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EX-31.1 - CERTIFICATION OF CHIEF EXECUTIVE OFFICER PURSUANT TO RULE 13A-14(A) - KRISPY KREME DOUGHNUTS INCexhibit31-1.htm
EX-32.1 - CERTIFICATION BY CHIEF EXECUTIVE OFFICER PURSUANT TO 18 U.S.C. SECTION 1350 - KRISPY KREME DOUGHNUTS INCexhibit32-1.htm
EX-32.2 - CERTIFICATION BY CHIEF FINANCIAL OFFICER PURSUANT TO 18 U.S.C. SECTION 1350 - KRISPY KREME DOUGHNUTS INCexhibit32-2.htm
EX-31.2 - CERTIFICATION OF CHIEF FINANCIAL OFFICER PURSUANT TO RULE 13A-14(A) - KRISPY KREME DOUGHNUTS INCexhibit31-2.htm
EXCEL - IDEA: XBRL DOCUMENT - KRISPY KREME DOUGHNUTS INCFinancial_Report.xls
      


UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
___________________ 
 
Form 10-Q
 
 
(Mark one)
  þ           QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
           For the quarterly period ended July 31, 2011
OR
  o   TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
      For the transition period from                 to
 
Commission file number 001-16485
KRISPY KREME DOUGHNUTS, INC.
(Exact name of registrant as specified in its charter)
 
North Carolina 56-2169715
(State or other jurisdiction of incorporation or organization) (I.R.S. Employer Identification No.)
370 Knollwood Street, 27103
Winston-Salem, North Carolina (Zip Code)
(Address of principal executive offices)  

Registrant’s telephone number, including area code:
(336) 725-2981
 
     Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes  þ No  o
 
     Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes  þ No  o
 
     Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
 
Large accelerated filer  o                               Accelerated filer  þ 
Non-accelerated filer  o    Smaller reporting company  o 
 
     Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes  No  þ
 
     Number of shares of Common Stock, no par value, outstanding as of August 26, 2011: 67,932,031.
 

 
 
 
 
 

TABLE OF CONTENTS
 
          Page
FORWARD-LOOKING STATEMENTS 3
 
PART I - FINANCIAL INFORMATION 4
 
Item 1.   FINANCIAL STATEMENTS 4
Item 2.   MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND  
           RESULTS OF OPERATIONS 23
Item 3.   QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK 53
Item 4.   CONTROLS AND PROCEDURES 54
 
PART II - OTHER INFORMATION 54
 
Item 1.   LEGAL PROCEEDINGS 54
Item 1A.   RISK FACTORS 54
Item 2.   UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS 54
Item 3.   DEFAULTS UPON SENIOR SECURITIES 54
Item 4.   (REMOVED AND RESERVED) 54
Item 5.   OTHER INFORMATION 54
Item 6.   EXHIBITS 54
 
    SIGNATURES 55
 
    EXHIBIT INDEX 56

2
 

 

     As used herein, unless the context otherwise requires, “Krispy Kreme,” the “Company,” “we,” “us” and “our” refer to Krispy Kreme Doughnuts, Inc. and its subsidiaries. References to fiscal 2012 and fiscal 2011 mean the fiscal years ended January 29, 2012 and January 30, 2011, respectively.
 
FORWARD-LOOKING STATEMENTS
 
     This quarterly report contains forward looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”) that relate to our plans, objectives, estimates and goals. Statements expressing expectations regarding our future and projections relating to products, sales, revenues, expenditures, costs and earnings are typical of such statements, and are made under the Private Securities Litigation Reform Act of 1995. Forward-looking statements are based on management’s beliefs, assumptions and expectations of our future economic performance, considering the information currently available to management. These statements are not statements of historical fact. Forward-looking statements involve risks and uncertainties that may cause our actual results, performance or financial condition to differ materially from the expectations of future results, performance or financial condition we express or imply in any forward-looking statements. The words “believe,” “may,” “could,” “will,” “should,” “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;
     
  • risks related to the food service industry, including food safety and protection of personal information;
     
  • increased costs or other effects of new government regulations relating to healthcare benefits; and
     
  • other factors in Krispy Kreme’s periodic reports and other information filed with the Securities and Exchange Commission (the “SEC”), including under Part I, Item 1A, “Risk Factors,” in the Company’s Annual Report on Form 10-K for the fiscal year ended January 30, 2011 (the “2011 Form 10-K”).
     All such factors are difficult to predict, contain uncertainties that may materially affect actual results and may be beyond our control. New factors emerge from time to time, and it is not possible for management to predict all such factors or to assess the impact of each such factor on the Company. Any forward-looking statement speaks only as of the date on which such statement is made, and we do not undertake any obligation to update any forward-looking statement to reflect events or circumstances after the date on which such statement is made.
 
     We caution you that any forward-looking statements are not guarantees of future performance and involve known and unknown risks, uncertainties and other factors which may cause our actual results, performance or achievements to differ materially from the facts, results, performance or achievements we have anticipated in such forward-looking statements except as required by the federal securities laws.
 
3
 

 

PART I - FINANCIAL INFORMATION
 
Item 1. FINANCIAL STATEMENTS.
 
  Page
Index to Financial Statements  
Consolidated statement of operations for the three and six months ended July 31, 2011 and August 1, 2010 5
Consolidated balance sheet as of July 31, 2011 and January 30, 2011 6
Consolidated statement of cash flows for the six months ended July 31, 2011 and August 1, 2010 7
Consolidated statement of changes in shareholders’ equity for the six months ended July 31, 2011 and August 1, 2010 8
Notes to financial statements 9

4
 

 

KRISPY KREME DOUGHNUTS, INC.
 
