the KK Supply Chain segment, which supplies doughnut mix, other ingredients and supplies and doughnut making equipment to both Company and franchisee-owned stores. All intercompany sales by the KK Supply Chain segment to the Company Stores segment are at prices intended to reflect an arms-length transfer price and are eliminated in consolidation. Operating income for the Company Stores segment does not include any profit earned by the KK Supply Chain segment on sales of doughnut mix and other items to the Company Stores segment; such profit is included in KK Supply Chain operating income. The following table presents the results of operations of the Company’s operating segments for the three and nine months ended October 30, 2011 and October 31, 2010. Segment operating income is consolidated operating income before unallocated general and administrative expenses and impairment charges and lease termination costs.
Segment information for total assets and capital expenditures is not presented as such information is not used in measuring segment performance or allocating resources among segments. 16 Note 8 — Investments in Franchisees As of October 30, 2011, the Company had investments in three franchisees. These investments have been made in the form of capital contributions and, in certain instances, loans evidenced by promissory notes. These investments are reflected as “Investments in equity method franchisees” in the consolidated balance sheet. The Company’s financial exposures related to franchisees in which the Company has an investment are summarized in the tables below.
The Company has guaranteed certain loans from third-party financial institutions on behalf of Equity Method Franchisees, primarily to assist the franchisees in obtaining third-party financing. The loans are collateralized by certain assets of the franchisee, generally the Krispy Kreme store and related equipment. The 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 30, 2011 and January 30, 2011 include accruals for potential payments under loan guarantees of approximately $1.9 million and $2.2 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 indebtedness 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, as amended, matures in October 2012. The aggregate amount of such indebtedness was approximately $4.2 million at October 30, 2011. On May 5, 2011, the Company sold its 30% equity interest in Krispy Kreme Mexico, S. de R.L. de C.V. (“KK Mexico”), the Company’s franchisee in Mexico, to KK Mexico’s majority shareholder. The Company received cash proceeds of approximately $7.7 million in exchange for its equity interest and, after deducting costs of the transaction, realized a gain of approximately $6.2 million on the disposition. After provision for payment of Mexican income taxes related to the sale of approximately $1.5 million, the Company reported an after tax gain on the disposition of approximately $4.7 million in the quarter ending July 31, 2011. The net after tax proceeds of the sale of approximately $6.2 million were used to prepay a portion of the outstanding balance of the 2011 Term Loan. 17 In connection with the Company’s sale of its KK Mexico interest, KK Mexico paid approximately $765,000 of amounts due to the Company which were evidenced by promissory notes, relating principally to past due royalties and fees due to the Company. As a consequence of this payment, in the quarter ended May 1, 2011, the Company reversed an allowance for doubtful notes receivable of approximately $391,000 and recorded royalty and franchise fee income of approximately $280,000 and $95,000 respectively. The reserve had previously been established, and the royalties and fees had not previously been recognized as revenue, because of uncertainty surrounding the collection of these amounts. Note 9 — 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 and directors 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 30, 2011 and October 31, 2010 is set forth in the following table. The Company did not realize any excess tax benefits from the exercise of stock options or the vesting of restricted stock or restricted stock units during any of the periods.
Note 10 — 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:
18 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 30, 2011 and January 30, 2011.
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 30, 2011 and October 31, 2010.
