Attached files

file filename
EX-21 - LIST OF SUBSIDIARIES - KRISPY KREME DOUGHNUTS INCexhibit21.htm
EX-3.1 - RESTATED ARTICLES OF INCORPORATION OF THE REGISTRANT - KRISPY KREME DOUGHNUTS INCexhibit3-1.htm
EX-32.1 - CERTIFICATION BY CHIEF EXECUTIVE OFFICER PURSUANT TO 18 U.S.C. SECTION 1350 - KRISPY KREME DOUGHNUTS INCexhibit32-1.htm
EX-23.1 - CONSENT OF PRICEWATERHOUSECOOPERS LLP - KRISPY KREME DOUGHNUTS INCexhibit23-1.htm
EX-31.1 - CERTIFICATION OF CHIEF EXECUTIVE OFFICER - KRISPY KREME DOUGHNUTS INCexhibit31-1.htm
EX-23.2 - CONSENT OF BALLMAN KALLICK, LLP - KRISPY KREME DOUGHNUTS INCexhibit23-2.htm
EX-31.2 - CERTIFICATION OF CHIEF FINANCIAL OFFICER - KRISPY KREME DOUGHNUTS INCexhibit31-2.htm
EX-32.2 - CERTIFICATION BY CHIEF FINANCIAL OFFICER PURSUANT TO 18 U.S.C. SECTION 1350 - KRISPY KREME DOUGHNUTS INCexhibit32-2.htm



UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
______________
Form 10-K

 
(Mark one)
þ      ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
     
For the fiscal year ended January 31, 2010
     
OR
 
o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
     
For the transition period from        to
 
Commission file number 001-16485
KRISPY KREME DOUGHNUTS, INC.
(Exact name of registrant as specified in its charter)
 
North Carolina 56-2169715
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
 
370 Knollwood Street, 27103
Winston-Salem, North Carolina (Zip Code)
(Address of principal executive offices)
 
Registrant’s telephone number, including area code:
(336) 725-2981
 
Securities registered pursuant to Section 12(b) of the Act:
Name of
Each Exchange
on Which
Title of Each Class Registered
Common Stock, No Par Value New York Stock Exchange
Preferred Share Purchase Rights New York Stock Exchange
 
Securities registered pursuant to Section 12(g) of the Act:
None
 
      Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o No þ
 
     Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes o No þ
 
      Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o
 
      Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes o No o
 


     Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§ 229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  þ
 
     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 the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
 
Large accelerated filer o     Accelerated filer þ     Non-accelerated filer o     Smaller Reporting Company o
 
     Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes o No þ
 
     The aggregate market value of voting and non-voting common equity of the registrant held by nonaffiliates of the registrant as of August 2, 2009 was $205.5 million.
 
     Number of shares of Common Stock, no par value, outstanding as of March 26, 2010: 67,434,436.
 
DOCUMENTS INCORPORATED BY REFERENCE:
 
     Portions of the definitive proxy statement for the registrant’s 2010 Annual Meeting of Shareholders to be held on June 22, 2010 are incorporated by reference into Part III hereof.
 




TABLE OF CONTENTS
 
Page
FORWARD-LOOKING STATEMENTS 1
  PART I
Item 1.      Business 2
Item 1A. Risk Factors 22
Item 1B. Unresolved Staff Comments 27
Item 2. Properties 27
Item 3. Legal Proceedings 28
Item 4. Reserved 30
PART II
Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters  
       and Issuer Purchases of Equity Securities 31
Item 6. Selected Financial Data 34
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations 35
Item 7A. Quantitative and Qualitative Disclosures about Market Risk 65
Item 8. Financial Statements and Supplementary Data 67
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 107
Item 9A. Controls and Procedures 107
Item 9B. Other Information 107
PART III
Item 10. Directors, Executive Officers and Corporate Governance 108
Item 11. Executive Compensation 108
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder  
       Matters 108
Item 13. Certain Relationships and Related Transactions, and Director Independence 108
Item 14. Principal Accountant Fees and Services 108
PART IV
Item 15. Exhibits and Financial Statement Schedules 109
SIGNATURES 113



     As used herein, unless the context otherwise requires, “Krispy Kreme,” the “Company,” “we,” “us” and “our” refer to Krispy Kreme Doughnuts, Inc. and its subsidiaries. References to fiscal 2011, fiscal 2010, fiscal 2009 and fiscal 2008 mean the fiscal years ended January 30, 2011, January 31, 2010, February 1, 2009 and February 3, 2008, respectively. Please note that fiscal 2008 contained 53 weeks.
 
FORWARD-LOOKING STATEMENTS
 
     This Annual Report on Form 10-K contains forward looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”) that relate to our plans, objectives, estimates and goals. Statements expressing expectations regarding our future and projections relating to products, sales, revenues, costs and earnings are typical of such statements, and are made under the Private Securities Litigation Reform Act of 1995. Forward-looking statements are based on management’s beliefs, assumptions and expectations of our future economic performance, considering the information currently available to management. These statements are not statements of historical fact. Forward-looking statements involve risks and uncertainties that may cause our actual results, performance or financial condition to differ materially from the expectations of future results, performance or financial condition we express or imply in any forward-looking statements. The words “believe,” “may,” “could,” “will,” “should,” “anticipate,” “estimate,” “expect,” “intend,” “objective,” “seek,” “strive” or similar words, or the negative of these words, identify forward-looking statements. Factors that could contribute to these differences include, but are not limited to:
  • the quality of Company and franchise store operations;
     
  • our ability, and our dependence on the ability of our franchisees, to execute on our and their business plans;
     
  • our relationships with our franchisees;
     
  • our ability to implement our international growth strategy;
     
  • our ability to implement our new domestic operating model;
     
  • political, economic, currency and other risks associated with our international operations;
     
  • the price and availability of raw materials needed to produce doughnut mixes and other ingredients;
     
  • compliance with government regulations relating to food products and franchising;
     
  • our relationships with off-premises customers;
     
  • our ability to protect our trademarks and trade secrets;
     
  • restrictions on our operations and compliance with covenants contained in our secured credit facilities;
     
  • changes in customer preferences and perceptions;
     
  • risks associated with competition; and
     
  • other factors discussed below in Item 1A, “Risk Factors” and in Krispy Kreme’s periodic reports and other information filed with the Securities and Exchange Commission (the “SEC”).
     All such factors are difficult to predict, contain uncertainties that may materially affect actual results and may be beyond our control. New factors emerge from time to time, and it is not possible for management to predict all such factors or to assess the impact of each such factor on the Company. Any forward-looking statement speaks only as of the date on which such statement is made, and we do not undertake any obligation to update any forward-looking statement to reflect events or circumstances after the date on which such statement is made.
 
     We caution you that any forward-looking statements are not guarantees of future performance and involve known and unknown risks, uncertainties and other factors which may cause our actual results, performance or achievements to differ materially from the facts, results, performance or achievements we have anticipated in such forward-looking statements except as required by the federal securities laws.
 


PART I
 
Item 1. BUSINESS.
 
Company Overview
 
     Krispy Kreme is a leading branded retailer and wholesaler of high-quality doughnuts and packaged sweets. The Company’s principal business, which began in 1937, is owning and franchising Krispy Kreme stores, at which over 20 varieties of high-quality doughnuts, including the Company’s Original Glazed® doughnut, are sold and distributed together with complementary products, and where a broad array of coffees and other beverages are offered.
 
     The Company generates revenues from four segments: Company stores, domestic franchise stores, international franchise stores, and the KK Supply Chain. The revenues and operating income of each of these segments for each of the three most recent fiscal years is set forth in Note 17 to the Company’s consolidated financial statements appearing elsewhere herein.
 
     Company Stores. The Company Stores segment is comprised of the doughnut shops operated by the Company. These stores sell doughnuts and complementary products through the on-premises and off-premises sales channels and come in two formats: factory stores and satellite stores. Factory stores have a doughnut-making production line, and many of them sell products through both on-premises and off-premises sales channels to more fully utilize production capacity. Satellite stores, which serve only on-premises customers, are smaller than most factory stores, and include the hot shop and fresh shop formats. As of January 31, 2010, there were 83 Company stores in 18 states and the District of Columbia, including 69 factory and 14 satellite stores.
 
     Domestic Franchise Stores. The Domestic Franchise segment consists of the Company’s domestic store franchise operations. Domestic franchise stores sell doughnuts and complementary products through the on-premise and off-premise sales channels in the same way and using the same store formats as in the Company Stores segment. As of January 31, 2010, there were 141 domestic franchise stores in 29 states, including 104 factory and 37 satellite stores.
 
     International Franchise Stores. The International Franchise segment consists of the Company’s international store franchise operations. International franchise stores sell doughnuts and complementary products almost exclusively through the on-premises sales channel in the same way and using the same store formats as in the Company Stores segment, and also using a kiosk format. A portion of sales by the franchisees in the United Kingdom and in Australia are made to off-premises customers. As of January 31, 2010, there were 358 international franchise stores in 18 countries, including 95 factory and 263 satellite stores.
 
     KK Supply Chain. The KK Supply Chain produces doughnut mixes and manufactures doughnut-making equipment, which all factory stores, both Company and franchise, are required to purchase. In addition, KK Supply Chain sells other ingredients, packaging and supplies principally to Company-owned and domestic franchise stores.
 
     As of January 31, 2010, there were 224 Krispy Kreme stores operated domestically in 37 U.S. states and in the District of Columbia, and 358 shops in other countries around the world. Of the 582 total stores, 268 were factory stores and 314 were satellites. The ownership and location of those stores is as follows:
 
      Domestic       International       Total
Company stores 83   83
Franchise stores 141   358     499
       Total   224   358 582
                       
     The Company and its franchisees sell products through two channels:
  • On-premises sales: Sales to customers visiting Company and franchise factory and satellite stores, including sales made through drive-thru windows, along with discounted sales to community organizations that in turn sell doughnuts for fundraising purposes. A substantial majority of the doughnuts sold in our shops are consumed elsewhere.
2
 


  • Off-premises sales: Sales of fresh doughnuts and packaged sweets primarily on a branded basis to a variety of retail customers, including convenience stores, grocery stores/mass merchants and other food service and institutional accounts. These customers display and resell the doughnuts from self-service display cases, and in packages merchandised on stand-alone display units. Products are delivered to customer locations by our fleet of delivery trucks operated by a commissioned employee sales force. Distribution through off-premises sales channels generally is limited to stores in the United States. Only a small minority of sales by international franchisees are made to off-premises customers.
Company History
 
     In 1933, Vernon Carver Rudolph, the founder of Krispy Kreme, went to work for his uncle, who had acquired a doughnut shop in Paducah, Kentucky from a French chef originally from New Orleans, which included, among other items, the rights to a secret yeast-raised doughnut recipe. In the mid 1930s, they decided to look for a larger market, and moved their operations to Nashville, Tennessee. Shortly thereafter, Mr. Rudolph acquired the business, together with his father and brother, and they soon opened shops in Charleston, West Virginia and Atlanta, Georgia. At this time, the business focused on selling doughnuts to local grocery stores.
 
     During the early summer of 1937, Mr. Rudolph decided to leave Nashville to open his own doughnut shop. Along with two friends, he set off in a 1936 Pontiac and arrived in Winston-Salem, North Carolina with $25 in cash, a few pieces of doughnut-making equipment, the secret recipe, and the name Krispy Kreme Doughnuts. They used their last $25 to rent a building across from Salem Academy and College in what is now called historic Old Salem.
 
     On July 13, 1937, the first Krispy Kreme doughnuts were made at the new Winston-Salem shop, with the first batch of ingredients purchased on credit. Mr. Rudolph was 21 years of age. Soon afterward, people began stopping by to ask if they could buy hot doughnuts right there on the spot. The demand was so great that Mr. Rudolph opened the shop for retail business by cutting a hole in the wall and selling doughnuts directly to customers, marking the beginning of Krispy Kreme’s restaurant business.
 
     In 1939, Mr. Rudolph registered the Krispy Kreme name with the United States Patent Office. The business grew rapidly and the number of shops grew, opened first by family members and later by licensees.
 
     In the 1950s and 1960s, steps were taken to mechanize the doughnut-making process. Proofing, cooking, glazing, screen loading, and cutting became entirely automatic. Most of these doughnut-making processes are still used by Krispy Kreme stores today, although they have been further modernized.
 
     Following Mr. Rudolph’s death, in May 1976 Krispy Kreme became a wholly-owned subsidiary of Beatrice Foods Company of Chicago, Illinois. In February 1982, a group of Krispy Kreme franchisees purchased Krispy Kreme from Beatrice Foods.
 
     With new leadership, a renewed focus on the hot doughnut experience became a priority for the Company and led to the birth of the Doughnut Theater®, in which the doughnut-making production line is visible to consumers, creating a multi-sensory experience unique to Krispy Kreme and which is an important distinguishing feature of our brand. The Company began to expand outside of the Southeast and opened its first store in New York City in 1996. Soon afterward, in 1999, the Company opened its first store in California and began its national expansion. In April 2000, Krispy Kreme held an initial public offering of common stock, and in December 2001, the Company opened its first international store, in Canada, and began its international expansion.
 
     When the Company turned 60 years old in 1997, Krispy Kreme’s place as a 20th century American icon was recognized by the induction of Company artifacts into the Smithsonian Institution’s National Museum of American History.
 
     The last decade of the 20th century and the early years of the 21st was a period of rapid growth in the number of stores and domestic geographic reach of Krispy Kreme, particularly following the April 2000 initial public offering. In many instances, the Company took minority ownership positions in new franchisees, both domestic and international. Enthusiasm for the brand generated very high average unit sales volumes as Krispy Kreme stores expanded into new geographic territories, and the Company generated significant earnings driven by the domestic store expansion. The initial success of a number of franchisees led the Company to reacquire several franchise markets in the United States in 2003 and early 2004, often at substantial premiums. By late 2003, average unit volumes began to fall as initial sales levels in many new stores proved to be unsustainable, which adversely affected earnings at both the Company and franchisees, leading to a period of retrenchment characterized by over 240 domestic store closings from 2004 through 2009. The Company’s revenues fell significantly during this period, principally as a result of store closings by the Company and by franchisees, and the Company incurred significant losses, including almost $300 million in impairment charges and lease termination costs over the past six years related principally to store closings and to the writeoff of goodwill from the franchise acquisitions.
 
3
 


     The decline in earnings and in the price of the Company’s shares, together with questions raised in the financial media about the Company’s accounting practices, led to the initiation of securities class action and shareholder derivative litigation and the commencement of investigations by various governmental entities. These events led to the formation by the Board of Directors of a Special Committee of newly elected independent directors in October 2004 to conduct an independent review and investigation of any and all issues raised by, among other things, the regulatory investigations and the shareholder derivative actions. Shortly thereafter, the Company announced that it would restate its financial results for multiple years, a process that was completed in April 2006. The Special Committee issued its report in August 2005, concluding, among other things, that top management had devoted too little attention to establishing accounting controls and an appropriate tone at the top, and too much attention to meeting Wall Street earnings expectations, including actions which strongly suggested an intention to manage earnings, and directing the Company to take remedial actions, including significant changes in corporate culture and governance. The Company has implemented all of those directives, and has remediated the 17 material weaknesses in its internal control over financial reporting that it identified in its initial report on internal control under the Sarbanes-Oxley Act. All persons who the Special Committee believed had any substantial involvement in or responsibility for the accounting errors left the Company in or before June 2005. All of the securities class action and shareholder derivative litigation and the governmental investigations have been concluded.
 
     While the 2004 through 2006 period was tumultuous in many respects, it was not without progress. In particular, the Company greatly increased its international development efforts. Those efforts, which are continuing, have resulted in the recruitment of new franchisees in 14 countries since the end of 2004, and those franchisees, together with existing franchisees in four other countries, have opened a cumulative net total of 337 Krispy Kreme stores since the end of 2004. As of January 31, 2010, of the 582 Krispy Kreme stores worldwide, 358 are operated by franchisees outside the United States. Many of those franchisees pioneered the development of new small Krispy Kreme shop formats which, in tandem with traditional factory stores or commissaries, serve as the prototype for the small shop business model and hub and spoke distribution system the Company currently is developing to serve domestic markets and reignite growth in the United States.
 
     Today, Krispy Kreme enjoys over 65% unaided brand awareness, and our Hot Krispy Kreme Original Glazed Now® sign is an integral contributor to the brand’s mystique. In addition, our Doughnut Theatres® in factory stores provide a multi-sensory introduction to the brand and reinforce the unique Krispy Kreme experience in 19 countries around the world.
 
Industry Overview
 
     Krispy Kreme operates within the quick service restaurant, or QSR, segment of the restaurant industry. In the United States, the QSR segment is the largest segment of the restaurant industry and has demonstrated steady growth over a long period of time. According to The NPD Group, Inc.’s CREST®, which tracks consumer usage of the foodservice industry, QSR sales have grown at an annual rate of 3% over the past 10 years. The National Restaurant Association projects QSR sales to rise 3% in calendar 2010 from the $160 billion posted in calendar 2009.
 
     We believe that the QSR segment is generally less vulnerable to economic downturns than the casual dining segment, due to the value that QSRs deliver to consumers, as well as some “trading to value” by consumers from other restaurant industry segments during adverse economic conditions, as they seek to preserve the “away from home” dining experience on tighter budgets. However, high unemployment, low consumer confidence, tightened credit and other factors have taken their toll on consumers and their ability to increase spending, resulting in fewer visits to restaurants and related dollar growth. As a result, QSR sales may continue to be adversely impacted by the current recessionary environment or sharp increases in commodity or energy prices. The Company believes the potential for increased prices of agricultural products and energy are more likely to significantly affect its business than are economic conditions generally, because the Company believes its products are affordable indulgences that appeal to consumers in all economic environments.
 
4
 


     Our QSR competitors include Dunkin’ Donuts, which has the largest number of outlets in the doughnut retail industry, as well as Tim Hortons and regionally and locally owned doughnut shops. Dunkin’ Donuts and Tim Hortons have substantially greater financial resources than we do and are expanding to other geographic regions, including areas where we have a significant store presence. We also compete against other retailers who sell sweet treats such as cookie stores and ice cream stores. We compete on elements such as food quality, convenience, location, customer service and value.
 
     In addition to retail doughnut outlets, the domestic doughnut market is comprised of several other sales channels, including grocery store packaged products, in-store bakeries within grocery stores, convenience stores, foodservice and institutional accounts, and vending. Our off-premises competitors include makers of doughnuts and snacks sold through all of these off-premises sales channels. Customer service, including frequency of deliveries and maintenance of fully stocked shelves, is an important factor in successfully competing for convenience store and grocery/mass merchant business. There is an industry trend moving towards expanded fresh product offerings at convenience stores during morning and evening drive times, and products are either sourced from a central commissary or brought in by local bakeries. In the packaged doughnut market, we compete for sales with many sweet treats, including those made by well-known producers, such as Dolly Madison, Entenmann’s and Hostess, as well as regional brands.
 
     Comprehensive, reliable doughnut industry statistics are not readily available; however, with regard to specific sales channels within the industry, data are available. Information Resources, Inc. data indicate that, during calendar 2009, doughnut sales rose approximately 5% year-over-year in grocery stores and rose approximately 3% in convenience stores.
 
     Our international franchisees, which serve the on-premises market almost exclusively, compete against a broad set of global, regional and local retailers of doughnuts and treats such as Dunkin’ Donuts, Tim Hortons, Mister Donut and Donut King.
 
Krispy Kreme Brand Elements
 
     Krispy Kreme has several important brand elements which we believe have created a bond with many of our customers. The key elements are:
 
One-of-a-kind taste. The taste experience of our doughnuts is the foundation of our concept and the common thread that binds generations of our loyal customers. Our doughnuts are made based on a secret recipe that has been in our Company since 1937. We use premium ingredients, which are blended by our proprietary processing equipment in accordance with our standard operating procedures, to create this unique and very special product.
 
Doughnut Theater®. Our factory stores typically showcase our Doughnut Theater®, which is designed to produce a multi-sensory customer experience and establish a brand identity. Our goal is to provide our customers with an entertainment experience and to reinforce our commitment to quality and freshness by allowing them to see doughnuts being made.
 
Hot Krispy Kreme Original Glazed Now® sign. The Hot Krispy Kreme Original Glazed Now® sign, when illuminated, is a signal that our hot Original Glazed® doughnuts are being served. The Hot Krispy Kreme Original Glazed Now® sign is an impulse purchase generator and an integral contributor to our brand. Our Original Glazed® doughnuts are made for several hours every morning and evening, and at other times during the day at our factory stores. We also operate hot shops, which are satellite locations supplied with unglazed doughnuts from a nearby factory store or commissary. Hot shops use tunnel ovens to heat unglazed doughnuts throughout the day, which are then finished using the same glaze waterfall process used at traditional factory stores.
 
Sharing. Krispy Kreme doughnuts are a popular choice for sharing with friends, family, fellow workers and fellow students. Consumer research shows that approximately 75% of purchases at our domestic shops are for sharing occasions; and in Company stores, approximately 60% of retail transactions are for sales of one or more dozen doughnuts. The strength of our brand in shared-use occasions transcends international borders. Sales of dozens comprise a significant portion of shop sales transactions around the world, and the sharing concept is an integral part of our global marketing approach.
 
5
 


Community relationships. We are committed to local community relationships. Our store operators support their local communities through fundraising programs and sponsorship of charitable events. Many of our loyal customers have memories of selling Krispy Kreme doughnuts to raise money for their schools, clubs and community organizations.
 
Strategic Initiatives
 
     We have developed a number of strategic initiatives designed to foster the Company’s growth and improve its profitability. The major initiatives to which we have devoted our efforts over the past two years, and which we expect to be the focus of our efforts in the next two years, are discussed below.
 
   Developing and Testing Small Shop Formats To Drive Sales and Profitability
 
     We are working to refine our domestic store operating model to focus on small retail shops, including both satellite shops to which we supply doughnuts from a nearby factory store in a hub and spoke distribution model, and shops that manufacture doughnuts but which are smaller and have less capacity than traditional factory stores. The objectives of the small retail shop model are, among other things:
  • to stimulate an increase in on-premises sales of doughnuts and complementary products by increasing the number of retail distribution points to provide customers more convenient access to our products;
     
  • to reduce the investment required to produce a given level of sales and reduce operating costs by operating smaller satellite stores instead of larger, more expensive factory stores;
     
  • to achieve greater production efficiencies by centralizing doughnut production to minimize the burden of fixed costs;
     
  • to achieve greater consistency of product quality through a reduction in the number of doughnut-making locations;
     
  • to enable store employees to focus on achieving excellence in customer satisfaction and in-shop consumer experience; and
     
  • to achieve sufficient store density to enable cost-effective use of broadcast media advertising to drive sales and introduce new menu items to consumers.
 
     We intend to focus development of Company stores in the Southeast in order to achieve economies of scale and minimize the geographic span of our Company store operations, and to develop the other domestic markets through franchising. We view successful development and demonstration of the small shop hub and spoke economic model as critical to attracting ongoing franchisee investment.
 
     We have completed initial market research in the following markets in the Southeast which we have targeted for development of Company stores in the near term: Piedmont Triad, Raleigh and Charlotte, North Carolina; Columbia, South Carolina; Lexington and Louisville, Kentucky; Nashville, Memphis and Knoxville, Tennessee; and Tidewater, Virginia. We believe there is an opportunity to build over 65 new Krispy Kreme Company shops in these markets.
 
     We chose these markets as our initial focus of small shop development because (1) they are markets in which our brand has been particularly successful; (2) they have an existing base of Krispy Kreme factory shops from which to build; and (3) the number of additional shops necessary to make use of broadcast media economically feasible is relatively small. By choosing markets with these characteristics, we hope to develop small shops and implement the hub and spoke model on a market-wide basis more rapidly than would be possible in larger markets. In addition, there are large population centers in the Southeast which we believe have the capacity to absorb a large number of new Company-owned Krispy Kreme shops, including Washington, D.C. and Atlanta. Moreover, successful development of small shop economic models could allow us to locate shops in smaller population towns and areas than has traditionally been possible, which could significantly increase the potential number of franchise stores nationwide.
 
     We opened six new small shops in fiscal 2010, and expect to open between seven and ten additional small shops in each of the next two fiscal years.
 
6
 


   Enhancing Our Focus on Shop Operations
 
     We believe that we can improve our shop operating margins by improving our operating methods; creating and deploying management tools, including labor cost and food cost management tools; enhancing our hospitality, service and cleanliness standards; and continuously training our people on new methods and standards. Our goal is to drive same store sales and operate our stores more efficiently through a focus on operating excellence and world class guest experience. Late in fiscal 2010, we implemented two new guest experience measures: a new mystery shopper assessment tool performed on a regular schedule, and a new guest reporting tool with industry norms that will allow us to compare ourselves to the best in the QSR industry.
 
   Developing, Testing and Deploying New Products
 
     Sales of doughnuts comprise over 88% of our retail sales. In addition to improving consumer convenience by expanding the number of shops in our markets, we need to develop and deploy a broader range of menu offerings to give consumers more reasons to visit Krispy Kreme shops and to improve our sales in relatively less busy dayparts. Toward that end, we are extensively testing a new semi-frozen concept, Kool Kreme® soft serve, and conducting initial testing of baked goods. Our goal for product diversification is to raise our on-premises average unit volumes by 10% by fiscal 2014, notwithstanding expected cannibalization from resulting from greater store density.
 
   Improving Our Off-Premises Business
 
     Over half of our Company shops’ sales are sales to grocers, mass merchants, convenience stores and other off-premises customers. We believe we have less pricing power to recover higher costs of agricultural commodities in the off-premises channel than we do in the on-premises channel, and we have the additional cost pressures associated with generally rising fuel costs and substantial product returns stemming from the relatively short shelf-life of our signature yeast-raised doughnut. We are focusing on introducing new longer shelf-life products and emphasizing marketing of existing long shelf-life products, as well as modernizing our delivery fleet, rationalizing delivery routes and enhancing customer service to improve the profitability of off-premises distribution.
 
     We believe the Krispy Kreme brand should be represented in off-premises distribution channels. Over time, we expect our off-premises product line to become increasingly differentiated from the products offered in our shops in order to improve the economics of this distribution channel.
 
   Building On Our Success Internationally
 
     Our international franchisees’ expansion in the past three years has been outstanding, with international stores growing from 123 to 358 and from 31% of our total store count to 62%. We have been devoting additional resources, principally people, to supporting the growth of our international franchisees, and we expect to devote even more resources to supporting international franchisees in the next two fiscal years. Krispy Kreme is now represented in 18 countries outside the United States, and we view the growth potential as virtually limitless, at least for the foreseeable future.
 
   Enhancing Franchisee Support
 
     The success of our franchisees is key to our success. We are devoting additional resources to franchisee operational support, both domestically and internationally, and we expect to expand the level of that support over the next two years. We are increasing the number of personnel devoted to helping our franchisees succeed, not only franchisee field support employees, but also additional personnel in the KK Supply Chain to more effectively and rapidly support an increasingly global business. In addition, many of the operational tools we are developing for our Company shops also can be deployed by our franchisees to improve their shop economics.
 
Company Stores Business Segment
 
     Our Company Stores segment is comprised of the operating activities of our Company-owned stores. These stores sell doughnuts and complementary products through the on-premises and off-premises sales channels described above under “Company Overview.” Expenses for this business segment include cost of goods sold, store level operating expenses along with direct general and administrative expenses, certain marketing costs and allocated corporate costs.
 
7
 


   Products
 
     Doughnuts and Related Products. We currently make and sell over 20 varieties of high-quality doughnuts, including our Original Glazed® doughnut. Most of our doughnuts, including the Original Glazed® doughnut, are yeast-raised doughnuts, although we also offer several varieties of cake doughnuts and crullers. In recent years, we have introduced doughnuts in a variety of non-traditional shapes, which can be seasonally customized using icings and other toppings, including hearts, pumpkins, footballs, eggs and snowmen. In addition to specially shaped doughnuts, we periodically offer other doughnut varieties on a limited time offer basis. Generally, products for domestic stores are first tested in our Company stores and then rolled out to our franchise stores, although we have approved for testing at franchise locations new products which we believe are compatible with our brand image and which meet our demanding quality standards. Sales of doughnuts comprise approximately 88% of total retail sales, with the balance comprised principally of beverage sales.
 
     Many of the doughnut varieties we offer in our doughnut shops also are distributed through off-premises sales channels. In addition, we offer a number of products exclusively through off-premises channels, including honeybuns, fruit pies, mini-crullers, cupcakes and various chocolate enrobed products, generally packaged as individually wrapped snacks or packaged in snack bags. We also have introduced non-traditional packaging offerings for distribution through grocery stores, mass merchants and convenience stores. Sales of yeast-raised doughnuts comprise approximately 80% of total off-premises sales, with cake doughnuts and all other product offerings as a group each comprising approximately 10% of total off-premises sales.
 
     Complementary products. In fiscal 2009, we began initial testing of a new soft serve menu of traditional cones, shakes and sundaes paired with a variety of toppings. In fiscal 2010, we expanded our testing of the concept, called Kool Kreme® soft serve, into all of our new Company shops and into most existing shops in the markets in which the new shops are located. We expect to have the soft serve platform fully deployed in approximately 15 shops in four test markets by the spring of calendar 2010, which should position the product for meaningful consumer exposure over the summer months, supported by media and extensive promotional activity. Our Company store tests, combined with testing by two of our franchisees, will give us additional assessments of consumer acceptance on which to base a full rollout decision.
 
     We have also begun very limited in-store testing of baked goods, including sweet rolls, pecan rolls, muffins and bagels, and plan to expand this testing to franchisees in fiscal 2011.
 
     Beverages. We have a complete beverage program which includes drip coffees, both coffee-based and noncoffee-based frozen drinks, juices, sodas, milks, water and packaged and fountain beverages. In addition, many of our stores offer a complete line of espresso-based coffees, including flavors. We continue to seek to improve our beverage program and plan to launch a revamped coffee program late in fiscal 2011. Sales of beverages comprise approximately 11% of our total retail sales.
 
   Traditional Factory Store Format
 
     Historically, the Krispy Kreme business has been centered around large facilities which operated both as quick service restaurants and as consumer packaged goods distributors, with doughnut-making production lines located in each shop which served both the on-premises and off-premises distribution channels. The operation of these traditional factory stores tends to be complex, and their relatively high initial cost and their location in retail-oriented real estate results in a relatively high level of fixed costs which, in turn, results in high breakeven points. In recent years, we have been developing several new small shop formats to serve on-premises customers exclusively, with the goal of permitting us to operate a larger number of stores that are more convenient to our customers; reducing the initial store investment; reducing our per store fixed costs and lowering breakeven points; and leveraging the production capacity in the existing installed base of traditional factory stores. These small shop formats include new small factory stores that operate independently, as well as satellite stores, which are located in proximity to existing traditional factory stores which supply finished and unglazed doughnuts to the satellites using a hub and spoke distribution system.
 
8
 


     Traditional factory stores generally are located in freestanding suburban locations generally ranging in size from approximately 2,400 to 8,000 square feet, and typically have the capacity to produce between 2,400 and 4,000 dozen doughnuts daily. The relatively larger factory stores often engage in both on-premises and off-premises sales, with the allocation between such channels dependent on the stores’ capacities and the characteristics of the markets in which the stores operate. Relatively smaller traditional factory stores, which typically have less production capacity, serve only on-premises customers. Our newest traditional factory store is located in Pensacola, Florida, and serves both on-premises and off-premises customers. The store was constructed in fiscal 2008; its aggregate cost was approximately $1.8 million, including the core building, building upfit, equipment, furniture and fixtures and signage, but excluding the land, which the Company has owned for many years.
 
     When the production line is producing our Original Glazed® doughnut, each factory store illuminates the Hot Krispy Kreme Original Glazed Now® sign to signal customers that the Company’s Original Glazed® doughnuts are being served hot off the line. Our high volume dayparts are mornings and early evenings. The breakdown of our sales by daypart is approximately as follows (hours between 11:00 p.m. and 6:00 a.m. have been omitted because very few of our stores are open to the public during these hours):
 
Hours      Percentage of Retail Sales
6 a.m.     11 a.m. 35 %
11 a.m. 2 p.m.   13 %
  2 p.m.   6 p.m. 21 %  
6 p.m.   11 p.m. 27 %

     The factory store category also includes six commissaries, five of which have multiple production lines; each line has the capacity to produce between 4,000 dozen and 10,000 dozen doughnuts daily. The commissaries typically serve off-premises customers exclusively, although some commissaries produce certain products (typically longer shelf-life products such as honeybuns) that are shipped to other factory stores where they are distributed to off-premises customers together with products manufactured at the receiving store.
 
     Historically, the relatively large size and high cost of traditional factory stores limited the density of our stores in many markets, causing many of our consumers to utilize them as “destination” locations, which limited their frequency of use. The relatively small number of stores in many markets made use of broadcast media advertising cost prohibitive, and historically the Company did little advertising. In addition, each factory store has significant fixed or semi-fixed costs, and margins and profitability are significantly affected by doughnut production and sales volume. Many of our traditional factory stores and commissaries have more capacity to produce doughnuts than is currently is being utilized.
 
   Small Retail Shop Format
 
     Our consumer research indicates that the typical Krispy Kreme on-premises customer visits Krispy Kreme an average of once a month, and a significant obstacle to more frequent customer visits is our relative lack of convenience. Our consumer demographics are very much in line with the general population in which we do business. Our consumer research also indicates that consumers give us permission to leverage our brand into a variety of complementary products, so long as the quality of those products is consistent with the very high quality perception consumers attribute to our Original Glazed® doughnut.
 
     We are developing a number of small retail shops to more fully penetrate markets of all sizes. In addition to improving customer convenience by increasing the number of Krispy Kreme shops in our markets, we believe the greater store density will make use of broadcast media advertising more economically feasible and enable us to drive sales through broadcast advertising. Moreover, we view the ability to utilize broadcast advertising as essential to promoting and encouraging trial usages of new menu items, including an enhanced beverage program. Broadening our menu to drive additional sales in relatively slower dayparts is an important opportunity for us to improve the economics of our business, as is the opportunity to increase the number of offerings in the traditionally strong breakfast daypart and the opportunity to increase sales of beverages, which today represent a small fraction of our retail sales.
 
     Small Factory Stores. We have developed a small retail-only factory store which occupies approximately 2,400 square feet and which contains a full doughnut production line, but on a smaller scale than the production equipment in a traditional factory store. We operate two of these small factory stores, and view this format as a viable alternative with which to deliver the Krispy Kreme Doughnut Theater® experience to consumers in relatively smaller geographic markets. Each of our two small factory stores has the capacity to produce approximately 1,000 dozen doughnuts per day, although the small factory store configuration, with minor modification, can accommodate equipment with the capacity to produce approximately 2,400 dozen doughnuts per day. The capital cost of the small factory store we opened in fiscal 2010 was approximately $850,000, including equipment, furniture and fixtures, signage and building upfit. We are continuing to refine the small factory model to reduce the initial capital cost of this format.
 
9
 


     Satellite Stores. In addition, we have developed and are testing satellite stores, all of which serve only on-premises customers, are smaller than traditional factory stores, and do not contain a doughnut making production line. Satellite stores consist of the hot shop and fresh shop formats, and typically range in size from approximately 900 to 2,400 square feet (exclusive of larger factory stores that have been converted to satellites). In each of these formats, the Company sells doughnuts, beverages and complementary products, with the doughnuts supplied by a nearby traditional factory store or a commissary.
 
     Hot shops utilize tunnel oven doughnut heating and finishing equipment scaled to accommodate on-premises sales volumes. This equipment heats unglazed doughnuts and finishes them using a warm glaze waterfall that is the same as that used in a traditional factory store. Hot shop equipment allows the Company to offer customers our hot Original Glazed® doughnuts throughout the day, and to signal customers that our signature product is available using the Hot Krispy Kreme Original Glazed Now® illuminated sign. Products other than our Original Glazed® doughnut generally are delivered to the hot shop already finished, although in some locations we perform some finishing functions at the hot shop, including application of icings and fillings, to provide consumers with elements of our Doughnut Theater® experience in hot shop locations.
 
     Fresh shops are similar to hot shops, but do not contain doughnut heating and finishing equipment. All of the doughnuts sold at fresh shops are delivered fully finished from the factory hub.
 
     Hot shops and fresh shops typically are located in shopping centers, and end cap spaces that can accommodate drive-through windows are particularly desirable. We also intend to build and test hot shops in a freestanding format on outparcels of shopping centers and other retail centers, as well as shops in pedestrian-rich environments including urban settings and college and university campuses. We view the hot shop and fresh shop formats as ways to achieve market penetration and greater consumer convenience in a variety of market sizes and settings. Our international franchisees led the initial development of the satellite shop formats, and we have been working to adapt their work to the domestic market.
 
     We opened six new Company-operated small retail shops in fiscal 2010, including one small factory store, three hot shops and two fresh shops. We converted one traditional factory store to a hot shop using tunnel oven equipment to reduce operating costs and increase the number of hours each day the store offers the Company’s hot Original Glazed® doughnuts, and closed 10 traditional factory stores and two factory stores that had been converted to satellites. We plan to open seven to ten small retail shops in fiscal 2011, all in the Southeastern United States. The average capital cost of the satellite stores we opened in fiscal 2010 was approximately $410,000, including equipment, furniture and fixtures, signage and building upfit. We are continuing to refine these shop models in order to reduce their initial capital cost.
 
10
 

 
     The following table sets forth the type and locations of Company stores as of January 31, 2010.
 
Number of Company Stores
State      Factory Stores      Hot Shops      Fresh Shops      Total
Alabama 3     3
District of Columbia 1 1
Florida 4   4
Georgia 6 4 10
Indiana 3 2 5
Kansas 3 3
Kentucky   3 3
Louisiana 1 1
Maryland 1 1
Michigan 3 3
Missouri 4 4
Mississippi 1 1
North Carolina 11 2 13
Ohio 6 6
South Carolina 2 1 3
Tennessee 7 4 11
Texas 3 3
Virginia 7 7  
West Virginia 1 1
Total 69 12 2 83
                           
     Changes in the number of Company stores during the past three fiscal years are summarized in the table below.
 
Number of Company Stores
Factory Stores      Hot Shops      Fresh Shops      Total
JANUARY 28, 2007   108 2 3 113
Opened 1 1
Closed (9 ) (9 )
Converted to satellites (3 ) 3
FEBRUARY 3, 2008 97 5 3 105
Opened
Closed (4 ) (2 ) (6 )
Refranchised (5 ) (1 ) (6 )
Converted from satellites 1 (1 )
Converted to satellites (6 ) 6
FEBRUARY 1, 2009 83 10 93
Opened 1 3 2 6
Closed (10 ) (2 ) (12 )
Refranchised (4 ) (4 )
Converted to satellites (1 ) 1
JANUARY 31, 2010 69 12   2   83  
                                   
   Off-Premises Sales
 
     Off-premises sales accounted for slightly over half of fiscal 2010 revenues in the Company Stores segment. Of the 83 stores operated by the Company as of January 31, 2010, 45 serve the off-premises distribution channel, including six commissaries. We sell our traditional yeast-raised and cake doughnuts in a variety of packages, generally containing from six to 15 doughnuts. In addition, we offer in the off-premises distribution channel a number of doughnuts and complementary products that we do not offer in our restaurants, including honeybuns, mini-crullers, fruit pies and a variety of snack doughnuts. These products typically have longer shelf lives than our traditional doughnuts and are packaged in snack bags or as individually wrapped snacks. Packaged products generally are marketed from Krispy Kreme branded displays, but occasionally are stocked on customers’ shelves. We strongly prefer marketing our products from our branded display tables because those displays give our products substantially greater visibility in the store than does on-shelf stocking. In addition to packaged products, we sell individual loose doughnuts through our in-store bakery (“ISB”) program, using branded self-service display cases that also contain branded packaging for loose doughnut sales.
 
11
 


     The off-premises distribution channel is composed of two principal customer groups: grocers/mass merchants and convenience stores. Substantially all sales to grocers and mass merchants consist of packaged products, while a significant majority of sales to convenience stores consists of loose doughnuts sold through the ISB program.
 
     We deliver doughnuts to off-premises customers using a fleet of delivery trucks operated by a commissioned employee sales force. We typically deliver products to packaged doughnut customers three times per week, on either a Monday/Wednesday/Friday or Tuesday/Thursday/Saturday schedule. ISB customers generally are serviced daily, six times per week. In addition to delivering product, our salespeople are responsible for merchandising our products in the displays and picking up unsold products for return to the Company shop. Our principal products are yeast-raised doughnuts having a short shelf-life, which results in unsold product costs in the off-premises distribution channel, most of which are absorbed by the Company.
 
     The off-premises channel is highly competitive, and the Company has not increased selling prices in recent years sufficiently to recover increased costs, particularly higher costs resulting from rising agricultural commodity costs and higher fuel costs. In addition, a number of customers, mainly convenience store chains, have converted from branded doughnut offerings to vertically-integrated private label systems.
 
     In response to these off-premises trends, the Company has introduced a small number of new, longer shelf-life branded products manufactured for the Company by third parties, has reemphasized marketing of existing longer shelf-life products made by the Company, and has developed order management systems to more closely match display quantities and assortments with consumer demand and reduce the amount of unsold product. The goals of these efforts are to reduce spoilage and to increase the average weekly sales derived from each off-premises distribution point. In addition, where possible, the Company has eliminated relatively lower sales volume distribution points and consolidated off-premises sales routes in order to reduce delivery costs and increase the average revenue per distribution point and the average revenue per mile driven.
 
   Store Operations
 
     General store operations. We outline standard specifications and designs for each Krispy Kreme store format and require compliance with our standards regarding the operation of each store, including, but not limited to, varieties of products, product specifications, sales channels, packaging, sanitation and cleaning, signage, furniture and fixtures, image and use of logos and trademarks, training and marketing and advertising. We currently are in the process of revising and improving these store operating manuals.
 
     Our stores generally operate seven days a week, excluding some major holidays. Traditionally, our domestic sales have been slower during the winter holiday season and the summer months.
 
     Quality standards and customer service. We encourage our employees to be courteous, helpful, knowledgeable and attentive. We emphasize the importance of performance by linking a portion of both a Company store manager’s and assistant manager’s incentive compensation to profitability and customer service. We also encourage high levels of customer service and the maintenance of our quality standards by frequently monitoring our stores through a variety of methods, including periodic quality audits, “mystery shoppers” and a toll-free consumer telephone number. In addition, our customer experience department handles customer comments and conducts routine satisfaction surveys of our on-premises customers.
 
     Management and staffing. Our President – U.S. Stores, along with other corporate officers responsible for store operations, is charged with corporate interaction with our regional vice presidents, market managers and store management. Through our regional vice presidents and market managers, each of whom is responsible for a specific geographic region, we communicate frequently with all store managers and their staff using store audits, weekly communications by telephone or e-mail and both scheduled and surprise store visits.
 
     We offer a comprehensive manager training program covering the critical skills required to operate a Krispy Kreme store and a training program for all positions in the store. The manager training program includes classroom instruction, computer-based training modules and in-store training.
 
12
 


     Our staffing varies depending on a store’s size, volume of business and number of sales channels. Stores, depending on the sales channels they serve, have employees handling on-premises sales, processing, production, bookkeeping, sanitation and delivery. Hourly employees, along with route sales personnel, are trained by local store management through hands-on experience and training manuals.
 
     In fiscal 2011, we plan to enhance our shops’ timekeeping systems by deploying new labor scheduling technology to help our shop managers better match staffing levels with consumer traffic.
 
     We currently operate Company stores in 18 states and the District of Columbia. Over time, we plan to refranchise all of our stores in markets outside our 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. Of the 83 stores operated by the Company as of January 31, 2010, approximately 25 stores having fiscal 2010 sales of approximately $70.2 million are candidates for refranchising at the appropriate time.
 