CONSOLIDATED STATEMENT OF OPERATIONS
(Unaudited)
 
    Three Months Ended   Six Months Ended
    July 31,   August 1,   July 31,   August 1,
        2011       2010       2011       2010
        (In thousands, except per share amounts)
 
Revenues   $ 97,952     $ 87,932     $ 202,552     $ 180,049  
Operating expenses:                                
       Direct operating expenses (exclusive of depreciation                                
              expense shown below)     85,697       77,075       172,680       154,230  
       General and administrative expenses     4,930       4,981       10,574       10,725  
       Depreciation expense     2,087       1,937       4,025       3,801  
       Impairment charges and lease termination costs     301       (216 )     545       1,083  
Operating income     4,937       4,155       14,728       10,210  
Interest income     56       82       101       122  
Interest expense     (414 )     (1,567 )     (891 )     (3,438 )
Equity in income (losses) of equity method franchisees     12       (165 )     3       181  
Gain on sale of interest in equity method franchisee     6,198       -       6,198       -  
Other non-operating income and (expense), net     86       81       172       162  
Income before income taxes     10,875       2,586       20,311       7,237  
Provision for income taxes     2,036       379       2,301       562  
Net income   $ 8,839     $ 2,207     $ 18,010     $ 6,675  
 
Earnings per common share:                                
       Basic   $ 0.13     $ 0.03     $ 0.26     $ 0.10  
       Diluted   $      0.12     $      0.03     $      0.25     $      0.10  
                                 
The accompanying notes are an integral part of the financial statements.
 
5
 

 

KRISPY KREME DOUGHNUTS, INC.
 
CONSOLIDATED BALANCE SHEET
(Unaudited)
 
    July 31,   January 30,
        2011       2011
        (In thousands)
ASSETS
CURRENT ASSETS:                
Cash and cash equivalents   $ 32,324     $ 21,970  
Receivables     20,569       20,261  
Receivables from equity method franchisees     582       586  
Inventories     18,556       14,635  
Other current assets     5,099       5,970  
       Total current assets     77,130       63,422  
Property and equipment     71,183       71,163  
Investments in equity method franchisees     -       1,663  
Goodwill and other intangible assets     23,776       23,776  
Other assets     9,892       9,902  
       Total assets   $ 181,981     $ 169,926  
 
LIABILITIES AND SHAREHOLDERS’ EQUITY
CURRENT LIABILITIES:                
Current maturities of long-term debt   $ 2,078     $ 2,513  
Accounts payable     11,860       9,954  
Accrued liabilities     27,278       28,379  
       Total current liabilities     41,216       40,846  
Long-term debt, less current maturities     25,593       32,874  
Other long-term obligations     18,213       19,778  
 
Commitments and contingencies                
 
SHAREHOLDERS’ EQUITY:                
Preferred stock, no par value     -       -  
Common stock, no par value     373,525       370,808  
Accumulated other comprehensive loss     (230 )     (34 )
Accumulated deficit     (276,336 )     (294,346 )
       Total shareholders’ equity     96,959       76,428  
              Total liabilities and shareholders’ equity   $        181,981     $        169,926  
                 
The accompanying notes are an integral part of the financial statements.
 
6
 

 

KRISPY KREME DOUGHNUTS, INC.
 
CONSOLIDATED STATEMENT OF CASH FLOWS
(Unaudited)
 
    Six Months Ended
    July 31,   August 1,
        2011       2010
    (In thousands)
CASH FLOWS FROM OPERATING ACTIVITIES:                
Net income   $ 18,010     $ 6,675  
Adjustments to reconcile net income to net cash provided by operating activities:                
       Depreciation expense     4,025       3,801  
       Deferred income taxes     128       (70 )
       Impairment charges     -       709  
       Accrued rent expense     315       (395 )
       Loss on disposal of property and equipment     213       279  
       Gain on sale of interest in equity method franchisee     (6,198 )     -  
       Share-based compensation     1,806       1,934  
       Provision for doubtful accounts     (399 )     (193 )
       Amortization of deferred financing costs     218       312  
       Equity in income of equity method franchisees     (3 )     (181 )
       Other     676       (210 )
Change in assets and liabilities:                
       Receivables     199       (1,113 )
       Inventories     (3,921 )     (106 )
       Other current and non-current assets     (735 )     (2,707 )
       Accounts payable and accrued liabilities     (102 )     (3,055 )
       Other long-term obligations     (1,540 )     (287 )
              Net cash provided by operating activities     12,692       5,393  
CASH FLOWS FROM INVESTING ACTIVITIES:                
Purchase of property and equipment     (4,146 )     (4,029 )
Proceeds from disposals of property and equipment     19       1,268  
Proceeds from sale of interest in equity method franchisee     7,723       -  
Escrow deposit recovery     1,000       -  
Other investing activities     13       27  
              Net cash provided by (used for) investing activities     4,609       (2,734 )
CASH FLOWS FROM FINANCING ACTIVITIES:                
Repayment of long-term debt     (7,846 )     (1,599 )
Deferred financing costs     (12 )     -  
Proceeds from exercise of stock options     1,036       -  
Proceeds from exercise of warrants     -       4  
Repurchase of common shares     (125 )     (44 )
              Net cash used for financing activities     (6,947 )     (1,639 )
Net increase in cash and cash equivalents     10,354       1,020  
Cash and cash equivalents at beginning of period     21,970       20,215  
Cash and cash equivalents at end of period   $      32,324     $      21,235  
                 
The accompanying notes are an integral part of the financial statements.
 
7
 

 

KRISPY KREME DOUGHNUTS, INC.
 
CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS' EQUITY
(Unaudited)
 
                  Accumulated                
    Common           Other                
    Shares   Common   Comprehensive   Accumulated        
        Outstanding       Stock       Income (Loss)       Deficit       Total
                  (In thousands)                
Balance at January 30, 2011   67,527     $ 370,808     $ (34 )   $ (294,346 )   $ 76,428  
Comprehensive income:                                      
       Net income for the six months ended                                      
              July 31, 2011                           18,010       18,010  
       Foreign currency translation adjustment, net                                      
              of income taxes of $23                   34               34  
       Unrealized loss on cash flow hedge, net                                      
              of income taxes of $151                   (230 )             (230 )
       Total comprehensive income                                   17,814  
Exercise of stock options   397       1,036                       1,036  
Cancelation of restricted shares   (8 )     -                       -  
Share-based compensation   28       1,806                       1,806  
Repurchase of common shares   (16 )     (125 )                     (125 )
Balance at July 31, 2011   67,928     $ 373,525     $ (230 )   $ (276,336 )   $ 96,959  
 
Balance at January 31, 2010   67,441     $ 366,237     $ (180 )   $ (303,290 )   $ 62,767  
Effect of adoption of new accounting standard                                      
       (Note 1)                           1,345       1,345  
Comprehensive income:                                      
       Net income for the six months ended                                      
              August 1, 2010                           6,675       6,675  
       Foreign currency translation adjustment, net                                      
              of income taxes of $10                   15               15  
       Amortization of unrealized loss on interest                                      
              rate derivative, net of income taxes of $60                   92               92  
       Total comprehensive income                                   6,782  
Exercise of warrants           4                       4  
Share-based compensation   29       1,934                       1,934  
Repurchase of common shares   (12 )     (44 )                     (44 )
Balance at August 1, 2010         67,458     $      368,131     $          (73 )   $      (295,270 )   $      72,788  
                                       
Total comprehensive income for the three months ended July 31, 2011 and August 1, 2010 was $8.7 million and $2.2 million, respectively.
 
The accompanying notes are an integral part of the financial statements.
 
8
 

 

KRISPY KREME DOUGHNUTS, INC.
 
NOTES TO FINANCIAL STATEMENTS
(Unaudited
)
 
Note 1 — Accounting Policies
 
     Krispy Kreme Doughnuts, Inc. (“KKDI”) and its subsidiaries (collectively, the “Company”) are engaged in the sale of doughnuts and complimentary products through Company-owned stores. The Company also derives revenue from franchise and development fees and royalties from franchisees. Additionally, the Company sells doughnut mix, other ingredients and supplies and doughnut-making equipment to franchisees.
 
Significant Accounting Policies
 
     BASIS OF PRESENTATION. The consolidated financial statements contained herein should be read in conjunction with the Company’s 2011 Form 10-K. The accompanying interim consolidated financial statements are presented in accordance with the requirements of Article 10 of Regulation S-X and, accordingly, do not include all the disclosures required by generally accepted accounting principles (“GAAP”) with respect to annual financial statements. The interim consolidated financial statements have been prepared in accordance with the Company’s accounting practices described in the 2011 Form 10-K, but have not been audited. In management’s opinion, the financial statements include all adjustments, which consist only of normal recurring adjustments, necessary for a fair statement of the Company’s results of operations for the periods presented. The consolidated balance sheet data as of January 30, 2011 were derived from the Company’s audited financial statements but do not include all disclosures required by GAAP.
 
     BASIS OF CONSOLIDATION. The financial statements include the accounts of KKDI and its subsidiaries, the most significant of which is KKDI’s principal operating subsidiary, Krispy Kreme Doughnut Corporation.
 
     Investments in entities over which the Company has the ability to exercise significant influence but which the Company does not control, and whose financial statements are not otherwise required to be consolidated, are accounted for using the equity method. These entities typically are 25% to 35% owned and are hereinafter sometimes referred to as “Equity Method Franchisees.”
 
     EARNINGS PER SHARE. The computation of basic earnings per share is based on the weighted average number of common shares outstanding during the period. The computation of diluted earnings per share reflects the additional common shares that would have been outstanding if dilutive potential common shares had been issued, computed using the treasury stock method. Such potential common shares consist of shares issuable upon the exercise of stock options and warrants and the vesting of currently unvested shares of restricted stock and restricted stock units.
 
     The following table sets forth amounts used in the computation of basic and diluted earnings per share:
 
    Three Months Ended   Six Months Ended
    July 31,   August 1,   July 31,   August 1,
        2011       2010       2011       2010
    (In thousands)
Numerator: net income   $      8,839   $      2,207   $      18,010   $      6,675
                         
Denominator:                        
       Basic earnings per share - weighted average shares outstanding     68,900     68,195     68,827     68,145
       Effect of dilutive securities:                        
              Stock options and warrants     2,080     658     1,868     662
              Restricted stock and restricted stock units     726     474     743     472
       Diluted earnings per share - weighted average shares                        
              outstanding plus dilutive potential common shares     71,706     69,327     71,438     69,279
                         
     The sum of the quarterly earnings per share amounts does not necessarily equal earnings per share for the year to date.
 
     Stock options and warrants with respect to 6.5 million and 8.7 million shares for the three months ended July 31, 2011 and August 1, 2010, respectively, as well as 136,000 unvested shares of restricted stock and unvested restricted stock units for the three months ended August 1, 2010, have been excluded from the computation of the number of shares used to compute diluted earnings per share because their inclusion would be antidilutive.
 
9
 

 

     Stock options and warrants with respect to 7.3 million and 8.7 million shares, as well as 67,000 and 139,000 unvested shares of restricted stock and unvested restricted stock units, have been excluded from the computation of the number of shares used to compute diluted earnings per share for the six months ended July 31, 2011 and August 1, 2010, respectively, because their inclusion would be antidilutive.
 
     INCOME TAXES. The Company recognizes deferred tax assets and liabilities based upon management’s expectation of the future tax consequences of temporary differences between the income tax and financial reporting bases of assets and liabilities. Deferred tax liabilities generally represent tax expense recognized for which payment has been deferred, or expenses which 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 GAAP, which provides that such valuation allowances shall be established unless realization of the income tax benefits is more likely than not.
 