19
Long-Lived Assets During the nine months ended October 31, 2010, long-lived assets having 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. 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. Lease Termination Liabilities During the nine months ended October 31, 2010, 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 6; 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. Fair Values of Financial Instruments at the Balance Sheet Dates The carrying values and approximate fair values of certain financial instruments as of October 30, 2011 and January 30, 2011 were as follows:
20 Note 11 — 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 is exposed to credit-related losses in the event of non-performance by the counterparties to its over-the-counter interest rate derivative instruments. The Company mitigates this risk of nonperformance by dealing with highly rated counterparties. Additional disclosure about the fair value of derivative instruments is included in Note 10. 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, from time to time the Company purchases exchange-traded commodity futures contracts, and options on such contracts, for raw materials which are ingredients of its products or which are components of such ingredients, including wheat and soybean oil. The Company 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 a cash flow from operating activities. At October 30, 2011, the Company had commodity derivatives with an aggregate contract volume of 365,000 bushels of wheat and 126,000 gallons of gasoline. Other than the requirement to meet minimum margin requirements with respect to the commodity derivatives, there are no collateral requirements related to such contracts. Interest Rate Risk All of the borrowings under the Company’s secured credit facilities bear interest at variable rates based upon either the Fed funds rate, the lenders’ prime rate or LIBOR. 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 March 3, 2011, the Company entered into an interest rate derivative contract having an aggregate notional principal amount of $17.5 million. The derivative contract entitles the Company to receive from the counterparty the excess, if any, of the three-month LIBOR rate over 3.00% for each of the calendar quarters in the period beginning April 2012 and ending December 2015. The Company is accounting for this derivative contract as a cash flow hedge. 21 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 30, 2011 and January 30, 2011:
The effect of derivative
instruments on the consolidated statement of operations for the three and nine
months ended October 30, 2011 and October 31, 2010, was as
follows:
22
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. Income tax matters The Company recognizes deferred tax assets and liabilities based upon management’s expectation of the future tax consequences of temporary differences between the income tax and financial reporting bases of assets and liabilities. Deferred tax liabilities generally represent tax expense recognized for which payment has been deferred, or expenses which have been deducted in the Company’s tax return but which have not yet been recognized as an expense in the consolidated financial statements. Deferred tax assets generally represent tax deductions or credits that will be reflected in future tax returns for which the Company has already recorded a tax benefit in its consolidated financial statements. The Company establishes valuation allowances for deferred tax assets in accordance with GAAP, which provides that such valuation allowances shall be established unless realization of the income tax benefits is more likely than not. Realization of deferred income tax assets is dependent upon the Company’s generation of taxable income in future years. As of January 30, 2011, the Company had a valuation allowance against deferred tax assets of $159 million, representing the total amount of such assets in excess of the Company’s deferred tax liabilities. The Company has maintained an allowance equal to 100% of such excess since fiscal 2005, principally because the substantial losses incurred by the Company during this period indicated that it was more likely than not that the Company’s deferred tax assets would not be realized. The Company generated a cumulative profit over its three most recent fiscal years, although substantially all of that profit was earned in fiscal 2011, the most recently completed year. The Company is encouraged by the favorable trend in the Company’s financial results, including the $8.9 million pretax profit earned in fiscal 2011, and the continued improvement in earnings in fiscal 2012. The assessment of the amount of the Company’s deferred tax assets that is more likely than not to be realized, and therefore the amount of the valuation allowance that is appropriate, is a matter that requires significant management judgment. This judgment is largely dependent upon management’s estimate of the amount of taxable income the Company will generate in future periods. The Company’s financial results for the first three quarters of fiscal 2012 have continued to build upon the positive results of fiscal 2011. Notwithstanding this improvement, as previously disclosed, in light of the significant losses incurred in fiscal 2005 through fiscal 2009, the significant changes affecting the Company since fiscal 2005, and other factors affecting the business currently, management believes that it is appropriate that, among other things, the Company achieve at least two full fiscal years of significant pretax earnings before concluding that future profitability is sustainable. The fourth quarter of fiscal 2012 therefore remains an important data element for the Company in assessing the recoverability of its deferred tax