Domestic Franchise Business Segment
 
     The Domestic Franchise segment consists of the Company’s domestic store franchise operations. This segment derives revenue principally from initial development and franchise fees related to new stores and from royalties on sales by franchise stores. In October 2007, the Company decided to waive initial development and franchise fees for all new stores opened prior to October 1, 2010 by existing franchisees as of October 2007. Domestic Franchise direct operating expenses include costs incurred to recruit new domestic franchisees, to assist with domestic store openings, to assist in the development of domestic marketing and promotional programs, and to monitor and aid in the performance of domestic franchise stores, as well as direct general and administrative expenses and certain allocated corporate costs.
 
     As of January 31, 2010, domestic franchisees operated 141 stores. During the year then ended, domestic franchisees opened 12 stores and closed seven stores. Existing development and franchise agreements for territories in the United States provide for the development of approximately 40 additional stores in fiscal 2011 and thereafter.
 
     Domestic franchise stores include stores that we historically have referred to as associate stores and area developer stores, as well as franchisee stores that have opened since the beginning of calendar 2008. The rights of our franchisees to build new stores and to use the Krispy Kreme trademark and related marks vary by franchisee type and are discussed below.
  • Associates. Associate franchisees are located principally in the Southeast, and their stores have attributes that are similar to Company stores located in the Southeast. Associates typically have many years of experience operating Krispy Kreme stores and selling Krispy Kreme branded products both on-site and off-premises in defined territories. This group of franchisees generally concentrates on growing sales within the current base of stores rather than developing new stores. Under their associate license agreements, associates generally have the exclusive right to open new stores in their geographic territories, but they are not obligated to develop additional stores. We cannot grant new franchises within an associate’s territory during the term of the license agreement. Further, we generally cannot sell within an associate’s territory any Krispy Kreme branded products, because we have granted those exclusive rights to the franchisee for the term of the license agreement.

    Associates typically have license agreements that expire in 2020. Associates generally pay royalties of 3.0% of on-premises sales and 1.0% of all other sales. Some associates also contribute 0.75% of all sales to the Company-administered public relations and advertising fund, which we refer to as the Brand Fund.
     
  • Area developers. In the mid-1990s, we franchised territories in the United States, usually defined by metropolitan statistical areas, pursuant to area development agreements. These development agreements established the number of stores to be developed in an area, and the related franchise agreements governed the operation of each store. Most of the area development agreements have expired or have been terminated. Under their franchise agreements, area developers generally have the exclusive right to sell Krispy Kreme branded products within a one-mile radius of their stores and in off-premises accounts that they have serviced in the last 12 months.
13
 


The franchise agreements for area developers have a 15-year term that may be renewed by the Company. These franchise agreements provide for royalties of 4.5% of sales and contributions to the Brand Fund of 1.0% of sales. In fiscal 2009, the Company elected to reduce temporarily the Brand Fund contribution rate for domestic area developers to 0.75%. For fiscal 2009, the Company elected to reduce the royalty rate payable by area developers on off-premises sales from 4.5% to 3.5%, and for fiscal 2010, the Company elected to reduce the royalty rate on off-premises sales to 2.5%. The Company has informed its domestic area developers that it will reduce the royalty rate on off-premises sales to 1.75% for fiscal 2011. Off-premises sales represented approximately 25% of area developer sales.
 
As of January 31, 2010, we had an equity interest in two of the domestic area developers. Where we are an equity investor in an area developer, we contribute equity or guarantee debt or lease commitments of the franchisee generally proportionate to our ownership interest. See Note 18 to the consolidated financial statements appearing elsewhere herein for additional information on our franchisee investments. We do not currently expect to own any equity interests in any future franchisees.
  • Recent franchisees. During the past two fiscal years, the Company has signed new franchise agreements with respect to 31 stores in the United States. Six of these recent franchise agreements resulted from the expiration of existing agreements, two were related to new stores opened by persons who were franchisees as of the end of fiscal 2008, and two resulted from a change in ownership. The remaining 21 agreements were related to refranchising, in which the Company refranchised Company markets to franchisees. Of the agreements related to refranchising, six were related to existing Company stores sold to franchisees and 15 were related to stores opened by new franchisees. Some of the recent franchisees have signed development agreements, which require the franchisee to build a specified number of stores in an exclusive geography within a specified time period, usually five years or less. The franchise agreements with this group of franchisees have a 15-year term, renewable at the Company’s discretion, and they generally do not contemplate off-premises business. Additionally, these franchise agreements generally allow the Company to sell Krispy Kreme branded products in close geographic proximity to the franchisees’ stores. These franchise agreements and development agreements are used for all new franchisees and, in general, for the renewal of older franchise agreements and associate license agreements. We are charging recent franchisees the same royalty and Brand Fund rates as those charged to area developer franchisees.
14
 

 
     The following table sets forth the type and locations of domestic franchise stores as of January 31, 2010.
 
Number of Domestic Franchise Stores
State       Factory       Hot Shop       Fresh Shop       Total
Alabama 5 2 7
Arkansas 2 2
Arizona 2 9 11
California 11 3 14
Connecticut 1 3 4
Colorado 2 2
Florida 11 5 1 17
Georgia 7 4 11
Hawaii 1 1
Iowa 1 1
Idaho 1 1
Illinois 4 4
Louisiana 3 3
Missouri 3 3
Mississippi 2 2
North Carolina 6 1 7
Nebraska 1 1
New Mexico 1 1
Nevada 3 1 2 6
New York 1 1 2
Oklahoma 3 3
Oregon 2 2
Pennsylvania 4 1 1 6
South Carolina 6 2 8
Tennessee 2 2
Texas 8 1 9
Utah 2 2
Wisconsin 1 1
Washington 8 8
Total 104    14    23    141
 
     Changes in the number of domestic franchise stores during the past three fiscal years are summarized in the table below.
 
Number of Domestic Franchise Stores
      Factory       Hot Shop       Fresh Shop       Kiosks       Total
JANUARY 28, 2007 137 13 14 1   165
Opened   3 3
Closed (17 ) (3 ) (2 ) (1 ) (23 )
Converted to satellites (2 ) 2
FEBRUARY 3, 2008 118 15 12 145
Opened 1 1 4 6
Closed (17 ) (4 ) (21 )
Refranchised 1 1 2
Converted from satellites 2 (2 )
Converted to satellites (1 ) 1
Change in store type 2 (2 )
FEBRUARY 1, 2009 104 13 15 132
Opened 3 9 12
Closed (4 )   (3 ) (7 )
Refranchised 4 4
Converted from satellites
Converted to satellites (3 ) 2 1
Change in store type (1 ) 1
JANUARY 31, 2010     104          14             23      141
 
15
 


     Most of our domestic franchisees serve the off-premises distribution channel in addition to their on-premises operations, although off-premises sales by domestic franchisees generally comprise a smaller percentage of total sales than do off-premises sales at Company stores. For the year ended January 31, 2010, approximately 27% of sales by domestic franchisees were made through off-premises channels.
 
     We generally assist our franchisees with issues such as operating procedures, advertising and marketing programs, public relations, store design, training and technical matters. We also provide an opening team to provide on-site training and assistance both for the week prior to and during the first week of operation for each initial store opened by a new franchisee. The number of opening team members providing this assistance is reduced with each subsequent store opening for an existing franchisee.
 
International Franchise Business Segment
 
     The International Franchise segment consists of the Company’s international store franchise operations. The franchise agreements with international area developers typically provide for the payment of royalties of 6.0% of all sales, contributions to the Brand Fund of 0.25% of sales and one-time development and franchise fees ranging from $15,000 to $50,000 per store. Direct operating expenses for this business segment include costs incurred to recruit new international franchisees, to assist with international store openings, to assist in the development of international marketing and promotional programs, and to monitor and aid in the performance of international franchise stores, as well as direct general and administrative expenses and allocated corporate costs.
 
     The operations of international franchise stores are similar to those of domestic stores, except that substantially all of the sales of international franchise stores are made to on-premises customers. International franchisees generally have adopted varieties of the hub and spoke business model, in which centralized factory stores or commissaries provide fresh doughnuts to satellite locations. Internationally, the fresh shop satellite format predominates, and shops typically are located in pedestrian-rich environments, including transportation hubs and shopping malls. Some of our international franchisees have developed small kiosk formats, which also are typically located in transportation hubs.
 
     Our International Franchisees have renewable development agreements regarding the build-out of Krispy Kreme stores in their territories. Territories are typically country or region-wide, but for large countries, the development territory may encompass only a portion of a country. The international franchise agreements have a renewable 15-year term. These agreements generally do not contemplate off-premises sales, although our franchisees in Australia and the United Kingdom make such sales. Under these agreements, the Company retains the right to use the trademarks at locations other than the franchise stores.
 
     Product offerings at shops outside the United States include our signature Original Glazed® doughnut, a core set of doughnut varieties offered in our domestic shops, and a complementary set of localized doughnut varieties tailored to meet the unique taste preferences and dietary norms in the market. Often, our glazes, icings and filling flavors are tailored to meet local palette preferences. We work closely with our franchisees outside the United States to conduct marketing research to understand local tastes and usage occasions, which drives development of new products and marketing approaches.
 
     Internationally, we believe that complementary products such as baked goods, ice cream and other treat products could play an increasingly important role for our franchisees as they penetrate their markets and further establish the Krispy Kreme brand. These items offer franchisees the opportunity to fill and/or strengthen day part offerings to meet a broader set of customer needs. Currently, Australia and Mexico offer their customers ice cream products including cones, cups, sundaes and milkshakes. In fiscal 2010, we developed a baked platform for international markets designed to meet needs across a broad set of markets. Testing of a baked program was launched in fiscal 2010 in Australia, and there are plans to conduct additional testing in international markets during fiscal 2011.
 
     Beverage offerings at shops outside the United States include a complete program consisting of hot and iced espresso based beverages, frozen drinks, teas, juices, sodas, water and bottled or canned beverages. Drip coffee is also offered in many international markets, but represents a much smaller component of the beverage program relative to the United States due to international consumer preferences. In-store consumption occasions often play a key role in total beverage consumption internationally due to store locations and consumer habits, and we work closely with international franchisees to adapt the store environment and product offerings to take advantage of this dynamic. We continue to look for ways to improve our beverage program and bring cross-market efficiencies to international franchisees.
 
16
 


     Markets outside the United States have been a significant source of growth, all of which we plan to develop by franchising. In the past two years, we have focused our international development efforts primarily on opportunities in markets in Asia and the Middle East. In addition to ongoing development efforts in these areas, we plan to begin initial franchisee recruitment efforts in Europe in fiscal 2011. Existing development and franchise agreements for territories outside the United States provide for the development of over 155 additional stores in fiscal 2011 and thereafter.
 
     The types and locations of international franchise stores as of January 31, 2010 are summarized in the table below.
 
Number of International Franchise Stores
Country       Factory       Hot Shop       Fresh Shop       Kiosk       Total
Australia 6 4 24 20 54
Bahrain 2 2 4 8
Canada 5 5
China 1 1
Indonesia 3 2 3 8
Japan 9 3 12
Kuwait 3 21 3 27
Lebanon 2 4 3 9
Malaysia 2 1 1 4
Mexico 5 1 22 18 46
Philippines 4   3 8 1 16
The Commonwealth of Puerto Rico 3 3
Qatar 2 3 1 6
The Republic of Korea 28 1 7 36
The Kingdom of Saudi Arabia 8   44   7 59
Turkey 1 1   2
The United Arab Emirates 2 19 1 22
The United Kingdom 9 4 20   7 40
Total    95    14    180    69    358
 
     Changes in the number of international franchise stores during the past three fiscal years are summarized in the table below.
 
Number of International Franchise Stores
      Factory       Hot Shops       Fresh Shops       Kiosks       Total
JANUARY 28, 2007 51 23 26 17 117
Opened 32 4 27 22 85
Closed (1 ) (2 ) (3 )
Converted to satellites (2 ) 1 1
FEBRUARY 3, 2008 80 28 52   39 199
Opened   18   2 75 19 114
Closed (6 ) (4 ) (5 ) (4 ) (19 )
Refranchised 4 4  
Converted to satellites (2 )   2
Change in store type 2 (2 )
FEBRUARY 1, 2009 94 26   126 52   298
Opened 9 3   52 18 82
Closed (7 ) (9 ) (6 ) (22 )
Converted to satellites (1 )   1
Change in store type (15 ) 10 5
JANUARY 31, 2010       95            14            180        69   358  
 
     The Company has equity interests in the franchisees operating stores in Mexico and Western Canada. The Company currently does not expect to own equity interests in franchisees formed in the future.
 
17
 


KK Supply Chain Business Segment
 
     The Company operates an integrated supply chain to help maintain the consistency and quality of products throughout the Krispy Kreme system. The KK Supply Chain segment buys and processes ingredients it uses to produce doughnut mixes and manufactures doughnut-making equipment that all factory stores are required to purchase.
 
     The Company manufactures doughnut mix at its facility in Winston-Salem, North Carolina. In February 2009, the Company entered into an agreement with an independent food company to manufacture certain doughnut mixes for regions outside the Southeastern United States and to provide doughnut mix production in the event of a disruption of business at the Winston-Salem facility. In addition, the Company has for several years utilized contract mix manufacturers in the United Kingdom and in Australia to blend mixes for certain international franchisees using mix concentrate supplied from Winston-Salem.
 
     The KK Supply Chain segment also purchases and sells key supplies, including icings and fillings, other food ingredients, juices, signage, display cases, uniforms and other items to both Company and franchisee-owned stores. In addition, through KK Supply Chain, the Company utilizes volume-buying power, which the Company believes helps lower the cost of supplies to stores and enhances profitability. KK Supply Chain operates a distribution center which supplies domestic stores in the Eastern United States and certain international franchise stores with key supplies. The Company has subcontracted with an independent distributor to supply the domestic stores not supplied from the Winston-Salem distribution facility, which generally consist of stores west of the Mississippi River.
 
     Substantially all domestic stores purchase all of their ingredients and supplies from the KK Supply Chain, while KK Supply Chain sales to international franchise stores are comprised principally of sales of doughnut mix. The Company is actively studying its distribution system, including its export practices, to reduce the delivered cost of products to both Company and franchise stores. The Company expects to employ increased local sourcing for international franchisees in order to reduce costs.
 
     The Supply Chain business unit is volume-driven, and its economics are enhanced by the opening of new stores and the growth of sales by existing stores.
 
Revenues by Geographic Region
 
     Set forth below is a table presenting our revenues by geographic region for fiscal 2010, 2009 and 2008. Revenues by geographic region are presented by attributing revenues from customers on the basis of the location to which the Company’s products are delivered or, in the case of franchise segment revenues, the location of the franchise store from which the franchise revenue is derived.
 
Year Ended
Jan. 31,
2010
      Feb. 1,
2009
      Feb. 3,
2008
      (In thousands)
Revenues by geographic region:
       United States $ 314,528 $ 333,599 $ 382,570
       Other North America 4,231 14,513 14,995
       Asia/Pacific 15,469 18,927 15,070
       Middle East 8,852 10,477 10,210
       Europe 3,440 8,006 7,525
              Total revenues $     346,520 $    385,522 $    430,370
 
Marketing
 
     Krispy Kreme’s approach to marketing is a natural extension of our brand equity, brand attributes, relationship with our customers and our values.
 
18
 


   Domestic
 
     To build our brand and drive our sales in a manner aligned with our brand values, we have focused our domestic marketing activities in the following areas:
 
     Store Experience. Our factory stores and hot shops are where most customers first experience a hot Original Glazed® doughnut. Customers know that when our Hot Krispy Kreme Original Glazed Now® sign in the store window is illuminated, they can enjoy a hot Original Glazed® doughnut. We believe this experience begins our relationship with our customers and forms the foundation of the Krispy Kreme experience.
 
     Relationship Marketing. Many of our brand-building activities are grassroots-based and focused on building customer and community relevancy by developing relationships with our constituents — consumers, local non-profit organizations and businesses. Specific initiatives include:
  • Good neighbor product deliveries to create trial uses;
     
  • Sponsorship of local events and nonprofit organizations;
     
  • Friends of Krispy Kreme eNewsletters sent to customers registered to receive monthly updates about new products, promotions and store openings;
     
  • Fundraising programs designed to assist local charitable organizations in raising money for their non-profit causes; and
     
  • Digital marketing efforts including use of social media sites such as Facebook and Twitter to communicate product and promotional activity, new store openings and local store marketing programs. We have over 1.2 million fans on Facebook and are ranked #17 of the Facebook 50, The Big Money’s ranking of the 50 companies making best use of Facebook.
     Public Relations. We utilize media relations, product placement and event marketing as vehicles to generate brand awareness and trial usage for our products. Our public relations activity creates opportunities for media and consumers to interact with the Krispy Kreme brand. Our key messages are as follows:
  • Krispy Kreme doughnuts are the preferred doughnut of choice for people nationwide; and
     
  • Krispy Kreme is a trusted food retailer with a long history of providing superior, innovative products and delivering quality customer service.
     Advertising and Sales Promotions. Grass roots marketing has been central to building our brand awareness. Although our marketing strategy has not historically employed traditional advertising, we occasionally utilize free-standing newspaper inserts, direct mail, radio, television and/or sales promotions to generate awareness and usage of our products. Advertising and sales promotion activity center around our limited time offerings and shaped doughnut varieties, such as Valentine’s Day Hearts, Fall Footballs, Halloween Pumpkins and Holiday Snowmen. Krispy Kreme encourages its customers to stay engaged with the Company and its promotions through its Friends of Krispy Kreme program and social media activity on Facebook and Twitter. We expect broadcast media advertising will play an increasing role in our advertising programs as the number of stores in a market increases.
 
   International
 
     Krispy Kreme's approach to international marketing utilizes many of the same elements as the domestic marketing approach described above to ensure global consistency. We provide strategic leadership, marketing expertise and consulting on local market issues through dedicated regional resources. In partnership with our franchisees, we assist in local marketing planning, product offering innovation, promotional activation and consumer messaging. In addition, we develop cross-market product, promotional and store event programs to supplement local marketing initiatives and bring marketing efficiencies to international franchisees. During fiscal 2010, we initiated a new occasion-based brand thematic campaign with tools to drive consumer brand affinity, build the brand personality and drive purchase frequency. In conjunction with this campaign, we launched a promotional program entitled the "Krispy Kreme International Fave Fan Search" to identify our most passionate fans in nine countries around the world. Program participants submitted entries describing how Krispy Kreme had made their lives special, with winners selected in each country through online voting. Winners from each country participated in our Fave Fan Celebration in Winston-Salem in March 2010, and each designed their own Krispy Kreme doughnut. In addition, we developed exciting new product promotions for Valentine’s Day, Halloween and holiday/Winter that were utilized in most international markets.
 
19
 


   Brand Fund
 
     We administer domestic and international public relations and advertising funds, which we refer to as the Brand Funds. Franchise agreements with domestic area developers and international area developers require these franchisees to contribute 1.0% and 0.25% of their sales, respectively, to the Brand Fund. Company stores contribute to the Brand Fund on the same basis as domestic area developers, as do some associate franchisees. In fiscal 2009, the Company reduced the contribution from its associate and domestic area developer franchisees to 0.75%. Proceeds from the Brand Fund are utilized to develop programs to increase sales and brand awareness and build brand affinity. Brand Fund proceeds are also utilized to measure consumer feedback and the performance of our products and stores. In fiscal 2010, we and our domestic and international franchisees contributed approximately $2.8 million to the Brand Funds.
 
Competition
 
     Our competitors include retailers of doughnuts and snacks sold through convenience stores, supermarkets, restaurants and retail stores. We compete against Dunkin’ Donuts, which has the largest number of outlets in the doughnut retail industry, as well as against Tim Hortons and regionally and locally owned doughnut shops and distributors. Dunkin’ Donuts and Tim Hortons have substantially greater financial resources than we do and are expanding to other geographic regions, including areas where we have a significant store presence. We also compete against other retailers who sell sweet treats such as cookie stores and ice cream stores. We compete on elements such as food quality, convenience, location, customer service and value. Customer service, including frequency of deliveries and maintenance of fully stocked shelves, is an important factor in successfully competing for convenience store and grocery/mass merchant business. There is an industry trend moving towards expanded fresh product offerings at convenience stores during morning and evening drive times, and products are either sourced from a central commissary or brought in by local bakeries.
 
     In the packaged doughnut market, an array of doughnuts is typically merchandised on a free-standing branded display. We compete for sales with many sweet treats, including those made by well-known producers, such as Dolly Madison, Entenmann’s and Hostess, and regional brands.
 
     Internationally, our competitors include a broad set of global, regional and local retailers of doughnuts and treats such as Dunkin’ Donuts, Mister Donut and Donut King.
 
     We view the uniqueness of our Original Glazed® doughnut as an important factor that distinguishes our brand from competitors, both in the doughnut category and in sweet goods generally.
 
Trademarks and Trade Names
 
     Our doughnut shops are operated under the Krispy Kreme® trademark, and we use many federally registered trademarks and service marks, including Krispy Kreme Original Glazed® and Hot Krispy Kreme Original Glazed Now® and the logos associated with these marks. We have also registered some of our trademarks in approximately 40 other countries. We generally license the use of these trademarks to our franchisees for the operation of their doughnut shops.
 
     Although we are not aware of anyone else using “Krispy Kreme” or “Hot Krispy Kreme Original Glazed Now” as a trademark or service mark in the United States, we are aware that some businesses are using “Krispy” or a phonetic equivalent, such as “Crispie Creme,” as part of a trademark or service mark associated with retail doughnut stores. There may be similar uses of which we are unaware that could arise from prior users. When necessary, we aggressively pursue persons who use our trademarks without our consent.
 
Government Regulation
 
     Environmental regulation. The Company is subject to a variety of federal, state and local environmental laws and regulations. Except for the legal and settlement costs totaling approximately $2.5 million in fiscal 2010 associated with the settlement of litigation relating to alleged damage to a sewer system in Fairfax Count, Virginia, as described in Note 12 to the Company’s consolidated financial statements appearing elsewhere herein, such laws and regulations have not had a significant impact on the Company’s capital expenditures, earnings or competitive position.
 
20
 


     Local regulation. Our stores, both those in the United States and those in international markets, are subject to licensing and regulation by a number of government authorities, which may include health, sanitation, safety, fire, building and other agencies in the states or municipalities in which the stores are located. Developing new doughnut stores in particular areas could be delayed by problems in obtaining the required licenses and approvals or by more stringent requirements of local government bodies with respect to zoning, land use and environmental factors. Our agreements with our franchisees require them to comply with all applicable federal, state and local laws and regulations, and indemnify us for costs we may incur attributable to their failure to comply.
 
     Food product regulation. Our doughnut mixes are produced at our manufacturing facility in Winston-Salem, North Carolina. Production at and shipments from our Winston-Salem facility are subject to the applicable federal and state governmental rules and regulations. Similar state regulations may apply to products shipped from our doughnut stores to convenience stores or groceries/mass merchants.
 
     As is the case for other food producers, numerous other government regulations apply to our products. For example, the ingredient list, product weight and other aspects of our product labels are subject to state and federal regulation for accuracy and content. Most states periodically check products for compliance. The use of various product ingredients and packaging materials is regulated by the United States Department of Agriculture and the Federal Food and Drug Administration. Conceivably, one or more ingredients in our products could be banned, and substitute ingredients would then need to be identified.
 
     International trade. The Company conducts business outside the United States in compliance with all foreign and domestic laws and regulations governing international trade. In connection with our international operations, we typically export our products, principally our doughnut mixes (or concentrate which is combined with other ingredients sourced locally to manufacture mix) to our franchisees in markets outside the United States. Numerous government regulations apply to both the export of food products from the United States as well as the import of food products into other countries. If one or more of the ingredients in our products are banned, alternative ingredients would need to be identified. Although we intend to be proactive in addressing any product ingredient issues, such requirements may delay our ability to open stores in other countries in accordance with our desired schedule.
 
     Franchise regulation. We must comply with regulations adopted by the Federal Trade Commission (the “FTC”) and with several state and foreign laws that regulate the offer and sale of franchises. The FTC’s Trade Regulation Rule on Franchising (“FTC Rule”) and certain state and foreign laws require that we furnish prospective franchisees with a franchise disclosure document containing information prescribed by the FTC Rule and applicable state and foreign laws and regulations. We register in domestic and foreign jurisdictions that require registration for the sale of franchises. Our domestic franchise disclosure document complies with FTC disclosure requirements, and our international disclosure documents comply with applicable requirements.
 
     We also must comply with a number of state and foreign laws that regulate some substantive aspects of the franchisor-franchisee relationship. These laws may limit a franchisor’s ability to: terminate or not renew a franchise without good cause; interfere with the right of free association among franchisees; disapprove the transfer of a franchise; discriminate among franchisees with regard to charges, royalties and other fees; and place new stores near existing franchises.
 
     Bills intended to regulate certain aspects of franchise relationships have been introduced into the United States Congress on several occasions during the last decade, but none have been enacted.
 
     Employment regulations. We are subject to state and federal labor laws that govern our relationship with employees, such as minimum wage requirements, overtime and working conditions and citizenship requirements. Many of our store employees are paid at rates related to the federal minimum wage. Accordingly, further increases in the minimum wage could increase our labor costs. Furthermore, the work conditions at our facilities are regulated by the Occupational Safety and Health Administration and are subject to periodic inspections by this agency.
 
     Other regulations. We are subject to a variety of consumer protection and similar laws and regulations at the federal, state and local level. Failure to comply with these laws and regulations could subject us to financial and other penalties. We have several contracts to serve United States military bases, which require compliance with certain applicable regulations. The stores which serve these military bases are subject to health and cleanliness inspections by military authorities. We are also subject to federal and state environmental regulations, but we currently believe that these will not have a material effect on our operations.
 
21
 


Employees
 
     We employ approximately 3,570 people. Of these, approximately 190 are employed in our headquarters and administrative offices and approximately 150 are employed in our manufacturing and distribution center. In our Krispy Kreme stores, we have approximately 3,230 employees. Of our total workforce, approximately 2,460 are full-time employees, of which approximately 460 are managers and supervisors, including approximately 330 store managers and supervisors.
 
     We are not a party to any collective bargaining agreement although we have experienced occasional unionization initiatives. We believe our relationships with our employees generally are good.
 
Available Information
 
     We maintain a website at www.krispykreme.com. The information on our website is available for information purposes only and is not incorporated by reference in this Annual Report on Form 10-K.
 
     We make available on or through our website certain reports and amendments to those reports, if applicable, that we file with or furnish to the SEC in accordance with the Exchange Act. These include our annual reports on Form 10-K, our quarterly reports on Form 10-Q, our current reports on Form 8-K and amendments to those reports. We make this information available on our website free of charge as soon as reasonably practicable after we electronically file the information with, or furnish it to, the SEC.
 
     In addition, many of our corporate governance documents are available on our website. Our Nominating and Corporate Governance Committee Charter is available at www.krispykreme.com/gov_charter.pdf, our Compensation Committee Charter is available at www.krispykreme.com/comp_charter.pdf, our Audit Committee Charter is available at www.krispykreme.com/audit_charter.pdf, our Corporate Governance Guidelines are available at www.krispykreme.com/corpgovernance.pdf, our Code of Business Conduct and Ethics is available at www.krispykreme.com/code_of_ethics.pdf, and our Code of Ethics for Chief Executive and Senior Financial Officers is available at www.krispykreme.com/officers_ethics.pdf. Each of these documents is available in print to any shareholder who requests it by sending a written request to Krispy Kreme Doughnuts, Inc., 370 Knollwood Street, Suite 500, Winston-Salem, NC 27103, Attention: Secretary.
 
Item 1A. RISK FACTORS.
 
     Our business, operations and financial condition are subject to various risks. Some of these risks are described below, and you should take such risks into account in evaluating us or any investment decision involving our Company. This section does not describe all risks that may be applicable to us, our industry or our business, and it is intended only as a summary of certain material risk factors. More detailed information concerning the risk factors described below is contained in other sections of this Annual Report on Form 10-K.
 
RISKS RELATING TO OUR BUSINESS
 
We have experienced declines in revenues and have incurred net losses in each of the last three fiscal years and may experience further declines and losses in the future.
 
     We incurred net losses of $67.1 million, $4.1 million and $157,000 in fiscal 2008, 2009 and 2010, respectively. We also experienced a decline in revenues in each of the last three fiscal years. The revenue decline reflects fewer Company stores in operation, a decrease in off-premises sales at Company Stores, a decline in domestic royalty revenues and in sales of mixes and other ingredients resulting from lower sales by the Company’s domestic franchisees. The reduction in revenues also reflects, to a limited extent, decisions by the Company to reduce certain royalties and fees charged to franchisees, as well as decisions to lower selling prices of certain goods sold to franchisees. Lower revenues have adversely affected operating margins because of the fixed or semi-fixed nature of many of our direct operating expenses. In addition, we have recorded significant asset impairment charges, principally related to underperforming Company stores and, in fiscal 2008, a manufacturing and distribution facility we divested. We may experience further revenue declines, asset impairments and net losses in the future.
 
22
 


Store profitability is sensitive to changes in sales volume.
 
     Each factory store has significant fixed or semi-fixed costs, and margins and profitability are significantly affected by doughnut sales volume. Our average weekly sales per store have declined over the past three years. We are in the process of reevaluating our business and have taken steps to improve our sales. There can be no assurance, however, that these steps will produce the desired results. Because significant fixed and semi-fixed costs prevent us from reducing our operating expenses in proportion with declining sales, our earnings are negatively impacted if sales decline.
 
     A number of factors have historically affected, and will continue to affect, our sales results, including, among other factors:
  • Consumer trends, preferences and disposable income;
     
  • Our ability to execute our business strategy effectively;
     
  • Competition;
     
  • General regional and national economic conditions; and
     
  • Seasonality and weather conditions.
     Changes in our sales results could cause the price of our common stock to fluctuate substantially.
 
We rely in part on our franchisees. Disputes with our franchisees, or failures by our franchisees to operate successfully, to develop or finance new stores or build them on suitable sites or open them on schedule, could adversely affect our growth and our operating results.
 
     Franchisees, which are all independent operators and not Krispy Kreme employees, contributed (including through purchases from KK Supply Chain) approximately 29% of our total revenues in fiscal 2010. We rely in part on these franchisees and the manner in which they operate their locations to develop and promote our business. We occasionally have disputes with franchisees. Future disputes could materially adversely affect our business, financial condition and results of operations. We provide training and support to franchisees, but the quality of franchise store operations may be diminished by any number of factors beyond our control. The failure of our franchisees to operate franchises successfully could have a material adverse effect on us, our reputation and our brands, and could materially adversely affect our business, financial condition and results of operations. In addition, although we do not control our franchisees and they operate as independent contractors, actions taken by any of our franchisees may be seen by the public as actions taken by us, which, in turn, could adversely affect our reputation or brands.
 
     Reduced access to financing by our franchisees on reasonable terms, which the Company believes has occurred in the past two years, could adversely affect our future operations by limiting franchisees’ ability to open new stores or leading to additional franchisee store closures, which would in turn reduce our franchise revenues and KK Supply Chain revenues. Most development agreements specify a schedule for opening stores in the territory covered by the agreement. These schedules form the basis for our expectations regarding the number and timing of new Krispy Kreme store openings. In the past, Krispy Kreme has agreed to extend or modify development schedules for certain franchisees and may do so in the future.
 
     Franchisees opened 94 stores and closed 29 stores in fiscal 2010. Royalty revenues and most KK Supply Chain revenues are directly related to sales by franchise stores and, accordingly, the success of franchisees’ operations has a direct effect on our revenues, results of operations and cash flows.
 
A portion of our growth strategy depends on opening new Krispy Kreme stores internationally. Our ability to expand our store base is influenced by factors beyond our and our franchisees’ control, which may slow store development and impair our strategy.
 
     As we work to stabilize our operations and to refine our store format for new domestic stores, we do not expect that we or our franchisees will open a significant number of domestic factory stores in the near future, although we currently plan to open a modest number of new Company-operated satellite stores in fiscal 2011, and domestic franchisees also may open additional satellite stores. Our recent growth strategy has depended on the opening of new Krispy Kreme stores internationally. Our ability to expand our store base both domestically and internationally is influenced by factors beyond our and our franchisees’ control, which may slow store development and impair our strategy. The success of these new stores will be dependent in part on a number of factors, which neither we nor our franchisees can control.
 
23
 


Our new domestic store operating model may not be successful.
 
     We are working to refine our domestic store operating model to focus on small retail shops, including both satellite shops and shops that manufacture doughnuts but which are smaller and have lower capacity than traditional factory stores. Satellite stores in a market are provided doughnuts from a single traditional factory store or commissary at which all doughnut production for the market takes place. The Company currently plans to open a modest number of new Company-operated satellite stores in fiscal 2011, and domestic franchisees also may open additional satellite stores and a small number of factory stores, as we work to refine our store formats for new domestic stores. However, we do not expect that we or our franchisees will open a significant number of domestic factory stores in the near future. We cannot predict whether this new model will be successful in increasing our profitability.
 
Political, economic, currency and other risks associated with our international operations could adversely affect our and our international franchisees’ operating results.
 
     As of January 31, 2010, there were 358 Krispy Kreme stores operated outside of the United States, all of which were operated by franchisees. Our revenues from international franchisees are exposed to the potentially adverse effects of our franchisees’ operations, political instability, currency exchange rates, local economic conditions and other risks associated with doing business in foreign countries. Royalties are based on a percentage of net sales generated by our foreign franchisees’ operations. Royalties payable to us by our international franchisees are based on a conversion of local currencies to U.S. dollars using the prevailing exchange rate, and changes in exchange rates could adversely affect our revenues. To the extent that the portion of our revenues generated from international operations increases in the future, our exposure to changes in foreign political and economic conditions and currency fluctuations will increase.
 
     We typically export our products, principally our doughnut mixes and doughnut mix concentrates, to our franchisees in markets outside the United States. Numerous government regulations apply to both the export of food products from the United States as well as the import of food products into other countries. If one or more of the ingredients in our products are banned, alternative ingredients would need to be identified. Although we intend to be proactive in addressing any product ingredient issues, such requirements may delay our ability to open stores in other countries in accordance with our desired schedule.
 
Our profitability is sensitive to changes in the cost of raw materials.
 
     Although we utilize forward purchase contracts and futures contracts and options on such contracts to mitigate the risks related to commodity price fluctuations, such contracts do not fully mitigate commodity price risk, particularly over the longer term. In addition, the portion of our anticipated future commodity requirements that is subject to such contracts varies from time to time.
 
     Flour, shortening and sugar are our three most significant ingredients. The prices of wheat and soybean oil, which are the principal components of flour and shortening respectively, reached record highs in fiscal 2009. Sugar prices reached a multi-year high in fiscal 2010. Adverse changes in commodity prices could adversely affect the Company’s profitability and liquidity.
 
We are the exclusive supplier of doughnut mixes or mix concentrates to all Krispy Kreme stores worldwide. We also supply other key ingredients and flavors to all domestic Krispy Kreme Company stores. If we have any problems supplying these ingredients, our and our franchisees’ ability to make doughnuts will be negatively affected.
 
     We are the exclusive supplier of doughnut mixes for many domestic and international Krispy Kreme stores. As to other stores, we are the exclusive supplier of doughnut mix concentrates that are blended with other ingredients to produce doughnut mixes. We also are the exclusive supplier of other key ingredients and flavors to all domestic Company stores, most domestic franchise stores and some international franchise stores. We manufacture the doughnut mixes and concentrates at our mix manufacturing facility located in Winston-Salem, North Carolina. We distribute doughnut mixes and other key ingredients and flavors from our distribution center in Winston-Salem and using an independent contract distributor for Krispy Kreme shops west of the Mississippi River. We have a backup source to manufacture our doughnut mixes in the event of a loss of our Winston-Salem facility; this backup source currently produces mix for us for distribution in most Krispy Kreme stores west of the Mississippi River. Nevertheless, an interruption of production capacity at our manufacturing facility could impede our ability or that of our franchisees to make doughnuts. In addition, in the event that any of our supplier relationships terminate unexpectedly, even where we have multiple suppliers for the same ingredient, we may not be able to obtain adequate quantities of the same high-quality ingredient at competitive prices.
 
24
 


We are the only manufacturer of substantially all of our doughnut-making equipment. If we have any problems producing this equipment, our stores’ ability to make doughnuts will be negatively affected.
 
     We manufacture our custom doughnut-making equipment in one facility in Winston-Salem, North Carolina. Although we have limited backup sources for the production of our equipment, obtaining new equipment quickly in the event of a loss of our Winston-Salem facility would be difficult and would jeopardize our ability to supply equipment to new stores or new parts for the maintenance of existing equipment in established stores on a timely basis.
 
We have only one supplier of glaze flavoring, and any interruption in supply could impair our ability to make our signature hot Original Glazed® doughnut.
 
     We utilize a sole supplier for our glaze flavoring. Any interruption in the distribution from our current supplier could affect our ability to produce our signature hot Original Glazed® doughnut.
 
We are subject to franchise laws and regulations that govern our status as a franchisor and regulate some aspects of our franchise relationships. Our ability to develop new franchised stores and to enforce contractual rights against franchisees may be adversely affected by these laws and regulations, which could cause our franchise revenues to decline.
 
     As a franchisor, we are subject to regulation by the FTC and by domestic and foreign laws regulating the offer and sale of franchises. Our failure to obtain or maintain approvals to offer franchises would cause us to lose future franchise revenues and KK Supply Chain revenues. In addition, domestic or foreign laws that regulate substantive aspects of our relationships with franchisees may limit our ability to terminate or otherwise resolve conflicts with our franchisees. Because we plan to grow primarily through franchising, any impairment of our ability to develop new franchise stores will negatively affect us and our growth strategy.
 
Off-premises sales represent a significant portion of our sales. The infrastructure necessary to support off-premises sales results in significant fixed and semi-fixed costs. Also, the loss of one of our large off-premises customers could adversely affect our financial condition and results of operations.
 
     The Company operates a fleet network to support off-premises sales. Declines in off-premises sales without a commensurate reduction in operating expenses, as well as rising fuel costs, may adversely affect our business.
 
     We have several large off-premises customers. Our top two such customers accounted for approximately 12% of total Company store sales during fiscal 2010. The loss of one of our large national off-premises customers could adversely affect our results of operations across all domestic business segments. These customers do not enter into long-term contracts; instead, they make purchase decisions based on a combination of price, product quality, consumer demand and service quality. They may in the future use more of their shelf space, including space currently used for our products, for other products, including private label products. If our sales to one or more of these customers are reduced, this reduction may adversely affect our business.
 
Our failure or inability to enforce our trademarks could adversely affect the value of our brands.
 
     We own certain common-law trademark rights in the United States, as well as numerous trademark and service mark registrations in the United States and in other jurisdictions. We believe that our trademarks and other intellectual property rights are important to our success and our competitive position. We therefore devote appropriate resources to the protection of our trademarks and aggressively pursue persons who unlawfully and without our consent use or register our trademarks. We have a system in place that is designed to detect potential infringement on our trademarks, and we take appropriate action with regard to such infringement as circumstances warrant. The protective actions that we take, however, may not be sufficient, in some jurisdictions, to secure our trademark rights for some of the goods and services that we offer or to prevent imitation by others, which could adversely affect the value of our trademarks and service marks.
 
25
 


     In certain jurisdictions outside the United States, specifically Costa Rica, Guatemala, India, Indonesia, Nigeria, Peru, the Philippines and Venezuela, we are aware that some businesses have registered, used and/or may be using “Krispy Kreme” (or its phonetic equivalent) in connection with doughnut-related goods and services. There may be similar such uses or registrations of which we are unaware and which could perhaps arise from prior users. These uses and/or registrations could limit our operations and possibly cause us to incur litigation costs, or pay damages or licensing fees to a prior user or registrant of similar intellectual property.
 
Loss of our trade secret recipes could adversely affect our sales.
 
     We derive significant competitive benefit from the fact that our doughnut recipes are trade secrets. Although we take commercially reasonable steps to safeguard our trade secrets, should they become known to competitors, our competitive position could suffer substantially.
 
Our secured credit facilities impose restrictions and obligations upon us that significantly limit our ability to operate our business, and in the past we have sought and received waivers relating to these restrictions and obligations.
 
     Our secured credit facilities impose financial and other restrictive covenants that limit our ability to plan for and respond to changes in our business. Under our secured credit facilities, we are required to meet certain financial tests, including a maximum leverage ratio and a minimum interest coverage ratio. In addition, we must comply with covenants which, among other things, limit the incurrence of additional indebtedness, liens, investments, dividends, transactions with affiliates, asset sales, acquisitions, capital expenditures, mergers and consolidations, prepayments of other indebtedness and other matters customarily restricted in such agreements. Any failure to comply with these covenants could result in an event of default under our secured credit facilities.
 
RISKS RELATING TO THE FOOD SERVICE INDUSTRY
 
The food service industry is affected by consumer preferences and perceptions. Changes in these preferences and perceptions may lessen the demand for our doughnuts, which would reduce sales and harm our business.
 
     Food service businesses are often affected by changes in consumer tastes, national, regional and local economic conditions and demographic trends. Individual store performance may be adversely affected by traffic patterns, the cost and availability of labor, purchasing power, availability of products and the type, number and location of competing stores. Our sales have been and may continue to be affected by changing consumer tastes, such as health or dietary preferences that cause consumers to avoid doughnuts in favor of foods that are perceived as healthier. Moreover, because we are primarily dependent on a single product, if consumer demand for doughnuts should decrease, our business would suffer more than if we had a more diversified menu.
 
The food service industry is affected by litigation, regulation and publicity concerning food quality, health and other issues, which can cause customers to avoid our products and result in liabilities.
 
     Food service businesses can be adversely affected by litigation, by regulation and by complaints from customers or government authorities resulting from food quality, illness, injury or other health concerns or operating issues stemming from one store or a limited number of stores, including stores operated by our franchisees. In addition, class action lawsuits have been filed and may continue to be filed against various food service businesses (including quick service restaurants) alleging, among other things, that food service businesses have failed to disclose the health risks associated with high-fat foods and that certain food service business marketing practices have encouraged obesity. Adverse publicity about these allegations may negatively affect us and our franchisees, regardless of whether the allegations are true, by discouraging customers from buying our products. Because one of our competitive strengths is the taste and quality of our doughnuts, adverse publicity or regulations relating to food quality or other similar concerns affects us more than it would food service businesses that compete primarily on other factors. We could also incur significant liabilities if such a lawsuit or claim results in a decision against us or as a result of litigation costs regardless of the result.
 
26
 


Our success depends on our ability to compete with many food service businesses.
 
     We compete with many well-established food service companies. At the retail level, we compete with other doughnut retailers and bakeries, specialty coffee retailers, bagel shops, fast-food restaurants, delicatessens, take-out food service companies, convenience stores and supermarkets. At the wholesale level, we compete primarily with grocery store bakeries, packaged snack foods and vending machine dispensers of snack foods. Aggressive pricing by our competitors or the entrance of new competitors into our markets could reduce our sales and profit margins. Moreover, many of our competitors offer consumers a wider range of products. Many of our competitors or potential competitors have substantially greater financial and other resources than we do which may allow them to react to changes in pricing, marketing and the quick service restaurant industry better than we can. As competitors expand their operations, we expect competition to intensify. In addition, the start-up costs associated with retail doughnut and similar food service establishments are not a significant impediment to entry into the retail doughnut business. We also compete with other employers in our markets for hourly workers and may be subject to higher labor costs.
 
RISKS RELATING TO OWNERSHIP OF OUR COMMON STOCK
 
The market price of our common stock has been volatile and may continue to be volatile, and the value of any investment may decline.
 
     The market price of our common stock has been volatile and may continue to be volatile. This volatility may cause wide fluctuations in the price of our common stock, which is listed on the New York Stock Exchange (“NYSE”). The market price may fluctuate in response to many factors including:
  • Changes in general conditions in the economy or the financial markets;
     
  • Variations in our quarterly operating results or our operating results failing to meet the expectations of securities analysts or investors in a particular period;
     
  • Changes in financial estimates by securities analysts;
     
  • Other developments affecting Krispy Kreme, our industry, customers or competitors; and
     
  • The operating and stock price performance of companies that investors deem comparable to Krispy Kreme.
Our charter, bylaws and shareholder protection rights agreement contain anti-takeover provisions that may make it more difficult or expensive to acquire us in the future or may negatively affect our stock price.
 