     At January 30, 2011, the Company had a valuation allowance against deferred income tax assets of $159 million, representing the total amount of such assets in excess of the Company’s deferred income tax liabilities. The Company has operated at a cumulative profit over the past three fiscal years; however, substantially all of that profit was earned in fiscal 2011, the most recently completed year. While the Company is encouraged by the $8.9 million pretax profit earned in fiscal 2011 and by the favorable trend in the Company’s financial results over the past three years, management believes it is appropriate to obtain confirmatory evidence that the improvement in the Company’s results of operations is sustainable, and that realization of at least some of the deferred income tax assets is more likely than not, before reversing a portion of the valuation allowance to earnings.
 
     The Company intends to review its conclusions about the appropriate amount of its deferred income tax asset valuation allowance in light of circumstances existing in future periods. Given the nature of the confirmatory evidence the Company seeks, management does not expect to record any reversal of the allowance until late in fiscal 2012, at which time the Company’s fiscal 2012 results will be known. If the Company again generates significant core earnings (generally meaning pretax earnings adjusted for non-recurring items) in fiscal 2012, then, absent other factors indicating a contrary conclusion, it is likely the Company will conclude it is appropriate to reverse a portion of the valuation allowance to earnings in the fourth quarter of fiscal 2012. If such a reversal is recorded, it appears unlikely that the reversal will equal the entire $159 million valuation allowance recorded as of January 30, 2011, although it is likely the amount will be material to the Company’s results of operations. Any reversal will have no effect on the Company’s cash flows.
 
     While any reversal of a portion of the valuation allowance will have a positive effect on the Company’s results of operations in the period in which any reversal is recorded, any reversal will most likely have the effect of reducing the Company’s earnings in subsequent periods as a result of an increase in the provision for income taxes in such periods. This negative effect on earnings in subsequent periods occurs because the reversal of the valuation allowance will reflect the recognition of future income tax benefits in the period in which the reversal is recorded; absent the reversal of the valuation allowance, such tax benefits would be recognized in the future periods in which their realization occurs upon the generation of taxable income. Accordingly, subsequent to any reversal of a portion of the valuation allowance, the Company’s effective income tax rate, which currently bears no relationship to pretax income, is likely to more closely reflect the blended federal and state income tax rates to which the Company’s earnings are subject.
 
     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.
 
Reclassification
 
     Beginning in the third quarter of fiscal 2011, the caption “Other operating income and expense, net” previously included in the consolidated statement of operations was eliminated, and amounts previously reported in this caption were reclassified to direct operating expense and general and administrative expenses. Amounts previously reported for the three and six months ended August 1, 2010, have been reclassified to conform to the new presentation. None of the reclassified amounts was material.
 
Recent Accounting Pronouncements
 
     Effective February 1, 2010, the first day of fiscal 2011, the Company was required to adopt new accounting standards related to the consolidation of variable interest entities (“VIEs”). Those standards require an enterprise to qualitatively assess whether it is the primary beneficiary of a VIE based on whether the enterprise has the power to direct matters that most significantly impact the activities of the VIE and has the obligation to absorb losses of, or the right to receive benefits from, the VIE that could potentially be significant to the VIE. An enterprise must consolidate the financial statements of VIEs of which it is the primary beneficiary. Under the new accounting standards, the Company was no longer the primary beneficiary of its franchisee in northern California, which required the Company to deconsolidate the franchisee and recognize a divestiture of the three stores the Company sold to the franchisee in the third quarter of fiscal 2010. The cumulative effect of adoption of the new standards has been reflected as a $1.3 million credit to the opening balance of retained earnings as of February 1, 2010. Adoption of the standards had no material effect on the Company’s financial position, results of operations or cash flows.
 
10
 

 

     In May 2011, the Financial Accounting Standards Board (the “FASB”) issued an Accounting Standards Update (“ASU”) related to fair value measurements. The ASU clarifies some existing concepts, eliminates wording differences between GAAP and International Financial Reporting Standards (“IFRS”), and in some limited cases, changes some principles to achieve convergence between GAAP and IFRS. The ASU also expands the disclosures for fair value measurements that are estimated using significant unobservable (Level 3) inputs. The ASU is effective for the Company in fiscal 2013. The Company does not expect the adoption of the new accounting standards to have a material effect on the Company’s financial condition or results of operations.
 
     In June 2011, the FASB issued new accounting standards which require an entity to present the total of comprehensive income, the components of net income, and the components of other comprehensive income either in a single continuous statement of comprehensive income, or in two separate but consecutive statements. The new accounting rules eliminate the option to present components of other comprehensive income as part of the statement of changes in shareholders’ equity. The new accounting rules will be effective for the Company in fiscal 2013. The Company does not expect the adoption of the new accounting rules to have a material effect on the Company’s financial condition or results of operations.
 
Note 2 — Receivables
 
     The components of receivables are as follows:
 
    July 31,   January 30,
        2011       2011
    (In thousands)
Receivables:                
       Off-premises customers   $ 10,056     $ 9,990  
       Unaffiliated franchisees     11,013       9,805  
       Other receivables     577       1,565  
       Current portion of notes receivable     230       235  
      21,876       21,595  
       Less — allowance for doubtful accounts:                
              Off-premises customers
    (327 )     (326 )
              Unaffiliated franchisees
    (980 )     (1,008 )
      (1,307 )     (1,334 )
    $         20,569     $         20,261  
 
Receivables from Equity Method Franchisees (Note 8):                
       Trade   $ 582     $ 586  
 

     The changes in the allowance for doubtful accounts are summarized as follows:
 
    Six Months Ended
    July 31,   August 1,
        2011       2010
    (In thousands)
Allowance for doubtful accounts related to receivables:                
       Balance at beginning of period
  $ 1,334     $ 1,343  
       Provision for doubtful accounts
    13       (36 )
       Chargeoffs
    (47 )     (52 )
       Recoveries
    7       -  
       Balance at end of period
  $        1,307     $        1,255  
 
Allowance for doubtful accounts related to receivables from Equity Method Franchisees:                
       Balance at beginning of period
  $ -     $ 739  
       Provision for doubtful accounts
    -       10  
       Chargeoffs
    -       -  
       Transfers to allowances for notes receivable
    -       (471 )
       Balance at end of period
  $ -     $ 278  
 

11
 

 

     The Company also has notes receivable from franchisees which are summarized in the following table. These balances are included in “Other assets” in the accompanying consolidated balance sheet.
 