assets. Accordingly, when the Company conducted an assessment of the recoverability of its deferred tax assets as of October 30, 2011, management remained unable to conclude that recoverability of those assets was more likely than not, notwithstanding the Company’s improved financial results in fiscal 2012. If the Company’s favorable operating results are sustained in the fourth quarter, and sufficient other evidence considered necessary to support recoverability of the deferred tax assets is present, then management could conclude that a reversal of some or all of the valuation allowance is appropriate. While the Company cannot presently predict whether a reversal will occur, or whether any reversal would equal the entire $159 million valuation allowance recorded as of January 30, 2011 or some lesser amount, management believes that any reversal is likely to be material to the Company’s results of operations. Any reversal will have no effect on the Company’s cash flows. 23 While any reversal of a portion of the valuation allowance would have a positive effect on the Company’s results of operations in the period in which any reversal is recorded, any reversal will most likely have the effect of reducing the Company’s earnings in subsequent periods as a result of an increase in the provision for income taxes in such future periods. This negative effect on earnings in subsequent periods occurs because the reversal of the valuation allowance will reflect the recognition of previously generated, but not recognized, income tax benefits in the period in which the reversal is recorded. Absent the reversal of the valuation allowance, any such tax benefits would be recognized in the future periods in which their realization were to occur upon the generation of taxable income. Accordingly, subsequent to any reversal of the valuation allowance, the Company’s effective income tax rate, which currently bears little relationship to pretax income, is likely to more closely reflect the blended federal and state income tax rates in jurisdictions in which the Company operates. Notwithstanding any increase in the Company’s effective income tax rate as a result of a potential future reversal of some or all of the valuation allowance, the Company’s cash payments for income taxes will remain unchanged, and are likely to be insignificant for the foreseeable future because of the Company’s substantial net operating loss carryovers. The determination of income tax expense and the related balance sheet accounts, including valuation allowances for deferred income tax assets, requires management to make estimates and assumptions regarding future events, including future operating results and the outcome of tax-related contingencies. If future events are different from those anticipated, the amount of income tax assets and liabilities, including valuation allowances for deferred income tax assets, could be materially affected. Results of Operations The following table sets forth operating metrics for the three and nine months ended October 30, 2011 and October 31, 2010. 24
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 30, 2011 and October 31, 2010.
26
The following table sets forth data about the number of store operating weeks for the three and nine months ended October 30, 2011 and October 31, 2010.
The following table sets forth the types and locations of Company stores as of October 30, 2011.
27 Changes in the number of Company stores during the three and nine months ended October 30, 2011 and October 31, 2010 are summarized in the table below.
28 The following table sets forth the types and locations of domestic franchise stores as of October 30, 2011.
29 Changes in the number of domestic franchise stores during the three and nine months ended October 30, 2011 and October 31, 2010 are summarized in the table below.
30 The types and locations of international franchise stores as of October 30, 2011 are summarized in the table below.
31 Changes in the number of international franchise stores during the three and nine months ended October 30, 2011 and October 31, 2010 are summarized in the table below.
Overview Total revenues rose by 9.4% to $98.7 million for the three months ended October 30, 2011 compared to $90.2 million for the three months ended October 31, 2010. Consolidated operating income increased to $5.6 million in the three months ended October 30, 2011 from $4.1 million in the three months ended October 31, 2010. Consolidated net income was $4.7 million in the three months ended October 30, 2011 compared to $2.4 million in the three months ended October 31, 2010. 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). 32
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). 33
A reconciliation of Company Stores segment sales from the third quarter of fiscal 2011 to the third quarter of fiscal 2012 follows:
Sales at Company Stores increased 9.8% in the third quarter of fiscal 2012 from the third quarter of fiscal 2011 due to an increase in sales from existing stores and stores opened in fiscal 2011 and fiscal 2012. Selling price increases in the on-premises and off-premises distribution channels accounted for approximately 7.2 percentage points of the increase in sales, exclusive of the effects of higher pricing on unit volumes; such effects are difficult to measure reliably. As with all consumer products, however, higher prices may negatively affect sales. The Company believes this phenomenon is more pronounced in the off-premises channel where competing products are merchandised alongside those of the Company. 34 The following table presents sales metrics for Company stores:
The components of the change in same store sales at Company stores are as follows:
On March 7, 2011, the Company implemented price increases at substantially all its stores designed to help offset the rising costs of doughnut mixes, other ingredients and fuel resulting from higher commodity prices. The price increases, which affected approximately 60% of on-premises sales, averaged approximately 14%. Additionally, during the third quarter, the Company raised its fundraising prices approximately 8%. The Company believes that the expected cannibalization effect of new stores in expansion markets adversely affected same store customer count in the third quarter of fiscal 2012. “Cannibalization effect” means the tendency for new stores to become successful, in part or in whole, by “stealing” sales from existing stores in the same market. The Company continues to implement 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 increased 11.2% to $36.3 million in the third quarter of fiscal 2012 from $32.6 million in the third quarter of fiscal 2011. Approximately 6.4 percentage points of the sales increase reflects price increases implemented in the first quarter of fiscal 2012. The Company’s sales increase was greater than that of the doughnut industry as a whole, according to industry data. The Company started implementing price increases for some products offered in the off-premises channel mid-April 2011, and substantially completed implementing the increases during the second quarter. Those price increases affected products comprising approximately 60% of off-premises sales, and the average price increase on those products was approximately 11%. 35 Sales to grocers and mass merchants increased 17.0% to $21.7 million, with a 15.9% increase in average weekly sales per door and a 1.4% increase in the average number of doors served. In addition to pricing, the Company believes that average weekly sales per door in the grocer/mass merchant channel have grown as a result of, among other things, improved customer service, introduction of additional price points, a redesign of product packaging to improve its shelf appeal, and the addition of new relatively higher volume doors. Convenience store sales rose 3.4% to $13.8 million, reflecting a 14.0% increase in the average weekly sales per door partially offset by a 9.3% decline in the average number of doors served. The decline in the average number of doors served in the convenience store channel in the third quarter reflects, among other things, route management efforts to eliminate deliveries to relatively low volume doors. The Company is implementing strategies designed to improve sales through convenience stores, including offering additional price points and increasing the quantity and assortment of packaged products offered in this channel. In addition, the Company is seeking to shift customers in the convenience store channel to sales agreements which provide that the Company will absorb unsold product rather than the retailer. While this strategy will increase the cost of product returns, the Company believes that the increase will be more than offset by higher unit pricing and, because the Company will have much greater control over product assortment and quantities merchandised, increased unit sales from both existing products and packaged products not traditionally offered through convenience stores. Costs and expenses Cost of sales as a percentage of revenues increased by 0.3 percentage points from the third quarter of fiscal 2011 to 72.8% of revenues in the third quarter of fiscal 2012. Before considering the potential loss of unit volume as a result of on-premises and off-premises selling price increases, those increases more than offset higher costs of food, beverages and packaging in the third quarter of fiscal 2012. The effects of price increases on unit volumes are difficult to measure reliably. The combined effects of higher selling prices and increased input costs accounted for all of the increase in the cost of food, beverage and packing as a percentage of revenues for the third quarter of fiscal 2012 compared to the third quarter of last year. Exclusive of the effects of pricing and input costs, food, beverage and packaging costs as a percentage of revenues fell slightly. The Company currently estimates that input costs for the remainder of fiscal 2012 will decline slightly from the levels in the third quarter of this year. Except for sugar, the Company currently anticipates the cost of doughnut mix, shortening and other ingredients to remain relatively flat in fiscal 2013. Excluding sugar, the Company has fixed the prices of approximately half of its raw materials and ingredients through the second quarter of fiscal 2013. The Company had entered into contracts covering substantially all of its estimated sugar requirements for fiscal 2013 at average prices somewhat lower than its contract prices for the second half of fiscal 2012, but higher than its average price for fiscal 2012 as a whole. In addition, the Company has entered into contracts for approximately half of its estimated sugar requirements for both fiscal 2014 and fiscal 2015. Shop labor as a percentage of revenues declined by 1.5 percentage points from the third quarter of fiscal 2011 to 18.4% of revenues in the third quarter of fiscal 2012, principally due to higher sales resulting from price increases. Vehicle costs as a percentage of revenues increased from 6.1% of revenues in the third quarter of fiscal 2011 to 6.3% of revenues in the third quarter of fiscal 2012, principally as a result of higher fuel costs and higher expense of leased delivery trucks in the third quarter of fiscal 2012 compared to the third quarter of fiscal 2011. This increase was partially offset by a decrease in repairs and maintenance expense in the third quarter of fiscal 2012 as a result of the Company replacing a portion of its aging delivery fleet. Other operating expenses as a percentage of revenues declined by 0.9 percentage points from the third quarter of fiscal 2011 to 6.9% of revenues in the third quarter of fiscal 2012 reflecting, among other things, lower store-level marketing expense. Other segment operating costs as a percentage of revenues declined by 1.2 percentage points from the third quarter of fiscal 2011 to 4.8% of revenues in the third quarter of fiscal 2012 reflecting, among other things, a decrease in spending on off-premises selling and support expenses. 36 Domestic Franchise