     Our articles of incorporation, bylaws and shareholder protection rights agreement contain several provisions that may make it more difficult for a third party to acquire control of us without the approval of our board of directors. These provisions may make it more difficult or expensive for a third party to acquire a majority of our outstanding voting common stock. They may also delay, prevent or deter a merger, acquisition, tender offer, proxy contest or other transaction that might otherwise result in our shareholders’ receiving a premium over the market price for their common stock.
 
Item 1B. UNRESOLVED STAFF COMMENTS.
 
     None.
 
Item 2. PROPERTIES.
 
     Stores. As of January 31, 2010, there were 582 Krispy Kreme stores systemwide, of which 83 were Company stores and 499 were operated by franchisees.
  • As of January 31, 2010, all of our Company stores, except commissaries, had on-premises sales, and 44 of our Company factory stores also engaged in off-premises sales.
     
  • Of the 83 Company stores as of January 31, 2010, we owned the land and building for 42 stores, we owned the building and leased the land for 23 stores and leased both the land and building for 18 stores.
     
27
 


     KK Supply Chain facilities. We own a 147,000 square foot mix manufacturing plant and distribution center in Winston-Salem, North Carolina. Additionally, we own a 103,000 square foot facility in Winston-Salem, which we use primarily as our equipment manufacturing facility, but which also includes our research and development and training facilities.
 
     Other properties. Our corporate headquarters is located in Winston-Salem, North Carolina. We occupy approximately 59,000 square feet of this multi-tenant facility under a lease that expires on November 30, 2024, with two five-year renewal options.
 
Item 3. LEGAL PROCEEDINGS.
 
Pending Matters
 
     Except as disclosed below, the Company currently is not a party to any material legal proceedings.
 
   K² Asia 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 Matters
 
   TAG Litigation
 
     In February 2008, the Company filed suit in the U.S. District Court for the Middle District of North Carolina against The Advantage Group Enterprise, Inc. (“TAG”), alleging that TAG failed to properly account for and pay the Company for sales of equipment that the Company consigned to TAG. Based on these allegations, the Company asserted various claims including breach of fiduciary duty and conversion, and it sought an accounting and constructive trust. In addition, the Company sought a declaration that it did not owe TAG approximately $1 million for storage fees and alleged lost profits. In March 2008, TAG answered the complaint, denying liability and asserting counterclaims against the Company including breach of contract, services rendered, unjust enrichment, violation of the North Carolina Unfair Trade Practices Act and fraud in the inducement. TAG sought approximately $1 million in actual damages as well as punitive and treble damages. The parties settled this matter in March 2010. The accompanying balance sheet as of January 31, 2010 reflects an accrued liability of approximately $150,000 for the settlement of this matter, which was recorded in the second quarter of fiscal 2010 and which is included in Domestic Franchise operating expenses.
 
   Federal Securities Class Actions and Settlement Thereof and Federal Court Shareholder Derivative Actions and Settlement Thereof
 
     Beginning in May 2004, a series of purported securities class actions were filed on behalf of persons who purchased the Company’s publicly traded securities between August 21, 2003 and May 7, 2004 against the Company and certain of its former officers in the United States District Court for the Middle District of North Carolina, alleging violations of federal securities law in connection with various public statements made by the Company. All the actions ultimately were consolidated.
 
     In addition to the purported securities class action, three shareholder derivative actions were filed in the United States District Court for the Middle District of North Carolina against certain current and former directors of the Company, certain former officers of the Company, including Scott Livengood (the Company’s former Chairman and Chief Executive Officer), as well as certain persons or entities that sold franchises to the Company. The complaints in these actions alleged that the defendants breached their fiduciary duties in connection with their management of the Company and the Company’s acquisitions of certain franchises.
 
28
 


     In October 2006, the Company entered into a Stipulation and Settlement Agreement (the “Stipulation”) with the lead plaintiffs in the securities class action, the derivative plaintiffs and all defendants named in the class action and derivative litigation, except for Mr. Livengood, providing for the settlement of the securities class action and a partial settlement of the derivative action. The Stipulation contained no admission of fault or wrongdoing by the Company or the other defendants. In February 2007, the Court entered final judgment dismissing all claims with respect to all defendants in the derivative action, except for claims that the Company may assert against Mr. Livengood, and entered final judgment dismissing all claims with respect to all defendants in the securities class action.
 
     With respect to the securities class action, the settlement class received total consideration of approximately $76.0 million, consisting of a cash payment of approximately $35.0 million made by the Company’s directors’ and officers’ insurers, cash payments of $100,000 each made by each of a former Chief Operating Officer and former Chief Financial Officer of the Company, a cash payment of $4 million made by the Company’s independent registered public accounting firm, and common stock and warrants to purchase common stock issued by the Company having an estimated aggregate value of approximately $36.9 million as of their issuance on March 2, 2007. Claims against all defendants were dismissed with prejudice; however, claims that the Company may have against Mr. Livengood that may be asserted by the Company in the derivative action for contribution to the securities class action settlement or otherwise under applicable law are expressly preserved.
 
     The Company issued 1,833,828 shares of its common stock and warrants to purchase 4,296,523 shares of its common stock at a price of $12.21 per share in connection with the Stipulation. The Company recorded a charge to earnings in fiscal 2006 for the fair value of the stock and warrants, measured as of the date on which the Company agreed to settle the litigation, and adjusted that charge in subsequent periods to reflect changes in the securities’ fair value until their issuance in the first quarter of fiscal 2008. Such subsequent adjustments resulted in a non-cash charge to fiscal 2007 earnings of $16.0 million and a non-cash credit to fiscal 2008 earnings of $14.9 million.
 
     The Stipulation also provided for the settlement and dismissal with prejudice of claims against all defendants in the derivative action, except for claims against Mr. Livengood. The Company settled its claims against Mr. Livengood in February 2010 in exchange for the payment by Mr. Livengood of $320,000 and his surrender to the Company of vested options to purchase 905,700 shares of the Company’s common stock.
 
     All litigation surrounding the above matters has now been settled.
 
   Fairfax County, Virginia Environmental Matter
 
     Since 2004, the Company has operated a commissary in the Gunston Commerce Center in Fairfax County, Virginia (the “County”). The County has investigated alleged damage to its sewer system near the commissary. On May 8, 2009, the County filed a lawsuit in Fairfax County Circuit Court alleging that the Company caused damage to the sewer system and violated the County’s Sewer Use Ordinance and the Company’s Wastewater Discharge Permit. The County sought from the Company repair and replacement costs of approximately $2 million and civil penalties of approximately $18 million. The Company removed the case to the U.S. District Court for the Eastern Division of Virginia, and in December 2009, the parties reached an agreement to resolve the litigation. During the third quarter of fiscal 2010, the Company recorded a provision of $750,000 for the settlement of this matter, which is included in Company Stores direct operating expenses.
 
   California Wage/Hour Litigation
 
     The Company was a defendant in a wage/hour suit pending in the Superior Court of Alameda County, California, in which the plaintiffs seek class action status and unspecified damages on behalf of a putative class of approximately 35 persons. In January 2010, the parties reached an agreement in principle to resolve the litigation and the Company recorded a provision of $950,000 for the settlement of this matter, which is included in Company Stores direct operating expenses and accrued liabilities in the accompanying balance sheet.
 
29
 


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.
 
Item 4. RESERVED.
 
30
 


PART II
 
Item 5.   MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES.

Market Information
 
     Our common stock is listed on the NYSE under the symbol “KKD.” The following table sets forth the high and low sales prices for our common stock in composite trading as reported by the NYSE for the fiscal periods shown.
 
     High      Low
Year Ended February 1, 2009:
First Quarter $    3.48 $    2.50
Second Quarter 5.65 3.00
Third Quarter 4.72 1.76
Fourth Quarter 3.00 1.35
Year Ended January 31, 2010:
First Quarter $ 4.38 $ 1.01
Second Quarter 4.23 2.51
Third Quarter 4.75 2.71
Fourth Quarter 3.94 2.56

Holders
 
     As of March 26, 2010, there were approximately 15,900 shareholders of record of our common stock.
 
Dividends
 
     We did not pay any dividends in fiscal 2010 or fiscal 2009. We intend to retain any earnings to finance our business and do not anticipate paying cash dividends in the foreseeable future. Furthermore, the terms of our secured credit facilities prohibit the payment of dividends on our common stock.
 
Securities Authorized for Issuance Under Equity Compensation Plans
 
     The following table provides information with respect to securities authorized for issuance under all of the Company’s equity compensation plans as of January 31, 2010.
 
Number of
Securities Remaining
Number of Available For
Securities to Future Issuance
Be Issued Weighted Average Under Equity
Upon Exercise Exercise Price Compensation
of Outstanding of Outstanding Plans (Excluding
Options, Warrants Options, Warrants Securities Reflected
and Rights and Rights in Column (a))
Plan Category        (a)        (b)        (c)
Equity compensation plans approved by security
       holders 6,068,900 (1) $ 13.01 2,630,800 (2)
Equity compensation plans not approved by  
       security holders(3)(4) 80,000 (3) $ 8.06  
Total 6,148,900 $ 12.94 2,630,800
 
____________________
 
(1)       Represents shares of common stock issuable pursuant to outstanding options under the 2000 Stock Incentive Plan.

31
 


(2)       Represents shares of common stock which may be issued pursuant to awards under the 2000 Stock Incentive Plan and the Employee Stock Purchase Plan. Under the Employee Stock Purchase Plan, each employee of the Company or any participating subsidiary (other than those whose customary employment was for not more than five months per calendar year) was eligible to participate after the employee completed 12 months of employment, and each participant could elect to purchase shares of Company common stock at the end of quarterly offering periods. The amount of shares that could be purchased was based on the amount of payroll deductions a participant elected to have withheld and applied at the end of the purchase period to the purchase of shares (ranging from 1 to 15% of the participant’s base compensation). The purchase price for the shares was the lesser of the fair market value of the shares on the first day of the purchase period or the last day of the purchase period. Effective October 21, 2005, the Company halted purchases under the Employee Stock Purchase Plan.
 
(3) Represents shares of common stock issuable pursuant to outstanding options under the 1998 Stock Option Plan. The 1998 Stock Option Plan was adopted prior to the initial public offering of the Company’s common stock, and it was not submitted for approval by shareholders. The plan provides for the grant of stock options to employees, directors and consultants, as determined by the Compensation Committee, and it is administered by the Compensation Committee. No grants have been made under the 1998 Stock Option Plan subsequent to April 5, 2000, and the Company will not make any further grants under the plan.
 
(4) The Company maintained a Nonqualified Stock Ownership Plan under which management or other highly compensated employees selected by the Compensation Committee could participate. The plan was designed to provide benefits that could not be provided under the Company’s tax-qualified Profit Sharing Stock Ownership Plan due to Internal Revenue Code limitations. Each year, the Company credited benefits under the plan based on a discretionary percentage of the employees’ compensation in excess of Internal Revenue Code limits. Amounts credited under the plan were deemed to be invested in Company stock, and benefits were payable in the form of Company stock or, at the election of the participant, in cash. No amounts were credited to participants in the plan in fiscal 2010, fiscal 2009 or fiscal 2008. The Company also maintained a Nonqualified Deferred Compensation Plan under which management or other highly compensated employees selected by the Compensation Committee could participate. The plan was designed to allow participants to defer a portion of their compensation. Amounts deferred under the plan could, at the election of the participant, be deemed to be invested in Company stock, and benefits deemed vested in Company stock were payable in the form of Company stock or, at the election of the participant, in cash. The ability of participants to deem investments to be in Company stock was suspended effective November 8, 2005. Neither the Nonqualified Stock Ownership Plan nor the Nonqualified Deferred Compensation Plan was submitted for shareholder approval. On December 10, 2008, the Board of Directors merged the Nonqualified Stock Ownership Plan with and into the Nonqualified Deferred Compensation Plan, effective December 31, 2008, and both plans as merged were amended and restated generally effective as of January 1, 2005 to comply with Section 409A of the Internal Revenue Code.
 
Recent Sales of Unregistered Securities
 
     None.
 
Purchases of Equity Securities
 
     No purchases were made by or on behalf of the Company of its equity securities during the fourth quarter of fiscal 2010.
 
32
 


Stock Performance Graph
 
     The performance graph shown below compares the percentage change in the cumulative total shareholder return on our common stock against the cumulative total return of the NYSE Composite Index and Standard & Poor’s Restaurants Index for the period from January 28, 2005 through January 31, 2010. The graph assumes an initial investment of $100 and the reinvestment of dividends.
 
 
January January January February February January
30, 2005 29, 2006 28, 2007 3, 2008 1, 2009 31, 2010
Krispy Kreme Doughnuts, Inc. $100.00 $  61.55 $148.73 $  33.37 $  16.05 $  32.56
NYSE Composite Index 100.00 115.13 130.18 131.93 73.89 97.89
S&P 500 Restaurants Index 100.00 117.36 137.60 145.24 138.28 171.37

33
 


Item 6. SELECTED FINANCIAL DATA.
 
     The following selected financial data should be read in conjunction with Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and the Company’s consolidated financial statements appearing elsewhere herein.
 
Year Ended
Jan. 31, Feb. 1, Feb. 3, Jan. 28, Jan. 29,
     2010      2009      2008      2007      2006
(In thousands, except per share and number of stores data)
STATEMENT OF OPERATIONS DATA:
Revenues   $    346,520   $    385,522   $    430,370   $    461,195   $ 543,361
Operating expenses:
       Direct operating expenses (exclusive of
              depreciation shown below) 297,185 346,545 381,065 389,379 474,591
       General and administrative expenses 22,728 23,458 26,303 48,860 67,727
       Depreciation and amortization expense 8,191 8,709 18,433 21,046 28,920
       Impairment charges and lease termination costs 5,903 548 62,073 12,519 55,062
       Settlement of litigation (14,930 ) 15,972 35,833
       Other operating (income) and expenses, net 739 1,501 13 1,916 (1,741 )
       Operating income (loss) 11,774 4,761 (42,587 ) (28,497 ) (117,031 )
Interest income 93 331 1,422 1,627 1,110
Interest expense (10,685 ) (10,679 ) (9,796 ) (20,334 ) (20,211 )
Loss on extinguishment of debt (9,622 )
Equity in losses of equity method franchisees (488 ) (786 ) (933 ) (842 ) (4,337 )
Other non-operating income and (expense), net (276 ) 2,815 (3,211 ) 7,021 (248 )
Income (loss) from continuing operations
       before income taxes 418 (3,558 ) (64,727 ) (41,025 ) (140,717 )
Provision for income taxes (benefit) 575 503 2,324 1,211 (776 )
Net loss (157 ) (4,061 ) (67,051 ) (42,236 )      (139,941 )
Net loss attributable to  
       noncontrolling interests   4,181
Net loss attributable to  
       Krispy Kreme Doughnuts, Inc. ($157 ) ($4,061 ) ($67,051 ) ($42,236 )      ($135,760 )
Net loss per common share
       Basic $ $ (.06 ) $ (1.05 ) $ (.68 ) $ (2.20 )
       Diluted $ $ (.06 ) $ (1.05 ) $ (.68 ) $ (2.20 )
BALANCE SHEET DATA (AT END OF YEAR):
Working capital (deficit)(1) $ 21,550 $ 36,190 $ 32,862 $ (3,052 ) $ (6,894 )
Total assets 165,276 194,926 202,351 349,492 410,855
Long-term debt, less current maturities 42,685 73,454 75,156 105,966 118,241
Total shareholders’ equity 62,767 57,755 56,624 78,962 108,671
Number of stores at end of year:
       Company 83 93 105 113 133
       Franchise 499 430 344 282 269
       Systemwide 582 523 449 395 402
____________________
 
(1)       Reflects a liability, net of amounts recoverable from insurance companies, of approximately $51.8 million and $35.8 million as of January 28, 2007 and January 29, 2006, respectively, related to the settlement of certain litigation. This liability was satisfied in March 2007 through the issuance of shares of common stock and warrants to acquire shares of common stock as described in Note 12 to the consolidated financial statements appearing elsewhere herein.

34
 


Item 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 
     The following discussion of the Company’s financial condition and results of operations should be read in conjunction with the consolidated financial statements and notes thereto appearing elsewhere herein.
 
Results of Operations
 
     The following table sets forth operating metrics for each of the three fiscal years in the period ended January 31, 2010. The Company’s fiscal year ends on the Sunday closest to January 31, which periodically results in a 53-week year. Fiscal 2008 contained 53 weeks. To enhance comparability among the last three fiscal years, amounts in the below table for fiscal 2008 have been computed based upon the 52-week period ended January 27, 2008.
 
Year Ended
Jan. 31, Feb. 1, Feb. 3,
     2010      2009      2008
Same Store Sales (on-premises sales only):
       Company stores 3.5 % (0.7 )% 0.0 %
       Domestic Franchise stores 0.9 (3.3 ) (1.9 )
       International Franchise stores (24.2 ) (23.4 ) (11.0 )
       International Franchise stores, in constant dollars (1) (21.1 ) (18.6 ) (17.1 )
 
Off-Premises Metrics (Company stores only): (2)
       Average weekly number of doors served:
              Grocers/mass merchants 5,634 6,306 6,858
              Convenience stores 5,285 5,985 6,302
 
       Average weekly sales per door:
              Grocers/mass merchants $ 242 $ 219 $ 230
              Convenience stores 208 217 243
 
Systemwide Sales (in thousands): (3)
       Company stores $    243,387 $    263,888 $    298,703
       Domestic Franchise stores 220,629 235,558 282,122
       International Franchise stores 263,601 273,054 194,116
       International Franchise stores, in constant dollars (4) 263,601 261,488 180,055
 
Average Weekly Sales Per Store (in thousands):
       Company stores:
              Factory stores:
                     Commissaries — off-premises $ 155.7 $ 164.6 $ 167.0
                     Dual-channel stores:
                            On-premises 26.1 23.5 23.0
                            Off-premises 31.4 29.3 33.2
                                   Total 57.5 52.8 56.2
                     On-premises only stores 31.9 30.6 30.1
                     All factory stores 57.2 54.5 56.7
              Satellite stores 18.1 17.8 18.1
              All stores 52.2 50.8 53.0
 
       Domestic Franchise stores: (5)
              Factory stores $ 37.1 $ 39.3 $ 42.9
              Satellite stores 14.8 15.4 15.6

35
 


Year Ended
Jan. 31, Feb. 1, Feb. 3,
     2010      2009      2008
International Franchise stores (5):
       Factory stores $    36.2 $    46.7 $    48.2
       Satellite stores 9.4 12.3 16.6
____________________
 
(1) Represents the change in International Franchise same store sales computed by reconverting franchise store sales in each foreign currency to U.S. dollars at a constant rate of exchange for all periods.
 
(2) Metrics exclude off-premises sales by Company stores in Eastern Canada, which the Company refranchised in the fourth quarter of fiscal 2009 as the data for these stores was not available.
 
(3) Excludes sales among Company and franchise stores.
 
(4) Represents International Franchise store sales computed by reconverting International Franchise store sales for fiscal 2009 and 2008 to U.S. dollars based upon the weighted average of the exchange rates prevailing in fiscal 2010.
 
(5)       Metrics include only stores open at January 31, 2010.
 
     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.
 
     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.
 
36
 

 
     The following table sets forth data about the number of systemwide stores as of January 31, 2010, February 1, 2009 and February 3, 2008, and the number of store operating weeks for each of the years then ended.
 
Year Ended
Jan. 31, Feb. 1, Feb. 3,
     2010      2009      2008
Number of Stores Open At Year End:
      Company stores:
            Factory:
                  Commissaries 6 6 6
                  Dual-channel stores 38 51 62
                  On-premises only stores 25 26 29
            Satellite stores 14 10 8
                        Total Company stores 83 93 105
 
      Domestic Franchise stores:
            Factory stores 104 104 118
            Satellite stores 37 28 27
                  Total Domestic Franchise stores 141 132 145
 
      International Franchise stores:
            Factory stores 95 94 80
            Satellite stores 263 204 119
                  Total International Franchise stores 358 298 199
 
                        Total systemwide stores 582 523 449
 
Store Operating Weeks: (1)
      Company stores:
            Factory stores:
                  Commissaries 312 312 312
                  Dual-channel stores 2,541 3,191 3,551
                  Retail only stores 1,217 1,196 1,243
            Satellite stores 592 487 520
 
      Domestic Franchise stores: (2)
            Factory stores 5,324 5,098 4,992
            Satellite stores 1,449 1,085 974
 
      International Franchise stores: (2)
            Factory stores 4,303 3,714 2,523
            Satellite stores 11,177 7,274 3,623
____________________
 
(1) Amounts for fiscal 2008 have been computed based upon the 52-week period ended January 27, 2008.
 
(2)       Metrics include only stores open at January 31, 2010.
 
37
 

 
FISCAL 2010 COMPARED TO FISCAL 2009
 
Overview
 
     Revenues by business segment (expressed in dollars and as a percentage of total revenues) and operating income by business segment are set forth in the table below (percentage amounts may not add to totals due to rounding).
 
Year Ended
Jan. 31, Feb. 1,
     2010      2009
(Dollars in thousands)
Revenues by business segment:
       Company Stores $    246,373 $    265,890
       Domestic Franchise 7,807 8,042
       International Franchise 15,907 17,495
       KK Supply Chain:
              Total revenues 162,127 191,456
              Less – intersegment sales elimination (85,694 ) (97,361 )
                     External KK Supply Chain revenues 76,433 94,095
                            Total revenues $ 346,520 $ 385,522
 
Segment revenues as a percentage of total revenues:
       Company Stores 71.1 % 69.0 %
       Domestic Franchise 2.3 2.1
       International Franchise 4.6 4.5
       KK Supply Chain (external sales) 22.1 24.4
  100.0 % 100.0 %
Operating income (loss):
       Company Stores $ 2,288 $ (9,813 )
       Domestic Franchise 3,268 4,965
       International Franchise 9,896 11,550
       KK Supply Chain 25,962 23,269
              Total segment operating income 41,414 29,971
       Unallocated general and administrative expenses (23,737 ) (24,662 )
       Impairment charges and lease termination costs (5,903 ) (548 )
              Consolidated operating income $ 11,774 $ 4,761
 

     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.
 
     Through fiscal 2009, the Company reported its results of operations of its franchise business as a single business segment. In fiscal 2010, the Company began disaggregating the results of operations of its franchise business into domestic and international components in its internal financial reporting. The Company has made the corresponding changes to its segment reporting, and now reports the revenues and expenses associated with its domestic and international franchise operations as separate segments. The Company’s segment disclosures continue to be consistent with the way in which management views and evaluates the business. Amounts previously reported for the franchise segment for fiscal 2009 and fiscal 2008 have been restated to conform to the new disaggregated segment presentation
 
38
 

 
   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).
 
Percentage of Total Revenues
Year Ended Year Ended
Jan. 31, Feb. 1, Jan. 31, Feb. 1,
     2010      2009      2010      2009
(In thousands)
Revenues:
       On-premises sales:
              Retail sales $    103,856 $    107,142 42.2 % 40.3 %
              Fundraising sales 13,481 13,260 5.5 5.0
                     Total on-premises sales 117,337 120,402 47.6 45.3
       Off-premises sales:
              Grocers/mass merchants 70,952 75,556 28.8 28.4
              Convenience stores 55,451 67,071 22.5 25.2
              Other off-premises 2,371 2,861 1.0 1.1
                     Total off-premises sales 128,774 145,488 52.3 54.7
       Other revenues 262 0.1
                            Total revenues 246,373 265,890      100.0     100.0
 
Operating expenses:
       Cost of sales:
              Food, beverage and packaging 84,551 96,208 34.3 36.2
              Shop labor 48,714 53,113 19.8 20.0
              Delivery labor 21,280 25,419 8.6 9.6
              Employee benefits 19,145 21,269 7.8 8.0
                     Total cost of sales 173,690 196,009 70.5 73.7
              Vehicle costs (1) 11,491 16,877 4.7 6.3
              Occupancy (2) 10,140 12,225 4.1 4.6
              Utilities expense 5,737 7,236 2.3 2.7
              Depreciation expense 6,293 6,402 2.6 2.4
              Settlement of litigation 1,700 0.7
              Other operating expenses 19,114 21,079 7.8 7.9
                     Total store level costs 228,165 259,828 92.6 97.7
       Store operating income 18,208 6,062 7.4 2.3
       Other segment operating costs 9,567 10,031 3.9 3.8
       Allocated corporate overhead 6,353 5,844 2.6 2.2
Segment operating income (loss) $ 2,288 $ (9,813 ) 0.9 % (3.7 )%
 
____________________

(1) Includes fuel, maintenance and repairs, rent, taxes and other costs of operating the delivery fleet, exclusive of depreciation.
 
(2)      Includes rent, property taxes, common area maintenance charges, insurance, building maintenance and other occupancy costs, exclusive of utilities and depreciation.

     A reconciliation of Company Store segment sales from fiscal 2009 to fiscal 2010 follows:
 
     On-Premises      Off-Premises      Total
(In thousands)
Fiscal 2009 sales $    120,402 $    145,488 $    265,890
Less:
      Effect of stores closed and refranchised in fiscal 2009 (5,529 ) (5,939 ) (11,468 )
      Effect of stores closed and refranchised in fiscal 2010 (5,436 ) (5,814 ) (11,250 )
Change in sales at mature stores 4,680 (4,961 ) (281 )
Sales from fiscal 2010 new stores 3,220 3,220
Fiscal 2010 sales $ 117,337 $ 128,774 $ 246,111
 

39
 

 
     Sales at Company stores decreased in fiscal 2010 from fiscal 2009 due to store closings and refranchisings. The increase in on-premises sales from stores opened in fiscal 2010 was offset by a decline in off-premises sales at existing stores. The following table presents sales metrics for Company stores (off–premises metrics for fiscal 2009 excludes data for the four stores in Eastern Canada refranchised by the Company in December 2008):
 
Year Ended
Jan. 31, Feb. 1,
2010      2009
On-premises:
              Change in same store sales 3.5 % (0.7 )%
Off-premises:
       Grocers/mass merchants:
              Change in average weekly number of doors (10.7 )% (8.0 )%
              Change in average weekly sales per door 10.5 % (4.8 )%
       Convenience stores:
              Change in average weekly number of doors (11.7 )% (5.0 )%
              Change in average weekly sales per door (4.1 )% (10.7 )%

   On-premises sales
 
     Same store sales at Company stores rose 3.5% in fiscal 2010 over fiscal 2009. Price testing at approximately one-third of the Company’s stores initiated at the beginning of the second quarter contributed approximately 1.4 percentage points to the increase. In addition, the improvement in same store sales reflects generally lower use of couponing and other price promotions in fiscal 2010, as well as generally lower values of coupons and other price promotions.
 
     The Company is implementing programs designed to improve on-premises sales, including increased focus on local store marketing efforts, improved employee training, store refurbishment efforts and the introduction of new products.
 
   Off-premises sales
 
     Sales to grocers and mass merchants in fiscal 2009 include approximately $3.8 million of off-premises sales of four stores in Eastern Canada that the Company refranchised in December 2008. Exclusive of the sales of the Canadian stores that were refranchised, sales to grocers and mass merchants decreased slightly to $71 million, with the 10.7% decline in the average number of doors served offset by a 10.5% increase in the average weekly sales per door. Convenience store sales fell due to both a decline in the average number of doors served and in the average weekly sales per door. Among other reasons, sales to convenience stores have declined as a result of several large customers implementing in-house doughnut programs to replace the Company’s products. Declines in the average weekly sales per door adversely affect profitability because of the increased significance of delivery costs in relation to sales.
 
     The Company is implementing strategies to increase sales, increase average per door sales and reduce costs in the off-premises channel. These strategies include improved route management and route consolidation (including elimination of or reduction in the number of stops at relatively low volume doors), new sales incentives and performance-based pay programs, increased emphasis on relatively longer shelf-life products and has developed order management systems to more closely match display quantities and assortments with consumer demand.
 
   Costs and expenses
 
     Cost of sales as a percentage of revenues improved by 3.2 percentage points from fiscal 2009, falling to 70.5% of revenues in fiscal 2010. Lower costs for doughnut mix and shortening drove the improvement. Lower costs of flour and shortening resulting from lower agricultural commodity costs enabled KK Supply Chain to reduce prices on these key items in fiscal 2010. While the cost of doughnut mix and other ingredients has been relatively stable during fiscal 2010, Company Stores’ cost of sugar rose approximately 20% in the fourth quarter and an additional 5% in the first quarter of fiscal 2011 as a result of price increases resulting from the expiration of a favorable KK Supply Chain sugar supply contract. The Company currently estimates that the overall increase in the cost of materials and ingredients in fiscal 2011 will be approximately $4 million, or approximately 2% of sales. The Company is implementing programs intended to improve store operations and reduce costs as a percentage of revenues, including improved employee training and the introduction of food and labor cost management tools.
 
40
 


     Improved route management and the implementation of performance-based pay programs in the off-premises channel drove a 1.0 percentage point decrease in delivery labor as a percentage of off-premises sales in fiscal 2010 compared to fiscal 2009.
 
     Vehicle costs as a percentage of revenues improved 1.6 percentage points from 6.3% of revenues in fiscal 2009 to 4.7% of revenues in fiscal 2010. Lower fuel prices and improved route management and route consolidation drove the improvement in vehicle costs.
 
     The Company is self-insured for workers’ compensation, vehicle and general liability claims, but maintains stop-loss coverage for individual claims exceeding certain amounts. The Company provides for claims under these self-insured programs using actuarial methods as described in Note 1 to the consolidated financial statements appearing elsewhere herein, and updates actuarial valuations of its self-insurance reserves at least annually. Such periodic actuarial valuations result in changes over time in the estimated amounts which ultimately will be paid for claims under these programs to reflect the Company’s actual claims experience for each policy year as well as trends in claims experience over multiple years. Such claims, particularly workers’ compensation claims, often are paid over a number of years following the year in which the insured events occur, and the estimated ultimate cost of each year’s claims accordingly is adjusted over time as additional information becomes available. The Company recorded favorable adjustments to its self-insurance claims liabilities related to prior policy years of approximately $3.2 million in fiscal 2010, of which $2.0 million was recorded in the fourth quarter and $1.8 million in fiscal 2009, of which $1.0 million was recorded in the fourth quarter. Of the $3.2 million in favorable adjustments recorded in fiscal 2010, $2.1 million relates to workers’ compensation liability claims and is included in employee benefits in the table above, $660,000 relates to vehicle liability claims and is included in vehicle costs in the table above and $390,000 relates to general liability claims and is included in other operating expenses in the table above. Of the $1.8 million in favorable adjustments recorded in fiscal 2009, $1.6 million relates to workers’ compensation liability claims and $240,000 relates to general liability claims.
 
     During fiscal 2010, the Company Stores segment recorded charges totaling $1.7 million (of which $950,000 was recorded in the fourth quarter) for the settlement of environmental and wage/hour litigation, as described in Note 12 to the consolidated financial statements appearing elsewhere herein.
 
     The Company stores segment closed or refranchised a total of 28 stores in the last two fiscal years, none of which have been accounted for as discontinued operations because the Company continues to have significant continuing involvement in the markets in which the stores were or are located, through either continuing operations of other stores in or serving the market or through its relationship as a franchisor. In order to assist readers in understanding the results of operations of the Company’s ongoing stores, the following table presents the components of revenues and expenses for stores operated by the Company as of January 31, 2010, and excludes the revenues and expenses for stores closed and refranchised prior to that date. Percentage amounts may not add to totals due to rounding.
 
41
 


Stores in Operation at January 31, 2010
Percentage of Total Revenues
Year Ended Year Ended
Jan. 31, Feb. 1, Jan. 31, Feb. 1,
     2010      2009      2010      2009
(In thousands)
Revenues:
       On-premises sales:
              Retail sales $ 93,982 $ 87,028 40.6 % 38.1 %
              Fundraising sales 12,906 11,960 5.6 5.2
                     Total on-premises sales 106,888 98,988 46.1 43.3
       Off-premises sales:
              Grocers/mass merchants 68,335 66,475 29.5 29.1
              Convenience stores 53,888 60,256 23.3 26.4
              Other off-premises 2,326 2,779 1.0 1.2
                     Total off-premises sales 124,549 129,510 53.8 56.7
       Other revenues 262 0.1
                            Total revenues 231,699 228,498      100.0      100.0
 
Operating expenses:
       Cost of sales:
              Food, beverage and packaging 79,407 82,704 34.3 36.2
              Shop labor 45,014 43,706 19.4 19.1
              Delivery labor 20,470 22,243 8.8 9.7
              Employee benefits 17,610 17,517 7.6 7.7
                     Total cost of sales 162,501 166,170 70.1 72.7
              Vehicle costs 10,898 13,866 4.7 6.1
              Occupancy 8,567 8,474 3.7 3.7
              Depreciation expense 6,051 5,879 2.6 2.6
              Utilities expense 5,143 5,694 2.2 2.5
              Settlement of litigation 750 0.3
              Other operating expenses 17,269 16,937 7.5 7.4
                     Total store level costs    211,179    217,020 91.1 95.0
       Store operating income-ongoing stores 20,520 11,478 8.9 5.0
       Store operating loss-closed and refranchised stores (2,312 ) (5,416 )
Store operating income $ 18,208 $ 6,062
 

   Domestic Franchise
 
Year Ended
Jan. 31, Feb. 1,
     2010      2009
(In thousands)
Revenues:
       Royalties $ 7,542 $ 7,810
       Development and franchise fees 50 3
       Other 215 229
              Total revenues 7,807 8,042
 
Operating expenses:
       Segment operating expenses 4,016 2,838
       Depreciation expense 71 86
       Allocated corporate overhead 452 153
              Total operating expenses 4,539 3,077
Segment operating income $    3,268 $    4,965
 

42
 


     Domestic Franchise revenues decreased 2.9% to $7.8 million in fiscal 2010 from $8.0 million in fiscal 2009, driven by a decline in domestic royalty revenues resulting from a decrease in sales by domestic franchise stores from approximately $236 million in fiscal 2009 to $221 million in fiscal 2010.
 
     Domestic franchise same store sales rose 0.9% in fiscal 2010. Generally, same store sales at Associate franchise stores, which are located principally in the Southeast, rose during the year, while same store sales at Area Developer franchise stores fell.
 
     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. Domestic Franchise operating expenses rose in fiscal 2010 compared to fiscal 2009, primarily due to increased resources devoted to the development and support of domestic franchisees, higher incentive compensation provisions of approximately $245,000 and an increase in bad debt provisions to approximately $125,000 related principally to a single domestic franchisee. Additionally, during fiscal 2010, the Company recorded charges of approximately $150,000 to the Domestic Franchise segment for the settlement of litigation as described in Note 12 to the consolidated financial statements appearing elsewhere herein.
 
     Domestic franchisees opened 12 stores and closed seven stores in fiscal 2010. 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
 
Year Ended
Jan. 31, Feb. 1,
     2010      2009
(In thousands)
Revenues:
       Royalties $    14,164 $    14,942
       Development and franchise fees 1,743 2,460
       Other 93
              Total revenues 15,907 17,495
 
Operating expenses:
       Segment operating expenses 4,926 5,016
       Allocated corporate overhead 1,085 929
              Total operating expenses 6,011 5,945
Segment operating income $ 9,896 $ 11,550
 

     International Franchise royalties declined $778,000, driven by a decrease in sales by international franchise stores from $273 million in fiscal 2009 to $264 million in fiscal 2010. Changes in the rates of exchange between the U.S. dollar and the foreign currencies in which the Company’s international franchisees do business reduced sales by international franchisees measured in U.S. dollars by approximately $11.7 million in fiscal 2010 compared to fiscal 2009, which adversely affected international royalty revenues by approximately $700,000. Additionally, the Company did not recognize as revenue approximately $680,000 and $920,000 of uncollected royalties which accrued during fiscal 2010 and 2009, respectively, because the Company did not believe collection of these royalties was reasonably assured.
 
     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, fell 21.1%. The decline in International Franchise same store sales reflects the large number of new stores opened internationally over the past two years, the cannibalization effects on initial stores in new markets of additional store openings in those markets, and the overall softness in global economic conditions, particularly in more developed markets. International franchisees opened 281 stores in the past three fiscal years, including 121 stores in markets in which there were no International Franchise stores at the end of fiscal 2007. Of the 281 openings over the past three years, 174 stores have been open at least 57 weeks and are included in the same store sales computation for fiscal 2010. Many of these new stores experienced very high sales in their initial year or more of operation, and their average weekly sales are declining to more sustainable levels.
 
43
 


     International development and franchise fees decreased $717,000 in fiscal 2010 due to fewer store openings by international franchisees in fiscal 2010 than in fiscal 2009.
 
     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 rose in the fiscal 2010 compared to fiscal 2009 primarily due to increased resources devoted to the development and support of franchisees outside the United States and to higher incentive compensation provisions of $455,000. These increases were partially offset by a decrease in the bad debt provision to $605,000 in fiscal 2010 compared to $1.3 million in fiscal 2009.
 
     International franchisees opened 82 stores and closed 22 stores in fiscal 2010. 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) are set forth in the table below (percentage amounts may not add to totals due to rounding).
 
Percentage of Total Revenues
Before Intersegment
Sales Elimination
Year Ended Year Ended
Jan. 31, Feb. 1, Jan. 31, Feb. 1,
     2010      2009      2010      2009
(In thousands)
Revenues:
       Doughnut mixes $ 58,332 $ 73,312 36.0 % 38.3 %
       Other ingredients, packaging and supplies 97,622 106,054 60.2 55.4
       Equipment 6,173 8,749 3.8 4.6
       Fuel surcharge 3,341 1.7
              Total revenues before intersegment sales elimination    162,127    191,456      100.0      100.0
 
Operating expenses:
       Cost of sales:
             Cost of goods produced and purchased 108,502 131,594 66.9 68.7
              Inbound freight 3,483 7,550 2.1 3.9
                     Total cost of sales 111,985 139,144 69.1 72.7
       Distribution costs:
              Outbound freight 10,007 13,806 6.2 7.2
              Other distribution costs 3,372 3,357 2.1 1.8
                     Total distribution costs 13,379 17,163 8.3 9.0
       Other segment operating costs 8,751 9,496 5.4 5.0
       Depreciation expense 883 1,019 0.5 0.5
       Allocated corporate overhead 1,167 1,365 0.7 0.7
              Total operating costs 136,165 168,187 84.0 87.8
Segment operating income $ 25,962 $ 23,269 16.0 % 12.2 %
 

     KK Supply Chain revenues before intersegment sales elimination fell $29.3 million, or 15.3%, in fiscal 2010 compared to fiscal 2009. The decrease reflects lower unit sales of doughnut mixes, ingredients and supplies by KK Supply Chain resulting from lower sales by Company and domestic franchise stores. The decline also reflects selling price reductions for doughnut mixes and certain other ingredients instituted by KK Supply Chain in fiscal 2010 in order to pass along to Company and franchise stores reductions in KK Supply Chain’s cost of flour and shortening. Finally, in fiscal 2009, the Company utilized a fuel surcharge program to recoup additional freight costs resulting from increased fuel costs. Charges under the program were based upon the price of diesel fuel; the price benchmark was reset in fiscal 2010 and no fuel surcharges were made under the program in fiscal 2010.
 
44
 


     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.
 
     Cost of sales as a percentage of revenues fell in fiscal 2010 compared to fiscal 2009. The most significant reason for the decrease was the reduced selling price of doughnut mix in fiscal 2010 resulting principally from lower flour costs. While the selling prices of doughnut mixes in fiscal 2010 were lower than in fiscal 2009 as a result of lower raw materials costs, overall gross margins widened because the Company attempts to maintain the gross profit on sales of doughnut mixes relatively constant on a per unit basis. Lower inbound freight costs reflect a decrease in freight rates resulting from lower fuel prices. In addition, the Company closed its California distribution center in fiscal 2009 and engaged an independent contractor to supply Company and franchise stores west of the Mississippi; the inbound freight cost associated with goods delivered by the contractor is reflected in the fee paid to the contractor, which is included in other distribution costs.
 
     Outbound freight costs fell in fiscal 2010 compared to fiscal 2009, reflecting both lower unit sales volumes and reduced costs resulting from lower fuel prices. In addition, outbound freight in fiscal 2009 includes a charge of approximately $1.7 million (approximately 0.9% of KK Supply Chain revenues before intersegment sales elimination) related to payments made by the Company to its former third-party freight consolidator which were improperly not remitted to the freight carriers by the freight consolidator. The actions of the third-party freight consolidator, which filed for bankruptcy protection, resulted in a loss to the Company which the Company has not recovered.
 
     Other segment operating costs include segment management, purchasing, customer service and support, laboratory and quality control costs and research and development expenses. These costs include a net credit of approximately $935,000 for bad debt expense in fiscal 2010 and a net credit of approximately $950,000 in fiscal 2009. The net credits principally reflect sustained improved payment performance and/or reduced credit exposure with respect to a small number of franchisees and, in fiscal 2009, a recovery of receivables previously written off. Net credits in bad debt expense should not be expected to occur on a regular basis. As of January 31, 2010, the Company’s allowance for doubtful accounts from affiliate and unaffiliated franchisees totaled approximately $1.8 million.
 
     Domestic and international franchisees opened 94 stores and closed 29 stores in fiscal 2010. The majority 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.
 
   General and Administrative Expenses
 
     General and administrative expenses were $22.7 million, or 6.6% of total revenues, in fiscal 2010 compared to $23.5 million, or 6.1% of total revenues, in fiscal 2009. General and administrative expenses in fiscal 2010 include approximately $2.6 million of incentive compensation provisions to reflect fiscal 2010 results (with an additional charge of approximately $2.2 million included in direct operating expenses); there were no incentive compensation provisions in general and administrative expenses for fiscal 2009. General and administrative expenses in fiscal 2010 reflect higher legal costs compared to fiscal 2009, including legal fees of approximately $1.7 million related to the resolved environmental litigation described in Note 12 to the consolidated financial statements appearing elsewhere herein.
 
     General and administrative expenses include professional fees and other costs, together with related insurance recoveries, associated with certain securities litigation and related investigations, including costs arising from the Company’s obligation to indemnify certain former officers of the Company for costs incurred by them in connection with those matters. Those matters are described under “Other Litigation — Federal Securities Class Actions and Shareholder Derivative Actions and Settlement Thereof in Note 12 to the consolidated financial statements appearing elsewhere herein. Those costs and expenses were a net credit of approximately $1.8 million in fiscal 2010 and a charge of approximately $1.3 million in fiscal 2009. The net credit in fiscal 2010 reflects insurance reimbursements of approximately $2.5 million of costs incurred in prior periods in connection with such litigation and investigations, of which $1.3 million was recorded in the fourth quarter. All matters with respect to this litigation have been resolved, and the Company does not anticipate that these expenses will be incurred going forward.
 
45
 

 
   Impairment Charges and Lease Termination Costs 
 
     Impairment charges and lease termination costs were $5.9 million in fiscal 2010 compared to $548,000 in fiscal 2009.
 
     Impairment charges related to long-lived assets totaled $3.1 million in fiscal 2010 and $1.1 million in fiscal 2009, of which approximately $3.1 million and $900,000, respectively, related principally to underperforming stores. 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 decisions, the effects of changing costs on current results of operations, observed trends in operating results, and evidence of changed circumstances observed as a part of periodic reforecasts of future operating results and as part of the Company’s annual budgeting process. When the Company concludes that the carrying value of long-lived assets is not recoverable (based on future projected undiscounted cash flows), the Company records impairment charges to reduce the carrying value of those assets to their estimated fair values. During fiscal 2010, the Company recorded impairment charges related to long-lived assets, substantially all of which were real properties; the fair values of these assets were estimated based on the present value of estimated future cash flows, on independent appraisals and, in the case of properties which the Company currently is negotiating to sell, based on the Company’s negotiations with unrelated third-party buyers. The charges relate to stores closed, refranchised or expected to be closed, as well as charges with respect 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. In addition to the foregoing, impairment charges for fiscal 2010 reflect a one-time cash recovery of $482,000 from the bankruptcy estate of Freedom Rings, LLC, a former subsidiary of the Company which filed for bankruptcy in fiscal 2006, as more fully described in Note 13 to the consolidated financial statements appearing elsewhere herein.
 