    July 31,   January 30,
        2011       2011
    (In thousands)
Notes receivable:                
       Note receivable from Equity Method Franchisee (Note 8)   $ -     $ 391  
       Notes receivable from franchisees            1,007              1,300  
      1,007       1,691  
       Less — portion due within one year     (230 )     (235 )
       Less — allowance for doubtful accounts     (68 )     (538 )
    $ 709     $ 918  
 

     The changes in the allowance for doubtful accounts related to notes receivable are summarized as follows:
 
    Six Months Ended
    July 31,   August 1,
        2011       2010
    (In thousands)
Balance at beginning of period   $ 538     $ 129  
Provision for doubtful accounts            (412 )            (167 )
Chargeoffs     (79 )     -  
Recoveries     21       157  
Transfers from allowances for trade receivables     -       471  
Balance at end of period   $ 68     $ 590  
 

     In addition to the foregoing notes receivable, the Company had promissory notes totaling approximately $3.3 million and $3.7 million at July 31, 2011 and January 30, 2011, respectively, representing payment obligations related to royalties and fees due to the Company which, as a result of doubt about their collection, the Company had not yet recorded as revenues. No payments were required to be made currently on any of the July 31, 2011 amount. During the quarter ended May 1, 2011, the Company recognized approximately $375,000 of previously unrecognized revenues related to KK Mexico which were received on May 5, 2011 in connection with the Company’s sale of its 30% equity interest in the franchisee, as more fully described in Note 8. During the quarter ended May 1, 2011, the Company also reversed an allowance for doubtful notes receivable of approximately $391,000 related to KK Mexico; such note also was paid in full on May 5, 2011.
 
Note 3 — Inventories
 
     The components of inventories are as follows:
 
    July 31,   January 30,
        2011       2011
    (In thousands)
Raw materials   $ 5,488   $ 5,265
Work in progress     64     54
Finished goods and purchased merchandise     12,844     9,212
Manufacturing supplies     160     104
    $        18,556   $        14,635
 

12
 

 

Note 4 — Long Term Debt
 
     Long-term debt and capital lease obligations consist of the following:
 
    July 31,   January 30,
        2011       2011
    (In thousands)
2011 Term Loan   $ 27,245     $ 35,000  
Capital lease obligations     426       387  
      27,671       35,387  
Less: current maturities     (2,078 )     (2,513 )
    $        25,593     $        32,874  
 

     On January 28, 2011, the Company closed new secured credit facilities (the “2011 Secured Credit Facilities”), consisting of a $25 million revolving credit line (the “2011 Revolver”) and a $35 million term loan (the “2011 Term Loan”), each of which mature in January 2016. The 2011 Secured Credit Facilities are secured by a first lien on substantially all of the assets of the Company and its domestic subsidiaries. The Company used the proceeds of the 2011 Term Loan to repay the outstanding borrowings under the Company’s prior secured credit facilities (the “2007 Secured Credit Facilities”). The 2007 Secured Credit Facilities, which consisted of a $25 million revolving credit facility (the “2007 Revolver”) and a term loan maturing in February 2014, which had an outstanding balance of approximately $35.1 million (the “2007 Term Loan”), were then terminated.
 
     Interest on borrowings under the 2011 Secured Credit Facilities is payable either at LIBOR or the Base Rate (which is the greatest of the prime rate, the Fed funds rate plus 0.50%, or the one-month LIBOR rate plus 1.00%), in each case plus the Applicable Percentage. The Applicable Percentage for LIBOR loans ranges from 2.25% to 3.00%, and for Base Rate loans ranges from 1.25% to 2.00%, in each case depending on the Company’s leverage ratio. As of July 31, 2011, all outstanding borrowings under the 2011 Secured Credit Facilities were based on LIBOR, and the Applicable Margin was 2.50%. The Company also pays fees on outstanding letters of credit issued under the 2011 Revolver equal to the Applicable Margin for LIBOR loans plus 0.125%. Such letters of credit totaled $10.2 million as of July 31, 2011.
 
     Interest on borrowings under the 2007 Revolver and 2007 Term Loan was payable either (a) at the greater of LIBOR or 3.25% or (b) at the Alternate Base Rate (which was the greater of Fed funds rate plus 0.50% or the prime rate), in each case plus the Applicable Margin. The Applicable Margin for LIBOR-based loans and for Alternate Base Rate-based loans was 7.50% and 6.50%, respectively. The Company also paid fees on outstanding letters of credit issued under the 2007 Revolver equal to the Applicable Margin for LIBOR loans plus 0.25%.
 
     The 2011 Term Loan is payable in quarterly installments of approximately $470,000, as adjusted to give effect to principal prepayments, and a final installment equal to the remaining principal balance in January 2016. The 2011 Term Loan is required to be prepaid with some or all of the net proceeds of certain equity issuances, debt issuances, asset sales and casualty events. On the closing date, the Company deposited into escrow $200,000 with respect to each of nine properties ($1.8 million in the aggregate) with respect to which the Company agreed to furnish to the lenders certain documentation on or before January 31, 2012, with amounts to be released from escrow upon the Company’s furnishing such documentation. If the Company does not furnish the documentation by January 31, 2012, then the amount remaining in escrow on that date will be used to make a prepayment of principal on the 2011 Term Loan. During the six months ended July 31, 2011, $1.0 million of the escrowed amount was returned to the Company; amounts remaining in escrow are included in “Other current assets” in the accompanying consolidated balance sheet.
 