Domestic Franchise revenues increased 14.1% to $2.3 million in the third quarter of fiscal 2012 from $2.0 million in the third quarter of fiscal 2011. The increase reflects higher domestic royalty revenues resulting from an increase in sales by domestic franchise stores from $58 million in the third quarter of fiscal 2011 to $65 million in the third quarter of fiscal 2012. Domestic Franchise same store sales rose 7.9% in the third quarter of fiscal 2012. Domestic Franchise operating expenses include costs to recruit new domestic franchisees, to assist in domestic store openings, and to monitor and aid in the performance of domestic franchise stores, as well as allocated corporate costs. The decrease in Domestic Franchise operating expenses in the third quarter of fiscal 2012 reflects the reversal of a previously recorded accrual of $110,000 related to a franchisee lease guarantee as a result of the Company receiving a release from the related guarantee. The decrease in operating expenses also reflects a decrease in legal fees of $340,000 in the third quarter of fiscal 2012 compared to the third quarter of fiscal 2011. In the third quarter of fiscal 2011, the Company recorded legal costs related to the Company’s termination of the franchise agreements of one of its domestic franchisees. Domestic franchisees opened two stores and closed nine stores in the third quarter of fiscal 2012. Of the nine closures, seven were operated by a franchisee whose franchise rights the Company terminated in the second quarter of fiscal 2012. As of November 30, 2011, existing development and franchise agreements for territories in the United States provide for the development of approximately 35 additional stores in the remainder of fiscal 2012 and thereafter. Royalty revenues are directly related to sales by franchise stores and, accordingly, the success of franchisees’ operations has a direct effect on the Company’s revenues, results of operations and cash flows. International Franchise
37 International Franchise royalties increased 24.6%, driven by an increase in sales by international franchise stores from $84 million in the third quarter of fiscal 2011 to $92 million in the third quarter of fiscal 2012. Changes in the rates of exchange between the U.S. dollar and the foreign currencies in which the Company’s international franchisees do business increased sales by international franchisees measured in U.S. dollars by approximately $3.1 million in the third quarter of fiscal 2012 compared to the third quarter of fiscal 2011, which positively affected international royalty revenues by approximately $190,000. The Company did not recognize as revenue approximately $700,000 of uncollected royalties which accrued during the third quarter of fiscal 2011 because the Company did not believe collection of these royalties was reasonably assured. Substantially all of the unrecognized royalties in the third quarter of fiscal 2011 related to the Company’s Australian franchisee, which commenced a voluntary administration process (similar to a bankruptcy filing in the U.S.) in October 2010. In connection with that process, in November 2010, the franchisee closed 24 of the 53 shops the franchisee operated prior to the reorganization. International Franchise same store sales, measured on a constant currency basis to remove the effects of changing exchange rates between foreign currencies and the U.S. dollar (“constant dollar same store sales”), fell 12.2%. The decline in International Franchise same store sales reflects, among other things, waning honeymoon effects from the large number of new stores opened internationally in recent years and the cannibalization effects on initial stores in new markets of additional store openings in those markets. “Honeymoon effect” means the common pattern for many start-up restaurants in which a flurry of activity due to start-up publicity and natural curiosity is followed by a decline during which a steady repeat customer base develops. Constant dollar same store sales in established markets fell 4.8% in the third quarter of fiscal 2012 and fell 18.9% in new markets. “Established markets” means countries in which the first Krispy Kreme store opened before fiscal 2006. Sales at stores in established markets comprised approximately 51% of aggregate constant dollar same store sales for the third quarter of fiscal 2012. While the Company considers countries in which Krispy Kreme first opened in fiscal 2005 and earlier to be established markets, franchisees in those markets continue to develop their business; these franchisees opened 232 of the 527 international stores opened since the beginning of fiscal 2006. International Franchise operating expenses include costs to recruit new international franchisees, to assist in international store openings, and to monitor and aid in the performance of international franchise stores, as well as allocated corporate costs. International Franchise operating expenses increased in the third quarter of fiscal 2012 compared to the third quarter of fiscal 2011 as a result of personnel additions, including benefits and travel costs, and other cost increases resulting from the Company’s decision to devote additional resources to the development and support of international franchisees. In addition, International Franchise segment