     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.
 
     In fiscal 2010, the Company recorded lease termination charges related to closed stores of approximately $3.2 million, compared to a net credit related to lease terminations of $502,000 in fiscal 2009. The charges in fiscal 2010 relate principally to terminations of two leases having rental rates substantially above current market levels. In fiscal 2009, changes in estimated sublease rentals on a closed store that was subsequently refranchised and the realization of proceeds on an assignment of another closed store lease resulted in a credit in the lease termination provision. This credit, along with the reversal of previously recorded accrued rent associated with stores closed, partially offset by charges related to other closed store leases, resulted in a net credit in the provision for lease termination costs in fiscal 2009.
 
     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.
 
     In fiscal 2010, the Company refranchised three operating Company stores to a new franchisee, as more fully described under “Basis of Consolidation” in Note 1 to the consolidated financial statements appearing elsewhere herein, and a fourth operating store to an existing franchisee. No gain or loss was recorded on the former transaction, while the second transaction resulted in an asset impairment charge of $193,000, as well as receipt of cash proceeds of $1.7 million, representing the proceeds of the sale of the store.
 
     In fiscal 2009, the Company refranchised one idled store acquired by the Company from a failed franchisee, refranchised two domestic operating stores to a new franchisee, and refranchised the four Company stores in Eastern Canada to a new franchisee. The Company received no proceeds in connection with any of these transactions. With the exception of a non-cash pretax gain of $2.8 million recorded in the fourth quarter of fiscal 2009 related to foreign currency translation arising from the Canadian disposal (which is included in non-operating income and expense), no significant gain or loss was recognized as a result of these 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 impairment losses on the related assets.
 
46
 


   Interest Income
 
     Interest income decreased to $93,000 in fiscal 2010 from $331,000 in fiscal 2009 due to lower short term interest rates and lower average cash balances in fiscal 2010 compared to fiscal 2009.
 
   Interest Expense
 
     The components of interest expense are as follows:
 
Year Ended
Jan. 31, Feb. 1,
        2010         2009
(In thousands)
Interest accruing on outstanding indebtedness $    5,789 $    6,402
Letter of credit and unused revolver fees 1,240 1,082
Fees associated with credit agreement amendments 925 261
Write-off of deferred financing costs associated with credit agreement amendments 89 289
Amortization of deferred financing costs 770 543
Mark to market adjustments on interest rate derivatives 559 798
Amortization of unrealized loss on interest rate derivatives 1,151 969
Payment to (from) counterparty on interest rate cap derivative 124
Other 162 211
$ 10,685 $ 10,679
 
     The decrease in interest accruing on outstanding indebtedness reflects the reduction in the past year in the outstanding principal balance of the Term Loan described in Note 10 to the consolidated financial statements appearing elsewhere herein. That reduction in interest expense was partially offset by the effects of higher lender margin and fees resulting from amendments to the Company’s Secured Credit Facilities in April 2009. The April 2009 amendments to the credit facilities increased the interest rate on the Company’s outstanding borrowings and letters of credit by 200 basis points annually, and the Company incurred fees and costs associated with those amendments and with similar amendments in April 2008, as described in Note 10.
 
     The interest rate derivative contracts which gave rise to the mark-to-market adjustments and the amortization of unrealized losses on interest rate derivatives expire in April 2010. Except for $152,000 of remaining unamortized losses on those derivative contracts which will be charged to earnings in the first quarter of fiscal 2011, there will be no significant additional income statement effects of such contracts. These interest rate derivative contracts are more fully described in Note 10 to the consolidated financial statements appearing elsewhere herein.
 
   Equity in Losses of Equity Method Franchisees
 
     Equity in losses of equity method franchisees totaled $488,000 in fiscal 2010 compared to $786,000 in fiscal 2009. This caption represents the Company’s share of operating results of equity method franchisees which develop and operate Krispy Kreme stores.
 
   Other Non-Operating Income and Expense, Net
 
     Other non-operating income and expense in fiscal 2010 includes a charge of approximately $500,000 to reflect a decline in the value of an investment in an Equity Method Franchisee that management concluded was other than temporary, as described in Note 18 to the consolidated financial statements appearing elsewhere herein.
 
     Other non-operating income and expense in fiscal 2009 includes a non-cash gain of approximately $2.8 million relating to the disposition of the Company’s Canadian subsidiary in connection with the refranchising of the Company’s four stores in Eastern Canada, substantially all of which represents the cumulative foreign currency translation adjustment related to the Canadian operations which, prior to the sale of the stores, had been reflected, net of tax, in accumulated other comprehensive income.
 
47
 


     In addition, other non-operating income and expense in fiscal 2009 includes a non-cash gain of $931,000 on the disposal of an investment in an Equity Method Franchisee, largely offset by a $900,000 charge for collectability risk on a note receivable from another Equity Method Franchisee, as described in Note 18 to the consolidated financial statements appearing elsewhere herein.
 
   Provision for Income Taxes
 
     The provision for income taxes was $575,000 and $503,000 in fiscal 2010 and fiscal 2009, respectively. 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 portion of the income tax provision represented by taxes estimated to be payable currently was approximately $900,000 and $1.6 million in fiscal 2010 and fiscal 2009, respectively, the majority of which represents foreign withholding taxes related to royalties and franchise fees paid by international franchisees. The current income tax provision for fiscal 2010 also includes a credit of $560,000 representing anticipated federal tax refunds resulting from an additional carryback of net operating losses made possible by the Worker, Homeownership and Business Assistance Act of 2009.
 
     The deferred income tax provision for fiscal 2009 includes $1.2 million of deferred income tax expense related to the cumulative foreign currency translation gain associated with the Company’s operations in Eastern Canada which, prior to the sale of the operations in the fourth quarter of fiscal 2009 and the resulting recognition of the currency gain, was included in accumulated other comprehensive income. In addition, as a result of the dissolution of one of the Company’s foreign subsidiaries and the resolution of related income tax uncertainties during fiscal 2009, the Company recorded a credit of approximately $1.8 million to the provision for income taxes to the Company’s accruals for uncertain tax positions.
 
   Net Loss
 
     The Company reported a net loss of $157,000 in fiscal 2010 compared to a net loss of $4.1 million in fiscal 2009.
 
FISCAL 2009 COMPARED TO FISCAL 2008
 
Overview
 
     Revenues by business segment (expressed in dollars and as a percentage of total revenues) and operating income by business segment are set forth in the table below (percentage amounts may not add to totals due to rounding).
 
48
 


Year Ended
Feb. 1, Feb. 3,
        2009         2008
(Dollars in thousands)
Revenues by business segment:
       Company Stores $    265,890 $    304,444
       Domestic Franchise 8,042 8,673
       International Franchise 17,495 14,285
       KK Supply Chain:
              Total revenues 191,456 205,499
              Less – intersegment sales elimination (97,361 ) (102,531 )
                     External KK Supply Chain revenues 94,095 102,968
                            Total revenues $ 385,522 $ 430,370
 
Segment revenues as a percentage of total revenues:
       Company Stores 69.0 % 70.7 %
       Domestic Franchise 2.1 2.0
       International Franchise 4.5 3.3
       KK Supply Chain (external sales) 24.4 23.9
100.0 % 100.0 %
 
Operating income (loss):
       Company Stores $ (9,813 ) $ (6,292 )
       Domestic Franchise 4,965 4,833
       International Franchise 11,550 9,484
       KK Supply Chain 23,269 24,083
              Total segment operating income 29,971 32,108
       Unallocated general and administrative expenses (24,662 ) (27,552 )
       Impairment charges and lease termination costs (548 ) (62,073 )
       Settlement of litigation 14,930
              Consolidated operating income (loss) $ 4,761 $ (42,587 )
 
     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).
 
49
 


Percentage of Total
Year Ended Year Ended
Feb. 1, Feb. 3, Feb. 1, Feb. 3,
        2009         2008         2009         2008
(In thousands)
Revenues:
       On-premises sales:
              Retail sales $   107,142 $   116,864 40.3 % 38.4 %
              Fundraising sales 13,260 14,118 5.0 4.6
                     Total on-premises sales 120,402 130,982 45.3 43.0
       Off-premises sales:
              Grocers/mass merchants 75,556 89,448 28.4 29.4
              Convenience stores 67,071 80,621 25.2 26.5
              Other off-premises 2,861 3,393 1.1 1.1
                     Total off-premises sales 145,488 173,462 54.7 57.0
                            Total revenues 265,890 304,444 100.0 100.0
 
Operating expenses:
       Cost of sales:
              Food, beverage and packaging 96,208 100,338 36.2 33.0
              Shop labor 53,113 60,518 20.0 19.9
              Delivery labor 25,419 29,574 9.6 9.7
              Employee benefits 21,269 25,097 8.0 8.2
                     Total cost of sales 196,009 215,527 73.7 70.8
              Vehicle costs 16,877 19,282 6.3 6.3
              Occupancy 12,225 13,361 4.6 4.4
              Utilities expense 7,236 7,563 2.7 2.5
              Depreciation expense 6,402 11,558 2.4 3.8
              Other operating expenses 21,079 25,095 7.9 8.2
                     Total store level costs 259,828 292,386 97.7 96.0
       Store operating income 6,062 12,058 2.3 4.0
       Other segment operating costs 10,031 11,024 3.8 3.6
       Allocated corporate overhead 5,844 7,326 2.2 2.4
Segment operating loss $ (9,813 ) $ (6,292 ) (3.7 )% (2.1 )%
 
     Company Stores revenues were $265.9 million in fiscal 2009 compared to $304.4 million in fiscal 2008. Excluding the 53rd week of fiscal 2008, Company Stores revenues decreased 11.0% in fiscal 2009 from $298.9 million in fiscal 2008. The decrease in revenues (measured on a 52-week basis) reflects a 7.8% decline in store operating weeks and a 4.2% decrease in average weekly sales per store. The decrease in store operating weeks reflects the refranchising or closure of 18 Company factory stores and three Company satellite stores since the end of fiscal 2007.
 
     The following table presents sales metrics for Company stores. All comparisons have been made excluding the 53rd week from fiscal 2008.
 
Year Ended
Feb. 1, Feb. 3,
        2009         2008
On-premises:
              Change in same store sales (0.7 )% 0.0 %
Off-premises: (1)
       Grocers/mass merchants:
              Change in average weekly number of doors (8.0 )% (4.7 )%
              Change in average weekly sales per door (4.8 )% (6.1 )%
       Convenience stores:
              Change in average weekly number of doors (5.0 )% 4.3 %
              Change in average weekly sales per door (10.7 )% (10.8 )%
____________________
 
(1)        Metrics exclude off-premises sales by Company stores in Eastern Canada, which the Company refranchised in the fourth quarter of fiscal 2009 as the data for these stores was not available.

50
 


   On-premises sales
 
     Same store sales at Company stores declined 0.7% in fiscal 2009 compared to fiscal 2008 generally reflecting a decrease in customer traffic partially offset by an increase in the average guest check. The Company increased on-premises selling prices in late fiscal 2008 to partially offset rising costs, particularly increased costs of doughnut mixes and shortening due to rising agricultural commodity prices. The Company believes the selling price increases adversely affected sales volumes.
 
   Off-premises sales
 
     Sales to grocers and mass merchants in fiscal 2009 and fiscal 2008 include approximately $3.8 million and $5.9 million, respectively, of off-premises sales of stores in Eastern Canada that the Company refranchised in December 2008. Exclusive of the sales of the Canadian stores that were refranchised and the 53rd week from fiscal 2008, sales to grocers and mass merchants decreased to $72 million in fiscal 2009 from $82 million in fiscal 2008, reflecting an 8.0% decline in the average number of doors served and a 4.8% decrease in the average weekly sales per door. Convenience store sales fell due to both a decline in the average number of doors served and in the average weekly sales per door. Declines in the average weekly sales per door adversely affect profitability because of the increased significance of delivery costs in relation to sales. The Company increased off-premises selling prices in early fiscal 2009 to partially offset rising costs, particularly increased costs of doughnut mixes and shortening due to rising agricultural commodity prices. The Company believes the selling price increases adversely affected sales volumes, particularly in the off-premises channel.
 
   Costs and expenses
 
     Cost of sales as a percentage of revenues increased by 2.9 percentage points from fiscal 2008, to 73.7% of revenues in fiscal 2009. Higher costs for materials resulting from price increases instituted by KK Supply Chain in fiscal 2009 in order to offset higher raw materials costs were not fully recovered through price increases to customers. Economic conditions led to significant reductions in the market prices of agricultural commodities and fuel which resulted in price reductions by KK Supply Chain in the fourth quarter of fiscal 2009.
 
     The Company is self-insured for workers’ compensation, automobile and general liability claims, but maintains stop-loss coverage for individual claims exceeding certain amounts. The Company provides for claims under these self-insured programs using actuarial methods as described in Note 1 to the consolidated financial statements appearing elsewhere herein, and updates actuarial valuations of its self-insurance reserves at least annually. Such periodic actuarial valuations result in changes over time in the estimated amounts which ultimately will be paid for claims under these programs to reflect the Company’s actual claims experience for each policy year as well as trends in claims experience over multiple years. Such claims, particularly workers’ compensation claims, often are paid over a number of years following the year in which the insured events occur, and the estimated ultimate cost of each year’s claims accordingly is adjusted over time as additional information becomes available. The Company recorded favorable adjustments to its self-insurance claims liabilities related to prior policy years of approximately $1.8 million in fiscal 2009, of which $1.0 million was recorded in the fourth quarter, and $1.7 million in fiscal 2008, of which $980,000 was recorded in the fourth quarter. Of the $1.8 million in favorable adjustments recorded in fiscal 2009, $1.6 million relates to workers’ compensation liability claims and is included in employee benefits in the table above and $240,000 relates to general liability claims and is included in other operating expenses in the table above. Of the $1.7 million in favorable adjustments recorded in fiscal 2008, $1.2 million relates to workers’ compensation liability claims, $250,000 relates to vehicle liability claims and is included in vehicle costs in the table above and $230,000 relates to general liability claims.
 
     Depreciation and amortization expense decreased to $6.4 million in fiscal 2009 from $11.6 million in fiscal 2008. The decline in depreciation and amortization expense is attributable principally to the reduction in the number of Company factory stores operating in fiscal 2009 compared to fiscal 2008, and to a lower depreciable base of property and equipment resulting from impairment writedowns.
 
51
 


   Domestic Franchise
 
Year Ended
Feb. 1, Feb. 3,
        2009         2008
(In thousands)
Revenues:
       Royalties $    7,810 $    8,301
       Development and franchise fees 3 174
       Other 229 198
              Total revenues 8,042 8,673
 
Operating expenses:
       Segment operating expenses 2,838 3,357
       Depreciation expense 86 92
       Allocated corporate overhead 153 391
              Total operating expenses 3,077 3,840
Segment operating income $ 4,965 $ 4,833
 
     Domestic Franchise revenues decreased 7.3% to $8.0 million in fiscal 2009 from $8.7 million in fiscal 2008. Excluding the 53rd week of fiscal 2008, Domestic Franchise revenues decreased 5.3% to $8.0 million in fiscal 2009 from $8.5 million in fiscal 2008. The decrease was driven by a decline in domestic royalty revenues resulting from a decrease in sales by domestic franchise stores from approximately $282 million in fiscal 2008 (measured on a 52-week basis) to $236 million in fiscal 2009, principally due to store closings. Royalty revenues measured on a 52-week basis declined to $7.8 million in fiscal 2009 from $8.1 million in fiscal 2008. Additionally, the Company did not recognize as revenue approximately $120,000 and $2.6 million of uncollected royalties which accrued during fiscal 2009 and 2008, respectively, because the Company did not believe collection of these royalties was reasonably assured.
 
     Domestic franchise same store sales decreased 3.3% in fiscal 2009, reflecting declines at both Associate franchise stores, which are located principally in the Southeast, and at Area Developer franchise stores.
 
     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. Domestic Franchise operating expenses decreased in fiscal 2009 compared to fiscal 2008, primarily lower marketing costs.
 
     Domestic franchisees opened six stores and closed 21 stores in fiscal 2009. 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
 
Year Ended
Feb. 1, Feb. 3,
        2009         2008
(In thousands)
Revenues:
       Royalties $    14,942 $    12,076
       Development and franchise fees 2,460 2,167
       Other 93 42
              Total revenues 17,495 14,285
 
Operating expenses:
       Segment operating expenses 5,016 3,966
       Allocated corporate overhead 929 835
              Total operating expenses 5,945 4,801
Segment operating income $ 11,550 $ 9,484
 
52
 


     International Franchise royalties increased $2.9 million in fiscal 2009 from $12.1 million in fiscal 2008. Excluding the 53rd week of fiscal 2008, International Franchise royalties increased 26.5% to $14.9 million in fiscal 2009 from $11.8 million in fiscal 2008. The increase was driven by an increase in sales by international franchise stores from $194 million in fiscal 2008 (measured on a 52-week basis) to $273 million in fiscal 2009. Changes in the rates of exchange between the U.S. dollar and the foreign currencies in which the Company’s international franchisees do business reduced sales by international franchisees measured in U.S. dollars by approximately $10 million in the fourth quarter of fiscal 2009 and for fiscal 2009 as a whole, compared to the comparable periods in fiscal 2008, which adversely affected international royalty revenues by approximately $600,000. Additionally, the Company did not recognize as revenue approximately $920,000 of uncollected royalties which accrued during fiscal 2009 because the Company did not believe collection of these royalties was reasonably assured.
 
     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, fell 18.6%. The decline in International Franchise same store sales reflects the large number of new stores opened internationally in fiscal 2009 and fiscal 2008, the cannibalization effects on initial stores in new markets of additional store openings in those markets and the effects of soft economic conditions.
 
     International development and franchise fees increased $293,000 in fiscal 2009 due to an increase in store openings compared to fiscal 2008. Development and franchise fees did not increase proportionately with the number of store openings principally because a greater percentage of fiscal 2009 openings were satellite stores compared to fiscal 2008; development and franchise fees per store are lower for satellite stores than for factory stores.
 
     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 rose in the fiscal 2009 compared to fiscal 2008. The increase in International Franchise operating expenses in fiscal 2009 compared to fiscal 2008 reflects a bad debt provision of approximately $1.3 million principally related to credit exposure on international franchisees, partially offset by lower store opening support expenses. Costs to support franchise store openings decline as individual franchisees gain experience opening stores and develop internal resources to assist in store openings.
 
     International franchisees opened 114 stores and closed 19 stores in fiscal 2009. 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) are set forth in the table below (percentage amounts may not add to totals due to rounding).
 
53
 


Percentage of Total Revenues
Before Intersegment
Sales Elimination
Year Ended Year Ended
Feb. 1, Feb. 3, Feb. 1, Feb. 3,
        2009         2008         2009         2008
(In thousands)
Revenues:
       Doughnut mixes $    73,312 $    71,509 38.3 % 34.8 %
       Other ingredients, packaging and supplies 106,054 118,688 55.4 57.8
       Equipment 8,749 13,086 4.6 6.4
       Fuel surcharge 3,341 2,216 1.7 1.1
              Total revenues before intersegment sales elimination 191,456 205,499 100.0 100.0
 
Operating expenses:
       Cost of sales:
              Cost of goods produced and purchased 131,594 138,374 68.7 67.3
              Inbound freight 7,550 6,062 3.9 2.9
                     Total cost of sales 139,144 144,436 72.7 70.3
       Distribution costs:
              Outbound freight 13,806 12,521 7.2 6.1
              Other distribution costs 3,357 1,308 1.8 0.6
                     Total distribution costs 17,163 13,829 9.0 6.7
       Other segment operating costs 9,496 15,768 5.0 7.7
       Depreciation expense 1,019 5,586 0.5 2.7
       Allocated corporate overhead 1,365 1,797 0.7 0.9
              Total operating costs 168,187 181,416 87.8 88.3
Segment operating income $ 23,269 $ 24,083 12.2 % 11.7 %
 
     KK Supply Chain revenues before intersegment sales elimination fell $14.0 million, or 6.8%, in fiscal 2009 compared to fiscal 2008. Excluding the 53rd week in fiscal 2008, KK Supply Chain revenues before intersegment eliminations decreased 5.0% from $201.5 million in fiscal 2008. The most significant reason for the decrease in revenues (measured on a 52-week basis) was lower unit sales of mixes, ingredients and supplies resulting from lower sales by Company and domestic franchise stores. In addition, an increasing percentage of franchisee 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. The decline in the KK Supply Chain revenue due to lower unit volume was partially offset by an increase in revenue resulting from price increases for mixes and certain other ingredients instituted by KK Supply Chain in fiscal 2009 in order to offset increases in the cost of materials. The KK Supply Chain revenue decrease was also attributable to a decrease in sales of equipment and equipment services in fiscal 2009 compared to fiscal 2008. Franchisee expansion in fiscal 2009 was comprised principally of satellite stores, which require less equipment than do factory stores.
 
     Cost of sales as a percentage of revenues increased in fiscal 2009 compared to fiscal 2008. The cost of raw materials used in the production of doughnut mix and of other goods sold to Company and franchise stores was higher in fiscal 2009 than in fiscal 2008. In particular, the prices of flour and shortening and the products from which they are made were significantly higher in fiscal 2009 compared to fiscal 2008. During fiscal 2009, KK Supply Chain increased the prices charged to Company and franchise stores for doughnut mixes, shortening and other goods in order to mitigate increases in the cost of these raw materials. However, while KK Supply Chain increased prices to cover its increased costs, profit margins as a percentage of sales decreased. In addition, cost of sales was adversely affected by higher inbound freight costs resulting from higher fuel prices.
 
     Outbound freight costs increased in fiscal 2009 compared to fiscal 2008. A significant component of the increase was a charge of approximately $1.7 million (approximately 0.9% of KK Supply Chain revenues before intersegment sales elimination) related to payments made by the Company to its former third-party freight consolidator which were improperly not remitted to the freight carriers by the freight consolidator. For many years, the Company utilized a third-party freight consolidator to review and pay freight bills on behalf of the Company. During the second quarter of fiscal 2009, the Company made routine payments to the third-party freight consolidator which were improperly not remitted to the freight carriers. The actions of the third-party freight consolidator, which has since filed for bankruptcy protection, resulted in a loss to the Company which the Company currently has not recovered.
 
54
 


     Other segment operating costs include segment management, purchasing, customer service and support, laboratory and quality control costs and research and development expenses. These costs include a net credit of approximately $950,000 for bad debts expense in fiscal 2009 compared to a charge of approximately $1.5 million in fiscal 2008. The net credit in fiscal 2009 reflects a reduction in the allowance for doubtful accounts resulting principally from a decrease in credit exposure with respect to certain franchisees and a recovery of certain receivables previously reserved, partially offset by bad debt provisions recorded with respect to other franchise receivables. As of February 1, 2009, the Company’s allowance for doubtful accounts from franchisees totaled approximately $2.8 million.
 
     Depreciation and amortization expense decreased to $1.0 million in fiscal 2009 from $5.6 million in fiscal 2008. Depreciation and amortization expense decreased approximately $4.3 million in fiscal 2009 compared to fiscal 2008 as a result of the Company’s divestiture in January 2008 of its manufacturing and distribution facility in Effingham, Illinois.
 
     Domestic and international franchisees opened 120 stores and closed 40 stores in fiscal 2009. The majority 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.
 
   General and Administrative Expenses
 
     General and administrative expenses decreased to $23.5 million in fiscal 2009 from $26.3 million in fiscal 2008. General and administrative expenses in fiscal 2008 include approximately $2.7 million recorded in the fourth quarter for severance costs related to the resignation of the Company’s former chief executive officer, of which approximately $1.6 million was share-based compensation (including accelerated vesting of certain equity awards). The decrease in general and administrative expenses in fiscal 2009 also reflects a decrease in other share-based compensation expense of approximately $700,000 due principally to executive officer turnover resulting in the forfeiture of stock and option awards, and the elimination of incentive compensation costs in fiscal 2009 due to the Company’s failure to achieve incentive compensation targets for the year, which reduced incentive compensation costs by approximately $1.0 million from fiscal 2008. These decreases in general and administrative expenses were partially offset by a charge of approximately $1.1 million in fiscal 2009 related to changes in the Company’s vacation policy.
 
     General and administrative expenses in fiscal 2009 include an out of period credit of approximately $600,000 related to the Company’s self-insured worker’s compensation program, and these costs in fiscal 2008 include unusual credits of $480,000 relating to the settlement of certain charitable pledge obligations.
 
     General and administrative expenses include professional fees and expenses related to the investigations and securities litigation described in Note 12 to the consolidated financial statements included elsewhere herein, which totaled approximately $1.3 million in fiscal 2009 and $1.1 million in fiscal 2008.
 
   Impairment Charges and Lease Termination Costs
 
     Impairment charges and lease termination costs were $548,000 in fiscal 2009 compared to $62.1 million in fiscal 2008.
 
     Impairment charges related to long-lived assets totaled $1.1 million in fiscal 2009 and $56.0 million in fiscal 2008, of which approximately $900,000 and $44.1 million, respectively, related to underperforming stores. The charges relate to stores closed or expected to be closed, as well as charges with respect 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. The Company closed six stores in fiscal 2009 and nine stores in fiscal 2008. 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 decisions, the effects of changing costs (including commodity 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.
 
55
 


     In addition, in fiscal 2008, the Company recorded an impairment charge of approximately $10.4 million with respect to its KK Supply Chain manufacturing and distribution facility in Effingham, Illinois. During the second quarter of fiscal 2008, the Company decided to divest the facility and determined that the projected cash flows from operation and ultimate sale of the facility were less than its carrying value; accordingly, the Company recorded an impairment charge to reduce the carrying value of the facility and related equipment to their estimated fair value. In the fourth quarter of fiscal 2008, the Company sold these assets for approximately $10.9 million cash (net of expenses), and recorded a credit to impairment charges of approximately $600,000, representing the excess of the ultimate selling price over the previously estimated disposition value of the facility and equipment. Also during fiscal 2008, the Company decided to close its KK Supply Chain coffee roasting operation and to sell the related assets, and recorded an impairment charge of approximately $1.5 million to reduce the carrying value of those assets to their estimated disposal value of $1.9 million. The Company sold these assets for approximately $1.9 million cash during the third quarter of fiscal 2008.
 
     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. In fiscal 2009, changes in estimated sublease rentals on a closed store that was subsequently refranchised and the realization of proceeds on an assignment of another closed store lease resulted in $1.2 million of credits to the provision for lease termination costs. These credits, in combination with the reversal of approximately $800,000 of previously recorded accrued rent expense related to stores closed during the year and approximately $1.5 million of charges related to other closed store leases, resulted in a net credit in the provision for lease termination costs of $502,000 in fiscal 2009. In fiscal 2008, the Company received proceeds of $966,000 on the assignment of leases related to closed stores, reversed approximately $1.7 million of previously recorded accrued rent expense related to stores closed during the year and recorded approximately $1.7 million of charges related to other closed store leases, resulting in a net provision for lease termination costs of $1.0 million in fiscal 2008.
 
     In fiscal 2009, the Company refranchised one idled store acquired by the Company from a failed franchisee, refranchised two domestic operating stores to a new franchisee, and refranchised the four Company stores in Eastern Canada to a new franchisee. The Company received no proceeds in connection with any of these transactions. With the exception of a non-cash pretax gain of $2.8 million recorded in the fourth quarter of fiscal 2009 related to foreign currency translation arising from the Canadian disposal (which is included in non-operating income and expense), no significant gain or loss was recognized as a result of the refranchisings.
 
   Settlement of Litigation
 
     In the first quarter of fiscal 2008, the Company issued common stock and warrants to acquire common stock in connection with the settlement of a federal securities class action and to settle, in part, certain shareholder derivative actions, as more fully described in Note 12 to the consolidated financial statements appearing elsewhere herein. The Company recorded a charge to earnings in fiscal 2006 for the fair value of the stock and warrants, measured as of the date on which the Company agreed to settle the litigation, and adjusted that charge in subsequent periods to reflect changes in the securities’ fair value until their issuance in the first quarter of fiscal 2008. Such subsequent adjustment resulted in a non-cash credit to fiscal 2008 earnings of $14.9 million.
 
   Interest Income
 
     Interest income decreased to $331,000 in fiscal 2009 from $1.4 million in fiscal 2008 primarily due to lower short term interest rates in fiscal 2009 compared to fiscal 2008.
 
56
 


   Interest Expense
 
     The components of interest expense are as follows:
 
Year Ended
Feb. 1, Feb. 3,
        2009         2008
(In thousands)
Interest accruing on outstanding indebtedness $    6,402 $    8,418
Letter of credit and unused revolver fees 1,082 736
Fees associated with credit agreement amendments 261
Write-off of deferred financing costs associated with credit agreement amendments 289
Fees associated with credit agreement refinancing 220
Amortization of deferred financing costs 543 522
Mark to market adjustments on interest rate derivatives 798 96
Amortization of unrealized (gain) loss on interest rate derivatives 969 (69 )
Payment to (from) counterparty on interest rate cap derivative 124 (163 )
Other 211 36
$ 10,679 $ 9,796
 
     Interest accruing on outstanding indebtedness was lower in fiscal 2009 than in fiscal 2008 because of a reduction in outstanding debt since the first quarter of fiscal 2008. This lower interest on outstanding indebtedness was partially offset by higher lender margin and fees resulting from the amendments to the Company’s 2007 Secured Credit Facilities described in Note 10 to the consolidated financial statements appearing elsewhere herein.
 
     As more fully described in Note 22 to the consolidated financial statements appearing elsewhere herein, effective April 9, 2008, the Company discontinued hedge accounting for certain interest rate derivatives as a result of amendments to its credit facilities. As a consequence of the discontinuance of hedge accounting, changes in the fair value of the derivative contracts subsequent to April 8, 2008 are reflected in earnings as they occur. Amounts included in accumulated other comprehensive income related to changes in the fair value of the derivative contracts for periods prior to April 9, 2008 are being charged to earnings through April 2010 when the underlying hedged transactions (interest expense on long-term debt) affect earnings.
 
   Loss on Extinguishment of Debt
 
     During the first quarter of fiscal 2008, the Company closed the 2007 Secured Credit Facilities and used the proceeds to retire other indebtedness, as more fully described in Note 10 to the consolidated financial statements appearing elsewhere herein. The Company recorded a loss on extinguishment of debt of approximately $9.6 million, consisting of a $4.1 million prepayment fee related to the other indebtedness and a $5.5 million write-off of unamortized deferred financing costs related to that debt.
 
   Equity in Losses of Equity Method Franchisees
 
     Equity in losses of equity method franchisees totaled $786,000 in fiscal 2009 compared to $933,000 in fiscal 2008. This caption represents the Company’s share of operating results of equity method franchisees which develop and operate Krispy Kreme stores.
 
   Other Non-Operating Income and Expense, Net
 
     Other non-operating income and expense in fiscal 2009 includes a non-cash gain of approximately $2.8 million relating to the disposition of the Company’s Canadian subsidiary in connection with the refranchising of the Company’s four stores in Eastern Canada, substantially all of which represents the cumulative foreign currency translation adjustment related to the Canadian operations which, prior to the sale of the stores, had been reflected, net of tax, in accumulated other comprehensive income. In addition, other non-operating income and expense in fiscal 2009 includes a non-cash gain of $931,000 on the disposal of an investment in an Equity Method Franchisee, largely offset by a $900,000 charge for collectability risk on a note receivable from another Equity Method Franchisee, as described in Note 18 to the consolidated financial statements appearing elsewhere herein.
 
     Other non-operating income and expense in fiscal 2008 includes a provision of $3.0 million recorded in the fourth quarter for estimated payments under the Company’s guarantees of certain debt and leases related to an Equity Method Franchisee and, in fiscal 2009, the Company paid approximately $250,000 related to these guarantees, which are more fully described in Note 18 to the consolidated financial statements appearing elsewhere herein. In addition, other non-operating income and expense in fiscal 2008 includes an impairment charge of approximately $572,000 to reduce the carrying value of the Company’s investment in a franchisee to its estimated fair value, partially offset by a gain of approximately $260,000 resulting from additional proceeds from the prior sale of an interest in another franchisee.
 
57
 


   Provision for Income Taxes
 
     The provision for income taxes was $503,000 and $2.3 million in fiscal 2009 and fiscal 2008, respectively. Each of these amounts includes 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, as well as a provision for income taxes estimated to be payable currently. The deferred income tax provision for fiscal 2009 includes $1.2 million of deferred income taxes related to the cumulative foreign currency translation gain associated with the Company’s operations in Eastern Canada which, prior to the sale of the operations in the fourth quarter of fiscal 2009 and the resulting recognition of the gain, was included in accumulated other comprehensive income. In addition, the fiscal 2009 income tax provision includes a credit of approximately $1.8 million to reduce accruals for uncertain tax positions, principally as a result of the dissolution of one of the Company’s foreign subsidiaries and the resolution of related income tax uncertainties.
 
   Net Loss
 
     The Company incurred net losses of $4.1 million and $67.1 million in fiscal 2009 and 2008, respectively.
 
Liquidity and Capital Resources
 
     The following table summarizes the Company’s cash flows from operating, investing and financing activities for fiscal 2010, 2009 and 2008:
 
Year Ended
Jan. 31, Feb. 1, Feb. 3,
        2010         2009         2008
(In thousands)
Net cash provided by operating activities $ 19,827 $ 16,593 $ 9,712
Net cash provided by (used for) investing activities (2,175 ) (4,296 ) 13,118
Net cash used for financing activities (32,975 ) (1,422 ) (34,425 )
Effect of exchange rate changes on cash (72 ) 88
       Net increase (decrease) in cash and cash equivalents $ (15,323 ) $ 10,803 $ (11,507 )
 
Cash Flows from Operating Activities
 
     Net cash provided by operating activities was $19.8 million in fiscal 2010, $16.6 million in fiscal 2009 and $9.7 million in fiscal 2008.
 
     The improvement in operating results accounted for all of the increase in cash provided by operating activities in fiscal 2010; the net loss, adjusted for non-cash charges and credits, improved by $4.9 million over fiscal 2009. While operating results improved, the scope of the Company’s operations has decreased in recent years as it has closed underperforming locations and rationalized other components of its business, resulting in a decrease in the amount of working capital funded by accounts payable and accruals, which have had a net decrease of $5.5 million in the past two years. Most of this decrease was offset by declines in accounts receivable as off-premises doughnut sales and sales to franchisees declined, and by decreases in the Company’s investment in inventories.
 
58
 


     In addition, cash provided by operating activities in fiscal 2008 reflects a cash outflow of approximately $4.1 million for a prepayment fee associated with the refinancing of the Company’s credit facilities described under “Cash Flows from Financing Activities” below.
 
Cash Flows from Investing Activities
 
     Net cash used for investing activities was approximately $2.2 million and $4.3 million in fiscal 2010 and 2009, respectively, compared to net cash provided by investing activities of $13.1 million in fiscal 2008.
 
     Cash used for capital expenditures increased to $8.0 million in fiscal 2010 from $4.7 million in fiscal 2009 and $5.5 million in fiscal 2008, reflecting the construction of six new stores in fiscal 2010 and increased store refurbishment efforts.
 
     In fiscal 2010, 2009 and 2008, the Company realized proceeds from the sale of property and equipment of $5.8 million, $748,000 and $18.3 million, respectively, which, except for approximately $10.9 million (net of expenses) received in fiscal 2008 from the sale of a mix manufacturing and distribution facility, related principally to the sale of closed or refranchised stores.
 
Cash Flows from Financing Activities
 
     Net cash used for financing activities was $33.0 million in fiscal 2010, $1.4 million in fiscal 2009 and $34.4 million in fiscal 2008.
 
     During fiscal 2010, the Company repaid approximately $31.7 million of outstanding term loan and capitalized lease indebtedness, consisting of approximately $1.1 million of scheduled principal amortization, a prepayment of $20 million in connection with amendments to the Company’s credit facilities in April 2009 as described in Note 10 to the consolidated financial statements appearing elsewhere herein, prepayments aggregating $5.6 million from the sale of assets related to three closed stores and one store which was refranchised, and a discretionary prepayment of $5 million made on the term loan during the third quarter of fiscal 2010. During fiscal 2009, the Company repaid approximately $2.0 million of outstanding term loan and capitalized lease indebtedness, consisting of approximately $1.2 million of scheduled amortization and a prepayment of approximately $750,000 from the proceeds of the assignment of a lease related to a closed store. Additionally, the Company paid approximately $1.9 million and $728,000 in fees to its lenders in fiscal 2010 and fiscal 2009, respectively, to amend its credit facilities. Of such aggregate amounts, $954,000 and $467,000, respectively, was capitalized as deferred financing costs, and the balance of approximately $925,000 and $261,000, respectively, was charged to interest expense.
 
     In fiscal 2009, the Company received $3.1 million in proceeds from the exercise of stock options. During the same period, present and former employees surrendered common shares having an aggregate fair value of $2.1 million to pay the exercise price of options exercised and to reimburse the Company for the minimum statutory withholding taxes paid by the Company on behalf of present and former employees arising from such exercise and from the vesting of restricted stock awards.
 
     In early fiscal 2008, the Company closed new secured credit facilities totaling $160 million. At closing, the Company borrowed $110 million under a term loan, and used the proceeds to retire approximately $107 million of indebtedness outstanding under its former secured credit facilities (which were terminated) and to pay prepayment fees under the former secured credit facilities and fees and expenses associated with the new credit facilities. Also in fiscal 2008, the Company prepaid approximately $32.8 million of the new term loan, of which $17.8 million was from the proceeds of sales of certain property and equipment and $15.0 million represented discretionary prepayments.
 
Capital Resources, Contractual Obligations and Off-Balance Sheet Arrangements
 
     In addition to cash flow generated from operations, the Company utilizes other capital resources and financing arrangements to fund its business. A discussion of these capital resources and financing techniques is included below.
 
   Debt
 
     The Company continuously monitors its funding requirements for general working capital purposes and other financing and investing activities. In the last three fiscal years, management focused on reducing or eliminating the Company’s investments in franchisees and the related guarantees of franchisees’ obligations, and on restructuring the Company’s borrowing arrangements to maintain credit availability to facilitate accomplishing the Company’s business restructuring initiatives.
 
59
 


     The Secured Credit Facilities described in Note 10 to the consolidated financial statements appearing elsewhere herein are the Company’s principal source of external financing. These facilities consist of a term loan having an outstanding principal balance of $43.1 million as of January 31, 2010 which matures in February 2014, and a $25 million revolving credit facility maturing in February 2013.
 
     The Secured Credit Facilities contain significant financial covenants. Based on the Company’s current working capital and the fiscal 2011 operating plan, management believes the Company can comply with the financial covenants and that the Company can meet its projected operating, investing and financing cash requirements.
 
     Failure to comply with the financial covenants contained in the Secured Credit Facilities, or the occurrence or failure to occur of certain events, would cause the Company to default under the facilities. The Company would attempt to negotiate waivers of any such default, should one occur. There can be no assurance that the Company would be able to negotiate any such waivers, and the costs or conditions associated with any such waivers could be significant. In the absence of a waiver of, or forbearance with respect to, any such default, the Company’s lenders would be able to exercise their rights under the credit agreement including, but not limited to, accelerating maturity of outstanding indebtedness and asserting their rights with respect to the collateral. Acceleration of the maturity of indebtedness under the Secured Credit Facilities could have a material adverse effect on the Company’s financial position, results of operations and cash flows. In the event that credit under the Secured Credit Facilities were not available to the Company, there can be no assurance that alternative sources of credit would be available to the Company or, if they are available, under what terms or at what cost.
 
     The operation of the financial covenants described above could limit the amount the Company may borrow under the revolving credit facility. In addition, the maximum amount which may be borrowed under the revolving facility is reduced by the amount of outstanding letters of credit, which totaled approximately $15 million as of January 31, 2010, the substantial majority of which secure the Company’s reimbursement obligations to insurers under the Company’s self- insurance arrangements. The maximum additional borrowing available to the Company as of January 31, 2010 was approximately $10 million.
 
     The Secured Credit Facilities also contain customary events of default including without limitation, payment defaults, breaches of representations and warranties, covenant defaults, cross-defaults to other indebtedness in excess of $5 million, certain events of bankruptcy and insolvency, judgment defaults in excess of $5 million and the occurrence of a change of control.
 
   Leases
 
     The Company conducts some of its operations from leased facilities and leases certain equipment. Generally, these leases have initial terms of two to 20 years and contain provisions for renewal options of five to 15 years. In determining whether to enter into a lease for an asset, the Company evaluates the nature of the asset and the associated lease terms to determine if leasing is an effective financing tool.
 
   Off-Balance Sheet Arrangements
 
     The Company’s only off-balance sheet arrangements, as defined by Item 303(a)(4) of SEC Regulation S-K, consist principally of the Company’s guarantees of indebtedness of certain franchisees, as discussed in Notes 12 and 18 to the consolidated financial statements appearing elsewhere herein.
 
60
 


Contractual Cash Obligations at January 31, 2010
 
     The Company’s contractual cash obligations as of January 31, 2010 are as follows:
 
Payments Due In
Less More
Than Than
Total 1 1-3 3-5 5
        Amount         Year         Years         Years         Years
(In thousands)
Long-term debt (excluding capital lease obligations),
       including current maturities $ 43,054 $ 564 $ 1,128 $ 41,362 $
Interest payment obligations (1) 22,415 5,857 11,552 5,006
Payment obligations on interest rate hedge 642 642
Capital lease obligations 393 198 195
Operating lease obligations 91,524 8,866 14,741 11,250 56,667
Purchase obligations 42,897 39,379 3,518
Contingent guarantee obligations (2) 3,730 3,199 531
Other long-term obligations, including current portion,
       reflected on the Company’s balance sheet:
              Self-insurance claims 14,682 5,355 3,824 1,777 3,726
              401(k) mirror plan liability 455 455
Total $ 219,792 $ 64,060 $ 35,489 $ 59,395 $ 60,848
____________________

(1) Estimated interest payments for variable rate debt are based upon the forward LIBOR interest rate curve as of January 29, 2010.
     
(2) Amounts represent 100% of the Company’s aggregate exposure at January 31, 2010 under loan guarantees related to franchisees in which the Company has an ownership interest.
 
     The preceding table of contractual cash obligations excludes income tax liabilities of approximately $540,000 as of January 31, 2010 for unrecognized tax benefits due to uncertainty in predicting the timing of any such related payments.
 
Capital Requirements
 
     In the next five years, the Company plans to use cash primarily for the following activities:
  • Working capital and other general corporate purposes
     
  • Opening new Company stores in selected markets, principally small retail shops
     
  • Remodeling and relocation of selected older Company shops
     
  • Investing in equipment to support the off-premises distribution channel
     
  • Maintaining and enhancing the Supply Chain manufacturing and distribution capabilities
     
  • Investing in systems and technology
     The Company’s capital requirements for these activities may be significant. The amount of these capital requirements will depend on many factors including the Company’s overall performance, the pace of store expansion and Company store remodels and other infrastructure needs. These capital outlays are subject to limitations contained in the Secured Credit Facilities. The Company currently estimates that its capital expenditures for fiscal 2011 will be in the range of from $13 million to $17 million. The most significant capital expenditures currently planned for fiscal 2011 are between seven and ten new satellite stores, refurbishments to existing stores, new point-of-sale hardware to replace existing hardware that is approaching the end of its useful life, and ongoing maintenance capital expenditures. The Company plans to fund these expenditures using cash provided by operations and current cash resources.
 
61
 


Recent Financial Performance and Business Conditions
 
     The Company experienced a decline in revenues and incurred net losses in each of the last three fiscal years. The revenue decline reflects fewer Company stores in operation resulting principally from the closure of lower performing locations, a decrease in off-premises sales at Company stores, a decline in domestic royalty revenues and lower sales of mixes and other ingredients resulting from lower sales by the Company’s domestic franchisees. Lower revenues have adversely affected operating margins because of the fixed or semi-fixed nature of many of the Company’s direct operating expenses. In addition, the prices of certain agricultural commodities and of oil, while volatile, have trended upward in the last fiscal three years, which has adversely affected the cost of the Company’s principal ingredients and increased the cost of gasoline consumed by the Company. Sales volumes and changes in the cost of major ingredients and fuel can have a material effect on the Company’s results of operations and cash flows. In addition, royalty revenues and most of KK Supply Chain 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.
 