     The 2011 Secured Credit Facilities require the Company to meet certain financial tests, including a maximum leverage ratio and a minimum fixed charge coverage ratio. The leverage ratio is required to be not greater than 2.75 to 1.0 in fiscal 2012, and declines to 2.5 to 1.0 thereafter. The fixed charge coverage ratio is required to be not less than 1.05 to 1.0 in fiscal 2012, increasing to a minimum of 1.1 to 1.0 in fiscal 2013 and to 1.2 to 1.0 thereafter.
 
     As of July 31, 2011, the Company’s leverage ratio was 1.0 to 1.0, and the fixed charge coverage ratio for the rolling four-quarter period then ended was 3.0 to 1.0. In accordance with the terms of the 2011 Secured Credit Facilities, interest and fees related to these facilities is reflected in the computation of the fixed charge coverage ratio by annualizing amounts incurred under those facilities subsequent to the closing date.
 
     The operation of the restrictive financial covenants described above may limit the amount the Company may borrow under the 2011 Revolver. The restrictive covenants did not limit the Company’s ability to borrow the full $14.8 million of unused credit under the 2011 Revolver at July 31, 2011.
 
13
 

 

Note 5 — Commitments and Contingencies
 
     Except as disclosed below, the Company currently is not a party to any material legal proceedings.
 
Pending Litigation
 
     On April 7, 2009, a Cayman Islands corporation, K2 Asia Ventures, and its owners filed a lawsuit in Forsyth County, North Carolina Superior Court against the Company, its franchisee in the Philippines, and other persons associated with the franchisee. The suit alleges that the Company and the other defendants conspired to deprive the plaintiffs of claimed “exclusive rights” to negotiate franchise and development agreements with prospective franchisees in the Philippines, and seeks unspecified damages. The Company believes that these allegations are false and intends to vigorously defend against the lawsuit.
 
Other Legal Matters
 
     The Company also is engaged in various legal proceedings arising in the normal course of business. The Company maintains customary insurance policies against certain kinds of such claims and suits, including insurance policies for workers’ compensation and personal injury, some of which provide for relatively large deductible amounts.
 
Other Commitments and Contingencies
 
     The Company has guaranteed certain loans from third-party financial institutions on behalf of Equity Method Franchisees primarily to assist the franchisees in obtaining third-party financing. The loans are collateralized by certain assets of the franchisee, generally the Krispy Kreme store and related equipment. The Company’s contingent liabilities related to these guarantees totaled approximately $2.9 million at July 31, 2011, and are summarized in Note 8. These guarantees require payment from the Company in the event of default on payment by the respective debtor and, if the debtor defaults, the Company may be required to pay amounts outstanding under the related agreements in addition to the principal amount guaranteed, including accrued interest and related fees.
 
     The aggregate recorded liability for these loan guarantees totaled $2.0 million as of July 31, 2011, which is included in accrued liabilities in the accompanying consolidated balance sheet. These liabilities represent the estimated amount of guarantee payments which the Company believed to be probable. While there is no current demand on the Company to perform under any of the guarantees, there can be no assurance that the Company will not be required to perform and, if circumstances change from those prevailing at July 31, 2011, additional guarantee payments or provisions for guarantee payments could be required with respect to any of the guarantees.
 
     In addition, accrued liabilities at July 31, 2011, includes approximately $1.1 million related to 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 assignees fail to perform under the leases they have assumed. During the quarter ended July 31, 2011, the Company recorded a provision of $820,000 for estimated payments the Company expects to make under a lease guarantee related to a franchisee whose franchise rights the Company terminated during the second quarter. The aggregate gross guarantee exposure under all such lease guarantees, without reduction for any potential sublease rentals or any other mitigation, was approximately $4.4 million as of July 31, 2011.
 
     One of the Company’s lenders had issued letters of credit on behalf of the Company totaling $10.2 million at July 31, 2011, all of which secure the Company’s reimbursement obligations to insurers under the Company’s self-insurance arrangements.
 
     In addition to entering into forward purchase contracts, the Company from time to time purchases exchange-traded commodity futures contracts or options on such contracts for raw materials which are ingredients of the Company’s products or which are components of such ingredients, including wheat and soybean oil. The Company typically assigns the futures contract to a supplier in connection with entering into a forward purchase contract for the related ingredient. The Company may also purchase futures, options on futures or enter into other hedging contracts to hedge its exposure to rising gasoline prices. See Note 11 for additional information about these derivatives.
 
14
 

 

Note 6 — Impairment Charges and Lease Termination Costs
 
     The components of impairment charges and lease termination costs are as follows:
 
    Three Months Ended   Six Months Ended
    July 31,   August 1,   July 31,       August 1,
        2011       2010       2011   2010
    (In thousands)
Impairment of long-lived assets:                            
       Current period charges   $ -   $ 50     $ -   $ 899  
       Adjustments to previously recorded estimates     -     (190 )     -     (190 )
              Total impairment of long-lived assets
    -     (140 )     -     709  
Lease termination costs:                            
       Provision for termination costs     301     568       545     1,018  
       Less — reversal of previously recorded accrued rent expense     -     (644 )     -     (644 )
              Net provision
    301     (76 )     545     374  
              Total impairment charges and lease termination costs
  $        301   $        (216 )   $        545   $        1,083  
   

     The Company tests long-lived assets for impairment when events or changes in circumstances indicate that their carrying value may not be recoverable. These events and changes in circumstances include store closing and refranchising decisions, the effects of changing costs on current results of operations, observed trends in operating results, and evidence of changed circumstances observed as a part of periodic reforecasts of future operating results and as part of the Company’s annual budgeting process. When the Company concludes that the carrying value of long-lived assets is not recoverable (based on future projected undiscounted cash flows), the Company records impairment charges to reduce the carrying value of those assets to their estimated fair values.
 
     Lease termination costs represent the estimated fair value of liabilities related to unexpired leases, after reduction by the amount of accrued rent expense, if any, related to the leases, and are recorded when the lease contracts are terminated or, if earlier, the date on which the Company ceases use of the leased property. The fair value of these liabilities are estimated as the excess, if any, of the contractual payments required under the unexpired leases over the current market lease rates for the properties, discounted at a credit-adjusted risk-free rate over the remaining term of the leases. The provision for lease termination costs also includes adjustments to liabilities recorded in prior periods arising from changes in estimated sublease rentals and from settlements with landlords.
 
