Krispy Kreme Reveals SEC Probe

"In addition to the possibility of an earnings restatement, we believe many fundamental problems persist, exclusive of any 'low-carb' impact,”…Some of those franchisees have included Krispy Kreme executives and other insiders, and questions have been raised by some analysts about the way the company accounted for those buy-backs.

Reuters
July 29, 2004

Krispy Kreme Reveals SEC Probe
Nichola Groom

NEW YORK (Reuters) - Krispy Kreme Doughnuts Inc. (KKD.N: Quote, Profile, Research) on Thursday said federal regulators are investigating its repurchase of franchises and lowered earnings outlook, sending the doughnut chain's shares down more than 15 percent.

The informal probe by the U.S. Securities and Exchange Commission comes as Krispy Kreme is struggling to revitalize sales, particularly in supermarkets.

The company in May slashed its profit forecast for the year by 10 percent, blaming the popularity of low-carbohydrate diets such as the Atkins and South Beach, which frown on starchy foods like pastries and bread.

But one analyst said Krispy Kreme's problems go beyond the low-carb trend and added that the company may be forced to restate some financial results.

"In addition to the possibility of an earnings restatement, we believe many fundamental problems persist, exclusive of any 'low-carb' impact," J.P. Morgan analyst John Ivankoe, who has an "underweight" rating on Krispy Kreme shares, said in a note to clients.

In addition to suffering declining sales in its wholesale business, Krispy Kreme has also more than doubled its debt load in the last year, in part because it launched an aggressive effort to buy back franchises from individual franchisees.

Some of those franchisees have included Krispy Kreme executives and other insiders, and questions have been raised by some analysts about the way the company accounted for those buy-backs.

"There's always the risk in self-dealing of looking like you're padding your own pockets," said Joseph Adler, vice chair of the franchise and distribution group for Davis & Co., a Vancouver-based law firm.

A company spokeswoman could not specify which buy-backs were being investigated.

According to regulatory filings, Krispy Kreme paid $33 million for the rights to certain franchise markets in Kansas and Missouri that were part owned by Philip Waugh, then the company's executive vice president of worldwide development. Waugh has since left the company.

That same year, Krispy Kreme also spent $67.5 million for franchise markets in Dallas and Shreveport, Louisiana, whose franchisees included former Krispy Kreme Director Joseph McAleer and Steven Smith, an emeritus director.

Earlier this year the company paid $16.8 million for the 33 percent stake it did not already own in Golden Gate, a franchisee for northern California that was part owned by Krispy Kreme Chief Executive Scott Livengood's ex-wife.

Some investors have been critical of these repurchase deals, not just because they involved insiders, but also because they were expensive.

"Krispy Kreme has strained its balance sheet in recent years by buying back franchises," said David Rocker, who heads Rocker Partners LP, a hedge fund that is short Krispy Kreme's stock.

"While I have no specific knowledge," Rocker said, "I would imagine that the SEC's concern relates to evaluating the appropriateness of acquisition accounting adjustments, which could have contributed to an overstatement of prior or future earnings."

Krispy Kreme, which operates nearly 400 stores in the United States and overseas, said it is confident in its accounting practices and is cooperating fully with the inquiry.

The company's shares, which are down more than 50 percent since its May profit warning, fell $2.95, or 15.8 percent, to close at $15.71 Thursday on the New York Stock Exchange. The stock hit a new 52-week low of $15.60 earlier in the session. (Additional reporting by Michael Flaherty)


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