     The Company generated cash flow from operating activities of $19.8 million, $16.6 million and $9.7 million in fiscal 2010, 2009 and 2008, respectively, and the Company has reduced its aggregate outstanding debt by $64.2 million over the past three fiscal years, using both cash generated from the sale of excess assets and cash generated by operations.
 
     The Company’s credit facilities described above and in Note 10 to the consolidated financial statements appearing elsewhere herein are the Company’s principal source of external financing. These facilities consist of a term loan having an outstanding principal balance of $43.1 million as of January 31, 2010 which matures in February 2014, and a $25 million revolving credit facility maturing in February 2013. The credit facilities contain significant financial covenants, which also are described in Note 10. Based on the Company’s current working capital and the fiscal 2011 operating plan, management believes the Company can comply with the these financial covenants and that the Company can meet its projected operating, investing and financing cash requirements.
 
Inflation
 
     The Company does not believe that general price inflation has had a material effect on its results of operations in recent years. However, prices of agricultural commodities and fuel have been volatile in recent years. Those price changes, which have generally trended upward, have had a significant effect on the cost of flour, shortening and sugar, the three most significant ingredients used in the production of the Company’s products, as well as on the cost of gasoline consumed by the Company’s off-premises delivery fleet.
 
Critical Accounting Policies
 
     The Company’s discussion and analysis of its financial condition and results of operations is based upon its financial statements that have been prepared in accordance with GAAP. The preparation of financial statements in accordance with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosures, including disclosures of contingencies and uncertainties. GAAP provides the framework from which to make these estimates, assumptions and disclosures. The Company chooses accounting policies within GAAP that management believes are appropriate to accurately and fairly report the Company’s operating results and financial position in a consistent manner. Management regularly assesses these policies in light of changes in facts and circumstances and discusses the selection of accounting policies and significant accounting judgments with the Audit Committee of the Board of Directors. The Company believes that application of the following accounting policies involves judgments and estimates that are among the more significant used in the preparation of the financial statements, and that an understanding of these policies is important to understanding the Company’s financial condition and results of operations.
 
   Allowance for Doubtful Accounts
 
     Accounts receivable arise primarily from royalties earned on sales by the Company’s franchisees, sales by KK Supply Chain to our franchisees of equipment, mix and other supplies necessary to operate a Krispy Kreme store, as well as from off-premises sales by company stores to convenience and grocery stores and other customers. During the three fiscal years in the period ended January 31, 2010, some of the Company’s franchisees experienced financial difficulties or for other reasons did not comply with the normal payment terms for settlement of amounts due to the Company. The Company has recorded provisions for doubtful accounts related to its accounts receivable, including receivables from franchisees, in amounts which management believes are sufficient to provide for losses estimated to be sustained on realization of these receivables. Such estimates inherently involve uncertainties and assessments of the outcome of future events, and changes in facts and circumstances may result in adjustments to the provision for doubtful accounts.
 
62
 


   Goodwill and Identifiable Intangible Assets
 
     The Financial Accounting Standards Board (“FASB”) guidance related to goodwill and other intangible assets addresses the accounting and reporting of goodwill and other intangible assets subsequent to their acquisition. This guidance requires intangible assets with definite lives to be amortized over their estimated useful lives, while those with indefinite lives and goodwill are not subject to amortization but must be tested annually for impairment, or more frequently if events and circumstances indicate potential impairment.
 
     For intangible assets with indefinite lives, the Company performs the annual test for impairment as of December 31. The impairment test for indefinite-lived intangible assets involves comparing the fair value of such assets with their carrying value, with any excess of carrying value over fair value recorded as an impairment charge. The goodwill impairment test involves determining the fair values of the reporting units to which goodwill is assigned and comparing those fair values to the reporting units’ carrying values, including goodwill. To determine fair value for each reporting unit, the Company uses the discounted cash flows that the reporting unit can be expected to generate in the future. This valuation method requires management to project revenues, operating expenses, working capital investment, capital spending and cash flows for the reporting units over a multi-year period, as well as determine the weighted average cost of capital to be used as a discount rate. The Company also considers the estimated fair values of its reporting units relative to the Company’s overall market capitalization in connection with its goodwill impairment assessment. Significant management judgment is involved in preparing these estimates. Changes in projections or estimates could significantly change the estimated fair value of reporting units. In addition, if management uses different assumptions or estimates in the future or if conditions exist in future periods that are different than those anticipated, operating results and the balances of goodwill could be affected by impairment charges. Impairment analyses of goodwill resulted in impairment charges of approximately $4.6 million in fiscal 2008. There were no goodwill impairment charges in fiscal 2010 or fiscal 2009. As of January 31, 2010, the remaining goodwill had a carrying value of $23.5 million, all of which was associated with the Domestic and International Franchise segments, each of which consists of a single reporting unit. The risk of goodwill impairment would increase in the event that the franchise segment operating results were to significantly deteriorate or the overall market capitalization of the Company were to decline below the book value of the Company’s shareholders’ equity.
 
   Asset Impairment
 
     When an asset group (typically a store) is identified as underperforming or when a decision is made to abandon an asset group or to close a store, the Company makes an assessment of the potential impairment of the related assets. The assessment is based upon a comparison of the carrying amount of the assets, primarily property and equipment, to the estimated undiscounted cash flows expected to be generated from those assets. To estimate cash flows, management projects the net cash flows anticipated from continuing operation of the asset group or store until its closing or abandonment, as well as cash flows, if any, anticipated from disposal of the related assets. If the carrying amount of the assets exceeds the sum of the undiscounted cash flows, the Company records an impairment charge in an amount equal to the excess of the carrying value of the assets over their estimated fair value.
 
     Determining undiscounted cash flows and the fair value of an asset group involves estimating future cash flows, revenues, operating expenses and disposal values. The projections of these amounts represent management’s best estimates at the time of the review. If different cash flows had been estimated, property and equipment balances and related impairment charges could have been affected. Further, if management uses different assumptions or estimates in the future or if conditions exist in future periods that are different than those anticipated, future operating results could be affected. In addition, the sale of assets whose carrying value has been reduced by impairment charges could result in the recognition of gains or losses to the extent the sales proceeds realized differ from the reduced carrying amount of the assets. In fiscal 2010, fiscal 2009 and fiscal 2008, the Company recorded impairment charges related to long-lived assets totaling approximately $3.1 million, $1.1 million and $56.0 million, respectively. Additional impairment charges may be necessary in future years.
 
   Insurance
 
     The Company is subject to workers’ compensation, vehicle and general liability claims. The Company is self-insured for the cost of all workers’ compensation, vehicle and general liability claims up to the amount of stop-loss insurance coverage purchased by the Company from commercial insurance carriers. The Company maintains accruals for the estimated cost of claims on an undiscounted basis, without regard to the effects of stop-loss coverage, using actuarial methods which evaluate known open and incurred but not reported claims and consider historical loss development experience. In addition, the Company records receivables from the insurance carriers for claims amounts estimated to be recovered under the stop-loss insurance policies when these amounts are estimable and probable of collection. The Company estimates such stop-loss receivables using the same actuarial methods used to establish the related claims accruals, and taking into account the amount of risk transferred to the carriers under the stop-loss policies. Many estimates and assumptions are involved in estimating future claims, and differences between future events and prior estimates and assumptions could affect future operating results and result in adjustments to these loss accruals and related insurance receivables.
 
63
 


   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 already 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 income tax assets in accordance with FASB guidance related to accounting for income taxes. At January 31, 2010, the Company has recorded a valuation allowance against deferred income tax assets of $160.6 million, representing the total amount of such assets in excess of the Company’s deferred income tax liabilities. The valuation allowance was recorded because management was unable to conclude, in light of the cumulative losses realized by the Company, that realization of the net deferred income tax asset was more likely than not. 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 assumed or anticipated, the amount of income tax assets and liabilities, including valuation allowances for deferred income tax assets, could be materially affected.
 
   Guarantee Liabilities
 
     The Company has guaranteed a portion of certain loan obligations of certain franchisees in which the Company owns an interest. The Company assesses the likelihood of making any payments under the guarantees and records estimated liabilities for anticipated payments when the Company believes that an obligation to perform under the guarantees is probable and the amount can be reasonably estimated. No liabilities for the guarantees were recorded at the time they were issued because the Company believed the value of the guarantees was immaterial. As of January 31, 2010, the Company has recorded liabilities of approximately $2.5 million related to such loan guarantees. The aggregate outstanding principal balance of loans subject to the Company’s guarantees was approximately $3.7 million at that date. Assessing the probability of future guarantee payments involves estimates and assumptions regarding future events, including the future operating results of the franchisees. If future events are different from those assumed or anticipated, the amounts estimated to be paid pursuant to such guarantees could change, and additional provisions to record such liabilities could be required.
 
   Investments in Franchisees
 
     The Company has investments in certain Equity Method Franchisees, the value of which cannot be verified by reference to quoted market prices. The Company’s assessment of the realizability of these investments involves assumptions concerning future events, including the future operating results of the franchisees. If future events are different from those assumed or anticipated by the Company, the assessment of realizability of the recorded investments in these entities could change, and impairment provisions related to these investments could be required. During the years ended January 31, 2010 and February 1, 2009, the Company recorded impairment charges of $500,000 and $957,000, respectively, related to investments in and advances to Equity Method Franchisees. As of January 31, 2010, the Company’s investment in Equity Method Franchisees was $781,000.
 
   Stock-Based Compensation
 
     The Company measures and recognizes compensation expense for share-based payment awards based on their fair values. Because options granted to employees differ from options on the Company’s common shares traded in the financial markets, the Company cannot determine the fair value of options granted to employees based on observed market prices. Accordingly, the Company estimates the fair value of stock options subject only to service conditions using the Black-Scholes option valuation model, which requires inputs including interest rates, expected dividends, volatility measures and employee exercise behavior patterns. Some of the inputs the Company uses are not market-observable and must be estimated. The fair value of stock options which contain market conditions as well as service conditions is estimated using Monte Carlo simulation techniques. In addition, the Company must estimate the number of awards which ultimately will vest, and periodically adjusts such estimates to reflect actual vesting events. Use of different estimates and assumptions would produce different option values, which in turn would affect the amount of compensation expense recognized.
 
64
 


     The Black-Scholes model is capable of considering the specific features included in the options granted to the Company’s employees that are subject only to service conditions. However, there are other models which could be used to estimate their fair value, and techniques other than Monte Carlo simulation could be used to estimate the value of stock options which are subject to both service and market conditions. If the Company were to use different models, the option values would differ despite using the same inputs. Accordingly, using different assumptions coupled with using different valuation models could have a significant impact on the fair value of employee stock options.
 
   Recent Accounting Pronouncements
 
     In March 2008, the FASB issued new disclosure standards about derivative instruments and hedging activities. The new standards are intended to improve financial reporting about derivative instruments and hedging activities by requiring enhanced disclosures to enable investors to better understand their effects on an entity’s financial position, financial performance and cash flows. The Company adopted the new standards prospectively as of February 2, 2009; accordingly, disclosures related to periods prior to the date of adoption have not been presented. Adoption of these standards did not have any effect on the Company’s financial position or results of operations. See Note 22 to the consolidated financial statements appearing elsewhere herein for additional information about derivative financial instruments owned by the Company.
 
     In the first quarter of fiscal 2009, the Company adopted new accounting standards with respect to financial assets and liabilities measured at fair value on both a recurring and non-recurring basis and with respect to nonfinancial assets and liabilities measured on a recurring basis. In the first quarter of fiscal 2010, the Company adopted new accounting standards with respect to nonrecurring measurements of nonfinancial assets and liabilities. Adoption of these standards had no material effect on the Company’s financial position or results of operations. See Note 21 to the consolidated financial statements appearing elsewhere herein for additional information regarding fair value measurements.
 
     In May 2009, the FASB issued new accounting standards with respect to subsequent events which establish general standards of accounting for, and disclosure of, events that occur after the balance sheet date but before the financial statements are issued or are available to be issued. The Company adopted these standards, which did not represent a significant change from existing practice, during the quarter ended August 2, 2009.
 
     In June 2009, the FASB issued amended accounting standards related to the consolidation of variable-interest entities. The amended standards require an enterprise to qualitatively assess the determination of the primary beneficiary of a variable interest entity (“VIE”) based on whether the enterprise has the power to direct matters that most significantly impact the activities of the VIE and has the obligation to absorb losses or the right to receive benefits of the VIE that could potentially be significant to the VIE. The amended standards require an ongoing reconsideration of the identity of the VIE’s primary beneficiary, if any, and provide a framework for the events that trigger a reassessment of whether an entity is a VIE. The amended standards are effective for the Company in the first quarter of fiscal 2011. Adoption of the new standards will result in the Company recognizing a divestiture of three stores that took place in a refranchising transaction in October 2009, as described under “Basis of Consolidation,” to the consolidated financial statements appearing elsewhere herein. Adoption of the standards will have no material effect on the Company’s financial position, results of operations or cash flows.
 
Item 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
 
Interest Rate Risk
 
     The Company is exposed to market risk from increases in interest rates on its outstanding debt. All of the borrowings under the Company’s secured credit facilities bear interest at variable rates based upon either the Fed funds rate or LIBOR. 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.
 
65
 


     As of January 31, 2010, the Company had approximately $43.4 million in borrowings outstanding. A hypothetical increase of 100 basis points in short-term interest rates would result in no increase in interest expense on the Company’s term debt due to the operation of an interest rate floor provision in the Company’s credit agreement. The Company’s credit facilities and the related interest rate derivatives are described in Note 10 to the consolidated financial statements appearing elsewhere herein.
 
Currency Risk
 
     The substantial majority of the Company’s revenue, expense and capital purchasing activities are transacted in U.S. dollars. The Company’s investment in its franchisee operating in Mexico exposes the Company to exchange rate risk. In addition, although royalties from international franchisees are payable to the Company in U.S. dollars, those royalties are computed based on local currency sales, and changes in the rate of exchange between the U.S. dollar and the foreign currencies used in the countries in which the international franchisees operate affect the Company’s royalty revenues. Because royalty revenues are derived from a relatively large number of foreign countries, and royalty revenues are not highly concentrated in a small number of such countries, the Company believes that the relatively small size of any currency hedging activities would adversely affect the economics of hedging strategies and, accordingly, the Company historically has not attempted to hedge these exchange rate risks.
 
     For the year ended January 31, 2010, the Company’s international franchisees had sales of approximately $264 million, and the Company’s related royalty revenues were approximately $14 million. A hypothetical 10% change in the average rate of exchange between the U.S. dollar and the currencies in which the Company’s international franchisees do business would have a corresponding effect on the Company’s international royalty revenues of approximately $1.4 million.
 
Commodity Price Risk
 
     The Company is exposed to the effects of commodity price fluctuations on the cost of ingredients of its products, of which flour, sugar and shortening are the most significant. In order to secure adequate supplies of materials and bring greater stability to the cost of ingredients, the Company routinely enters into forward purchase contracts and other purchase arrangements with suppliers. Under the forward purchase contracts, the Company commits to purchasing agreed-upon quantities of ingredients at agreed-upon prices at specified future dates. The outstanding purchase commitment for these commodities at any point in time typically ranges from one month’s to two years’ anticipated requirements, depending on the ingredient. Other purchase arrangements typically are contractual arrangements with vendors (for example, with respect to certain beverages and ingredients) under which the Company is not required to purchase any minimum quantity of goods, but must purchase minimum percentages of its requirements for such goods from these vendors with whom it has executed these contracts.
 
     In addition to entering into forward purchase contracts, 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 typically assigns the futures contract to a supplier in connection with entering into a forward purchase contract for the related ingredient.
 
     The Company operates a large fleet of delivery vehicles and is exposed to the effects of changes in gasoline prices. In fiscal 2010, the Company began periodically using futures and options on futures to hedge a portion of its exposure to rising gasoline prices.
 
66
 


Commodity Derivatives Outstanding at January 31, 2010
 
     Quantitative information about the Company’s unassigned option contracts and futures contracts and options on such contracts as of January 31, 2010, which mature in fiscal 2011 and fiscal 2012, is set forth in the table below.
 
Weighted Aggregate Aggregate
Average Contract Price Contract Price Fair
Contract Volume or Strike Price or Strike Price Value
(Dollars in thousands, except average prices)
Futures contracts:                        
       Wheat 245,000 bu. $ 5.44/ bu. $ 1,334 $ (69 )
       Gasoline 588,000 gal. $ 2.02/ gal. 1,191 (23 )

     Although the Company utilizes forward purchase contracts and futures contracts and options on such contracts to mitigate the risks related to commodity price fluctuations, such contracts do not fully mitigate price risk. In addition, the portion of the Company’s anticipated future commodity requirements that are subject to such contracts vary from time to time. Adverse changes in commodity prices could adversely affect the Company’s profitability and liquidity.
 
Sensitivity to Price Changes in Agricultural Commodities
 
     The following table illustrates the potential effect on the Company’s costs resulting from hypothetical changes in the cost of the Company’s three most significant ingredients.
 
Approximate Approximate Range Approximate Annual
Anticipated Fiscal 2011 of Prices Paid In Hypothetical Price Effect Of Hypothetical
Ingredient Purchases Fiscal 2010   Increase Price Increase
                        (In thousands)
Flour   53.6 million lbs. $0.1401 – $0.2679/lb.   $ 0.01/ lb.   $ 536
Shortening 37.8 million lbs.   $0.3710 – $0.6176/lb.   $ 0.01/ lb.   378
Sugar   64.6 million lbs. $0.2882 – $0.3060/lb.   $ 0.01/ lb.     646
Gasoline 2.4 million gal. $1.82 – $2.61/gal. $ 0.01/ gal. 24

     The ranges of prices paid for fiscal 2010 set forth in the table above reflect the effects of any forward purchase contracts entered into at various times prior to delivery of the goods and, accordingly, do not necessarily reflect the ranges of prices of these ingredients prevailing in the market during the fiscal year.
 
Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
 
      Page
Index to Financial Statements
Report of Independent Registered Public Accounting Firm 68
Consolidated statement of operations for each of the three years in the period
       ended January 31, 2010 69
Consolidated balance sheet as of January 31, 2010 and February 1, 2009
70
Consolidated statement of cash flows for each of the three years in the period
       ended January 31, 2010 71
Consolidated statement of changes in shareholders’ equity for each of the three years in the period
       ended January 31, 2010 72
Notes to financial statements 73

67
 


REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
 
To the Board of Directors and Shareholders of Krispy Kreme Doughnuts, Inc.
 
     In our opinion, the consolidated financial statements listed in the index appearing under Item 15(a)1 present fairly, in all material respects, the financial position of Krispy Kreme Doughnuts, Inc. and its subsidiaries (the "Company") at January 31, 2010 and February 1, 2009, and the results of their operations and their cash flows for each of the three years in the period ended January 31, 2010 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedules listed in the index appearing under Item 15(a)2 present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of January 31, 2010, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company's management is responsible for these financial statements and financial statement schedules, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in Management’s Report on Internal Control over Financial Reporting under Item 9A. Our responsibility is to express opinions on these financial statements, on the financial statement schedules, and on the Company's internal control over financial reporting based on our integrated audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.
 
     As discussed in Note 1 to the consolidated financial statements, the Company changed the manner in which it accounts for uncertain tax positions effective January 29, 2007.
 
     A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
 
     Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
 
PricewaterhouseCoopers LLP
Raleigh, North Carolina
April 15, 2010
 
68
 


KRISPY KREME DOUGHNUTS, INC.
 
CONSOLIDATED STATEMENT OF OPERATIONS
 
Year Ended
Jan. 31, Feb. 1, Feb. 3,
      2010       2009       2008
(In thousands, except per share amounts)
Revenues $    346,520 $    385,522 $    430,370
Operating expenses:
       Direct operating expenses (exclusive of depreciation and amortization
              shown below) 297,185 346,545 381,065
       General and administrative expenses 22,728 23,458 26,303
       Depreciation and amortization expense 8,191 8,709 18,433
       Impairment charges and lease termination costs 5,903 548 62,073
       Settlement of litigation (14,930 )
       Other operating (income) and expense, net 739 1,501 13
Operating income (loss) 11,774 4,761 (42,587 )
Interest income 93 331 1,422
Interest expense (10,685 ) (10,679 ) (9,796 )
Loss on extinguishment of debt (9,622 )
Equity in losses of Equity Method Franchisees (488 ) (786 ) (933 )
Other non-operating income and (expense), net (276 ) 2,815 (3,211 )
Income (loss) before income taxes 418 (3,558 ) (64,727 )
Provision for income taxes 575 503 2,324
Net loss $ (157 ) $ (4,061 ) $ (67,051 )
 
Loss per common share:
       Basic $ $ (.06 ) $ (1.05 )
 
       Diluted $ $ (.06 ) $ (1.05 )

The accompanying notes are an integral part of the financial statements.
 
69
 


KRISPY KREME DOUGHNUTS, INC.
 
CONSOLIDATED BALANCE SHEET
 
Jan. 31, Feb. 1,
      2010       2009
(In thousands)
ASSETS
CURRENT ASSETS:
Cash and cash equivalents $ 20,215 $ 35,538
Trade receivables 17,371 19,229
Receivables from Equity Method Franchisees 524 1,019
Inventories 14,321 15,587
Deferred income taxes 106
Other current assets 6,792 4,327
       Total current assets 59,223 75,806
Property and equipment 72,527 85,075
Investments in Equity Method Franchisees 781 1,187
Goodwill and other intangible assets 23,816 23,856
Other assets 8,929 9,002
       Total assets $    165,276   $    194,926
 
LIABILITIES AND SHAREHOLDERS’ EQUITY
CURRENT LIABILITIES:
Current maturities of long-term debt $ 762 $ 1,413
Accounts payable 6,708 8,981
Accrued liabilities 30,203 29,222
       Total current liabilities 37,673 39,616
Long-term debt, less current maturities 42,685 73,454
Deferred income taxes 106
Other long-term obligations 22,151 23,995
 
Commitments and contingencies
 
SHAREHOLDERS’ EQUITY:
Preferred stock, no par value; 10,000 shares authorized; none issued and
       outstanding
Common stock, no par value; 300,000 shares authorized; 67,441 and 67,512 shares
       issued and outstanding 366,237 361,801
Accumulated other comprehensive loss (180 ) (913 )
Accumulated deficit (303,290 ) (303,133 )
       Total shareholders’ equity 62,767 57,755
       Total liabilities and shareholders’ equity $ 165,276 $ 194,926

The accompanying notes are an integral part of the financial statements.
 
70
 


KRISPY KREME DOUGHNUTS, INC.
 
CONSOLIDATED STATEMENT OF CASH FLOWS
 
Year Ended
Jan. 31, Feb. 1, Feb. 3,
      2010       2009       2008
(In thousands)
CASH FLOW FROM OPERATING ACTIVITIES:
Net loss $ (157 ) $ (4,061 ) $ (67,051 )
Adjustments to reconcile net loss to net cash provided by operating activities:
       Depreciation and amortization 8,191 8,709 18,433
       Deferred income taxes (479 ) 651 889
       Impairment charges 2,666 1,050 61,041
       Settlement of litigation (14,930 )
       Accrued rent expense (412 ) (352 ) (663 )
       Loss on disposal of property and equipment 915 746 64
       Gain on refranchise of Canadian subsidiary (2,805 )
       Gain on disposal of interests in Equity Method Franchisees (931 ) (260 )
       Impairment of investment in Equity Method Franchisee 500
       Unrealized loss on interest rate derivatives 559 798 96
       Share-based compensation 4,779 5,152 7,599
       Provision for doubtful accounts (161 ) 270 1,786
       Amortization of deferred financing costs 859 832 6,041
       Equity in losses of Equity Method Franchisees 488 786 933
       Other (225 ) 1,820 991
       Change in assets and liabilities:
              Trade receivables 2,351 4,158 284
              Inventories 1,216 4,263 1,058
              Other current and non-current assets 394 590 2,009
              Accounts payable and accrued liabilities (1,650 ) (3,817 ) (7,550 )
              Other long-term obligations (7 ) (1,266 ) (1,058 )
                     Net cash provided by operating activities 19,827 16,593 9,712
CASH FLOW FROM INVESTING ACTIVITIES:
Purchase of property and equipment (7,967 ) (4,694 ) (5,509 )
Proceeds from disposals of property and equipment 5,752 748 18,314
Investments in Equity Method Franchisees (325 ) (113 )
Sale of interests in Equity Method Franchisee 300
Other investing activities 365 (237 ) 13
       Net cash provided by (used for) investing activities (2,175 ) (4,296 ) 13,118
CASH FLOW FROM FINANCING ACTIVITIES:
Proceeds from issuance of long-term debt 110,000
Repayment of long-term debt (31,678 ) (1,989 )    (141,733 )
Deferred financing costs (954 ) (467 ) (2,891 )
Proceeds from exercise of stock options 3,103 292
Repurchase of common shares (Note 16) (343 ) (2,069 ) (93 )
       Net cash used for financing activities (32,975 ) (1,422 ) (34,425 )
Effect of exchange rate changes on cash (72 ) 88
Net increase (decrease) in cash and cash equivalents    (15,323 ) 10,803 (11,507 )
Cash and cash equivalents at beginning of year 35,538 24,735 36,242
Cash and cash equivalents at end of year $ 20,215 $    35,538 $ 24,735
Supplemental schedule of non-cash investing and financing activities:
       Assets acquired under capital leases $ 258 $ 143 $ 750

The accompanying notes are an integral part of the financial statements.
 
71
 


KRISPY KREME DOUGHNUTS, INC.
 
CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS’ EQUITY
 
Accumulated
Other
Common Comprehensive
Shares Common Income Accumulated
      Outstanding       Stock       (Loss)       Deficit       Total
(In thousands)
BALANCE AT JANUARY 28, 2007 62,670 $ 310,942 $ 1,266 $ (233,246 ) $ 78,962
Effect of adoption of new accounting
       standard (Note 1) 1,225 1,225
Comprehensive income (loss):
       Net loss for the year ended
              February 3, 2008 (67,051 ) (67,051 )
       Foreign currency translation adjustment,
              net of income taxes of $117 357 357
       Unrealized loss on cash flow hedge, net
              of income taxes of $1,006 (1,542 )   (1,542 )
       Total comprehensive loss (68,236 )
Exercise of stock options 111 292 292
Issuance of common shares and warrants
       (Notes 12 and 16) 1,834 36,875 36,875
Share-based compensation (Note 16) 785 7,599 7,599
Repurchase of common shares (Note 16) (30 ) (93 )   (93 )
BALANCE AT FEBRUARY 3, 2008 65,370 355,615 81 (299,072 ) 56,624
Comprehensive income (loss):
       Net loss for the year ended
              February 1, 2009 (4,061 ) (4,061 )
       Recognition of foreign currency
              translation adjustment upon
              disposal of subsidiary, net of
              income taxes of $1,173    (1,797 ) (1,797 )
       Foreign currency translation adjustment,
              net of income taxes of $153 239 239
       Unrealized loss on cash flow hedge,
              net of income taxes of $14 (22 ) (22 )
       Amortization of unrealized loss on
              interest rate derivative, net of
              income taxes of $383 586 586
Total comprehensive loss (5,055 )
Exercise of stock options 2,387 3,103 3,103
Share-based compensation (Note 16) 301 5,152 5,152
Repurchase of common shares (Note 16) (546 ) (2,069 )   (2,069 )
BALANCE AT FEBRUARY 1, 2009       67,512    361,801 (913 )    (303,133 )    57,755
Comprehensive income (loss):
       Net loss for the year ended
              January 31, 2010 (157 ) (157 )
       Foreign currency translation adjustment,
              net of income taxes of $24 37 37
       Amortization of unrealized loss on
              interest rate derivative, net of
              income taxes of $455 696 696
Total comprehensive income 576
Cancellation of restricted shares (52 )
Share-based compensation (Note 16) 57 4,779 4,779
Repurchase of common shares (Note 16) (76 ) (343 ) (343 )
BALANCE AT JANUARY 31, 2010 67,441 $ 366,237 $ (180 ) $ (303,290 ) $ 62,767

The accompanying notes are an integral part of the financial statements.
 
72
 


KRISPY KREME DOUGHNUTS, INC.
 
NOTES TO FINANCIAL STATEMENTS
 
Note 1 — Accounting Policies
 
     Krispy Kreme Doughnuts, Inc. (“KKDI”) and its subsidiaries (collectively, the “Company”) are engaged in the sale of doughnuts and related items through Company-owned stores. The Company also derives revenue from franchise and development fees and royalties from franchisees. Additionally, the Company sells doughnut mix, other ingredients and supplies and doughnut-making equipment to franchisees.
 
Significant Accounting Policies
 
     The Company prepares its financial statements in accordance with accounting principles generally accepted in the United States of America (“GAAP”). The significant accounting policies followed by the Company in preparing the accompanying consolidated financial statements are as follows:
 
     BASIS OF CONSOLIDATION. The financial statements include the accounts of KKDI and its subsidiaries, the most significant of which is KKDI’s principal operating subsidiary, Krispy Kreme Doughnut Corporation. In October 2009, the Company refranchised three stores in Northern California to a new franchisee. The aggregate sales price of the stores’ assets was approximately $1.1 million, which was evidenced by a promissory note payable to the Company bearing interest at 7% and payable in weekly installments equal to a percentage of the stores’ retail sales, secured by the all the assets of the three stores. The new franchisee is a variable interest entity of which the Company is the primary beneficiary. Accordingly, the Company consolidated the financial statements of the new franchisee for post-acquisition periods and did not record a divestiture of the three stores. In the first quarter of fiscal 2011, the Company will adopt new accounting standards which will require the Company to deconsolidate the franchisee and recognize a divestiture of the stores; see “Recent Accounting Pronouncements” below. Except for a guarantee (which dates from fiscal 2002) of 59% of the lease payments related to one of the three stores’ leases, the Company has no guarantee of any obligation of the new franchisee.
 
     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 20% to 35% owned and are hereinafter sometimes referred to as “Equity Method Franchisees.”
 
     REVENUE RECOGNITION. A summary of the revenue recognition policies for each of the Company’s business segments is as follows:
  • Company Stores revenue is derived from the sale of doughnuts and complimentary products to on-premises and off-premises customers. Revenue is recognized at the time of sale for on-premises sales. For off-premises sales, revenue is recognized at the time of delivery, net of provisions for estimated product returns.
     
  • Domestic Franchise revenue is derived from development and initial franchise fees relating to new domestic store openings and ongoing royalties charged to domestic franchisees based on their sales. Development and franchise fees for domestic new stores are deferred until the store is opened, which is the time at which the Company has performed substantially all of the initial services it is required to provide. Royalties are recognized in income as underlying domestic franchisee sales occur unless there is significant uncertainty concerning the collectibility of such revenues, in which case royalty revenues are recognized when received. 
     
  • International Franchise revenue is derived from development and initial franchise fees relating to new international store openings and ongoing royalties charged to international franchisees based on their sales. Development and franchise fees for international new stores are deferred until the store is opened, which is the time at which the Company has performed substantially all of the initial services it is required to provide. Royalties are recognized in income as underlying international franchisee sales occur unless there is significant uncertainty concerning the collectibility of such revenues, in which case royalty revenues are recognized when received.
 
73
 


  • KK Supply Chain revenue is derived from the sale of doughnut mix, other ingredients and supplies and doughnut-making equipment. Revenues for the sale of doughnut mix and supplies are recognized upon delivery to the customer or, in the case of franchisees located outside North America, when the goods are loaded on the transport vessel at the U.S. port. Revenue for equipment sales and installation associated with new store openings is recognized at the store opening date. Revenue for equipment sales not associated with new store openings is recognized when the equipment is installed if the Company is responsible for the installation, and otherwise upon shipment of the equipment.
     FISCAL YEAR. The Company’s fiscal year ends on the Sunday closest to January 31, which periodically results in a 53-week year. Fiscal 2010 and fiscal 2009 each contained 52 weeks, while fiscal 2008 contained 53 weeks.
 
     CASH AND CASH EQUIVALENTS. The Company considers cash on hand, demand deposits in banks and all highly liquid debt instruments with an original maturity of three months or less to be cash and cash equivalents.
 
     INVENTORIES. Inventories are recorded at the lower of cost or market, with cost determined using the first-in, first-out method.
 
     PROPERTY AND EQUIPMENT. Depreciation of property and equipment is provided using the straight-line method over the assets’ estimated useful lives, which are as follows: buildings — 15 to 35 years; machinery and equipment — 2 to 15 years; and leasehold improvements — lesser of the useful life of the improvements or the lease term. The depreciable life of leasehold improvements ranges from one to 20 years.
 
     GOODWILL AND OTHER INTANGIBLE ASSETS. Goodwill represents the excess of the purchase price over the value of identifiable net assets acquired in business combinations. Goodwill has an indefinite life and is not amortized, but is tested for impairment annually or more frequently if events or circumstances indicate the carrying amount of the asset may be impaired. Such impairment testing is performed for each reporting unit to which goodwill has been assigned.
 
     Other intangible assets consist principally of franchise rights reacquired in acquisitions of franchisees, which the Company determined have indefinite lives and are not subject to amortization. Intangible assets with indefinite lives are reviewed for impairment annually or more frequently if events or circumstances indicate the carrying amount of the assets may be impaired.
 
     STORE PRE-OPENING COSTS. Store pre-opening costs are expensed as incurred in the Company Stores segment. Such costs were approximately $170,000 in fiscal 2010 and were not significant in fiscal 2009 or 2008.
 
     LEGAL COSTS. Legal costs associated with litigation and other loss contingencies are charged to expense as services are rendered.
 
     ASSET IMPAIRMENT. When an asset group (typically a store) is identified as underperforming or a decision is made to abandon an asset group or to close a store, the Company makes an assessment of the potential impairment of the related assets. The assessment is based upon a comparison of the carrying amount of the asset group, consisting primarily of property and equipment, to the estimated undiscounted cash flows expected to be generated from the asset group. To estimate cash flows, management projects the net cash flows anticipated from continuing operation of the asset group or store until its closing or abandonment as well as cash flows, if any, anticipated from disposal of the related assets. If the carrying amount of the assets exceeds the sum of the undiscounted cash flows, the Company records an impairment charge in an amount equal to the excess of the carrying value of the assets over their estimated fair value.
 
     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.
 
74
 


     The following table sets forth amounts used in the computation of basic and diluted earnings per share:
 
Year Ended
Jan. 31, Feb. 1, Feb. 3,
      2010       2009       2008
(In thousands)
Numerator: net loss $ (157 ) $ (4,061 ) $ (67,051 )
Denominator:
       Basic earnings per share — weighted average shares
              outstanding    67,493    65,940    63,805
       Diluted earnings per share — weighted average shares
              outstanding plus dilutive potential common shares 67,493 65,940 63,805

     Stock options and warrants with respect to 11.0 million, 10.8 million and 12.2 million shares, as well as 1.2 million, 1.4 million and 1.2 million unvested shares of restricted stock and restricted stock units have been excluded from the computation of the number of shares used in the diluted earnings per share for the fiscal years ended January 31, 2010, February 1, 2009 and February 3, 2008, respectively, because the Company incurred a net loss for each of these periods and their inclusion would be antidilutive.
 
     SHARE-BASED COMPENSATION. The Company measures and recognizes compensation expense for share-based payment awards by charging the fair value of each award at its grant date to earnings over the service period necessary for each award to vest.
 
      CONCENTRATION OF CREDIT RISK. Financial instruments that subject the Company to credit risk consist principally of receivables from off-premises customers and franchisees and guarantees of leases and indebtedness of franchisees. Off-premises receivables are primarily from grocery and convenience stores. The Company maintains allowances for doubtful accounts which management believes are sufficient to provide for losses which may be sustained on realization of these receivables. In fiscal 2010, 2009 and 2008, no customer accounted for more than 10% of Company-owned stores’ revenues. The two largest off-premises customers collectively accounted for approximately 12%, 11% and 10% of Company-owned stores’ revenues in fiscal 2010, 2009 and 2008, respectively. The two off-premises customers with the largest trade receivables balances collectively accounted for approximately 21% and 22% of off-premises doughnut customer trade receivables at January 31, 2010 and February 1, 2009, respectively.
 
     The Company also evaluates the recoverability of receivables from its franchisees and maintains allowances for doubtful accounts which management believes are sufficient to provide for losses which may be sustained on realization of these receivables. In addition, the Company evaluates the likelihood of potential payments by the Company under loan and lease guarantees and records estimated liabilities for payments the Company considers probable.
 
     SELF-INSURANCE RISKS AND RECEIVABLES FROM INSURERS. The Company is subject to workers’ compensation, vehicle and general liability claims. The Company is self-insured for the cost of all workers’ compensation, vehicle and general liability claims up to the amount of stop-loss insurance coverage purchased by the Company from commercial insurance carriers. The Company maintains accruals for the estimated cost of claims, without regard to the effects of stop-loss coverage, using actuarial methods which evaluate known open and incurred but not reported claims and consider historical loss development experience. In addition, the Company records receivables from the insurance carriers for claims amounts estimated to be recovered under the stop-loss insurance policies when these amounts are estimable and probable of collection. The Company estimates such stop-loss receivables using the same actuarial methods used to establish the related claims accruals, and taking into account the amount of risk transferred to the carriers under the stop-loss policies. The stop-loss policies provide coverage for claims in excess of retained self-insurance risks, which are determined on a claim-by-claim basis.
 
     The Company recorded favorable adjustments to its self-insurance claims liabilities related to prior policy years of approximately $3.2 million, $1.8 million and $1.7 million in fiscal 2010, 2009 and 2008, respectively.
 
     The Company provides health and medical benefits to eligible employees, and purchases stop-loss insurance from commercial insurance carriers which pays covered medical costs in excess of a specified annual amount incurred by each claimant.
 
75
 


     DERIVATIVE FINANCIAL INSTRUMENTS AND DERIVATIVE COMMODITY INSTRUMENTS. The Company reflects derivative financial instruments, which consist primarily of interest rate derivatives and commodity futures contracts and options on such contracts, in the consolidated balance sheet at their fair value. The difference between the cost, if any, and the fair value of the interest rate derivatives is reflected in income unless the derivative instrument qualifies as a cash flow hedge and is effective in offsetting future cash flows of the underlying hedged item, in which case such amount is reflected in other comprehensive income. 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 cash flow hedges.
 
     FOREIGN CURRENCY TRANSLATION. The Company has ownership interests in franchisees in Mexico and Western Canada accounted for using the equity method. The functional currency of each of these operations is the local currency. Assets and liabilities of these operations are translated into U.S. dollars using exchange rates as of the balance sheet date, and revenues, expenses and the Company’s equity in the earnings or losses of the franchisee are translated using the average exchange rate for the reporting period. The resulting cumulative translation adjustments are reported, net of income taxes, as a component of accumulated other comprehensive income. Transaction gains and losses resulting from remeasuring transactions denominated in currencies other than an entity’s functional currency are reflected in earnings.
 
     COMPREHENSIVE INCOME. Accounting standards on reporting comprehensive income requires that certain items, including foreign currency translation adjustments and mark-to-market adjustments on derivative contracts accounted for as cash flow hedges (which are not reflected in net income) be presented as components of comprehensive income. The cumulative amounts recognized by the Company under these standards are reflected in the consolidated balance sheet as accumulated other comprehensive income (loss), a component of shareholders’ equity, and are summarized in the following table:
 
Jan. 31, Feb. 1,
      2010       2009
(In thousands)
Accumulated other comprehensive income (loss):
       Unrealized losses on interest rate derivatives $ (152 ) $ (1,303 )
       Cumulative foreign currency translation adjustments (146 ) (207 )
  (298 )    (1,510 )
       Less: deferred income taxes 118 597
  $    (180 ) $ (913 )

     USE OF ESTIMATES. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results will differ from these estimates, and the differences could be material.
 
     UNCERTAIN TAX POSITIONS. Effective January 29, 2007, the first day of fiscal 2008, the Company adopted new accounting standards for accounting for uncertainty in income taxes. The standards prescribe recognition thresholds that must be met before a tax position is recognized in the financial statements and provide guidance on de-recognition, classification, interest and penalties, accounting in interim periods and disclosure. Under these standards, an entity may only recognize or continue to recognize tax positions that meet a “more likely than not” threshold. The cumulative effect of applying the new standards was recorded as a $1.2 million credit to the opening balance of accumulated deficit as of January 29, 2007, the date of adoption.
 
     ERROR CORRECTION. In fiscal 2009 and 2008, the Company reported freight charges billed to customers by the KK Supply Chain segment as a reduction in direct operating expenses, rather than as a component of revenues as required by GAAP. Such charges totaled approximately $3.3 million and $2.2 million in fiscal 2009 and 2008, respectively, of which $1.8 million and $1.2 million, respectively, were to the Company Stores segment and are eliminated in consolidation; there were no such charges in fiscal 2010. KK Supply Chain and consolidated revenues for fiscal 2009 and 2008 as set forth herein have been restated to correct this error, which had no effect on KK Supply Chain operating income or on consolidated earnings for either period.
 
76
 


RECENT ACCOUNTING PRONOUNCEMENTS
 
     In March 2008, the Financial Accounting Standards Board (“FASB”) issued new disclosure standards about derivative instruments and hedging activities. The new standards are intended to improve financial reporting about derivative instruments and hedging activities by requiring enhanced disclosures to enable investors to better understand their effects on an entity’s financial position, financial performance and cash flows. The Company adopted the new standards prospectively as of February 2, 2009; accordingly, disclosures related to periods prior to the date of adoption have not been presented. Adoption of these standards did not have any effect on the Company’s financial position or results of operations. See Note 22 for additional information about derivative financial instruments owned by the Company.
 
     In the first quarter of fiscal 2009, the Company adopted new accounting standards with respect to financial assets and liabilities measured at fair value on both a recurring and non-recurring basis and with respect to nonfinancial assets and liabilities measured on a recurring basis. In the first quarter of fiscal 2010, the Company adopted new accounting standards with respect to nonrecurring measurements of nonfinancial assets and liabilities. Adoption of these standards had no material effect on the Company’s financial position or results of operations. See Note 21 for additional information regarding fair value measurements.
 
     In May 2009, the FASB issued new accounting standards with respect to subsequent events which establish general standards of accounting for, and disclosure of, events that occur after the balance sheet date but before the financial statements are issued or are available to be issued. The Company adopted these standards, which did not represent a significant change from existing practice, during the quarter ended August 2, 2009.
 
     In June 2009, the FASB issued amended accounting standards related to the consolidation of variable-interest entities. The amended standards require an enterprise to qualitatively assess the determination of the primary beneficiary of a variable interest entity (“VIE”) based on whether the enterprise has the power to direct matters that most significantly impact the activities of the VIE and has the obligation to absorb losses or the right to receive benefits of the VIE that could potentially be significant to the VIE. The amended standards require an ongoing reconsideration of the identity of the VIE’s primary beneficiary, if any, and provide a framework for the events that trigger a reassessment of whether an entity is a VIE. The amended standards are effective for the Company in the first quarter of fiscal 2011. Adoption of the new standards will result in the Company recognizing a divestiture of three stores that took place in a refranchising transaction in October 2009, as described under “Basis of Consolidation,” above. Adoption of the standards will have no material effect on the Company’s financial position, results of operations or cash flows.
 
Note 2 – Recent Financial Performance and Business Conditions
 
     The Company experienced a decline in revenues and incurred net losses in each of the last three fiscal years. The revenue decline reflects fewer Company stores in operation resulting principally from the closure of lower performing locations, a decrease in off-premises sales at Company stores, a decline in domestic royalty revenues and lower sales of mixes and other ingredients resulting from lower sales by the Company’s domestic franchisees. Lower revenues have adversely affected operating margins because of the fixed or semi-fixed nature of many of the Company’s direct operating expenses. In addition, the prices of certain agricultural commodities and of oil, while volatile, have trended upward in the last fiscal three years, which has adversely affected the cost of the Company’s principal ingredients and increased the cost of gasoline consumed by the Company. Sales volumes and changes in the cost of major ingredients and fuel can have a material effect on the Company’s results of operations and cash flows. In addition, royalty revenues and most of KK Supply Chain 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.
 