operating expenses in the third quarter of fiscal 2011 include a credit of approximately $130,000 in bad debt expense. International franchisees opened 20 stores and closed five stores in the third quarter of fiscal 2012. As of November 30, 2011, existing development and franchise agreements for territories outside the United States provide for the development of approximately 280 additional stores in the remainder of fiscal 2012 and thereafter. Royalty revenues are directly related to sales by franchise stores and, accordingly, the success of franchisees’ operations has a direct effect on the Company’s revenues, results of operations and cash flows. KK Supply Chain The components of KK Supply Chain revenues and expenses (expressed in dollars and as a percentage of total revenues before intersegment sales elimination) are set forth in the table below (percentage amounts may not add to totals due to rounding). 38
KK Supply Chain revenues before intersegment sales elimination increased $5.3 million, or 11.7%, in the third quarter of fiscal 2012 compared to the third quarter of fiscal 2011. The increase reflects selling price increases for doughnut mix, sugar, shortening and certain other ingredients instituted by KK Supply Chain in order to pass along to Company and franchise stores increases in KK Supply Chain’s cost of sugar, flour and shortening. The unit volumes in most product categories fell in the third quarter of fiscal 2012 compared to the third quarter of fiscal 2011. The Company utilizes a fuel surcharge program to recoup additional freight costs resulting from increases in fuel costs. Charges under the program are based upon the price of diesel fuel. The increase in cost of goods produced and purchased as a percentage of sales in the third quarter of fiscal 2012 compared to the third quarter of fiscal 2011 reflects, among other things, an increase in the cost of agricultural commodities used in the production of doughnut mix and of other goods sold to Company and franchise stores. In particular, the prices of flour, shortening and sugar and the products from which they are made were significantly higher in the third quarter of fiscal 2012 compared to the third quarter of fiscal 2011. KK Supply Chain increased the prices charged to Company and franchise stores for doughnut mix, shortening, sugar and other goods in order to mitigate increases in the cost of certain raw materials. However, KK Supply Chain margins were adversely affected because, while the Company increased prices to cover higher costs, the Company did not raise prices to earn a proportionate gross profit on all of its higher costs. Distribution costs rose in the third quarter of fiscal 2012 compared to the third quarter of last year as a result of higher fuel costs, a portion of which was recovered through an increase in the fuel surcharge billed to customers. In addition, duplicate facility costs and other conversion expenses associated with the transition of product distribution for stores east of the Mississippi to an outsourced provider which began in June 2011, contributed to the increase. Other segment operating costs include segment management, purchasing, customer service and support, laboratory and quality control costs, and research and development expenses. Other segment operating costs as a percentage of revenues increased by 0.6 percentage points from the third quarter of fiscal 2011 to 7.1% of revenues in the third quarter of fiscal 2012. The increase in other segment operating costs reflects, among other things, charges of approximately $330,000 recorded to the KK Supply Chain segment for the settlement of certain sales tax litigation and an increase in segment management costs. 39 Franchisees opened 22 stores and closed 14 stores in the third quarter of fiscal 2012. A substantial portion of KK Supply Chain’s revenues are directly related to sales by franchise stores and, accordingly, the success of franchisees’ operations has a direct effect on the Company’s revenues, results of operations and cash flows. An increasing percentage of franchise store sales is attributable to sales by franchisees outside North America. Many of the ingredients and supplies used by international franchisees are acquired locally instead of from KK Supply Chain. Accordingly, KK Supply Chain revenues are less correlated with sales by international franchisees than with sales by domestic franchisees. General and Administrative Expenses General and administrative expenses remained relatively unchanged at $4.9 million, or 5.0% of total revenues in the third quarter of fiscal 2012 compared to $4.8 million, or 5.3% of total revenues in the third quarter of fiscal 2011. The Company is seeking to minimize general and administrative expenses in order to gain operating leverage as its revenues rise. Impairment Charges and Lease Termination Costs Impairment charges and lease termination costs were $135,000 in the third quarter of fiscal 2012 compared to $399,000 in the third quarter of fiscal 2011. The components of these charges are set forth in the following table:
Impairment charges relate to the Company Stores segment. 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. Impairment charges generally relate to stores expected
to be closed or refranchised, as well as to stores management believes will not
generate sufficient future cash flows to enable the Company to recover the
carrying value of the stores’ assets, but which management has not yet decided
to close. 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. The fair values of these assets are
estimated based on the present value of estimated future cash flows, on
independent appraisals and, in the case of assets the Company currently is
negotiating to sell, based on the Company’s negotiations with unrelated
third-party buyers.
