A legend grows stale

Today, Krispy Kreme shares have lost more than 70 per cent of their peak value last year…The company faces class-action lawsuits over allegedly misleading financial projections, and last month was revealed to be the target of a probe into its accounting practices by the U.S. Securities and Exchange Commission.

The Toronto Star
August 20, 2004

A legend grows stale
The myth-makers waxed rhapsodic as Krispy Kreme expanded internationally a few years back
David Olive

We should have known better.

In the winter of 2001, Krispy Kreme Doughnuts Inc. "carpet-bombed" the Star's newsroom, as the business editor put it, with a generous share of the 250,000 or so free donuts the company showers on local newsrooms, charities and sports events in advance of opening a store in a new market.

So we schlepped out to Mississauga to report on this phenomenon - a rare Old Economy growth story, nurtured in the U.S. south, whose shares had soared eight-fold since its 2000 initial public offering, and were trading in the nosebleed territory of more than 100 times earnings while stock in lowly General Electric Co. changed hands at a multiple in the 30s.

Practically every Toronto newspaper and broadcaster deemed the Mississauga event newsworthy, describing the "mobs" of folks who'd traveled many kilometres to wait for the chain's famous "Hot Now" sign to light up, signaling the arrival of a new batch of fat and calorie laden Original Glazed donuts rolling off new store's quaint, faux-1930s assembly line.

A local donut aficionado called Krispy Kremes the food of the angels, saying the gooey confections are "just out of this world."

"They see donuts rising through the proof box," explained CEO Scott Livengood, who trekked up from headquarters in Winston-Salem, N.C. for the occasion. "It's almost a Circadian rhythm. It's a stimulating visual presentation."

Sure, Canada's a crowded market, boasting one of the world's highest levels of per capita donut consumption. But Krispy Kreme would stand out, said Roly Morris, charged with spearheading the Canadian expansion, because it's a unique donut and coffee operation that doesn't confuse its image by peddling croissants, bagels, muffins and espresso.

Health scares? Not to worry. As Livengood would later say, "We're pretty transparent about who we are. People don't come to us for nutrition. It's all a question of balance - we're an affordable indulgence."

It was duly reported that with first-day sales of $70,920 (Canadian), the Mississauga outlet had set a chainwide record. It might seem to some that with the economy tanking, the stock market slumping, and competition fierce, perhaps the timing of Krispy Kreme's audacious breakout from its longtime redoubt in the U.S. southeast was a bit off. But not to worry. In a 2002 article, Dow Jones asserted that "Krispy Kreme's business is strong and its demand doesn't really fluctuate with the economy or the stock market, analysts said."

The recent meltdown of Krispy Kreme stock is a lesson for investors in the merit of waiting for the media exuberance about a new phenomenon to subside before placing a bet on what might, or might not, be the Next Big Thing.

Today, Krispy Kreme shares have lost more than 70 per cent of their peak value last year. The firm has reported its first quarterly loss, trimmed its profit forecast for the year, closed some unprofitable stores, taken a big writeoff on an ill-advised acquisition, and scaled back its expansion plans. The company faces class-action lawsuits over allegedly misleading financial projections, and last month was revealed to be the target of a probe into its accounting practices by the U.S. Securities and Exchange Commission.

The risk factors, all too familiar to fast-food industry veterans, were evident from the beginning: Rapid growth on the back of potentially unreliable franchisees; periodic diet fads; a limited menu of donuts and so-so coffee, pitted against Starbucks Corp. and other gourmet coffee vendors; an entrenched and vastly larger Dunkin' Donuts, backed by a deep-pocketed British conglomerate; and the full-menu Tim Hortons, also backed by a multibillion-dollar parent (Wendy's International Inc.). Tim Hortons will soon have more outlets in the U.S. alone than Krispy Kreme's entire network of stores scattered inefficiently across the globe.

So compelling was the "story" that Krispy Kreme had devised in its bid to conquer taste buds in Toronto, Mexico City, Sydney, London, Tokyo and Fargo, N.D., scant media attention was given to these and other risks.