     The Company generated cash flow from operating activities of $19.8 million, $16.6 million and $9.7 million in fiscal 2010, 2009 and 2008, respectively, and the Company has reduced its aggregate outstanding debt by $64.2 million over the past three fiscal years, using both cash generated from the sale of excess assets and cash generated by operations.
 
     The Company’s credit facilities described in Note 10 are the Company’s principal source of external financing. These facilities consist of a term loan having an outstanding principal balance of $43.1 million as of January 31, 2010 which matures in February 2014, and a $25 million revolving credit facility maturing in February 2013. The credit facilities contain significant financial covenants, which also are described in Note 10. Based on the Company’s current working capital and the fiscal 2011 operating plan, management believes the Company can comply with the these financial covenants and that the Company can meet its projected operating, investing and financing cash requirements.
 
77
 


Note 3 — Trade Receivables
 
     The components of trade receivables are as follows:
 
Jan. 31,       Feb. 1,
2010 2009
(In thousands)
Trade receivables:    
       Off-premises customers $ 9,010 $ 10,413
       Unaffiliated franchisees 9,636 11,573
       Current portion of notes receivable 68 100
  18,714 22,086
       Less — allowance for doubtful accounts:
              Off-premises customers (307 ) (313 )
              Unaffiliated franchisees (1,036 ) (2,544 )
(1,343 ) (2,857 )
  $    17,371 $    19,229
Receivables from Equity Method Franchisees (Notes 1 and 18):
       Trade $ 1,263 $ 1,268
       Less — allowance for doubtful accounts (739 ) (249 )
$ 524 $ 1,019
 

     The changes in the allowances for doubtful accounts are summarized as follows:
 
  Year Ended
Jan. 31,       Feb. 1,       Feb. 3,
2010 2009 2008
(In thousands)
Allowance for doubtful accounts related to trade receivables:
       Balance at beginning of year $ 2,857 $ 4,750 $ 2,745
       Provision for doubtful accounts (651 ) 71 2,150
       Chargeoffs (863 ) (2,064 ) (145 )
       Other 100
       Balance at end of year $    1,343 $ 2,857 $ 4,750
 
Allowance for doubtful accounts related to receivables from Equity
       Method Franchisees:
       Balance at beginning of year $ 249 $ 1,379 $ 2,903
       Provision for doubtful accounts 490 199 (364 )
       Chargeoffs    (1,329 )    (1,160 )
       Balance at end of year $ 739 $ 249 $ 1,379  
 

Note 4 — Inventories
 
     The components of inventories are as follows:
 
  Jan. 31,       Feb. 1,
2010 2009
(In thousands)
Raw materials $ 5,253 $ 5,625
Work in progress 4 6
Finished goods 3,688 4,905
Purchased merchandise 5,268 4,936
Manufacturing supplies 108 115
$    14,321 $    15,587
 
 
78
 


Note 5 — Other Current Assets
 
     Other current assets consist of the following:
 
Jan. 31,       Feb. 1,
2010 2009
(In thousands)
Closed stores held for sale $ 2,574 $
Current portion of claims against insurance carriers related to self-insurance
       programs (Notes 1, 8, 9 and 11) 679 755
Miscellaneous receivables 468 416
Prepaid expenses and other 3,071 3,156
$    6,792 $    4,327
 

Note 6 — Property and Equipment
 
     Property and equipment consists of the following:
 
Jan. 31,       Feb. 1,
  2010 2009
(In thousands)
Land $ 13,975 $ 19,091
Buildings 62,812 64,977
Leasehold improvements 9,146 10,018
Machinery and equipment 52,124 58,987
Construction in progress 432 427
   138,489    153,500
Less: accumulated depreciation (65,962 ) (68,425 )
$ 72,527 $ 85,075
 

     Depreciation expense was $7.7 million, $8.1 million and $17.8 million in fiscal 2010, 2009 and 2008, respectively. Machinery and equipment includes assets leased under capital leases having a net book value of $393,000 and $451,000 at January 31, 2010 and February 1, 2009, respectively.
 
Note 7 — Goodwill and Other Intangible Assets
 
     Goodwill and other intangible assets consist of the following:
 
  Jan. 31,       Feb. 1,
2010 2009
(In thousands)
Indefinite-lived intangible assets:
       Goodwill associated with International Franchise segment $    15,664 $    15,664
       Goodwill associated with Domestic Franchise segment 7,832 7,832
       Reacquired franchise rights associated with Company Stores segment 320 360
$ 23,816 $ 23,856
 
 
79
 


Note 8 — Other Assets
 
     The components of other assets are as follows:
 
Jan. 31,       Feb. 1,
2010 2009
(In thousands)
Non-current portion of claims against insurance carriers related to
       self-insurance programs (Notes 1, 5, 9 and 11) $ 3,116 $ 3,619
Deferred financing costs, net of accumulated amortization 2,099 2,004
Deposits 1,515 1,876
Computer software, net of accumulated amortization 459 676
401(k) mirror plan assets (Notes 11 and 20) 455 287
Non-current portion of notes receivable from unaffiliated franchisees 146 178
Other 1,139 362
$    8,929 $    9,002
 

Note 9 — Accrued Liabilities
 
     The components of accrued liabilities are as follows:
 
Jan. 31,       Feb. 1,
2010 2009
(In thousands)
Accrued compensation $ 6,571 $ 1,983
Accrued vacation pay 4,814 5,001
Current portion of self-insurance claims, principally worker’s compensation
       (Notes 1, 5, 8 and 11) 4,245 5,086
Accrued guarantee liabilities (Notes 12, 14 and 18) 2,702 2,922
Accrued taxes, other than income 2,097 2,458
Customer deposits 1,319 1,881
Accrued health care claims 1,110 1,030
Accrued professional fees 873 911
Fair value of interest rate derivative 641 2,348
Current portion of lease termination costs (Notes 11 and 13) 298 364
Accrued interest 292 144
Current portion of deferred franchise fee revenue 285 708
Other 4,956 4,386
$    30,203 $    29,222
 
 
Note 10 — Long Term Debt and Lease Commitments
 
     Long-term debt and capital lease obligations consist of the following:
 
Jan. 31,       Feb. 1,
2010 2009
(In thousands)
2007 Secured Credit Facilities $ 43,054 $ 74,416
Capital lease obligations 393 451
43,447 74,867
Less: current maturities (762 ) (1,413 )
$    42,685 $    73,454
 
 
80
 


     The following table presents maturities of long-term debt and capital lease obligations:
 
Fiscal Year (In thousands)
2011 $ 762
2012 685
2013 638
2014 564
2015 40,798
  $ 43,447
 

     Secured Credit Facilities
 
     In February 2007, the Company closed secured credit facilities totaling $160 million (the “Secured Credit Facilities”) then consisting of a $50 million revolving credit facility maturing in February 2013 (the “Revolver”) and a $110 million term loan maturing in February 2014 (the “Term Loan”). The Secured Credit Facilities are secured by a first lien on substantially all of the assets of the Company and its subsidiaries.
 
     The Revolver contains provisions which permit the Company to obtain letters of credit. Issuance of letters of credit under these provisions constitutes usage of the lending commitments and reduces the amount available for cash borrowings under the Revolver. The commitments under the Revolver were reduced from $50 million to $30 million in April 2008, and further reduced to $25 million in connection with amendments to the facilities in April 2009 (the “April 2009 Amendments”). In connection with the April 2009 Amendments, the Company prepaid $20 million of the principal balance outstanding under the 2007 Term Loan. The Company has made other payments of Term Loan principal since February 2007, consisting of $24.1 million representing the proceeds of asset sales, $20.0 million representing discretionary prepayments and $2.8 million representing scheduled amortization which, together with the $20 million prepayment in April 2009 have reduced the principal balance of the Term Loan to $43.1 million as of January 31, 2010.
 
     Interest on borrowings under the Revolver and Term Loan is payable either (a) at the greater of LIBOR or 3.25% or (b) at the Alternate Base Rate (which is the greater of Fed funds rate plus 0.50% or the prime rate), in each case plus the Applicable Margin. After giving effect to the April 2009 Amendments, the Applicable Margin for LIBOR-based loans and for Alternate Base Rate-based loans was 7.50% and 6.50%, respectively (5.50% and 4.50%, respectively, prior to the April 2009 Amendments, 3.50% and 2.50%, respectively, prior to amendments executed in April 2008 and 2.75% and 1.75%, respectively, prior to amendments executed in January 2008 to permit the sale of certain real estate).
 
     The Company is required to pay a fee equal to the Applicable Margin for LIBOR-based loans on the outstanding amount of letters of credit issued under the Revolver, as well as a fronting fee of 0.25% of the amount of such letter of credit payable to the letter of credit issuer. There also is a fee on the unused portion of the Revolver lending commitment, which increased from 0.75% to 1.00% in connection with the April 2009 Amendments.
 
     Borrowings under the Revolver (and issuances of letters of credit) are subject to the satisfaction of usual and customary conditions, including the accuracy of representations and warranties and the absence of defaults.
 
     The Term Loan is payable in quarterly installments of approximately $140,000 (as adjusted to give effect to prepayments of principal under the Term Loan) and a final installment equal to the remaining principal balance in February 2014. The Term Loan is required to be prepaid with some or all of the net proceeds of certain equity issuances, debt issuances, asset sales and casualty events and with a percentage of excess cash flow (as defined in the agreement) on an annual basis.
 
81
 

 
     The Secured Credit Facilities require the Company to meet certain financial tests, including a maximum consolidated leverage ratio (expressed as a ratio of total debt to Consolidated EBITDA) and a minimum consolidated interest coverage ratio (expressed as a ratio of Consolidated EBITDA to net interest expense), computed based upon Consolidated EBITDA and net interest expense for the most recent four fiscal quarters and total debt as of the end of such four-quarter period. As of January 31, 2010, the consolidated leverage ratio was required to not be greater than 4.0 to 1.0 and the consolidated interest coverage ratio was required to be not less than 2.35 to 1.0. As of January 31, 2010, the Company’s consolidated leverage ratio was approximately 2.0 to 1.0 and the Company’s consolidated interest coverage ratio was approximately 4.2 to 1.0. The maximum consolidated leverage ratio declines and the minimum consolidated interest coverage ratio increases after fiscal 2010, as set forth in the following tables:
 
Maximum
Period Leverage Ratio
Fiscal 2010 4.00 to 1.00
First Quarter of Fiscal 2011 3.75 to 1.00
Second Quarter of Fiscal 2011 3.50 to 1.00
Third Quarter of Fiscal 2011 3.25 to 1.00
Fourth Quarter of Fiscal 2011 3.00 to 1.00
Fiscal 2012 2.50 to 1.00
Fiscal 2013 and thereafter 2.00 to 1.00
  
Minimum Interest
Period Coverage Ratio
Fourth Quarter of Fiscal 2010 2.35 to 1.00
First Quarter of Fiscal 2011 2.75 to 1.00
Second Quarter of Fiscal 2011 2.75 to 1.00
Third Quarter of Fiscal 2011 2.95 to 1.00
Fourth Quarter of Fiscal 2011 3.15 to 1.00
Fiscal 2012 3.75 to 1.00
Fiscal 2013 and thereafter 4.50 to 1.00

     “Consolidated EBITDA” is a non-GAAP measure and is defined in the Secured Credit Facilities to mean, generally, consolidated net income or loss, exclusive of unrealized gains and losses on hedging instruments and amounts accrued with respect to the interest rate derivative contracts described below, gains or losses on the early extinguishment of debt and provisions for payments on guarantees of franchisee obligations plus the sum of net interest expense, income taxes, depreciation and amortization, non-cash charges, store closure costs, costs associated with certain litigation and investigations, and extraordinary professional fees; and minus payments, if any, on guarantees of franchisee obligations in excess of $3 million in any rolling four-quarter period and the sum of non-cash credits. In addition, the 2007 Secured Credit Facilities contain other covenants which, among other things, limit the incurrence of additional indebtedness (including guarantees), liens, investments (including investments in and advances to franchisees which own and operate Krispy Kreme stores), dividends, transactions with affiliates, asset sales, acquisitions, capital expenditures, mergers and consolidations, prepayments of other indebtedness and other activities customarily restricted in such agreements. The Secured Credit Facilities also prohibit the transfer of cash or other assets to KKDI from its subsidiaries, whether by dividend, loan or otherwise, but provide for exceptions to enable KKDI to pay taxes and operating expenses and certain judgment and settlement costs.
 
     The operation of the restrictive financial covenants described above may limit the amount the Company may borrow under the 2007 Revolver. In addition, the maximum amount which may be borrowed under the Revolver is reduced by the amount of outstanding letters of credit, which totaled approximately $15 million as of January 31, 2010, the substantial majority of which secure the Company’s reimbursement obligations to insurers under the Company’s self-insurance arrangements. The restrictive covenants did not limit the Company’s ability to borrow the full $10 million of unused credit under the Revolver at January 31, 2010.
 
     The Secured Credit Facilities also contain customary events of default including, without limitation, payment defaults, breaches of representations and warranties, covenant defaults, cross-defaults to other indebtedness in excess of $5 million, certain events of bankruptcy and insolvency, judgment defaults in excess of $5 million and the occurrence of a change of control.
 
     In May 2007, the Company entered into interest rate derivative contracts having an aggregate notional principal amount of $60 million. The derivative contracts entitle the Company to receive from the counterparties the excess, if any, of three-month LIBOR over 5.40%, and require the Company to pay to the counterparties the excess, if any, of 4.48% over three-month LIBOR, in each case multiplied by the notional amount of the contracts. The contracts expire in April 2010. See Notes 21 and 22 for additional information about theses derivative contracts.
 
82
 


     Lease Obligations
 
     The Company leases equipment and facilities under both capital and operating leases. The approximate future minimum lease payments under non-cancelable leases as of January 31, 2010 are set forth in the following table:
 
Operating       Capital
Fiscal Year Leases Leases
(In thousands)
2011 $ 8,866 $ 220
2012 7,972 131
2013 6,769 77
2014 5,830
2015 5,420
Thereafter 56,667
$    91,524 428
Less: portion representing interest and executory costs (35 )
$    393
 

     Rent expense, net of rental income, totaled $9.6 million in fiscal 2010, $11.8 million in fiscal 2009 and $14.8 million in fiscal 2008.
 
     Cash Payments of Interest
 
     Interest paid, inclusive of deferred financing costs, totaled $11.2 million in fiscal 2010, $9.2 million in fiscal 2009 and $16.5 million in fiscal 2008.
 
Note 11 — Other Long-Term Obligations
 
     The components of other long-term obligations are as follows:
 
  Jan. 31,       Feb. 1,
2010 2009
(In thousands)
Non-current portion of self-insurance claims, principally worker’s  
       compensation (Notes 1, 5, 8 and 9) $ 9,327 $ 11,069
Accrued rent expense 5,864 6,276
Non-current portion of deferred franchise fee revenue 3,191 3,137
Non-current portion of lease termination costs (Notes 9 and 13) 1,381 1,516
401(k) mirror plan liabilities (Notes 8 and 20) 455 287
Other 1,933 1,710
$    22,151 $    23,995
 

Note 12 — Commitments and Contingencies
 
Pending Matters
 
     Except as disclosed below, the Company currently is not a party to any material legal proceedings.
 
   K² Asia 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.
 
83
 


Other Matters
 
   TAG Litigation
 
     In February 2008, the Company filed suit in the U.S. District Court for the Middle District of North Carolina against The Advantage Group Enterprise, Inc. (“TAG”), alleging that TAG failed to properly account for and pay the Company for sales of equipment that the Company consigned to TAG. Based on these allegations, the Company asserted various claims including breach of fiduciary duty and conversion, and it sought an accounting and constructive trust. In addition, the Company sought a declaration that it did not owe TAG approximately $1 million for storage fees and alleged lost profits. In March 2008, TAG answered the complaint, denying liability and asserting counterclaims against the Company including breach of contract, services rendered, unjust enrichment, violation of the North Carolina Unfair Trade Practices Act and fraud in the inducement. TAG sought approximately $1 million in actual damages as well as punitive and treble damages. The parties settled this matter in March 2010. The accompanying balance sheet as of January 31, 2010 reflects an accrued liability of approximately $150,000 for the settlement of this matter, which was recorded in the second quarter of fiscal 2010 and which is included in Domestic Franchise operating expenses.
 
   Federal Securities Class Actions and Settlement Thereof and Federal Court Shareholder Derivative Actions and Settlement Thereof
 
     Beginning in May 2004, a series of purported securities class actions were filed on behalf of persons who purchased the Company’s publicly traded securities between August 21, 2003 and May 7, 2004 against the Company and certain of its former officers in the United States District Court for the Middle District of North Carolina, alleging violations of federal securities law in connection with various public statements made by the Company. All the actions ultimately were consolidated.
 
     In addition to the purported securities class action, three shareholder derivative actions were filed in the United States District Court for the Middle District of North Carolina against certain current and former directors of the Company, certain former officers of the Company, including Scott Livengood (the Company’s former Chairman and Chief Executive Officer), as well as certain persons or entities that sold franchises to the Company. The complaints in these actions alleged that the defendants breached their fiduciary duties in connection with their management of the Company and the Company’s acquisitions of certain franchises.
 
     In October 2006, the Company entered into a Stipulation and Settlement Agreement (the “Stipulation”) with the lead plaintiffs in the securities class action, the derivative plaintiffs and all defendants named in the class action and derivative litigation, except for Mr. Livengood, providing for the settlement of the securities class action and a partial settlement of the derivative action. The Stipulation contained no admission of fault or wrongdoing by the Company or the other defendants. In February 2007, the Court entered final judgment dismissing all claims with respect to all defendants in the derivative action, except for claims that the Company may assert against Mr. Livengood, and entered final judgment dismissing all claims with respect to all defendants in the securities class action.
 
     With respect to the securities class action, the settlement class received total consideration of approximately $76.0 million, consisting of a cash payment of approximately $35.0 million made by the Company’s directors’ and officers’ insurers, cash payments of $100,000 each made by each of a former Chief Operating Officer and former Chief Financial Officer of the Company, a cash payment of $4 million made by the Company’s independent registered public accounting firm, and common stock and warrants to purchase common stock issued by the Company having an estimated aggregate value of approximately $36.9 million as of their issuance on March 2, 2007. Claims against all defendants were dismissed with prejudice; however, claims that the Company may have against Mr. Livengood that may be asserted by the Company in the derivative action for contribution to the securities class action settlement or otherwise under applicable law are expressly preserved.
 
     The Company issued 1,833,828 shares of its common stock and warrants to purchase 4,296,523 shares of its common stock at a price of $12.21 per share in connection with the Stipulation. The Company recorded a charge to earnings in fiscal 2006 for the fair value of the stock and warrants, measured as of the date on which the Company agreed to settle the litigation, and adjusted that charge in subsequent periods to reflect changes in the securities’ fair value until their issuance in the first quarter of fiscal 2008. Such subsequent adjustments resulted in a non-cash charge to fiscal 2007 earnings of $16.0 million and a non-cash credit to fiscal 2008 earnings of $14.9 million.
 
84
 


     The Stipulation also provided for the settlement and dismissal with prejudice of claims against all defendants in the derivative action, except for claims against Mr. Livengood. The Company settled its claims against Mr. Livengood in February 2010 in exchange for the payment by Mr. Livengood of $320,000 and his surrender to the Company of vested options to purchase 905,700 shares of the Company’s common stock.
 
     All litigation surrounding the above matters has now been settled.
 
   Fairfax County, Virginia Environmental Matter
 
     Since 2004, the Company has operated a commissary in the Gunston Commerce Center in Fairfax County, Virginia (the “County”). The County has investigated alleged damage to its sewer system near the commissary. On May 8, 2009, the County filed a lawsuit in Fairfax County Circuit Court alleging that the Company caused damage to the sewer system and violated the County’s Sewer Use Ordinance and the Company’s Wastewater Discharge Permit. The County sought from the Company repair and replacement costs of approximately $2 million and civil penalties of approximately $18 million. The Company removed the case to the U.S. District Court for the Eastern Division of Virginia, and in December 2009, the parties reached an agreement to resolve the litigation. During the third quarter of fiscal 2010, the Company recorded a provision of $750,000 for the settlement of this matter, which is included in Company Stores direct operating expenses.
 
   California Wage/Hour Litigation
 
     The Company was a defendant in a wage/hour suit pending in the Superior Court of Alameda County, California, in which the plaintiffs seek class action status and unspecified damages on behalf of a putative class of approximately 35 persons. In January 2010, the parties reached an agreement in principle to resolve the litigation and the Company recorded a provision of $950,000 for the settlement of this matter, which is included in Company Stores direct operating expenses and accrued liabilities in the accompanying balance sheet.
 
   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 franchisee’s store and related equipment. The Company’s contingent liabilities related to these guarantees totaled approximately $3.7 million at January 31, 2010, and are summarized in Note 18. These guarantees require payment by 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 $2.5 million as of January 31, 2010 and $2.7 million as of February 1, 2009, 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. The Company made payments totaling approximately $650,000 related to guarantees of franchisee obligations during fiscal 2009. 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 January 31, 2010, additional guarantee payments or provisions for guarantee payments could be required with respect to any of the guarantees.
 
     In addition, accrued liabilities at January 31, 2010 includes approximately $200,000 recorded in connection with the Company’s assignment of operating leases on closed and refranchised stores. The Company is contingently liable to pay the rents on these stores to the landlords in the event the franchisees fail to perform under the leases they have assumed. The $200,000 accrual represents the estimated fair value of the Company’s contingent obligation.
 
85
 


     One of the Company’s lenders had issued letters of credit on behalf of the Company totaling $15 million at January 31, 2010, the substantial majority of which secure the Company’s reimbursement obligations to insurers under the Company’s self-insurance arrangements.
 
     The Company is exposed to the effects of commodity price fluctuations on the cost of ingredients of its products, of which flour, shortening and sugar are the most significant. In order to secure adequate supplies of product and bring greater stability to the cost of ingredients, the Company routinely enters into forward purchase contracts with suppliers under which the Company commits to purchasing agreed-upon quantities of ingredients at agreed-upon prices at specified future dates. Typically, the aggregate outstanding purchase commitment at any point in time will range from one month’s to two years’ anticipated ingredients purchases, depending on the ingredient. In addition, from time to time the Company enters into contracts for the future delivery of equipment purchased for resale and components of doughnut-making equipment manufactured by the Company. As of January 31, 2010, the Company had approximately $43 million of commitments under ingredient and other forward purchase contracts. While the Company has multiple suppliers for most of its ingredients, the termination of the Company’s relationships with vendors with whom the Company has forward purchase agreements, or those vendors’ inability to honor the purchase commitments, could adversely affect the Company’s results of operations and cash flows.
 
     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 may also purchase futures and options on futures to hedge its exposure to rising gasoline prices. The Company typically assigns the futures contract to a supplier in connection with entering into a forward purchase contract for the related ingredient. See Note 22 for additional information about these derivatives.
 
Note 13 — Impairment Charges and Lease Termination Costs
 
     The components of impairment charges and lease termination costs are as follows:
 
Year Ended
Jan. 31,       Feb. 1,       Feb. 3,
2010 2009 2008
(In thousands)
Impairment charges:
       Impairment of goodwill – Company Stores segment $ $ $ 4,598
       Impairment of long-lived assets 3,108 1,050 55,963
       Impairment of reacquired franchise rights 40 480
       Recovery from bankruptcy estate of former subsidiary (482 )
              Total impairment charges 2,666    1,050    61,041
Lease termination costs:
       Provision for termination costs 4,195 316 2,683
       Less — reversal of previously recorded accrued rent expense (958 ) (818 ) (1,651 )
              Net provision 3,237 (502 ) 1,032
$    5,903 $ 548 $ 62,073
 

     The goodwill impairment charges in fiscal 2008 were recorded to reduce the carrying value of goodwill to its estimated fair value, which the Company estimates using the present value of expected future cash flows. Such charges reflected reductions in the Company’s forecasted sales and earnings in certain of the reporting units in the Company Stores segment, which caused a reduction in the estimated fair value of those reporting units. The Company conducts its annual goodwill impairment testing as of December 31.
 
     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 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. Impairment charges related to Company Stores long-lived assets were approximately $3.1 million, $900,000 and $44.1 million in fiscal 2010, 2009 and 2008, respectively. Such charges relate to underperforming stores, including both stores closed or likely to be closed and stores which 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. The impaired store assets include real properties, the fair values of which were estimated based on independent appraisals or, in the case of properties which the Company currently is negotiating to sell, based on the Company’s negotiations with unrelated third-party buyers, leasehold improvements, which are typically abandoned when the leased properties revert to the lessor, and doughnut-making and other equipment.
 
86
 


     During the fiscal year ended January 31, 2010, the Company received $482,000 of cash proceeds from the bankruptcy estate of Freedom Rings, LLC (“Freedom Rings”), a former subsidiary which filed for bankruptcy in the third quarter of fiscal 2006. During fiscal 2006, the Company recorded impairment provisions related to long-lived assets of Freedom Rings under the assumption that there would be no recovery from the Freedom Rings bankruptcy estate. Had any such recovery been assumed, the impairment charges would have been reduced by the amount of the assumed recovery. Accordingly, the amount recovered in fiscal 2010 has been reported as a credit to impairment charges in the accompanying statement of operations.
 
     For the fiscal year ended February 3, 2008, the Company also recorded an impairment charge of approximately $10.4 million with respect to its KK Supply Chain manufacturing and distribution facility in Illinois. During the second quarter of fiscal 2008, the Company decided to divest the facility and determined that the projected cash flows from operation and ultimate sale of the facility were less than its carrying value; accordingly, the Company recorded an impairment charge to reduce the carrying value of the facility and related equipment to their estimated fair value. The Company sold these assets for approximately $10.9 million cash (net of expenses) in the fourth quarter of fiscal 2008, and recorded a credit to impairment charges of approximately $600,000, representing the excess of the ultimate selling price over the previously estimated disposition value of the facility and equipment.
 
     The Company also recorded an impairment charge of approximately $1.5 million during the fiscal year ended February 3, 2008 to reduce the carrying value of its KK Supply Chain coffee roasting assets to their estimated disposal value of $1.9 million. The Company sold these assets for approximately $1.9 million cash during the third quarter of fiscal 2008.
 
     The Company records impairment charges for reacquired franchise rights when such intangible assets are determined to be impaired as a result of store closing decisions or other developments.
 
     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.
 
87
 


     The transactions reflected in the accrual for lease termination costs are summarized as follows:
 
Year Ended
Jan. 31,       Feb. 1,       Feb. 3,
2010 2009 2008
(In thousands)
Balance at beginning of year $ 1,880 $ 2,837 $ 1,650
       Provision for lease termination costs:
              Provisions associated with store closings, net of estimated sublease rentals 2,427 380 1,961
              Adjustments to previously recorded provisions resulting from
                     settlements with lessors and adjustments of previous estimates 1,580 (284 ) 526
              Accretion of discount 188 220 196
                            Total provision 4,195 316 2,683
       Proceeds from assignment of leases 62 748 966
       Payments on unexpired leases, including settlements with lessors (4,458 )    (2,021 )    (2,462 )
                            Total reductions    (4,396 ) (1,273 ) (1,496 )
Balance at end of year $ 1,679 $ 1,880 $ 2,837
Accrued lease termination costs are included in the consolidated
       balance sheet as follows:
              Accrued liabilities $ 298 $ 364 $ 322
              Other long-term obligations 1,381 1,516 2,515
$ 1,679 $ 1,880 $ 2,837
 

Note 14 — Other Non-Operating Income and Expense
 
     The components of other non-operating income and (expense) are as follows:
 
Year Ended
Jan. 31,       Feb. 1,       Feb. 3,
2010 2009 2008
(In thousands)
Foreign currency transaction gain (loss) $ (1 ) $ (14 ) $ 70
Gain on refranchise of Canadian subsidiary 2,805
Gain on disposal of interests in Equity Method Franchisees (Note 18) 931 260
Impairment charges and provisions related to investments in Equity
       Method Franchisees (Note 18) (500 ) (957 ) (572 )
Provision for guarantee payments 225 50 (2,969 )
$    (276 ) $    2,815 $    (3,211 )
 

     In fiscal 2010, the Company recorded a charge of approximately $500,000 to reflect a decline in the value of an investment in an Equity Method Franchisee that management concluded is other than temporary as described in Note 18 to the consolidated financial statements appearing elsewhere herein.
 
     In the fourth quarter of fiscal 2009, the Company refranchised its four stores in Canada. The Company received no proceeds from the transaction. The Company recognized a non-cash gain on the sale of the stores of $2.8 million ($1.6 million after tax), substantially all of which represents the recognition in earnings of the cumulative foreign currency translation adjustments related to the Canadian subsidiary which, prior to its disposition, had been reflected, net of tax, in accumulated other comprehensive income.
 
     During fiscal 2008, the Company recorded a provision of $3.0 million for estimated payments under the Company’s guarantees of certain loans and leases related to KKSF, the Company’s franchisee in South Florida (See “Other Commitments and Contingencies” in Note 12 and Note 18). In the fourth quarter of fiscal 2008, the franchisee defaulted on certain of the obligations guaranteed by the Company and, while there was no demand on the Company to perform under the guarantees, the Company believed it was probable that the Company would be required to perform under some, and potentially all, of them. During fiscal 2010, the Company reduced its recorded liability for potential payments under the KKSF guarantees by $225,000 to reflect a reduction in the aggregate principal balance of KKSF obligations guaranteed by the Company.
 
88
 


Note 15 — Income Taxes
 
     The components of the provision for income taxes are as follows:
 
Year Ended
Jan. 31,       Feb. 1,       Feb. 3,
2010 2009 2008
(In thousands)
Current $    1,055   $    (148 ) $    1,435
Deferred (480 ) 651 889
$ 575 $ 503 $ 2,324
 

     The components of the income (loss) before income taxes are as follows:
 
Year Ended
Jan. 31,       Feb. 1,       Feb. 3,
2010 2009 2008
(In thousands)
Domestic $ 444 $ (1,405 ) $ (58,491 )
Foreign (26 ) (2,153 ) (6,236 )
       Total income (loss) before income taxes $    418 $    (3,558 ) $    (64,727 )
 

     A reconciliation of a tax provision computed at the statutory federal income tax rate and the Company’s provision for income taxes follows:
 
Year Ended
Jan. 31,       Feb. 1,       Feb. 3,
2010 2009 2008
(In thousands)
Income taxes at statutory federal rate $ 146 $ (1,245 ) $    (22,654 )
State income taxes 162 517 (3,718 )
Foreign losses with no tax benefit 9 47 114
Change in valuation allowance on deferred income tax assets (257 ) 1,811 27,642
Change in accruals for uncertain tax positions 74 (1,472 ) 332
Change in accruals for interest and penalties 86 (283 ) 220
Change in federal tax credit carryforwards (principally foreign tax credits)    (1,499 )    (1,557 ) (795 )
Foreign withholding taxes 1,400 1,361 773
Other 454 1,324 410
$ 575 $ 503 $ 2,324  
 

     The Company recorded an expense of approximately $160,000 to the provision for income taxes in fiscal 2010 to increase the Company’s accruals for uncertain tax positions.
 
     Income tax payments, net of refunds, were $1.5 million, $1.3 million and $682,000 in fiscal 2010, 2009 and 2008, respectively. The tax payments in all three fiscal years were comprised largely of foreign withholding taxes on revenues received from foreign franchisees.
 
89
 


     The components of deferred income taxes are as follows:
 
Jan. 31,       Feb. 1,
2010 2009
(In thousands)
Net current assets $    — $ 106
Net noncurrent liabilities    (106 )
       Net asset $ $
 

     The tax effects of temporary differences are as follows:
 
Jan. 31,       Feb. 1,
2010 2009
(In thousands)
Deferred income tax assets:
       Goodwill and other intangible assets $ 22,543 $ 26,008
       Accrued litigation settlement 7,315 7,315
       Allowance for doubtful accounts 1,034 1,432
       Other current assets 2,293 2,127
       Property and equipment 219
       Other non-current assets 2,829 1,968
       Insurance accruals 4,301 5,060
       Deferred revenue 2,617 2,767
       Other current liabilities 6,958 4,779
       Other non-current liabilities 2,862 3,078
       Share-based compensation 5,877 4,818
       Federal net operating loss carryforwards 82,829 83,811
       Federal tax credit carryforwards 6,247 5,365
       Charitable contributions carryforward 1,077 1,051
       State net operating loss and credit carryforwards 11,297 11,458
       Other 330 814
              Gross deferred income tax assets 160,628 161,851
              Valuation allowance on deferred income tax assets    (160,628 )    (160,885 )
                     Deferred income tax assets, net of valuation allowance 966
Deferred income tax liabilities:
       Property, plant and equipment (966 )
              Gross deferred income tax liabilities (966 )
              Net deferred income tax asset $ $
 

     Certain amounts set forth in the table above as of February 1, 2009 differ from amounts previously reported. However, the aggregate net deferred income tax asset at that date is unchanged.
 
     The Company has recorded a valuation allowance against deferred income tax assets of $160.6 million and $160.9 million at January 31, 2010 and February 1, 2009, respectively, representing the amount of its deferred income tax assets in excess of its deferred income tax liabilities. The valuation allowances were recorded because management was unable to conclude, in light of the cumulative loss realized by the Company for the three year period ended January 31, 2010, that realization of the net deferred income tax asset was more likely than not.
 
     The Company has approximately $237.7 million of federal income tax loss carryforwards expiring in fiscal 2024 through 2029. Of this amount, approximately $18.2 million is the result of tax deductions related to the exercise of stock options by employees, the tax benefits of which, if subsequently realized, will be recorded as an addition to common stock. The Company also has state income tax loss carryforwards expiring in fiscal 2011 through 2029.
 
     The Company is subject to U.S. federal income tax, as well as income tax in multiple U.S. state and local jurisdictions and a limited number of foreign jurisdictions. The Company’s income tax returns periodically are examined by the Internal Revenue Service and by other tax authorities in various jurisdictions. The Company assesses the likelihood of adverse outcomes resulting from these examinations in determining the provision for income taxes. All significant federal, state, local and foreign income tax matters have been concluded through fiscal 2006.
 
90
 


     The Company had $1.6 million of unrecognized tax benefits as of January 31, 2010. If recognized, approximately $540,000 of the unrecognized tax benefits would be recorded as a part of income tax expense and affect the Company’s effective income tax rate.
 
     The following table presents a reconciliation of the beginning and ending amounts of unrecognized tax benefits:
 
Year Ended
Jan. 31,       Feb. 1,       Feb. 3,
2010 2009 2008
(In thousands)
Unrecognized tax benefits at beginning of year $    1,680 $ 5,130 $    4,540
Increases in positions related to the current year 358 4 238
Increases (decreases) in positions taken in prior years 1    (1,354 ) 794
Settlements with taxing authorities (1,994 ) (41 )
Lapsing of statutes of limitations (469 ) (106 ) (401 )
Unrecognized tax benefits at end of year $ 1,570 $ 1,680 $ 5,130
 

     It is reasonably possible that the total amount of unrecognized tax benefits will decrease in fiscal 2011 by up to approximately $740,000, of which $16,000 would be recorded as part of income tax expense if recognized. Decreases in the unrecognized tax benefits may result from the lapsing of statutes of limitations.
 
     The Company’s policy is to recognize interest and penalties related to income tax issues as components of income tax expense. The Company’s balance sheet reflects approximately $470,000 and $385,000 of accrued interest and penalties as of January 31, 2010 and February 1, 2009, respectively.
 
Note 16 — Shareholders’ Equity
 
   Share-Based Compensation for Employees
 
     The Company’s shareholders approved the 2000 Stock Incentive Plan (the “2000 Plan”), under which incentive stock options, nonqualified stock options, stock appreciation rights, performance units, restricted stock (or units) and common shares may be awarded through June 30, 2012. The maximum number of shares of common stock with respect to which awards may be granted under the 2000 Plan is 13.0 million (which reflects a 3.0 million share increase in the number of authorized shares approved by the Company’s shareholders in fiscal 2010), of which 2.6 million remain available for grant after fiscal 2010. The 2000 Plan provides that options may be granted with exercise prices not less than the closing sale price of the Company’s common stock on the date of grant.
 
     The Company measures and recognizes compensation expense for share-based payment (“SBP”) awards based on their fair values. The fair value of SBP awards for which employees render the requisite service necessary for the award to vest is recognized over the related vesting period. The fair value of SBP awards which vest in increments and for which vesting is subject solely to service conditions is charged to expense on a straight-line basis over the aggregate vesting period of each award, which generally is four years. The fair value of SBP awards which vest in increments and for which vesting is subject to both market conditions and service conditions is charged to expense over the estimated vesting period of each increment of the award, each of which is treated as a separate award for accounting purposes.
 
91
 


     The aggregate cost of SBP awards charged to earnings in fiscal 2010, 2009 and 2008 is set forth in the following table. The Company did not realize any excess tax benefits from the exercise of stock options during any of the three fiscal years.
 
Year Ended
Jan. 31,       Feb. 1,       Feb. 3,
2010 2009 2008
(In thousands)
Costs charged to earnings related to:
       Stock options $ 1,254 $ 2,181 $ 2,561
       Restricted stock and restricted stock units 3,525 2,971 5,038
              Total costs $ 4,779 $ 5,152 $ 7,599
 
Costs included in:
       Direct operating expenses $ 1,673 $ 2,216 $ 2,384
       General and administrative expenses 3,106 2,936 5,215
              Total costs $    4,779 $    5,152 $    7,599
 

     During each of the last three fiscal years, the Company permitted holders of restricted stock awards to satisfy their obligations to reimburse the Company for the minimum required statutory withholding taxes arising from the vesting of such awards by surrendering vested common shares in lieu of reimbursing the Company in cash. In addition, the terms of certain stock options granted under the Company’s 1998 Stock Option Plan which were exercised in fiscal 2009 provided that reimbursement of minimum required withholdings taxes and payment of the exercise price could, at the election of the optionee, be made by surrendering common shares acquired upon the exercise of such options. The aggregate fair value of common shares surrendered related to the vesting of restricted stock awards was $343,000 in fiscal 2010. The aggregate fair value of common shares surrendered related to the vesting of restricted stock awards and the exercise of stock options was $300,000 and $1.8 million, respectively, in fiscal 2009. The aggregate fair value of common shares surrendered related to the vesting of restricted stock awards was $93,000 in fiscal 2008. The aggregate fair value of the surrendered shares of $343,000, $2.1 million and $93,000 in fiscal 2010, 2009 and 2008, respectively, has been reflected as a financing activity in the accompanying consolidated statement of cash flows and as a repurchase of common shares in the accompanying consolidated statement of changes in shareholders’ equity.
 
     The fair value of stock options subject only to service conditions was estimated using the Black-Scholes option pricing model. In addition to service conditions, certain stock options granted in fiscal 2008 also provide that the price of the Company’s common stock must increase by 20% after the grant date, and remain at or above the appreciated price for at least ten consecutive trading days, in order for the options to become vested and exercisable. The fair value of those stock options was estimated using Monte Carlo simulation techniques. Options granted generally have contractual terms of 10 years, the maximum term permitted under the 2000 Plan. The weighted average assumptions used in valuing stock options in fiscal 2010, 2009 and 2008 are set forth in the following table:
 
Year ended
Jan. 31,       Feb. 1,       Feb. 3,
2010 2009 2008
Expected life of option    7.0 years    7.0 years    6.9 years
Risk-free interest rate 3.12 % 2.74 % 4.42 %
Expected volatility of stock 50.0 % 50.0 % 50.0 %
Expected dividend yield  

     The expected life of stock options valued using the Black-Scholes option pricing model is estimated by reference to historical experience, published data and any relevant characteristics of the option. The expected life of stock options valued using Monte Carlo simulation techniques is based upon the vesting dates forecasted by the simulation and then assuming that options which vest are exercised at the midpoint between the forecasted vesting date and their expiration. The risk-free rate of interest is based on the yield of a zero-coupon U.S. Treasury bond on the date the award is granted having a maturity approximately equal to the expected term of the award. Expected volatility is based on a combination of the historical and implied volatility of the Company’s common shares and the shares of peer companies. The Company uses historical data to estimate forfeitures of awards prior to vesting.
 
92
 


     The number of options granted during fiscal 2010, 2009 and 2008 and the aggregate and weighed average fair value of such options were as follows:
 
Year ended
Jan. 31,       Feb. 1,       Feb. 3,
2010 2009 2008
Weighted average fair value per share of options granted $ 1.45 $ 1.22 $ 2.95
Total number of options granted 870,000 2,090,000 784,200
Total fair value of all options granted $    1,260,456 $    2,557,700 $    2,309,700

     The following table summarizes stock option transactions for fiscal 2010, 2009 and 2008. Option transactions include options granted under the 2000 Plan as well as options granted under the Company’s 1998 Stock Option Plan (the “1998 Plan”) pursuant to which grants may no longer be awarded.
 
      Weighted             Weighted
Shares Average Average
Subject Exercise Aggregate Remaining
to Price Intrinsic Contractual
Option Per Share Value Term
(Dollars in thousands, except per share amounts)
Outstanding at January 28, 2007 7,075,200 $    14.40   $    35,366 4.8 years
Granted 784,200 $ 5.21
Exercised (110,800 ) $ 2.63 $ 526
Forfeited (1,352,800 ) $ 13.76
Outstanding at February 3, 2008 6,395,800 $ 13.61 $ 3,796 3.6 years
Granted 2,090,000 $ 2.25
Exercised (2,387,300 ) $ 1.30 $ 7,238
Forfeited (185,500 ) $ 11.47
Outstanding at February 1, 2009 5,913,000 $ 14.70 $ 6.2 years
Granted 870,000 $ 2.65
Exercised $ $
Forfeited (634,100 ) $ 15.18
Outstanding at January 31, 2010 6,148,900 $ 12.94 $ 1,383 5.9 years
 
Exercisable at January 31, 2010 3,835,400 $ 18.76 $ 309 4.1 years
 

     Additional information regarding stock options outstanding as of January 31, 2010 is as follows:
 
Options Outstanding            
      Weighted        
Average Options Exercisable
Remaining Weighted Weighted
  Contractual Average Average
Range of Life Exercise Exercise
Exercise Prices   Shares (Years) Price Shares Price
$  1.40 - $3.41 3,243,400 8.4 $ 2.53 1,189,900 $ 2.79
$  5.25 - $9.71 413,300 5.9 $ 9.13 233,300 $ 8.69
$10.20 - $16.94 877,800 3.1 $    14.37 797,800 $ 14.56
$28.11 - $28.58 559,900 2.3 $ 28.34 559,900 $ 28.34
$30.98 - $44.22 1,054,500 2.6 $ 37.09 1,054,500 $    37.09

93
 


     In addition to stock options, the Company periodically has awarded restricted stock and restricted stock units (which are settled in common stock) under the 2000 Plan. The following table summarizes changes in unvested restricted stock and restricted stock unit awards for fiscal 2010, 2009 and 2008:
 
Weighted
Average
Unvested Grant Date
Shares       Fair Value
Unvested at January 28, 2007 744,000 $    8.71
Granted 1,552,000 $ 4.68
Vested (795,500 ) $ 4.96
Forfeited (315,000 ) $ 7.24
Unvested at February 3, 2008 1,185,500 $ 6.33
Granted 1,347,400 $ 2.42
Vested (483,400 ) $ 4.91
Forfeited (215,700 ) $ 6.11
Unvested at February 1, 2009 1,833,800 $ 3.86
Granted 727,200 $ 3.14
Vested    (1,111,200 ) $ 2.96
Forfeited (63,600 ) $ 5.65
Unvested at January 31, 2010 1,386,200 $ 4.13
 
     The total fair value as of the grant date of shares vesting during fiscal 2010, 2009 and 2008 was $3.3 million, $2.4 million and $3.9 million, respectively.
 