     The transactions reflected in the accrual for lease termination costs are summarized as follows:
 
    Three Months Ended   Six Months Ended
    July 31,   August 1,   July 31,   August 1,
        2011       2010       2011       2010
    (In thousands)
Balance at beginning of period   $ 1,290     $ 1,803     $ 1,995     $ 1,679  
       Provision for lease termination costs:                                
              Provisions associated with store closings, net of estimated                                
                     sublease rentals
    -       394       -       394  
              Adjustments to previously recorded provisions resulting                                
                     from settlements with lessors and adjustments of previous
                               
                     estimates
    280       124       492       529  
              Accretion of discount     21       50       53       95  
                     Total provision
    301       568       545       1,018  
       Payments on unexpired leases, including settlements with                                
              lessors     (439 )     (271 )     (1,388 )     (597 )
Balance at end of period   $        1,152     $        2,100     $        1,152     $        2,100  
 

 
 
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Note 7 — Segment Information
 
     The Company’s reportable segments are Company Stores, Domestic Franchise, International Franchise and KK Supply Chain. The Company Stores segment is comprised of the stores operated by the Company. These stores sell doughnuts and complementary products through both on-premises and off-premises sales channels, although some stores serve only one of these distribution channels. The Domestic Franchise and International Franchise segments consist of the Company’s franchise operations. Under the terms of franchise agreements, domestic and international franchisees pay royalties and fees to the Company in return for the use of the Krispy Kreme name and ongoing brand and operational support. Expenses for these segments include costs to recruit new franchisees, to assist in store openings, to support franchisee operations and marketing efforts, as well as allocated corporate costs. The majority of the ingredients and materials used by Company stores are purchased from the KK Supply Chain segment, which supplies doughnut mix, other ingredients and supplies and doughnut making equipment to both Company and franchisee-owned stores.
 
     All intercompany sales by the KK Supply Chain segment to the Company Stores segment are at prices intended to reflect an arms-length transfer price and are eliminated in consolidation. Operating income for the Company Stores segment does not include any profit earned by the KK Supply Chain segment on sales of doughnut mix and other items to the Company Stores segment; such profit is included in KK Supply Chain operating income.
 
     The following table presents the results of operations of the Company’s operating segments for the three and six months ended July 31, 2011 and August 1, 2010. Segment operating income is consolidated operating income before unallocated general and administrative expenses and impairment charges and lease termination costs.
 
    Three Months Ended   Six Months Ended
    July 31,   August 1,   July 31,   August 1,
        2011       2010       2011       2010
    (In thousands)
Revenues:                                
       Company Stores   $ 65,992     $ 59,970     $ 135,467     $ 122,504  
       Domestic Franchise     2,349       2,074       4,718       4,274  
       International Franchise     5,352       4,009       10,988       8,769  
       KK Supply Chain:                                
              Total revenues     50,341       44,892       104,224       90,797  
              Less – intersegment sales elimination     (26,082 )     (23,013 )     (52,845 )     (46,295 )
                     External KK Supply Chain revenues     24,259       21,879       51,379       44,502  
                            Total revenues   $ 97,952     $ 87,932     $ 202,552     $ 180,049  
 
Operating income (loss):                                
       Company Stores   $ (1,049 )   $ (1,734 )   $ 1,125     $ (1,765 )
       Domestic Franchise     216       1,041       1,363       2,195  
       International Franchise     3,409       2,500       7,580       5,986  
       KK Supply Chain     7,745       7,329       16,087       16,019  
              Total segment operating income     10,321       9,136       26,155       22,435  
       Unallocated general and administrative expenses     (5,083 )     (5,197 )     (10,882 )     (11,142 )
       Impairment charges and lease termination costs     (301 )     216       (545 )     (1,083 )
              Consolidated operating income   $ 4,937     $ 4,155     $ 14,728     $ 10,210  
 
Depreciation expense:                                
       Company Stores   $ 1,689     $ 1,459     $ 3,226     $ 2,854  
       Domestic Franchise     55       55       110       110  
       International Franchise     2       2       4       3  
       KK Supply Chain     188       205       377       417  
       Corporate administration     153       216       308       417  
              Total depreciation expense   $ 2,087     $ 1,937     $ 4,025     $ 3,801  
 

     Segment information for total assets and capital expenditures is not presented as such information is not used in measuring segment performance or allocating resources among segments.
 
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Note 8 — Investments in Franchisees
 
     As of July 31, 2011, the Company had investments in three franchisees. These investments have been made in the form of capital contributions and, in certain instances, loans evidenced by promissory notes. These investments are reflected as “Investments in equity method franchisees” in the consolidated balance sheet.
 
     The Company’s financial exposures related to franchisees in which the Company has an investment are summarized in the tables below.
 
    July 31, 2011
    Company   Investment                    
    Ownership   and         Notes   Loan
        Percentage       Advances       Receivables       Receivable       Guarantees
    (Dollars in thousands)
Kremeworks, LLC   25.0 %   $ 900     $ 367   $ -   $ 880
Kremeworks Canada, LP   24.5 %     -       29     -     -
Krispy Kreme of South Florida, LLC   35.3 %     -       186     -     1,988
            900       582     -   $ 2,868
Less: reserves and allowances           (900 )     -     -      
          $ -     $ 582   $ -      
 
 
    January 30, 2011
    Company   Investment                    
    Ownership   and         Notes   Loan
    Percentage   Advances   Receivables   Receivable   Guarantees
    (Dollars in thousands)
Kremeworks, LLC   25.0 %   $ 900     $ 270   $ -     $ 1,008
Kremeworks Canada, LP   24.5 %     -       22     -       -
Krispy Kreme of South Florida, LLC   35.3 %     -       190     -       2,161
Krispy Kreme Mexico, S. de R.L. de C.V.          30.0 %     1,663       104     391       -
                   2,563              586     391     $        3,169
Less: reserves and allowances           (900 )     -            (391 )      
          $ 1,663     $ 586   $ -        
 

     The Company has guaranteed certain loans from third-party financial institutions on behalf of Equity Method Franchisees, primarily to assist the franchisees in obtaining third-party financing. The loans are collateralized by certain assets of the franchisee, generally the Krispy Kreme store and related equipment. The loan guarantee amounts represent the portion of the principal amount outstanding under the related loan that is subject to the Company’s guarantee.
 