Emulating the low-cost publicity gimmicks of Body Shop, Ben & Jerry's and Sir Richard Branson, the folks in Winston-Salem relentlessly hyped their story in a given market for as much as a year, pumping media interest to fever pitch prior to each opening. Not by accident, Krispy Kreme launched its expansion blitz with two new outlets in New York, media capital of the continent. It then deluged Hollywood as well, with tons of donuts in return for free product placements in some 80 movies, including Erin Brockovich and Primary Colors, and plugs on hit TV shows like "Ally McBeal" and "Sex and the City."

Reporters were paraded through founder Vernon Carver Rudolph's original Ivy Ave. plant in Winston-Salem, which opened in 1937 and has been inducted into the Smithsonian Institution's National Museum of American History.

Many journalists gained the impression that the Ivy Ave. shrine was the sole source of donut mix, baking equipment and all else to be found in Krispy Kreme outlets, no matter how far-flung. And the firm's "minister of culture," Mike Cecil, 55, displayed the safe in which is stored Rudoph's secret recipe. And what are those secret ingredients? "I could tell you, but then I'd have to shoot you," one reporter was told.

Much of this ersatz heritage does not stand up to scrutiny.

Among the holes in the story, so to speak, is the seldom-mentioned second, and more modern, plant in Illinois that churns out Krispy Kreme donut mix more efficiently than its Winston-Salem cousin. The famed red-neon "Hot Now" sign traces its origins not to the Dirty Thirties, but to a Chattanooga franchisee who first experimented with it in 1980. And Rudolph's recipe, calling for potato flour and rendered pig fat, was long ago abandoned. Krispy Kreme's flagship Original Glazed Donut has undergone many alterations since Rudolph's time. "Airier" than Rudolph's creation and no longer hand-cut, it is currently made from wheat flour and soybean oil.

But the appearance of this regional icon on the U.S. national radar with Krispy Kreme's IPO in April, 2000, just one month after the dot-com collapse, proved irresistible to a financial media eager to glom onto a post-crash comfort stock. The media easily succumbed to the sugar high from Krispy Kreme's ceaseless outpouring of PR treacle - including tales of besotted devotees like the woman who traveled 65 kilometres to stand in line for the opening of the first Los Angeles store. And the denizens of the NATO base in Keflavik, Iceland, whose cravings are satisfied only by the 350 boxes of Krispy Kremes shipped to them every week from an airfield in Virginia.

"Unless the fat police run riot across this land, Krispy Kreme is here to stay," Fortune insisted in a 2003 cover story. "It isn't some fly-by-night dot-com. There's 66 years of history here. It's a product that people not only love but understand."

Fast Company magazine rhapsodized, "the mood in a Krispy Kreme store (is) so evocative, you can't enter without smiling." A Saturday Night magazine writer concluded, "the Krispy Kreme Hot Original Glazed is America's madeleine, invoking a Proustian recollection of another time." Scribes lost for words could always cite actress Susan Sarandon's characteristically ethereal observation about that memorable first encounter: "It's kind of like taking a hallucinogen. You have to have someone that goes with you on your first trip and kind of walks you through it."

There were a few disbelievers. Bagel eaters, no doubt. (Krispy Kreme Hot Original Glazed Doughnut fat count: 12 grams. Bagel fat count: 1.14 grams.)

As early as October, 2000, Business Week's investment counselor Robert Barker studied the donut marketer's fundamentals and opined, "Anyone paying $83 (U.S.) a share for a stake in Krispy Kreme will have only an insanity plea based on the Twinkie defence to rely on after it plunges." (The stock closed Friday at $13.74).

And plunge it did, in stages, after an investigative team at the Wall Street Journal learned last September that same-store sales at Krispy Kreme's new outlets in Southern California had dropped 10 per cent, and that repeat business - Krispy Kreme's hallmark - was off by almost 20 per cent.

It was downhill from there, as the press began to turn on its own creation. The ballyhooed first-week sales of $500,000 at Krispy Kreme's first Boston outlet, for example, were no indication of future performance. More typical, it was reported by the Journal and others, were average weekly sales of $19,000 in Tampa and $25,000 in suburban Chicago.

The only unusual aspect of that trend was the failure of analysts and reporters to note much earlier that new-store sales at expanding chains typically do settle down after their debut. "As the chain opens its third, sixth or 20th outlet in a region," explained John Ivankoe of J.P. Morgan Securities last fall, "the buzz fades, stores start to cannibalize each other, and Krispy Kreme becomes just another donut shop."