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 provision for lease termination costs also includes adjustments to liabilities recorded in prior periods arising from changes in estimated sublease rentals and from settlements with landlords. In the third quarter of fiscal 2012 and 2011, the Company recorded lease termination charges of $135,000 and $318,000, respectively, principally reflecting a change in estimated sublease rentals and settlements with landlords on stores previously closed. The Company intends to refranchise certain geographic markets, expected to consist principally of, but not necessarily limited to, markets outside the Company’s traditional base in the Southeastern United States. The franchise rights and other assets in many of these markets were acquired by the Company in business combinations in prior years. 40 Since the beginning of fiscal 2009, the Company has refranchised a total of 11 stores and received consideration totaling $2.5 million in connection with those transactions. During this period, the Company recorded impairment charges totaling approximately $490,000 related to completed and anticipated refranchisings. The Company cannot predict the likelihood of refranchising any additional stores or markets or the amount of proceeds, if any, which might be received therefrom, including the amounts which might be realized from the sale of store assets and the execution of any related franchise agreements. Refranchising could result in the recognition of additional impairment losses on the related assets. Interest Expense The components of interest expense are as follows:
The decrease in interest accruing on outstanding term loan indebtedness
and in letter of credit and unused revolver fees reflects the substantial
reduction in lender margin on the Company’s credit facilities resulting from the
refinancing of those facilities in January 2011, as more fully described in Note
4 to the consolidated financial statements appearing elsewhere herein, as well
as the reduction in the principal outstanding under the Company’s term
loan.
Equity in Income (Losses) of Equity Method Franchisees The Company recorded equity in the losses of equity method franchisees of $72,000 in the third quarter of fiscal 2012 compared to earnings of $190,000 in the third quarter of fiscal 2011. This caption represents the Company’s share of operating results of equity method franchisees which develop and operate Krispy Kreme stores. On May 5, 2011, the Company sold its 30% equity interest in Krispy Kreme Mexico, S. de R.L. de C.V. (“KK Mexico”), the Company’s franchisee in Mexico, to KK Mexico’s majority shareholder, as more fully described in Note 8 to the consolidated financial statements appearing elsewhere herein. The Company’s equity in earnings of KK Mexico was approximately $260,000 for the three months ended October 31, 2010. Provision for Income Taxes The provision for income taxes was $495,000 in the third quarter of fiscal 2012 compared to $417,000 in the third quarter of fiscal 2011. Each of these amounts includes, among other things, adjustments to the valuation allowance for deferred income tax assets to maintain such allowance at an amount sufficient to reduce the Company’s aggregate net deferred income tax assets to zero, and a provision for income taxes estimated to be payable or refundable currently, the majority of which represents foreign tax withholdings. See “— Income Tax Matters,” above, for additional information about the valuation allowance on deferred income tax assets and the effects on the Company’s future financial condition and results of operations of potential changes in the amount of such valuation allowance. Net Income The Company reported net income of $4.7 million for the three months ended October 30, 2011 and $2.4 million for the three months ended October 31, 2010. 41 Nine months ended October 30, 2011 compared to nine months ended October 31, 2010 Overview Total revenues rose by 11.5% to $301.3 million for the nine months ended October 30, 2011 compared to $270.3 million for the nine months ended October 31, 2010. Consolidated operating income increased to $20.3 million in the nine months ended October 30, 2011 from $14.3 million in the nine months ended October 31, 2010. Consolidated net income was $22.7 million in the nine months ended October 30, 2011 compared to $9.1 million in the nine months ended October 31, 2010. 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).
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