     As of January 31, 2010, the total unrecognized compensation cost related to SBP awards was approximately $6.2 million. The remaining service periods over which compensation cost will be recognized for these awards range from approximately three months to four years, with a weighted average remaining service period of approximately 1.2 years.
 
     At January 31, 2010, there were approximately 10.2 million shares of common stock reserved for issuance pursuant to awards granted under the 2000 Plan and the 1998 Plan.
 
   Common Shares and Warrants Issued in Connection With Settlement of Litigation
 
     On March 2, 2007, the Company issued 1,833,828 shares of common stock and warrants to acquire 4,296,523 shares of common stock at a price of $12.21 per share expiring in March 2012 in connection with the settlement of certain litigation as described in Note 12. As of that date, the aggregate fair value of the common shares was approximately $18.4 million and the aggregate fair value of the warrants was approximately $18.5 million. The estimated fair value of the warrants was computed using the Black-Scholes option pricing model with the following assumptions: an exercise price of $12.21 per share; a market price of common stock of $10.01 per share; an expected term of 5.0 years; a risk-free rate of 4.46%; a dividend yield of zero; and expected volatility of 50%.
 
     The common stock and warrants had a fair value as of January 28, 2007 of approximately $51.8 million. The decrease in the estimated fair value of the common stock and warrants from January 28, 2007 to their issuance on March 2, 2007 of approximately $14.9 million was credited to earnings in the first quarter of fiscal 2008, at which time the aggregate fair value of the securities of approximately $36.9 million was reclassified from liabilities to common stock.
 
     Shareholder Protection Rights Agreement
 
     Each share of the Companys common stock is accompanied by one preferred share purchase right (a “Right”) issued pursuant to the terms of a Shareholder Protection Rights Agreement, dated as of January 14, 2010 (the “Rights Agreement”).  Each Right entitles the registered shareholder to purchase from the Company one one-hundredth (1/100) of a share of Krispy Kreme Series A Participating Cumulative Preferred Stock, no par value (“Participating Preferred Stock”), at a price of $13.50 (the “Exercise Price”), subject to adjustment from time to time to prevent dilution.   The Company may redeem the Rights for a nominal amount at any time prior to an event that causes the Rights to become exercisable.  The Rights expire on January 14, 2013.  The holders of Rights, solely by reason of their ownership of Rights, have no rights as shareholders of the Company, including, without limitation, the right to vote or to receive dividends.   

     Under the Rights Agreement, the Rights are generally not exercisable until (a) the commencement of a tender offer or exchange offer by a person who, as a result of such transaction, would become the beneficial owner of 15% or more of the Companys common stock, (b) the acquisition by a person or group of 15% or more of the Company’s outstanding common stock, or (c) a person or group acquires 40% or more of the Companys common stock.
 
     If the exerciseability of Rights is triggered, each Right (other than Rights beneficially owned by an unapproved acquirer) will constitute the right to purchase shares of common stock of the Company at 50% of their market price. In addition, the Board of Directors of the Company may, under certain circumstances, elect to exchange the Rights (other than Rights beneficially owned by an unapproved acquirer) for shares of the Company’s common stock at an exchange ratio of one share of common stock per Right, appropriately adjusted to reflect any stock split, stock dividend or similar transaction occurring after the date the Rights become exercisable. 
 
     If the Rights are exercisable and the Company enters into certain consolidation or asset sale transactions involving the types of shareholders that trigger the exercisability of Rights, then the Company will enter into an arrangement for the benefit of the holders of the Rights, providing that, upon consummation of the transaction in question, each Right (other than Rights beneficially owned by the unapproved acquirer) will constitute the right to purchase shares of common stock of the other entity engaging in the transaction at 50% of their market price.
 
94
 


Note 17 — 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 majority of the ingredients and materials used by Company stores are purchased from the KK Supply Chain segment, which supplies doughnut mix, equipment and other items to both Company and franchisee-owned stores. The Domestic Franchise and International Franchise segments consist of the Company’s store 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.
 
     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, ingredients and supplies to the Company Stores segment; such profit is included in KK Supply Chain operating income. The gross profit earned by the KK Supply Chain segment on sales of equipment to the Company Stores segment and eliminated in consolidation is not included in the KK Supply Chain segment operating income shown below, and depreciation expense charged to Company Stores operating income reflects the elimination of that intercompany profit.
 
     Through fiscal 2009, the Company reported its results of operations of its franchise business as a single business segment. In fiscal 2010, the Company began disaggregating the results of operations of its franchise business into domestic and international components in its internal financial reporting. The Company has made the corresponding changes to its segment reporting, and now reports the revenues and expenses associated with its domestic and international franchise operations as separate segments. The Company’s segment disclosures continue to be consistent with the way in which management assesses the performance of and allocates resources to its businesses.. Amounts previously reported for the franchise segment for fiscal 2009 and fiscal 2008 have been restated to conform to the new disaggregated segment presentation.
 
95
 


     The following table presents the results of operations of the Company’s operating segments for fiscal 2010, 2009 and 2008. Segment operating income is consolidated operating income before unallocated general and administrative expenses, impairment charges and lease termination costs and settlement of litigation.
 
Year Ended
Jan. 31, Feb. 1, Feb. 3,
2010       2009       2008
(In thousands)
Revenues:
       Company Stores $ 246,373   $    265,890 $ 304,444
       Domestic Franchise 7,807 8,042 8,673
       International Franchise 15,907 17,495 14,285
       KK Supply Chain:
              Total revenues    162,127 191,456 205,499
                     Less – intersegment sales elimination (85,694 ) (97,361 )    (102,531 )
              External KK Supply Chain revenues 76,433 94,095 102,968  
                     Total revenues $ 346,520   $ 385,522 $ 430,370
 
Operating income (loss):
       Company Stores $ 2,288 $ (9,813 ) $ (6,292 )
       Domestic Franchise 3,268 4,965 4,833
       International Franchise 9,896 11,550   9,484
       KK Supply Chain 25,962 23,269 24,083
              Total segment operating income   41,414 29,971   32,108
       Unallocated general and administrative expenses (23,737 ) (24,662 ) (27,552 )
       Impairment charges and lease termination costs (5,903 )   (548 ) (62,073 )
       Settlement of litigation     14,930
              Consolidated operating income (loss) $ 11,774 $ 4,761 $ (42,587 )
 
Depreciation and amortization expense:
       Company Stores $ 6,293 $ 6,402 $ 11,558
       Domestic Franchise 71 86 92
       International Franchise
       KK Supply Chain 883 1,019 5,586
       Corporate administration 944 1,202 1,197
              Total depreciation and amortization expense $ 8,191 $ 8,709 $ 18,433
 
     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.
 
     Revenues for fiscal 2010, 2009 and 2008 include approximately $32 million, $52 million and $48 million, respectively, from customers outside the United States.
 
Note 18 — Investments in Franchisees
 
     As of January 31, 2010, the Company had investments in four franchisees. These investments have been made in the form of capital contributions and, in certain instances, loans evidenced by promissory notes. These investments are reflected as “Investments in Equity Method Franchisees” in the consolidated balance sheet.
 
96
 


     Information about the Company’s ownership in the Equity Method Franchisees and the markets served by those franchisees is set forth below:
 
Number of
Stores as
of Jan. 31, Ownership%
Geographic Market       2010       Company       Third Parties
Kremeworks, LLC Alaska, Hawaii, Oregon, 11   25.0 % 75.0 %
Washington
Kremeworks Canada, LP Western Canada   1 24.5 %   75.5 %
Krispy Kreme of South Florida, LLC South Florida 3 35.3 % 64.7 %
Krispy Kreme Mexico, S. de R.L. de C.V. Mexico 46 30.0 % 70.0 %

     The Company’s financial exposures related to franchisees in which the Company has an investment are summarized in the tables below.
 
January 31, 2010
Investment
and Trade Loan
Advances       Receivables       Guarantees
(In thousands)
Kremeworks, LLC $ 900 $ 327 $ 1,241
Kremeworks Canada, LP 16
Krispy Kreme of South Florida, LLC 138 2,489
Krispy Kreme Mexico, S. de R.L. de C.V. 781 782
1,681 1,263 $ 3,730
Less: reserves and allowances (900 ) (739 )
$ 781 $ 524
        
February 1, 2009
Investment Loan and
and Trade Lease
Advances Receivables Guarantees
(In thousands)
Kremeworks, LLC $ 900 $ 378 $ 1,754
Kremeworks Canada, LP 16
Krispy Kreme of South Florida, LLC     38   7,256
Krispy Kreme Mexico, S. de R.L. de C.V. 1,187   836  
   2,087   1,268   $    9,010
Less: reserves and allowances (900 ) (249 )
$            1,187 $             1,019  
 
     The guarantees at January 31, 2010 consist entirely of loan guarantees. As of February 1, 2009, the aggregate loan and lease guarantees consisted of $3.5 million of loan guarantees and $5.5 million of lease guarantees. The loan guarantee amounts were determined based upon the principal amount outstanding under the related loan and the lease guarantee amounts were determined based upon the gross amount of remaining lease payments.
 
     The Company has a 25% interest in Kremeworks, LLC (“Kremeworks”), whose results of operations and operating cash flow have declined and, although Kremeworks has paid all interest, fees and scheduled amortization of principal due under its bank indebtedness, it failed to comply with certain financial covenants related to such indebtedness, a portion of which matured, by its terms, in January 2009. The Company has guaranteed 20% of such indebtedness. During the third quarter of fiscal 2010, Kremeworks completed an amendment to its debt agreement which, among other things, waived the defaults related to the failure to comply with the financial covenants and extended the maturity of the indebtedness until July 2010. In connection with that amendment, during fiscal 2010 the Company and the majority owner of Kremeworks (which also is a guarantor of the indebtedness) made capital contributions to Kremeworks in the aggregate amount of $1 million (of which the Company’s contribution was $250,000), the proceeds of which were used to prepay a portion of the indebtedness as required by the amendment. The aggregate amount of Kremeworks indebtedness as of January 31, 2010 was approximately $6.2 million, of which approximately $1.2 million is guaranteed by the Company.
 
97
 


     The Company has a $900,000 note receivable from Kremeworks which is subordinate to the Kremeworks bank indebtedness. The note arose from cash advances made by the Company to Kremeworks in fiscal 2005 and earlier years. During fiscal 2009, the Company established a reserve equal to the entire $900,000 balance of its note receivable in recognition of the uncertainty surrounding its ultimate collection, the charge related to which is included in “Other non-operating income and expense, net” in the accompanying consolidated statement of operations.
 
     Krispy Kreme of South Florida, LLC (“KKSF”) incurred defaults with respect to certain credit agreements with its lenders, including agreements related to KKSF indebtedness guaranteed, in part, by the Company. During the fourth quarter of fiscal 2008, the Company recorded a provision of $3.0 million for potential payments related to guarantees of KKSF loans and leases. In September 2008, the Company, KKSF and one of KKSF’s lenders entered into agreements pursuant to which, among other things, the Company paid approximately $250,000 to the lender to effect a cure of certain KKSF defaults with respect to certain of the indebtedness subject to the Company’s guarantee. Such agreements also provided for a reduction in the amount of the Company’s debt guarantee obligations of approximately $125,000, and for the Company’s release from KKSF lease guarantees for which the Company’s potential guarantee obligation was approximately $4.0 million. In the first quarter of fiscal 2010, KKSF completed a transaction which resulted in the Company’s release from a lease guarantee for which the Company’s potential obligation was approximately $5.5 million, but which increased the Company’s guarantee of KKSF debt obligations by approximately $1.0 million. The aggregate guarantees of KKSF obligations were approximately $2.5 million (all of which related to loans), which approximates the amount of accrued liabilities reflected in the Company’s balance sheet for its KKSF guarantee obligations as of January 31, 2010.
 
     The Company has a 30% interest in Krispy Kreme Mexico, S. de R.L. de C.V. (“KK Mexico”), whose operating results have been adversely affected by economic weakness in that country. The franchisee also has been adversely affected by a decline in the value of the country’s currency relative to the U.S. dollar, which has made the cost of goods imported from the U.S. more expensive, and which has increased the amount of cash required to service the portion of the franchisee’s debt that is denominated in U.S. dollars. During the second quarter of fiscal 2010, management concluded that the decline in the value of the investment was other than temporary and, accordingly, the Company recorded a charge of approximately $500,000 during that period to reduce the carrying value of the investment in KK Mexico to its estimated fair value of $700,000. Such charge is included in “Other non-operating income and expense, net” in the accompanying consolidated statement of operations. In addition, during fiscal 2010, the Company increased its bad debt reserve related to KK Mexico by $490,000, of which $109,000 and $381,000 is included in KK Supply Chain and International Franchise direct operating expenses, respectively; such reserve at January 31, 2010 is equal to the Company’s aggregate receivables from this franchisee.
 
     In June 2008, the Company completed an agreement to dissolve Priz Doughnuts, LP, an equity method franchisee. In connection with this transaction, the Company conveyed the assets of one of the stores to an existing franchisee and conveyed the other store to the other partner of franchisee. In connection with the dissolution of the Company’s investment in this franchisee, the Company paid $400,000 to settle its loan guarantee related to the franchisee.
 
     In April 2008, the Company completed an agreement with two franchisees under common control pursuant to which, among other things, the Company conveyed to the majority owner of the franchisees the Company’s equity interests in the franchisees and compromised and settled certain disputed and past due amounts owed by them to the Company. In connection with this agreement, the Company was released from its obligations under all of its partial guarantees of certain of the franchisees’ indebtedness and lease obligations. The Company recorded a non-cash gain of $931,000 as a result of this transaction which is included in “Other non-operating income and expense, net” in the accompanying consolidated statement of operations for the fiscal year ended February 1, 2009.
 
     During fiscal 2008, the Company reevaluated its investment in Kremeworks Canada, LP (“Kremeworks Canada”) and concluded that the value of such investment was other than temporarily impaired; accordingly, the Company recorded an impairment charge of $572,000 to reduce the carrying value of the Company’s investment in Kremeworks Canada to zero. This charge is included in “Other non-operating income and expense, net” in the accompanying consolidated statement of operations for the fiscal year ended February 3, 2008.
 
     The following table summarizes the Company’s obligations under the loan guarantees as of January 31, 2010 and the scheduled expiration of these obligations in each of the next five fiscal years and thereafter. The amounts shown as the scheduled expiration of the guarantees are based upon the scheduled maturity of the underlying guaranteed obligation.
 
98
 


Total
Guarantee Loan Amounts Expiring in Fiscal Year
Percentages       Guarantees       2011       2012       2013       2014       2015       Thereafter
(In thousands)
Kremeworks, LLC 20 % $ 1,241 $ 1,241   $ $   $ $   $
Krispy Kreme of South                
       Florida, LLC 100 %   2,489   1,958   531        
$    3,730 $    3,199 $    531 $    — $    — $    — $    —
 

     Current liabilities at January 31, 2010 and February 1, 2009 include accruals for potential payments under loan guarantees of approximately $2.5 million and $2.7 million, respectively, related to KKSF. There was no liability reflected in the financial statements for other guarantees of franchisee obligations because the Company did not believe it was probable that the Company would be required to perform under such other guarantees.
 
     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 January 31, 2010, additional guarantee payments or provisions for guarantee payments could be required with respect to any of the guarantees, and such payments or provisions could be significant.
 
     Information about the financial position and results of operations of the Equity Method Franchisees in which the Company had an interest as of January 31, 2010, is set forth below:
 
Summary Financial Information (1)
Operating   Net Income Total
Income (Loss) Current Noncurrent Current   Noncurrent Equity
Revenues       (Loss)       (2)       Assets       Assets       Liabilities       Liabilities       (Deficit)
(In thousands)
(Unaudited)
Kremeworks, LLC
              2010 $ 17,091 $ (2,740 ) $ (3,138 ) $ 1,510 $ 15,961 $    12,613 $ 1,784 $ 3,074
              2009 18,504    (1,788 ) (2,728 ) 1,455 19,259 8,029 8,476 4,209
              2008    20,339 (738 )    (1,963 ) 1,381    22,134 7,659 10,467 5,389
Kremeworks Canada, LP
              2010 1,286 (764 ) (862 ) 424 1,800 3,896 (1,672 )
              2009 1,388 174 28 250 1,803 2,640 (587 )
              2008 1,511 (190 ) (419 ) 290 2,560 3,576 (726 )
Krispy Kreme of South        
       Florida, LLC  
              2010 11,256 1,346 1,102     1,173 3,991   4,793 4,592    (4,221 )
              2009 10,800   1,188   655 1,095   8,164   3,557     9,672 (3,970 )
              2008 13,196   595   53   640   8,386 2,925    10,111 (4,010 )
Krispy Kreme  
       Mexico, S. de R.L. de C.V.  
              2010 15,346 1,052 860 3,354 6,390 4,725 5,019
              2009 17,189 (386 ) (618 ) 2,425 5,877 4,365 3,937
              2008 14,238 (25 ) (322 )    3,036 7,780 5,242 5,574  
____________________

      (1)       The revenues and net income (loss) shown for each of these franchisees represents the amounts reported by the franchisee for calendar 2009, 2008 and 2007, and the amounts shown as assets and liabilities represent the corresponding amounts reported by each of the franchisees on or about December 31, 2009, 2008 and 2007.
 
(2) The net income or loss of each of these entities is includable on the income tax returns of their owners to the extent required by law. Accordingly, the financial statements of these entities do not include a provision for income taxes and as a result pretax income or loss for each of these entities is also their net income or loss.
 
99
 


Note 19 — Related Party Transactions
 
     All franchisees are required to purchase doughnut mix and production equipment from the Company. Revenues include $7.8 million, $10.4 million and $14.7 million in fiscal 2010, 2009 and 2008, respectively, of sales to franchise stores owned by franchisees in which the Company had an ownership interest during fiscal 2010. Revenues also include royalties from these franchisees of $1.6 million, $2.3 million and $2.9 million in fiscal 2010, 2009 and 2008, respectively. Trade receivables from these franchisees are included in receivables from related parties as described in Note 3. These transactions were conducted pursuant to development and franchise agreements, the terms of which are substantially the same as the agreements with unaffiliated franchisees.
 
     The Company’s franchisee for the Middle East is an affiliate of a shareholder which is the beneficial owner of approximately 13% of the Company’s common stock. The Company had transactions in the normal course of business with this franchisee (including sales of doughnut mix and equipment to the franchisee and royalties payable to the Company by the franchisee based on its sales at Krispy Kreme franchise stores) totaling approximately $8.9 million in fiscal 2010, $10.6 million in fiscal 2009 and $8.1 million in fiscal 2008. Such transactions were conducted pursuant to development and franchise agreements, the terms of which are substantially the same as the agreements with other international franchisees.
 
     In fiscal 2010, the Company entered into a $357,000 contract to refurbish the interior and exterior of two Company stores with Cummings Incorporated (“Cummings”), a store exterior design and remodeling company of which an independent director of the Company is 66.7% owner. While the unique nature of the refurbishing services provided by Cummings is not directly comparable to those provided by competitors, management believes the terms of the contract are no less favorable than could have been obtained from a non-affiliated entity for conventional remodeling services.
 
Note 20 — Employee Benefit Plans
 
     The Company has a 401(k) savings plan (the “401(k) Plan”) to which employees may contribute up to 100% of their salary and bonus to the plan on a tax deferred basis, subject to statutory limitations.
 
     The Company also has a Nonqualified Deferred Compensation Plan (the “401(k) Mirror Plan”) designed to enable officers of the Company whose contributions to the 401(k) Plan are limited by certain statutory limitations to have the same opportunity to defer compensation as is available to other employees of the Company under the qualified 401(k) savings plan. Participants may defer from 1% to 15% of their base salary and from 1% to 100% of their bonus (reduced by their contributions to the 401(k) Plan), subject to statutory limitations, into the 401(k) Mirror Plan and may direct the investment of the amounts they have deferred. The investments, however, are not a legally separate fund of assets, are subject to the claims of the Company’s general creditors, and are included in other assets in the consolidated balance sheet. The corresponding liability to participants is included in other long-term obligations. The balance in the asset and corresponding liability account was $455,000 and $287,000 at January 31, 2010 and February 1, 2009, respectively.
 
     The Company currently matches 50% of the first 6% of compensation contributed by each employee to these plans. Contributions expense for these plans totaled $730,000 in fiscal 2010, $754,000 in fiscal 2009 and $847,000 in fiscal 2008.
 
Note 21 — Fair Value Measurements
 
Principles of Fair Value Measurements
 
     In the first quarter of fiscal 2009, the Company adopted new accounting standards with respect to financial assets and liabilities measured at fair value on both a recurring and non-recurring basis and with respect to nonfinancial assets and liabilities measured on a recurring basis. In the first quarter of fiscal 2010, the Company adopted new accounting standards with respect to nonrecurring measurements of nonfinancial assets and liabilities.
 
     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. This standard is intended to establish a common definition of fair value to be used throughout GAAP, which is expected to make the measurement of fair value more consistent and comparable.
 
100
 


     The accounting standards for fair value measurements establish a three-level fair value hierarchy that prioritizes the inputs used to measure fair value. This hierarchy requires entities to maximize the use of observable inputs and minimize the use of unobservable inputs. The three levels of inputs used to measure fair value are as follows:
  • Level 1 - Quoted prices in active markets that are accessible at the measurement date for identical assets or liabilities.
     
  • Level 2 - Observable inputs other than quoted prices included within Level 1, such as quoted prices for similar assets and liabilities in active markets; quoted prices for identical or similar assets and liabilities in markets that are not active; or other inputs that are observable or can be corroborated by observable market data.
     
  • Level 3 - Unobservable inputs that are supported by little or no market activity and that are significant to the fair value measurement of the assets or liabilities. These include certain pricing models, discounted cash flow methodologies and similar techniques that use significant unobservable inputs.
     Adoption of these accounting standards had no material effect on the Company’s financial position or results of operations.
 
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 January 31, 2010.
 
January 31, 2010
Level 1       Level 2       Level 3
(In thousands)
Assets:
       401(k) mirror plan assets $    455 $ $
Liabilities:    
       Interest rate derivatives $ $    641   $
       Commodity futures contracts 92  
       Total liabilities $ 92 $ 641 $    —
 
Assets and Liabilities Measured at Fair Value on a Non-Recurring Basis
 
     The following tables present the nonrecurring fair value measurements recorded during the year ended January 31, 2010.
 
Fiscal Year Ended January 31, 2010
Total gain
Level 1       Level 2       Level 3       (loss)
(In thousands)
Long-lived assets $    —   $    10,506   $   $    (3,108 )
Investment in Equity Method Franchisee            700 (500 )
Lease termination liabilities   2,427   (1,469 )

   Long-Lived Assets
 
     During the fiscal year ended January 31, 2010, long-lived assets having an aggregate carrying value of $13.6 million were written down to their estimated fair values of $10.5 million, resulting in recorded impairment charges of $3.1 million, as described in Note 13. During fiscal 2010, the Company recorded impairment charges related to long-lived assets, substantially all of which were real properties; the fair values of these assets were estimated based on the present value of estimated future cash flows, on independent appraisals and, in the case of properties which the Company currently is negotiating to sell, based on the Company’s negotiations with unrelated third-party buyers. The charges relate to stores closed, refranchised or expected to be closed, as well as charges with respect 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. These inputs are classified as Level 2 within the valuation hierarchy.
 
101
 


   Investment in Equity Method Franchisee
 
     During the second quarter of fiscal 2010, the Company concluded that a decline in the value of an Equity Method Franchisee was other than temporary and, accordingly, recorded a writedown of $500,000 to reduce the carrying value of the investment to its estimated fair value of $700,000 as described in Note 18. The fair value of the investment was estimated based upon a multiple of the investee’s current normalized trailing earnings before interest, income taxes and depreciation and amortization. These inputs are classified as Level 3 within the valuation hierarchy.
 
   Lease Termination Liabilities
 
     During the fiscal year ended January 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 13; such provisions were reduced by previously recorded accrued rent expense related to those stores. The fair value of these liabilities were 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 fiscal year ended January 31, 2010, the fair value of lease termination liabilities related to closed stores of $2.4 million exceeded the $958,000 of previously recorded accrued rent expense related to such stores, and such excess has been reflected as a charge to lease termination costs during the period.
 
Fair Values of Financial Instruments at the Balance Sheet Dates
 
     The carrying values and approximate fair values of certain financial instruments as of January 31, 2010 and February 1, 2009 were as follows:
 
Jan. 31, 2010 Feb. 1, 2009
Carrying Fair Carrying Fair
Value       Value       Value       Value
(In thousands)
Assets
       Cash and cash equivalents $    20,215 $    20,215 $ 35,538 $ 35,538
       Trade receivables 17,371 17,371 19,229 19,229
       Receivables from Equity Method Franchisees 524 524 1,019   1,019
Liabilities:    
       Accounts payable   6,708   6,708   8,981 8,981
       Interest rate derivatives 641   641   2,348 2,348
       Commodity futures contracts 92   92
       Long-term debt (including current maturities) 43,447 41,872    74,867    58,022

Note 22 — Derivative Instruments
 
     The Company is exposed to certain risks relating to its ongoing business operations and utilizes derivative instruments as part of its management of 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 derivative instruments. The Company mitigates this risk of nonperformance by dealing with highly rated counterparties. The Company did not have any significant exposure to any individual counterparty at January 31, 2010.
 
102
 


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, shortening and sugar are the most significant. In order to bring greater stability to the cost of ingredients, the Company purchases, from time to time, exchange-traded commodity futures contracts, and options on such contracts, for raw materials which are ingredients of its products or which are components of such ingredients, including wheat and soybean oil. The Company is also exposed to the effects of commodity price fluctuations in the cost of gasoline used by its delivery vehicles. To mitigate the risk of fluctuations in the price of its gasoline purchases, the Company may purchase exchange-traded commodity futures contracts and options on such contracts. The difference between the cost, if any, and the fair value of commodity derivatives is reflected in earnings because the Company has not designated any of these instruments as hedges for accounting purposes. Gains and losses on these contracts are intended to offset losses and gains on the hedged transactions in an effort to reduce the earnings volatility resulting from fluctuating commodity prices. The settlement of commodity derivative contracts is reported in the consolidated statement of cash flows as cash flow from operating activities. At January 31, 2010, the Company had commodity derivatives with an aggregate contract volume of 245,000 bushels of wheat and 588,000 gallons of gasoline. Other than the requirement to meet minimum margin requirements with respect to the commodity derivatives, there are no collateral requirements related to such contracts.
 
Interest Rate Risk
 
     All of the borrowings under the Company’s Secured Credit Facilities bear interest at variable rates based upon either the Fed funds rate or LIBOR. The interest cost of the Company’s debt is affected by changes in these short-term interest rates and increases in those rates adversely affect the Company’s results of operations. In May 2007, the Company entered into interest rate derivative contracts having an aggregate notional principal amount of $60 million. The derivative contracts entitle the Company to receive from the counterparties the excess, if any, of three-month LIBOR over 5.40%, and require the Company to pay to the counterparties the excess, if any, of 4.48% over three-month LIBOR, in each case multiplied by the notional amount of the contracts. The contracts expire in April 2010. Settlements under these derivative contracts are reported as cash flow from operating activities in the consolidated statement of cash flows.
 
     These derivatives were accounted for as cash flow hedges from their inception through April 8, 2008. Hedge accounting was discontinued on that date because the derivative contracts could no longer be shown to be effective (as that term is defined in GAAP) in hedging interest rate risk as a result of amendments to the Company’s Secured Credit Facilities, which provided that interest on LIBOR-based borrowings is payable based upon the greater of the LIBOR rate for the selected interest period or 3.25%. As a consequence of the discontinuance of hedge accounting, changes in the fair value of the derivative contracts subsequent to April 8, 2008 are being reflected in earnings as they occur. Amounts included in accumulated other comprehensive income related to changes in the fair value of the derivative contracts for periods prior to April 9, 2008 are being charged to earnings in the periods in which the hedged forecasted transaction (interest on $60 million of the principal balance of the Term Loan) affects earnings, or earlier upon a determination that some or all of the forecasted transaction will not occur. Such charges totaled approximately $1.2 million in fiscal 2010 and $1.0 million in fiscal 2009. Accumulated other comprehensive income as of January 31, 2010 includes a remaining unamortized accumulated loss related to these derivatives of $92,000 (net of income taxes of $60,000), which will be charged to earnings in the first quarter of fiscal 2011.
 
     The counterparties to the interest rate derivatives are also lenders under the Secured Credit Facilities described in Note 10. Obligations under derivative instruments with counterparties that also are lenders under the Secured Credit Facilities are secured by the collateral that secures the Company’s obligations under the Secured Credit Facilities.
 
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 January 31, 2010:
 
Derivatives Not Designated As Asset Derivatives Liability Derivatives
Hedging Instruments Balance Sheet Location Fair Value Balance Sheet Location Fair Value
            (In thousands)             (In thousands)
Interest rate contracts Other current assets $   Accrued liabilities $ 641
Commodity futures contracts Other current assets     Accrued liabilities   92
       Total $ $ 733
  
103
 


     The effect of derivative instruments on the consolidated statement of operations for the fiscal year ended January 31, 2010 was as follows:
 
Derivatives Not Designated as Hedging Location of Derivative Gain or Loss Amount of Derivative Gain or (Loss)
Hedging Instruments   Recognized in Income Recognized in Income
            (In thousands)
Interest rate contracts Interest expense $ (559 )
Commodity futures contracts Direct operating expenses   (211 )
       Total $ (770 )
             
Note 23 — Selected Quarterly Financial Data (Unaudited)
 
     The tables below present selected quarterly financial data for fiscal 2010 and 2009.
 
Quarter Ended
May 3, Aug. 2, Nov. 1, Jan. 31,
2009       2009       2009       2010
(In thousands, except per share data)
Revenues $     93,420 $     82,730 $     83,600   $     86,770
Operating expenses:
       Direct operating expenses (exclusive of depreciation
              and amortization shown below) 76,968 71,258 74,369 74,590
       General and administrative expenses 6,314 4,817 6,128 5,469  
       Depreciation and amortization expense 1,993 1,999   2,154 2,045
       Impairment charges and lease termination costs 2,357 1,456 109   1,981
       Other operating (income) and expense, net 10 257 207 265
Operating income 5,778   2,943 633 2,420
Interest income 14 14 10     55
Interest expense   (3,817 ) (2,312 ) (2,295 ) (2,261 )
Equity in income (losses) of equity method franchisees 101   (214 ) (393 ) 18
Other non-operating income and (expense), net   (500 ) 144 80
Income (loss) before income taxes 2,076 (69 )   (1,901 ) 312
Provision for income taxes 208 88   487 (208 )
Net income (loss) $ 1,868 $ (157 ) $ (2,388 )   $ 520
 
Income (loss) per common share:
       Basic $ .03 $ $ (.04 ) $ .01
       Diluted $ .03 $ $ (.04 ) $ .01
 
 
104
 


Quarter Ended
May 4, Aug. 3, Nov. 2, Feb. 1,
2008       2008       2008       2009
(In thousands, except per share data)
Revenues $     104,050 $     94,726 $     94,827 $     91,919
Operating expenses:
       Direct operating expenses (exclusive of depreciation
              and amortization shown below) 89,888 88,793 87,632 80,232
       General and administrative expenses 6,847 4,717 5,842 6,052
       Depreciation and amortization expense 2,236 2,266 2,107 2,100
       Impairment charges and lease termination costs (645 ) (348 ) 345 1,196  
       Other operating (income) and expense, net 111 302 213 875
Operating income (loss) 5,613 (1,004 ) (1,312 ) 1,464
Interest income 126 96 65 44
Interest expense (2,063 ) (2,300 ) (2,978 ) (3,338 )
Equity in losses of equity method franchisees (268 ) (82 ) (335 ) (101 )
Other non-operating income and (expense), net 924   68   (921 )   2,744  
Income (loss) before income taxes   4,332 (3,222 ) (5,481 ) 813
Provision for income taxes 298 (1,315 )   404 1,116
Net income (loss) $ 4,034   $ (1,907 ) $ (5,885 )   $ (303 )
  
Income (loss) per common share:
       Basic $ .06 $ (.03 ) $ (.09 ) $
       Diluted $ .06 $ (.03 ) $ (.09 ) $
 
105
 


     The following tables display operating income by segment and a reconciliation of total segment operating income to consolidated operating income by quarter for fiscal 2010 and 2009.
 
Quarter ended
May 3, Aug. 2, Nov. 1, Jan. 31,
2009       2009       2009       2010
(In thousands)
Revenues:
       Company Stores $ 65,857 $ 59,853 $ 60,020 $ 60,643
       Domestic Franchise 2,051 1,802 1,945 2,009
       International Franchise 3,878 3,806 3,583 4,640
       KK Supply Chain:  
              Total revenues 44,858 37,754 39,314 40,201
              Less: intersegment sales elimination   (23,224 )     (20,485 ) (21,262 ) (20,723 )
                     External KK Supply Chain revenues 21,634 17,269 18,052 19,478
                            Total revenues $ 93,420 $ 82,730 $ 83,600 $ 86,770
  
Operating income (loss):
       Company Stores $ 2,944 $ 1,387 $ (1,380 ) $ (663 )
       Domestic Franchise 1,180 434 811   843
       International Franchise 2,435 1,943 2,117   3,401
       KK Supply Chain 8,139 5,687   5,549   6,587
              Total segment operating income 14,698 9,451 7,097 10,168
       Unallocated general and administrative expenses (6,563 )     (5,052 )   (6,355 ) (5,767 )
       Impairment charges and lease termination costs   (2,357 ) (1,456 ) (109 ) (1,981 )
              Consolidated operating income $ 5,778 $ 2,943 $ 633 $ 2,420
      
Quarter Ended
May 4, Aug. 3, Nov. 2, Feb. 1,
2008 2008 2008 2009
(In thousands)
Revenues:
       Company Stores $ 72,182 $ 65,071   $ 64,708   $ 63,929
       Domestic Franchise 2,046 2,249 1,882 1,865
       International Franchise 4,466 4,378 4,511 4,140
       KK Supply Chain:
              Total revenues 51,603 47,342 47,804 44,707
              Less: intersegment sales elimination (26,247 ) (24,314 )     (24,078 )     (22,722 )
                     External KK Supply Chain revenues 25,356 23,028 23,726 21,985
                            Total revenues   $     104,050   $ 94,726   $ 94,827   $ 91,919
  
Operating income (loss):
       Company Stores $ (294 ) $ (4,221 ) $ (4,470 ) $ (828 )
       Domestic Franchise 1,120 1,523 1,157 1,165
       International Franchise 3,322 2,375 3,031 2,822
       KK Supply Chain 7,992 3,999 5,449 5,829
              Total segment operating income 12,140 3,676 5,167 8,988
       Unallocated general and administrative expenses (7,172 ) (5,028 ) (6,134 ) (6,328 )
       Impairment charges and lease termination costs 645 348 (345 ) (1,196 )
              Consolidated operating income (loss) $ 5,613 $ (1,004 ) $ (1,312 ) $ 1,464  
 
106
 


 
Item 9.   CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.
     None.
 
Item 9A. CONTROLS AND PROCEDURES.
 
Evaluation of Disclosure Controls and Procedures
 
     As of January 31, 2010, the end of the period covered by this Annual Report on Form 10-K, management performed, under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer, an evaluation of the effectiveness of our disclosure controls and procedures as defined in Rules 13a-15(e) and 15d-15(e) of the Exchange Act. Our disclosure controls and procedures are designed to ensure that information required to be disclosed in the reports we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to management, including our Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosures. Based on this evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that, as of January 31, 2010, our disclosure controls and procedures were effective.
 
Management’s Report on Internal Control over Financial Reporting
 
     Management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Rules 13a-15(f) and 15d-15(f) of the Exchange Act. Internal control over financial reporting is a process, effected by an entity’s board of directors, management and other personnel, designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of consolidated financial statements for external purposes in accordance with GAAP. Internal control over financial reporting includes those policies and procedures which pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of assets; provide reasonable assurance that transactions are recorded as necessary to permit preparation of consolidated financial statements in accordance with GAAP; provide reasonable assurance that receipts and expenditures are being made only in accordance with management’s and/or the Board of Directors’ authorization; and provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of our assets that could have a material effect on our consolidated financial statements.
 
     Because of its inherent limitations, internal control over financial reporting may not prevent or detect material errors in our financial statements. Also, projection of any evaluation of the effectiveness of our internal control over financial reporting to future periods is subject to the risk that controls may become inadequate because of changes in conditions or because the degree of compliance with our policies and procedures may deteriorate.
 
     Management assessed the effectiveness of our internal control over financial reporting as of January 31, 2010, using the criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”). Based on our assessment, management has concluded that we maintained effective internal control over financial reporting as of January 31, 2010, based on the COSO criteria.
 
     The effectiveness of the Company’s internal control over financial reporting as of January 31, 2010, has been audited by PricewaterhouseCoopers LLP, an independent registered public accounting firm, as stated in their report which appears herein.
 
Changes in Internal Control over Financial Reporting
 
     During the quarter ended January 31, 2010, there were no changes in the Company’s internal control over financial reporting that materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.
 
Item 9B. OTHER INFORMATION.
 
     None.
 
107
 


PART III
 
Item 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE.
 
     Except as set forth below, the information required by this item is contained in our proxy statement for our 2010 Annual Meeting of Shareholders to be held on June 22, 2010, to be filed pursuant to Section 14 of the Exchange Act, and is incorporated herein by reference.
 
NYSE and SEC Certifications
 
     In accordance with Section 303A.12(a) of the NYSE Listed Company Manual, the Chief Executive Officer of the Company submits annual certifications to the NYSE stating that he is not aware of any violations by the Company of the NYSE corporate governance listing standards, qualifying the certification to the extent necessary. The last such annual certification was submitted on June 30, 2009 and contained no qualifications.
 
     We have filed certifications executed by our Chief Executive Officer and Chief Financial Officer with the SEC pursuant to Sections 302 and 906 of the Sarbanes-Oxley Act as exhibits to this Annual Report on Form 10-K.
 
Item 11. EXECUTIVE COMPENSATION.
 
     The information required by this item is contained in our proxy statement for our 2010 Annual Meeting of Shareholders to be held on June 22, 2010, to be filed pursuant to Section 14 of the Exchange Act, and is incorporated herein by reference.
 
Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS.
 
     The information required by this item is contained in our proxy statement for our 2010 Annual Meeting of Shareholders to be held on June 22, 2010, to be filed pursuant to Section 14 of the Exchange Act, and is incorporated herein by reference.
 
Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE.
 
     The information required by this item is contained in our proxy statement for our 2010 Annual Meeting of Shareholders to be held on June 22, 2010, to be filed pursuant to Section 14 of the Exchange Act, and is incorporated herein
 
Item 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
 
     The information required by this item is contained in our proxy statement for our 2010 Annual Meeting of Shareholders to be held on June 22, 2010, to be filed pursuant to Section 14 of the Exchange Act, and is incorporated herein by reference.
 