And, as also often happens, a phenom departs considerably from its "story" in a bid to maintain its early, intoxicating momentum. Hence the decision by Krispy Kreme's Canadian operation last fall to open downtown kiosks sans enticing aroma and the theatre of donut-making machinery.

And the decision over the past two years to clutter up the Krispy Kreme menu with frozen drinks and gourmet coffees, including espressos.

And the announcement earlier this year that the chain would experiment with a sugar-free donut - the antithesis of the advertised Krispy Kreme experience, which predictably became fodder for Jay Leno. (Then again, the chain's new freezie line includes the Frozen Original Kreme, a drinkable donut that packs 24 grams of fat - "for donut freaks who find chewing to be a waste of time and effort," as U.S. syndicated columnist Ken Hoffman put it last week after trying one.)

The health fads that would never bedevil Krispy Kreme are now fingered for its stalled growth. "You can't walk down a grocery aisle today without - on every level, on every shelf, every five feet - seeing ‘low carb’ on a package," the company's chief operating officer, John Tate, complained in May.

Could this be the same Tate who boasted about the "enormous upside potential" and "explosive growth prospects" of "this magical brand" when he joined Krispy Kreme as chief financial officer in 2000? No matter. Tate, 54, abruptly quit the company last week. With everyone from George Weston Ltd. to Kellogg Co. citing the low-carb obsession for profit slumps, it's easy to believe that Krispy Kreme has also fallen victim to the trend. But there's reason to wonder. As it happens, Krispy Kreme's reported profits showed no signs of ill-effects last fall when the Atkins diet was peaking. Neither has the Atkins mania dampened the performance of Dunkin' Donuts. And last month, Wendy's reported that a buoyant Tim Hortons accounted for a stunning 44 per cent of Wendy's total profits. Then again, Hortons claims one-third of the takeout bagel market.

For a long while, the Krispy Kreme hype - Elvis stocked Graceland with Krispy Kremes! Baseball legend Hank Aaron and entertainers Jimmy Buffett and Dick Clark have signed on as celebrity franchisees - also obscured some disturbing governance issues.

Insiders began dumping the firm's over-priced stock last year - including Livengood, 50, an erstwhile Winston-Salem firefighter, who reneged on his November, 2002, vow not to sell his stock for at least a year. In 2002 Krispy Kreme bowed to investor pressure to scrap an off-balance-sheet scheme to finance a new plant. And last month the firm disclosed that the SEC was probing franchise buy-backs in which recipients of the purchase payments included company insiders. The appearance of insider deals and Krispy Kreme's accounting practice, unusual in the fast-food industry, of refusing to amortize the acquired stores and thus avoid a hit to the bottom line, earned it an "F" for profit quality from forensic accounting analyst Donn Vickrey of Arizona's Camelback Research Alliance.

"For us to issue a grade of ‘F’, we have to have three things converge," Vickrey told the New York Times last month. "The fundamentals have to be flat or declining, giving the company a motivation to make things look better than they really are. We have to have visible evidence of accounting or transactions that are unusual or improper, and then we have to have some evidence that corporate governance is weak."

Soon after he signed on as a Krispy Kreme board member, Erskine Bowles, a North Carolina investment banker and Bill Clinton's former chief of staff, credited himself for doing plenty of due diligence on the firm. "I've got to tell you," he told Fortune last year, sounding no less rhapsodic than the media chorus, "I've never seen another company like it. It's clean, it's conservative, and I love the margins."

Judging from Krispy Kreme's record of insider dealings, aggressive accounting, and recent losses, more than a few newly distraught investors might invoke the cliched Voltaire assessment of the Holy Roman Empire to describe the stumbling donut purveyor.

Cured of the ills of its overexpansion, its "magical brand" may rise again. But for now, Krispy Kreme is neither sufficiently clean, nor conservative, nor a reliably profitable company to belong in any risk-averse portfolio.

One thing hasn't changed. As new revelations about it spill out every few weeks, Krispy Kreme continues to be a media sensation. And that's a lesson that should be as sobering to journalists as it is to disappointed investors.

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Risks: I loved the product so much, so as a fool I bought a franchise, U.S. Securities and Exchange Commission, Cannibalization of sales, Celebrity endorsement, Canada, United States, 20040822 A legend

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