108
 


PART IV
 
Item 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
 
(a) Financial Statements and Schedules
             
1.   Financial Statements. See Item 8, “Financial Statements and Supplementary Data.”  
 
2.   Financial Statement Schedules.  
 
         Schedule I — Condensed Financial Information of Registrant F-1
 
         Schedule II — Valuation and Qualifying Accounts and Reserves F-4
 
3. Exhibits.  

Exhibit    
Number           Description of Exhibits
3.1 * Restated Articles of Incorporation of the Registrant
3.2 Amended and Restated Bylaws of the Registrant (incorporated by reference to Exhibit 3.1 to the Registrant’s Current Report on Form 8-K filed on December 15, 2008)
4.1 Form of Certificate for Common Stock (incorporated by reference to Exhibit 4.1 to the Registrant’s Amendment No. 4 to Registration Statement on Form S-1 (Commission File No. 333-92909), filed on April 3, 2000)
4.2 Shareholder Protection Rights Agreement between the Company and American Stock Transfer & Trust Company, LLC, as Rights Agent, dated as of January 14, 2010 (incorporated by reference to Exhibit 4.1 to the Registrant’s Current Report on Form 8-K filed on January 19, 2010)
4.3 Warrant to Purchase Common Stock issued by Krispy Kreme Doughnuts, Inc. in favor of Kroll Zolfo Cooper LLC, dated July 31, 2005 (incorporated by reference to Exhibit 4.1 to the Registrant’s Current Report on Form 8-K filed on October 26, 2005)
4.4 Warrant Agreement, dated as of March 2, 2007, between Krispy Kreme Doughnuts, Inc. and American Stock Transfer & Trust Company (incorporated by reference to Exhibit 4.1 to the Registrant’s Current Report on Form 8-K filed on March 8, 2007)
10.1 Trademark License Agreement, dated May 27, 1996, between HDN Development Corporation and Krispy Kreme Doughnut Corporation (incorporated by reference to Exhibit 10.22 to the Registrant’s Amendment No. 1 to Registration Statement on Form S-1 (Commission File No. 333-92909), filed on February 22, 2000)
10.2 1998 Stock Option Plan dated August 6, 1998 (incorporated by reference to Exhibit 10.23 to the Registrant’s Amendment No. 1 to Registration Statement on Form S-1 (Commission File No. 333-92909), filed on February 22, 2000)**
10.3 Employment Agreement, dated as of April 23, 2007, among Krispy Kreme Doughnuts, Inc., Krispy Kreme Doughnut Corporation and Douglas R. Muir (incorporated by reference to Exhibit 10.2 to the Registrant’s Current Report on Form 8-K filed on April 27, 2007)**
10.4 Amendment, dated November 8, 2007, to Employment Agreement, dated as of April 23, 2007, among Krispy Kreme Doughnuts, Inc., Krispy Kreme Doughnut Corporation and Douglas R. Muir (incorporated by reference to Exhibit 10.1 to the Registrant’s Current Report on Form 8-K filed on November 13, 2007)**
10.5 Second Amendment, dated December 15, 2008, to Employment Agreement, dated as of April 23, 2007, among Krispy Kreme Doughnuts, Inc., Krispy Kreme Doughnut Corporation and Douglas R. Muir (incorporated by reference to Exhibit 10.2 to the Registrant’s Current Report on Form 8-K filed on December 19, 2008)**
10.6 Employment Agreement, dated as of February 27, 2008, among Krispy Kreme Doughnuts, Inc., Krispy Kreme Doughnut Corporation and James H. Morgan (incorporated by reference to Exhibit 10.1 to the Registrant’s Current Report on Form 8-K filed on March 5, 2008)**
10.7 Amendment, dated December 15, 2008, to Employment Agreement, dated as of February 27, 2008, among Krispy Kreme Doughnuts, Inc., Krispy Kreme Doughnut Corporation and James H. Morgan (incorporated by reference to Exhibit 10.1 to the Registrant’s Current Report on Form 8-K filed on December 19, 2008)**
 
109



10.8         Employment Agreement, dated as of November 7, 2007, among Krispy Kreme Doughnuts, Inc., Krispy Kreme Doughnut Corporation and Kenneth J. Hudson (incorporated by reference to Exhibit 10.18 to the Registrant’s Annual Report on Form 10-K filed on April 17, 2008)**
10.9 Amendment, dated December 15, 2008, to Employment Agreement, dated as of November 7, 2007, among Krispy Kreme Doughnuts, Inc., Krispy Kreme Doughnut Corporation and Kenneth J. Hudson (incorporated by reference to Exhibit 10.3 to the Registrant’s Current Report on Form 8-K filed on December 19, 2008)**
10.10   Employment Agreement, dated as of November 7, 2007, among Krispy Kreme Doughnuts, Inc., Krispy Kreme Doughnut Corporation and Jeffrey B. Welch (incorporated by reference to Exhibit 10.19 to the Registrant’s Annual Report on Form 10-K filed on April 17, 2008)**
10.11 Amendment, dated December 15, 2008, to Employment Agreement, dated as of November 7, 2007, among Krispy Kreme Doughnuts, Inc., Krispy Kreme Doughnut Corporation and Jeffrey B. Welch (incorporated by reference to Exhibit 10.4 to the Registrant’s Current Report on Form 8-K filed on December 19, 2008)**
10.12 Employment Agreement, dated as of October 3, 2008, among Krispy Kreme Doughnuts, Inc., Krispy Kreme Doughnut Corporation and Darryl R. Marsch (incorporated by reference to Exhibit 10.1 to the Registrant’s Quarterly Report on Form 10-Q filed on December 11, 2008)**
10.13 Amendment, dated December 15, 2008, to Employment Agreement, dated as of October 3, 2008, among Krispy Kreme Doughnuts, Inc., Krispy Kreme Doughnut Corporation and Darryl R. Marsch**
10.14 Employment Agreement, dated as of November 7, 2007, among Krispy Kreme Doughnuts, Inc., Krispy Kreme Doughnut Corporation and M. Bradley Wall (incorporated by reference to Exhibit 10.2 to the Registrant’s Quarterly Report on Form 10-Q filed on December 11, 2008)**
10.15 Amendment, dated December 15, 2008, to Employment Agreement, dated as of November 7, 2007, among Krispy Kreme Doughnuts, Inc., Krispy Kreme Doughnut Corporation and M. Bradley Wall**
10.16 Employment Agreement, dated as of November 7, 2007, among Krispy Kreme Doughnuts, Inc., Krispy Kreme Doughnut Corporation and Steven A. Lineberger (incorporated by reference to Exhibit 10.3 to the Registrant’s Quarterly Report on Form 10-Q filed on December 11, 2008)**
10.17 Amendment, dated December 15, 2008, to Employment Agreement, dated as of November 7, 2007, among Krispy Kreme Doughnuts, Inc., Krispy Kreme Doughnut Corporation and Steven A. Lineberger**
10.18 Employment Agreement, dated as of September 14, 2009, among Krispy Kreme Doughnuts, Inc., Krispy Kreme Doughnut Corporation and Cynthia A. Bay (incorporated by reference to Exhibit 10.1 to the Registrant’s Quarterly Report on Form 10-Q filed on December 7, 2009)**
10.19 2000 Stock Incentive Plan, as amended as of June 16, 2009 (incorporated by reference Exhibit 10.1 to the Registrant’s Current Report on Form 8-K filed on June 22, 2009)**
10.20 Fifth Amendment to the Krispy Kreme Doughnuts, Inc. 2000 Stock Incentive Plan dated December 10, 2008, and effective January 1, 2005 to the extent necessary to comply with Section 409A of the Internal Revenue Code of 1986, as amended and otherwise effective December 31, 2008**
10.21 Krispy Kreme Doughnut Corporation Nonqualified Deferred Compensation Plan, effective October 1, 2000 (incorporated by reference to Exhibit 10.20 to the Registrant’s Annual Report on Form 10-K for fiscal 2005)**
10.22 Credit Agreement, dated as of February 16, 2007, by and among Krispy Kreme Doughnut Corporation, Krispy Kreme Doughnuts, Inc., the Subsidiary Guarantors party thereto, the Lenders party thereto and Credit Suisse, Cayman Islands Branch, as administrative agent, collateral agent, issuing lender and swingline lender (the “Credit Agreement”) (incorporated by reference to Exhibit 10.1 to the Registrant’s Current Report on Form 8-K filed on February 23, 2007)
10.23 Security Agreement, dated as of February 16, 2007, by and among Krispy Kreme Doughnut Corporation, Krispy Kreme Doughnuts, Inc., the Subsidiary Guarantors party thereto and Credit Suisse, Cayman Islands Branch, as collateral agent (incorporated by reference to Exhibit 10.2 to the Registrant’s Current Report on Form 8-K filed on February 23, 2007)
10.24 Amendment No. 1, dated as of June 21, 2007, to the Credit Agreement (incorporated by reference to Exhibit 10.1 to the Registrant’s Current Report on Form 8-K filed on June 27, 2007)
10.25 Amendment No. 2, dated as of January 23, 2008, to the Credit Agreement (incorporated by reference to Exhibit 10.1 to the Registrant’s Current Report on Form 8-K filed on January 25, 2008)
10.26 Amendment No. 3, dated as of April 9, 2008, to the Credit Agreement (incorporated by reference to Exhibit 10.1 to the Registrant’s Current Report on Form 8-K filed on April 15, 2008)
 
110



10.27         Amendment No. 4, dated as of April 15, 2009, to the Credit Agreement (incorporated by reference to Exhibit 10.26 to the Registrant’s Annual Report on Form 10-K filed on April 17, 2009)
10.28 Form of Indemnification Agreement entered into between Krispy Kreme Doughnuts, Inc. and Lizanne Thomas and Michael Sutton (incorporated by reference to Exhibit 99.3 to the Registrant’s Current Report on Form 8-K filed on October 8, 2004)**
10.29 Form of Indemnification Agreement entered into between Krispy Kreme Doughnuts, Inc. and members of the Registrant’s Board of Directors (other than Lizanne Thomas and Michael Sutton) (incorporated by reference to Exhibit 10.42 to the Registrant’s Annual Report on Form 10-K for fiscal 2005)**
10.30 Form of Indemnification Agreement entered into between Krispy Kreme Doughnuts, Inc. and Officers of the Registrant (incorporated by reference to Exhibit 10.1 to the Registrant’s Current Report on Form 8-K filed on September 18, 2007)
10.31 Form of Nonqualified Stock Option Agreement (incorporated by reference to Exhibit 10.1 to the Registrant’s Current Report on Form 8-K filed on December 17, 2009)**
10.32 Annual Incentive Plan (incorporated by reference to Exhibit 10.32 to the Registrant’s Annual Report on Form 10-K filed on April 17, 2008)**
10.33 Form of Restricted Stock Agreement (incorporated by reference to Exhibit 10.33 to the Registrant’s Annual Report on Form 10-K filed on April 17, 2009) **
10.34 Form of Restricted Stock Unit Agreement (incorporated by reference to Exhibit 10.3 to the Registrant’s Current Report on Form 8-K filed on December 17, 2009)**
10.35 Form of Director Restricted Stock Unit Agreement (incorporated by reference to Exhibit 10.2 to the Registrant’s Current Report on Form 8-K filed on December 17, 2009)**
10.36 Compensation Recovery Policy (incorporated by reference to Exhibit 10.35 to the Registrant’s Annual Report on Form 10-K filed on April 17, 2009)**
21 * List of Subsidiaries
23.1 * Consent of PricewaterhouseCoopers LLP
23.2 * Consent of Ballman Kallick, LLP
24 * Powers of Attorney of certain officers and directors of the Company (included on the signature page of this Annual Report on Form 10-K)
31.1 * Certification of Chief Executive Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a) of the Securities Exchange Act of 1934, as amended
31.2 * Certification of Chief Financial Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a) of the Securities Exchange Act of 1934, as amended
32.1 * Certification by Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
32.2 * Certification by Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
____________________
 
*     Filed herewith.
 
** Identifies management contracts and executive compensation plans or arrangements required to be filed as exhibits pursuant to Item 15(b), “Exhibits and Financial Statement Schedules — Exhibits,” of this Annual Report on Form 10-K.
 
111
 

 
(c) Separate Financial Statements of 50 Percent or Less Owned Persons
        
      1.        Financial Statements of Kremeworks, LLC  
   
             Index to Financial Statements F-5
   
  2. Financial Statements of Krispy Kreme Mexico, S. de R L. de C.V. *
 
*  To be filed by amendment.
 
112
 


SIGNATURES
 
     Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
 
Krispy Kreme Doughnuts, Inc.
 
  
By:   /s/ Douglas R. Muir
  Name:     Douglas R. Muir
  Title: Executive Vice President and Chief
    Financial Officer
Date: April 15, 2010
 
POWER OF ATTORNEY
 
     Each person whose signature appears below hereby constitutes and appoints James H. Morgan and Douglas R. Muir, or either of them, his or her true and lawful attorney-in-fact and agent, with full power of substitution and resubstitution, for him or her and in his or her name, place and stead, in any and all capacities, to sign any or all amendments or supplements to this Annual Report on Form 10-K and to file the same with all exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorney-in-fact and agent full power and authority to do and perform each and every act and thing necessary or appropriate to be done with this Annual Report on Form 10-K and any amendments or supplements hereto, as fully to all intents and purposes as he or she might or could do in person, hereby ratifying and confirming all that said attorney-in-fact and agent, or his or her substitute or substitutes, may lawfully do or cause to be done by virtue hereof.
 
     Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities indicated on April 15, 2010.
 
Signature      Title
 
/s/  James H. Morgan Chairman of the Board of Directors, President and
James H. Morgan Chief Executive Officer (Principal Executive Officer)
 
/s/  Douglas R. Muir Executive Vice President and Chief Financial Officer
Douglas R. Muir (Principal Financial and Accounting Officer)
 
/s/  Charles A. Blixt   Director
Charles A. Blixt  
 
/s/  Lynn Crump-Caine Director
Lynn Crump-Caine  
 
/s/  C. Stephen Lynn Director
C. Stephen Lynn  
 
/s/  Robert S. McCoy, Jr. Director
Robert S. McCoy, Jr.  
 
113
 


Signature      Title
 
/s/ Andrew J. Schindler Director
Andrew J. Schindler
 
/s/ Michael H. Sutton Director
Michael H. Sutton
 
/s/ Lizanne Thomas Director
Lizanne Thomas
 
/s/ Togo D. West, Jr. Director
Togo D. West, Jr.
 
114
 


SCHEDULE I — CONDENSED FINANCIAL INFORMATION OF REGISTRANT
 
KRISPY KREME DOUGHNUTS, INC.
(PARENT COMPANY ONLY)
 
BALANCE SHEET
 
Jan. 31, Feb. 1,
2010      2009
(In thousands)
ASSETS
 
Investment in and advances to subsidiaries $   62,767     $   57,755  
 
SHAREHOLDERS’ EQUITY
 
Preferred stock $ $
Common stock 366,237 361,801  
Accumulated other comprehensive loss   (180 )   (913 )
Accumulated deficit (303,290 )   (303,133 )
Total shareholders’ equity $ 62,767   $ 57,755
  
F-1
 


SCHEDULE I — CONDENSED FINANCIAL INFORMATION OF REGISTRANT
 
KRISPY KREME DOUGHNUTS, INC.
(PARENT COMPANY ONLY)
 
STATEMENT OF OPERATIONS
 
Year Ended
Jan. 31, Feb. 1, Feb. 3,
2010      2009      2008
(In thousands)
Equity in losses of subsidiaries $     (157 ) $     (4,061 ) $     (67,051 )
Miscellaneous expenses  
Loss before income taxes (157 ) (4,061 ) (67,051 )
Provision for income taxes  
Net loss $ (157 ) $ (4,061 )   $ (67,051 )
     
Loss per common share:
       Basic $ $ (.06 ) $ (1.05 )
       Diluted $ $ (.06 ) $ (1.05 )
 
F-2
 


SCHEDULE I — CONDENSED FINANCIAL INFORMATION OF REGISTRANT
 
KRISPY KREME DOUGHNUTS, INC.
(PARENT COMPANY ONLY)
 
STATEMENT OF CASH FLOWS
 
Year Ended
Jan. 31, Feb. 1, Feb. 3,
2010      2009      2008
(In thousands)
CASH FLOW FROM OPERATING ACTIVITIES:
Net loss $    (157 ) $    (4,061 ) $    (67,051 )
Equity in losses of subsidiaries 157 4,061 67,051  
Net cash used by operating activities
CASH FLOW FROM INVESTING ACTIVITIES:  
Investments in subsidiaries 343     (1,034 ) (199 )
Net cash provided by (used for) investing activities 343   (1,034 ) (199 )
CASH FLOW FROM FINANCING ACTIVITIES:
Proceeds from exercise of stock options   3,103 292
Repurchase of common shares (343 ) (2,069 ) (93 )
Net cash provided by (used for) financing activities (343 ) 1,034   199
Net increase in cash and cash equivalents
Cash and cash equivalents at beginning of year    
Cash and cash equivalents at end of year $ $   $  
 
F-3
 


SCHEDULE II – VALUATION AND QUALIFYING ACCOUNTS AND RESERVES
 
KRISPY KREME DOUGHNUTS, INC.
 
Additions
Balance at Charged to Charged
beginning costs and to other Balance at
  Description        of year      expenses      accounts      Payments      end of year
(In thousands)
Accrual for self-insurance claims, principally
       worker’s compensation (current and
       non-current portions)
 
Year ended February 3, 2008 $   12,333 $   3,654 $   (3,684 ) $   12,303
 
Accrual included in:
       Accrued liabilities $ 5,885 $ 4,996
       Other long-term obligations 11,389 11,754
Less: Claims receivable under stop-loss insurance
policies included in:
       Other current assets (665 ) (609 )
       Other assets (4,276 ) (3,838 )
  $ 12,333 $ 12,303
   
Year ended February 1, 2009 $ 12,303 $ 3,707 $ (4,229 ) $ 11,781
 
Accrual included in:
       Accrued liabilities $ 4,996 $ 5,086
       Other long-term obligations 11,754 11,069
Less: Claims receivable under stop-loss insurance
policies included in:
       Other current assets (609 ) (755 )
       Other assets (3,838 ) (3,619 )
  $ 12,303   $ 11,781
 
Year ended January 31, 2010 $ 11,781 $ 1,372 $ (3,376 ) $ 9,777
 
Accrual included in:  
       Accrued liabilities $ 5,086   $ 4,245
       Other long-term obligations 11,069       9,327
Less: Claims receivable under stop-loss insurance  
policies included in:      
       Other current assets   (755 )     (679 )
       Other assets (3,619 )     (3,116 )
$ 11,781 $ 9,777
 
F-4
 


KREMEWORKS, LLC AND SUBSIDIARY
 
Page
Index to Financial Statements:
Independent Auditor’s Report F-6
Consolidated Balance Sheet as of December 30, 2010 and December 31, 2009 F-7
Consolidated Statement of Operations for each of the Three Years in the Period
       Ended December 30, 2010 F-9
Consolidated Statement of Comprehensive Loss for Each of the Three Years in the Period  
       Ended December 30, 2010 F-10
Consolidated statement of Cash Flows for Each of the Three Years in the Period
       Ended December 30, 2010 F-11
Consolidated Statement of Changes in Equity for Each of the Three Years in the Period
       Ended December 30, 2010 F-12
Notes to Consolidated Financial Statements F-13

F-5
 


Independent Auditor’s Report
 
Members
KremeWorks, LLC and Subsidiary
 
We have audited the accompanying consolidated balance sheets of KremeWorks, LLC and Subsidiary as of December 30, 2009 and December 31, 2008, and the related consolidated statements of loss, comprehensive loss, cash flows and changes in equity for each of the years in the three-year period ended December 30, 2009. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
 
We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
 
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of KremeWorks, LLC and Subsidiary as of December 30, 2009 and December 31, 2008, and the results of their operations and their cash flows for each of the years in the three-year period ended December 30, 2009 in conformity with accounting principles generally accepted in the United States of America (GAAPUSA).
 
Effective January 1, 2009, KremeWorks, LLC and Subsidiary adopted the guidance on noncontrolling interests under GAAPUSA.
 
Blackman Kallick, LLP
 
March 31, 2010
 
F-6
 


KremeWorks, LLC and Subsidiary
 
Consolidated Balance Sheets
 
December 30, 2009 and December 31, 2008
 
   
Assets
   
2009        2008
Current Assets          
              Cash $    866,563 $    823,990
              Receivables          
                            Credit cards 31,405 46,000
                            Member contributions   239,800     -
                            Other 22,017 22,526
              Inventories   336,513     388,783
              Prepaid expenses 13,521 173,664
                                   Total Current Assets   1,509,819     1,454,963
           
Property and Equipment (Net of accumulated
       depreciation and amortization) 15,702,599 18,949,605
           
Other Assets          
              Deferred area development
                     and franchise fees, net   258,731     275,065
              Deferred financing fee, net   -     34,115
                                   Total Other Assets 258,731 309,180
  $ 17,471,149   $ 20,713,748
  
The accompanying notes are an integral part of the consolidated financial
statements.
 
F-7
 


Liabilities and Equity
 
  2009        2008
Current Liabilities
       Notes payable to affiliates $    3,600,000 $    3,600,000
       Current portion of long-term debt 6,784,635 2,149,928
       Accounts payable
              Trade 89,151 124,220
              Affiliated entities 504,721 580,860
       Accrued expenses
              Salaries and wages 348,302 333,423
              Sales tax 19,500 24,117
              Rent and real estate taxes 14,438 23,689
              Accrued legal fees 60,000 80,000
              Accrued interest 1,082,520 980,134
              Other 110,340 132,271
                     Total Current Liabilities 12,613,607 8,028,642
Noncurrent Liabilities
       Long-term debt (Net of current portion) -   6,784,635
       Deferred rent 1,783,903 1,691,827
                     Total Noncurrent Liabilities 1,783,903 8,476,462
                     Total Liabilities   14,397,510   16,505,104
Equity (Deficit)  
       KremeWorks, LLC members' (deficit) equity (170,855 ) 318,060
       Noncontrolling interest 3,244,494 3,890,584
                     Total Equity 3,073,639 4,208,644
$ 17,471,149 $ 20,713,748
  
F-8
 


KremeWorks, LLC and Subsidiary
 
Consolidated Statements of Loss
 
Years Ended December 30, 2009, December 31, 2008 and December 26, 2007
 
   
  2009        2008        2007
Sales $     17,091,291   $     18,504,101   $   20,339,092  
Cost of Sales - Food and Beverage 3,656,477   4,271,443   4,190,233  
Gross Profit after Food and Beverage 13,434,814   14,232,658   16,148,859  
Store Payroll and Benefits 5,252,585   5,445,251   5,627,520  
Gross Profit 8,182,229   8,787,407   10,521,339  
Store Operating Expenses      
              Direct operating 1,442,366   1,458,527   1,480,428  
              Marketing 670,991   512,792   572,215  
              Occupancy 1,910,504   2,144,062   2,164,302  
              Depreciation and amortization 2,716,061   3,003,312   3,011,953  
              Impairment charge 615,000   -   -  
              Store general and administrative 507,634   549,335   579,321  
              Delivery 23,010   35,824   120,554  
              Other 82,039   84,968   95,645  
                            Total Store Operating      
                                   Expenses 7,967,605   7,788,820   8,024,418  
Income from Store Operations 214,624   998,587   2,496,921  
Other Operating Expenses      
              Other general and administrative 768,100   352,219   566,995  
              Divisional payroll and benefits 589,879   700,639   719,988  
              Royalty fees 769,140   832,615   915,328  
              Management fee 682,599   741,846   813,624  
              Franchise expense 16,334   16,334   16,334  
              Marketing fees 128,187   142,674   203,000  
                            Total Other Operating Expenses 2,954,239   2,786,327   3,235,269  
Loss from Operations   (2,739,615 ) (1,787,740 ) (738,348 )
Interest Expense, Net 398,820   940,583   1,224,741  
Net Loss (3,138,435 ) (2,728,323 ) (1,963,089 )
Less Net Loss Attributable to the        
       Noncontrolling Interest 646,090   562,358   403,744  
Net Loss Attributable to        
       KremeWorks, LLC $ (2,492,345 ) $ (2,165,965 ) $ (1,559,345 )
 
The accompanying notes are an integral part of the consolidated financial
statements.
 
F-9
 


KremeWorks, LLC and Subsidiary
 
Consolidated Statements of Comprehensive Loss
 
Years Ended December 30, 2009, December 31, 2008 and December 26, 2007
 
 
2009        2008        2007
Net Loss $    (3,138,435 ) $    (2,728,323 ) $    (1,963,089 )
Gain (Loss) on Derivative   - 25,174 (96,911 )
Comprehensive Loss (3,138,435 )   (2,703,149 ) (2,060,000 )
Comprehensive Loss Attributable    
       to Noncontrolling Interest 646,090   557,323   423,126
Comprehensive Loss Attributable      
       to KremeWorks, LLC $ (2,492,345 ) $ (2,145,826 ) $ (1,636,874 )
 
The accompanying notes are an integral part of the consolidated financial
statements.
 
F-10
 


KremeWorks, LLC and Subsidiary
 
Consolidated Statements of Cash Flows
 
Years Ended December 30, 2009, December 31, 2008 and December 26, 2007
 
 
2009        2008        2007
Cash Flows from Operating Activities                      
       Net loss $    (3,138,435 ) $    (2,728,323 ) $    (1,963,089 )
       Adjustments to reconcile net loss to net                      
              cash provided by operating activities                      
                     Depreciation and amortization 2,766,510 3,056,472 3,065,112
                     Impairment charge   615,000       -       -  
                     Deferred rent 92,076 222,752 275,168
                     (Increase) decrease in                      
                            Receivables 15,104 23,908 (18,748 )
                            Inventories   52,270       (18,227 )     (89,062 )
                            Prepaid expenses 160,143 (143,494 ) 3,935
                     Increase (decrease) in                      
                            Accounts payable 617,222 897,743 841,890
                            Accrued expenses   61,466       265,252       (76,669 )
                                   Total Adjustments 4,379,791 4,304,406 4,001,626
                                   Net Cash Provided by                      
                                          Operating Activities   1,241,356       1,576,083       2,038,537  
Cash Flows from Investing Activities
       Capital expenditures   (84,055 )     (182,820 )     (304,849 )
       Proceeds from sale of fixed asset - 1,692 -
                                   Net Cash Used in                      
                                          Investing Activities   (84,055 )     (181,128 )     (304,849 )
Cash Flows from Financing Activities
       Principal payments on long-term debt   (2,149,928 )     (1,834,110 )     (2,155,880 )
       Member contributions 1,035,200 375,000 -
                                   Net Cash Used in                      
                                          Financing Activities   (1,114,728 )     (1,459,110 )     (2,155,880 )
Net Increase (Decrease) in Cash 42,573 (64,155 ) (422,192 )
Cash, Beginning of Year   823,990       888,145       1,310,337  
Cash, End of Year $ 866,563 $ 823,990 $ 888,145  
 
The accompanying notes are an integral part of the consolidated financial
statements.
 
F-11
 


KremeWorks, LLC and Subsidiary
 
Consolidated Statements of Changes in Equity
 
Years Ended December 30, 2009, December 31, 2008 and December 26, 2007
 
 
KremeWorks, LLC Members' Equity
  Accumulated      
  Other KremeWorks, LLC    
Member      Accumulated      Comprehensive      Members’      Noncontrolling      Total
Contributions Deficit Income (Loss) Equity (Deficit) Interest Equity
Balance, December 27, 2006     $    2,536,256 $    (878,287 ) $    57,390 $    1,715,359 $    4,871,033 $    6,586,392
       Net loss - (1,559,345 ) -        (1,559,345 ) (403,744 ) (1,963,089 )
       Member contributions 862,616 - - 862,616 - 862,616
       Loss on derivative - -        (77,529 ) (77,529 ) (19,382 ) (96,911 )
Balance, December 26, 2007 3,398,872 (2,437,632 ) (20,139 ) 941,101    4,447,907 5,389,008
       Net loss - (2,165,965 ) - (2,165,965 ) (562,358 ) (2,728,323 )
       Member contributions 1,522,785 - - 1,522,785 - 1,522,785
       Gain on derivative - - 20,139 20,139 5,035 25,174
Balance, December 31, 2008 4,921,657 (4,603,597 ) - 318,060   3,890,584 4,208,644
       Net loss - (2,492,345 ) - (2,492,345 ) (646,090 ) (3,138,435 )
       Member contributions 2,003,430 - - 2,003,430 - 2,003,430
Balance, December 30, 2009 $ 6,925,087 $ (7,095,942 ) $ - $    (170,855 ) $    3,244,494 $ 3,073,639  
 
The accompanying notes are an integral part of the consolidated financial statements.
 
F-12
 


Note 1 - Industry Operations
 
KremeWorks, LLC and Subsidiary (the Company) have franchise rights to develop 23 Krispy Kreme doughnut stores in the states of Washington, Oregon, Hawaii and Alaska. As of December 30, 2009, the Company owns and operates 11 Krispy Kreme stores, of which eight are located in Washington, two are located in Oregon and one is located in Hawaii. The Company opened its first store on October 30, 2001. The Company opened one store in 2001, two stores in 2002, five stores in 2003 and three stores in 2004.
 
KremeWorks, LLC (KremeWorks) owns 80% of its subsidiary, KremeWorks USA, LLC (KW USA), which in turn owns 95% of its subsidiary, KremeWorks Oregon (KWO) and 100% of its subsidiaries, KremeWorks Washington (KWW), KremeWorks Hawaii (KWH) and KremeWorks Alaska (KWA).
 
KremeWorks is owned 67.6% (65.8% in 2008 and 2007) by ICON LLC (ICON), 25% by Krispy Kreme Doughnut Corporation (KKDC), 3.6% (5.5% in 2008 and 2007) by partners of Lettuce Entertain You Enterprises, Inc. (Lettuce) and 3.8% (3.7% in 2008 and 2007) by a member of ICON.
 
Note 2 - Summary of Significant Accounting Policies
 
Principles of Consolidation
 
The consolidated financial statements include the accounts of KremeWorks and its 80%-owned subsidiary, KW USA. All significant intercompany balances and transactions have been eliminated.
 
The KW USA operating agreement contains a provision stating that the amount of loss allocated to a member cannot create or increase a deficit in a member’s capital account if and to the extent that any other member has a positive capital account balance. If losses are ever allocated disproportionately as a result of this arrangement, an equal amount of subsequent profits will be allocated disproportionately until the member’s capital account is in accordance with the member’s respective interest on a cumulative basis. As of December 30, 2009 and December 31, 2008, KremeWorks’ capital account is in accordance with its ownership interest in KW USA on a cumulative basis.
 
In December 2007, the FASB issued new guidance on noncontrolling interests in consolidated financial statements. This guidance clarifies that a noncontrolling interest in a subsidiary, formerly referred to as minority interest, is an ownership interest in the consolidated entity that should be reported as equity in the consolidated financial statements. It also requires consolidated net income to be reported at amounts that include amounts attributable to both the parent and the noncontrolling interest, rather than only the amounts attributable to the parent under previous requirements. Lastly, it requires expanded disclosures in the consolidated financial statements that clearly identify the separate interests of the parent’s owners and the noncontrolling owners of a subsidiary and provides guidance when a subsidiary is deconsolidated. At the beginning of 2009, the Company adopted this guidance on a prospective basis, other than the presentation and disclosure requirements which have been adopted retrospectively.
 
F-13
 


The adoption of the noncontrolling interest guidance impacted the Company’s consolidated financial statements as follows:
  • The amounts previously shown as minority interest in prior consolidated balance sheets have been reclassified to equity and re-titled as noncontrolling interests, with no change in amount.
     
  • The amounts previously titled as loss before minority interest in the consolidated statements of loss have been re-titled as net loss, and the amounts previously titled as net loss have been re-titled as net loss attributable to KremeWorks, LLC.
     
  • The consolidated statements of comprehensive loss have been altered to present comprehensive loss in total with an allocation of such loss to the noncontrolling interest with the remainder attributable to KremeWorks, LLC.
     
  • The consolidated statements of members’ equity have been changed to the consolidated statements of changes in equity and present the changes in equity attributable to KremeWorks, LLC and the noncontrolling interest separately and in total.
Fiscal Year
 
The Company has a 52/53-week fiscal year ending on the last Wednesday in December. The fiscal years ended on December 30, 2009, December 31, 2008 and December 26, 2007 contained 52, 53 and 52 weeks, respectively.
 
Reclassifications
 
For comparability, the 2008 and 2007 financial statements reflect reclassifications where appropriate to conform to the financial statement presentation used in 2009.
 
Revenue Recognition
 
Sales of food and beverages are recognized as revenue at the point of sale.
 
Cash
 
Substantially all cash is held at Bank of America, N.A. The cash held in this institution may exceed federally insured limits from time to time. The Company has not experienced any losses in this account. The Company believes it is not exposed to any significant credit risk on cash.
 
Inventories
 
Inventories are valued at lower of cost (first-in, first-out) or market.
 
F-14
 


Property and Equipment
 
The Company’s policy is to depreciate the cost of property and equipment over the estimated useful lives of the assets using the straight-line method. The cost of leasehold improvements is amortized over the remaining term of the lease or the useful lives, if shorter, using the straight-line method. The average estimated depreciable lives for financial reporting purposes are as follows:
 
Years
Leasehold improvements 20
Furniture, fixtures and equipment 7
Automobiles 3
Computer equipment 3

Long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying value of an asset or asset group (typically a store) might not be recoverable. If the carrying amount of an asset exceeds its estimated future undiscounted cash flows, an impairment charge is recognized in the amount by which the carrying amount exceeds the estimated fair value of the asset. The Company recognized an impairment charge on one of its Washington stores in the amount of $615,000 in 2009 (see Notes 3 and 11).
 
Deferred Area Development and Franchise Fees
 
KremeWorks has entered into a development agreement with KKDC to develop and operate 23 Krispy Kreme stores. The original development agreement required the twenty-third store to be opened by August 1, 2007. On July 22, 2005, the agreement was amended effective December 31, 2004 to suspend the development schedule by a 24-month period for all stores to be opened on or after February 1, 2005. This amendment extended the due date for opening a new store until February 1, 2007 and the due date for opening the twenty-third until August 1, 2009.
 
As of the date of these consolidated financial statements, KremeWorks has no present plan to open any new stores and has not received any notice from KKDC of its expectation of the Company to open additional stores. The Company believes KKDC is addressing the Krispy Kreme business model in general and the type of retail stores that best represent the brand in particular, with a focus on retail stores substantially smaller than the factory stores called for in the current area development agreement. The Company believes that KKDC does not expect its franchisees to open any additional stores until a viable small store has been developed. The amended agreement also waived any requirement for off-premises sales by the Company pursuant to the Development Agreement and Franchise Agreement.
 
KremeWorks originally paid KKDC a $230,000 development fee, or $10,000 per store. In conjunction with the development agreement with KKDC, KremeWorks has also entered into a franchise fee agreement with KKDC whereby KremeWorks is required to pay a $25,000 franchise fee for each Krispy Kreme store that it opens. The $10,000 per store development fee is credited toward this franchise fee. These fees are being amortized over the lives of the respective stores’ leases on a straight-line basis. As of December 30, 2009 and December 31, 2008, the Company has capitalized area development and franchise fees in the amount of $395,000. As of December 30, 2009 and December 31, 2008, accumulated amortization for area development and franchise fees totaled $136,269 and $119,935, respectively.
 
F-15
 


Deferred Financing Fee
 
The Company capitalizes fees paid to secure debt financing and amortizes them over the terms of the respective loans on a straight-line basis. As of December 30, 2009 and December 31, 2008, the Company has capitalized financing fees in the amount of $240,000. As of December 31, 2008, accumulated amortization on deferred financing fees was $205,885. Such fees were fully amortized as of December 30, 2009.
 
Advertising Costs
 
Advertising costs are expensed as incurred. Advertising expense was $248,031, $240,218 and $201,084 in 2009, 2008 and 2007, respectively, and is included in store operating expenses in the consolidated statements of loss.
 
Financial Instruments
 
A financial instrument is cash, evidence of ownership interest in an entity or certain contracts involving future conveyances of cash or other financial instruments. The carrying values of the Company’s financial instruments approximate fair value.
 
Comprehensive Loss
 
Comprehensive loss is a measure of all changes in equity that result from recognized transactions and other economic events of the year, other than owner transactions, such as purchases of ownership interest and distributions. This presentation appears in the consolidated statement of comprehensive loss.
 
Aspects of the Limited Liability Company
 
The Company is treated as a partnership for federal income tax purposes. Consequently, federal income taxes are not payable by, or provided for, the Company. Members are taxed individually on their shares of the Company’s earnings. Accordingly, the consolidated financial statements do not reflect a provision for income taxes. The operating agreement provides for the allocation of profits, losses and distributions in proportion to each member’s respective interest.
 
All member units are identical in rights, preferences and privileges.
 
The Company has a limited life and, according to its Articles of Organization, will dissolve no later than December 31, 2052.
 
F-16
 


Income Taxes
 
The Company’s adoption of the Income Tax Topic regarding uncertain tax positions of GAAPUSA at the beginning of 2009 had no effect on its financial position as management believes the Company has no material uncertain tax positions. The Company would account for any potential interest or penalties related to possible future liabilities as income tax expense. The Company is no longer subject to examination by tax authorities for federal, state or local income taxes for periods before 2006. Prior to adoption of the Income Tax Topic, the Company accounted for tax positions under a contingent loss model, requiring recognition of a tax liability when it was both (1) probable that it had been incurred as of year-end and (2) the amount could be reasonably estimated.
 
Management Estimates
 
The preparation of financial statements in conformity with GAAPUSA requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
 
Note 3 - Fair Value Measurements
 
GAAPUSA defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants as of the measurement date. GAAPUSA describes three approaches to measuring the fair value of assets and liabilities: the market approach, the income approach and the cost approach. Each approach includes multiple valuation techniques. GAAPUSA does not prescribe which valuation technique should be used when measuring fair value, but does establish a fair value hierarchy that prioritizes the inputs used in applying the various techniques. Inputs broadly refer to the assumptions that market participants use to make pricing decisions, including assumptions about risk. Level 1 inputs are given the highest priority in the hierarchy while Level 3 inputs are given the lowest priority. Assets and liabilities carried at fair value are classified in one of the following three categories based on the nature of the inputs used to determine their respective fair values.
  • Level 1 - Observable inputs that reflect unadjusted quoted prices for identical assets or liabilities in active markets as of the reporting date. Active markets are those in which transactions for the asset or liability occur in sufficient frequency and volume to provide pricing information on an ongoing basis.
     
  • Level 2 - Observable market-based inputs or unobservable inputs that are corroborated by market data.
     
  • Level 3 - Unobservable inputs that are not corroborated by market data. These inputs reflect management’s best estimate of fair value using its own assumptions about the assumptions a market participant would use in pricing the asset or liability.
F-17
 


As required by GAAPUSA, assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement. The company’s assessment of the significance of a particular input to the fair value measurement requires judgment, and may affect their placement within the fair value hierarchy levels.
 
The following table sets forth by level within the fair value hierarchy the Company’s assets that were accounted for at fair value on a nonrecurring basis as of December 31, 2009:
 
Quoted Price Significant
in Active Other Significant Total Gains
Fair Values Market for Observable Unobservable (Losses) for the
as of Identical Asset Inputs Inputs Year Ended
Description       December 31, 2009       (Level 1)       (Level 2)       (Level 3)       December 31, 2009
Property and
equipment held        
and used $ 685,000   $ -   $ -   $   685,000   $               (615,000 )
 
During 2009 the Company wrote-down its property and equipment associated with its Puyallup, Washington store. These assets continue to be classified as property and equipment, rather than assets held for sale, because of the difficulties encountered by the Company in its efforts to sell and assign this location. The fair value reflects the current sales price at which the property and equipment is currently being marketed based on local market conditions.
 
Note 4 - Inventories
 
2009       2008
Food and beverages $    175,966 $    199,758
Packaging 58,872 68,356
Merchandise 101,675 120,669
$ 336,513   $ 388,783
 
 
F-18



Note 5 - Property and Equipment
 
      2009       2008
Leasehold improvements $    20,622,008 $    21,237,008
Furniture, fixtures and equipment 14,191,504 14,125,684
Automobiles 408,468 408,468
Computer equipment 160,175 141,940
35,382,155 35,913,100
Less: Accumulated depreciation and amortization (19,679,556 ) (16,963,495 )
$ 15,702,599 $ 18,949,605
 
Note 6 - Long-Term Debt
 
      2009       2008
Note payable to Bank of America in monthly principal
installments of $50,994 plus interest at the 30-day LIBOR
rate plus 2.75%. A one-time principal payment of $500,000
is due on December 31, 2009 and a final balloon payment
of $3,684,587 is due on July 31, 2010. $    4,541,545 $    5,812,622
Note payable to Bank of America in monthly principal
installments of $29,374 plus interest at the 30-day LIBOR
rate plus 2.75%. A final balloon payment of $2,037,472 is
due on July 31, 2010. 2,243,090 3,114,713
Other notes payable - 7,228
       Total long-term debt 6,784,635   8,934,563
Less current maturities   (6,784,635 ) (2,149,928 )
$ - $ 6,784,635
 
The notes payable to Bank of America are collateralized by substantially all of the Company’s assets and are guaranteed by the members of ICON and by KKDC up to an aggregate original amount of $10,666,667. Of that amount, the members of ICON personally guaranteed $8,000,000 and KKDC guaranteed $2,666,667. The borrowings under these notes are also subject to certain restrictive covenants including financial covenants related to leverage and cash flow ratios. It is management’s expectation that these notes will be refinanced in 2010.
 
Interest expense on the above notes was $264,812, $738,573 and $940,825 in 2009, 2008 and 2007, respectively.
 
Total interest expense was $399,023, $945,073 and $1,248,130 in 2009, 2008 and 2007, respectively.
 
F-19
 


Note 7 - Derivative Financial Instrument - Interest Rate Swap Agreement
 
KW USA had obtained a derivative financial instrument from Bank of America to reduce its exposure to market risks from changes in interest rates related to its financing described in Note 6. The instrument used to mitigate these risks was an interest rate swap. Under the Derivatives and Hedging Topic of GAAPUSA, derivatives are recognized in the balance sheet at fair value. Any changes in fair value are to be recognized immediately in earnings unless the derivatives qualify as hedges of future cash flows. The derivative instrument held by KW USA was designated as a highly effective cash flow hedge of interest rate risk on variable rate debt in accordance with the provisions of the Derivatives and Hedging Topic. As a result, the change in fair value of this instrument has been recorded as a component of other comprehensive loss. KW USA’s derivative instrument expired December 31, 2008.
 
Fluctuations in the fair value of the derivative resulted in gains and (losses) of $25,174 and ($96,911), in 2008 and 2007, respectively. The Company’s share of these gains and (losses) totaled $20,139 and ($77,529) in 2008 and 2007, respectively, and were included in other comprehensive loss. The remaining portion of these gains and (losses) had been allocated to the noncontrolling interest.
 
Note 8 - Operating Leases
 
The Company conducts its operations in facilities under operating leases. Minimum rent is recognized over the term of the leases using the straight-line method. The Company’s substantial investment in long-lived leasehold improvements was deemed to constitute a penalty under GAAPUSA in determining the lease term for each lease. In addition to minimum rent, the leases require the payment of common area expenses and real estate taxes. Total rental expense for the facilities was $1,677,048, $1,746,863 and $1,746,030 in 2009, 2008 and 2007, respectively. Under certain leases, the Company has options to purchase a 25% interest in the leased premises after 15 years, if the leases are then in full force and effect.
 
The following is a schedule by year of future minimum lease payments required under the operating leases as of December 30, 2009:
 
Fiscal Year Ending:        
2010 $ 1,539,905
2011 1,560,471
2012   1,575,654
2013 1,662,058
2014 1,828,177
Later years 16,391,441
$ 24,557,706
   
F-20
 


Note 9 - Related Party Transactions
 
The Company is affiliated through common ownership with KremeWorks Canada, LP, ICON and various entities associated with Lettuce, as well as Lettuce itself. In the normal course of business, the affiliated entities transfer inventory and share personnel and record such transfers at cost.
 
The Company has entered into a management agreement with Lettuce and ICON whereby it pays a management fee for services provided based on 4% of sales. The management fee amounted to $682,599, $741,846 and $813,624 for 2009, 2008 and 2007, respectively. Lettuce’s portion of this management fee was $137,500, $183,335 and $183,216 in 2009, 2008 and 2007, respectively, with the remainder payable to ICON. Services provided include, but are not limited to, accounting and payroll services, human resources, licensing and marketing. ICON also serves as a disbursing agent and paymaster for the Company’s payroll. Lettuce serves as a workers’ compensation and health insurance administrator in a group self-insurance program.
 
In conjunction with the development agreement with KKDC described in Note 2, the Company is required to pay royalty fees to KKDC on a weekly basis equal to 4.5% of gross sales. Royalty fees paid to KKDC totaled $769,140, $832,615 and $915,328 in 2009, 2008 and 2007, respectively.
 
The Company’s franchise agreement with KKDC requires the Company to purchase furnishings, fixtures, equipment, signs, doughnut mixes and other supplies that have been approved by KKDC for Krispy Kreme stores. KKDC is the sole supplier for certain doughnut production equipment and all doughnut mixes. Purchases from KKDC totaled $3,136,431, $4,201,283 and $4,163,369 in 2009, 2008 and 2007, respectively. As of December 30, 2009 and December 31, 2008, the amount due to KKDC for the previously described purchases totaled $396,792 and $456,069, respectively. This liability is included in the accounts payable to affiliated entities in the Company’s consolidated balance sheets. In 2008, the Company received $270,000 from KKDC relating to consulting services and reimbursement for concept development costs. This expense is included in other general and administrative expenses on the statements of loss.
 
As of December 30, 2009 and December 31, 2008, KW USA had a note payable to ICON in the amount of $2,700,000. The note is due on demand and bears interest at the prime rate plus ½%. Interest expense on this note for 2009, 2008 and, 2007 was $100,973, $154,103 and $229,001, respectively. As of December 30, 2009 and December 31, 2008, KW USA also had a note payable to KKDC, due on demand in the amount of $900,000, bearing interest at the prime rate plus ½%. Interest expense on this note for 2009, 2008 and 2007 was $33,658, $51,368 and $76,334, respectively. The loans from ICON and KKDC are pursuant to an agreement between the two companies and are in amounts that approximate the ratio of their respective ownership interests in KW USA.
 
A member of ICON is an attorney and his law firm provides legal services to the Company. The total expense for these services was $253, $1,279 and $28,571 for 2009, 2008 and 2007, respectively.
 
F-21
 


See Note 10 for additional related party transactions.
 
Note 10 - Other Cash Flow Information
 
Cash paid for interest amounted to $296,637, $749,915 and $1,231,806 for 2009, 2008 and 2007, respectively.
 
During 2009, there were capital contributions totaling $1,275,000, of which $239,800 was a receivable at year-end (see Note 12).
 
During 2009, ICON and KKDC made capital contributions in the amounts of $546,322 and $182,108, respectively, by forgiving amounts owed to them by the Company.
 
During 2008, ICON and KKDC made capital contributions in the amounts of $860,839 and $286,946, respectively, by forgiving amounts owed to them by the Company.
 
During 2007, ICON and KKDC made capital contributions in the amounts of $646,962 and $215,654, respectively, by forgiving amounts owed to them by the Company.
 
Note 11 - Status of Operations
 
The Company has experienced steadily declining revenues and significant losses over the last five years. While the Company is still generating positive cash flows from operations, members of KremeWorks made significant cash contributions to enable the Company to meet its cash flow needs and debt service requirements in 2009 and 2008. The Company’s current debt agreement with Bank of America expires on July 31, 2010 at which time approximately $5,700,000 in principal payments will become due. Management believes that it will be able to negotiate a new debt agreement with Bank of America or a similar institution. Management also believes operating cash flows will recover in the near future to a level that will allow the Company to meet its ongoing cash flow needs.
 
The Company is in discussions to sell and assign two of its under-performing stores and use the proceeds to reduce bank debt. Based on negotiations for the sale and assignment of its Puyallup, Washington location, the Company asked its landlord for consent to the proposed assignment. The landlord denied the consent and subsequently filed an action in Ohio (where the landlord is located) for accrued rent (since paid) and a declaratory judgment upholding its refusal or, alternatively, the landlord’s right to the proceeds of the sale of the location. The Company has filed an action in Washington (i) for a declaratory judgment that it has the right to assign its lease and sell its assets as proposed and (ii) for damages. With respect to the other under-performing store, the Company does not believe that it qualifies for held for sale accounting and has therefore continued to account for its long-lived assets as property and equipment.
 
F-22
 


In the event that management’s expectations mentioned above are not realized, alternative sources of financing might be required for the Company to continue operations beyond the near term.
 
Note 12 - Subsequent Events
 
The Company has evaluated subsequent events through March 31, 2010, the date the financial statements were available to be issued.
 
Payments for all $239,800 of the member contributions receivable balance as of December 30, 2009 were received by January 11, 2010.
 
The Company made a $500,000 principal payment to Bank of America on January 14, 2010.
 
F-23