     Current liabilities at July 31, 2011 and January 30, 2011 include accruals for potential payments under loan guarantees of approximately $2.0 million and $2.2 million, respectively, related to Krispy Kreme of South Florida, LLC (“KKSF”). The underlying indebtedness related to approximately $1.6 million of the Company’s KKSF guarantee exposure matured by its terms in October 2009. Such maturity has been extended on a month-to-month basis pursuant to an informal agreement between KKSF and the lender.
 
     There was no liability reflected in the financial statements for other guarantees of franchisee indebtedness because the Company did not believe it was probable that the Company would be required to perform under such other guarantees.
 
     The Company has a 25% interest in Kremeworks, LLC (“Kremeworks”), and has guaranteed 20% of the outstanding principal balance of certain of Kremeworks’ bank indebtedness, which matures in October 2011. The aggregate amount of such indebtedness was approximately $4.4 million at July 31, 2011.
 
     Kremeworks’ unaudited revenues, operating loss and net loss for the three and six months ended July 31, 2011 and August 1, 2010, based upon information provided by the franchisee, are set forth in the following table.
 
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    Three Months Ended   Six Months Ended
    July 31,   August 1,   July 31,   August 1,
        2011       2010       2011       2010
    (In thousands)
Revenues   $        4,772     $        4,555     $        9,038     $        8,707  
Operating income (loss)     50       (295 )     (80 )     (632 )
Net loss     (23 )     (368 )     (220 )     (785 )

     On May 5, 2011, the Company sold its 30% equity interest in Krispy Kreme Mexico, S. de R.L. de C.V. (“KK Mexico”), the Company’s franchisee in Mexico, to KK Mexico’s majority shareholder. The Company received cash proceeds of approximately $7.7 million in exchange for its equity interest and, after deducting costs of the transaction, realized a gain of approximately $6.2 million on the disposition. After provision for payment of Mexican income taxes related to the sale of approximately $1.5 million, the Company reported an after tax gain on the disposition of approximately $4.7 million in the quarter ending July 31, 2011. The net after tax proceeds of the sale of approximately $6.2 million were used to prepay a portion of the outstanding balance of the 2011 Term Loan.
 
     In connection with the Company’s sale of its KK Mexico interest, KK Mexico paid approximately $765,000 of amounts due to the Company which were evidenced by promissory notes, relating principally to past due royalties and fees due to the Company. As a consequence of this payment, in the quarter ended May 1, 2011, the Company reversed an allowance for doubtful notes receivable of approximately $391,000 and recorded royalty and franchise fee income of approximately $280,000 and $95,000 respectively. The reserve had previously been established, and the royalties and fees had not previously been recognized as revenue, because of uncertainty surrounding the collection of these amounts.
 
Note 9 — Shareholders’ Equity
 
     The Company measures and recognizes compensation expense for share-based payment (“SBP”) awards based on their fair values. The fair value of SBP awards for which employees and directors render the requisite service necessary for the award to vest is recognized over the related vesting period.
 
     The aggregate cost of SBP awards charged to earnings for the three and six months ended July 31, 2011 and August 1, 2010 is set forth in the following table. The Company did not realize any excess tax benefits from the exercise of stock options or the vesting of restricted stock or restricted stock units during any of the periods.
 
    Three Months Ended   Six Months Ended
    July 31,   August 1,   July 31,   August 1,
        2011       2010       2011       2010
    (In thousands)
Costs charged to earnings related to:                        
       Stock options   $ 395   $ 140   $ 770   $ 504
       Restricted stock and restricted stock units     518     725     1,036     1,430
              Total costs   $ 913   $ 865   $ 1,806   $ 1,934
 
Costs included in:                        
       Direct operating expenses   $ 483   $        399   $ 965   $ 788
       General and administrative expenses     430     466     841     1,146
              Total costs   $          913   $          865   $        1,806   $        1,934
 

Note 10 — Fair Value Measurements
 
     The accounting standards for fair value measurements define fair value as the price that would be received for an asset or paid to transfer a liability in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants at the measurement date.
 
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     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.
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 July 31, 2011 and January 30, 2011.
 
    July 31, 2011
        Level 1       Level 2       Level 3
    (In thousands)
Assets:                  
       401(k) mirror plan assets   $ 1,033   $ -   $ -
       Interest rate derivative     -     220     -
       Agricultural commodity futures contracts     25     -     -
       Total assets   $      1,058   $      220   $           -
Liabilities:                  
       Gasoline commodity futures contracts   $ 13   $ -   $ -
 
    January 30, 2011
    Level 1   Level 2   Level 3
    (In thousands)
Assets:                  
       401(k) mirror plan assets   $ 796   $ -   $ -
       Agricultural commodity futures contracts     144     -     -
       Total assets   $ 940   $ -   $ -
 

Assets and Liabilities Measured at Fair Value on a Non-Recurring Basis
 
     The following tables present the nonrecurring fair value measurements recorded during the three and six months ended July 31, 2011 and August 1, 2010.
 
    Three Months Ended July 31, 2011
        Level 1       Level 2       Level 3       Total gain (loss)
    (In thousands)
Long-lived assets   $ -   $ -   $ -   $ -
Lease termination liabilities   $ -   $ -   $ -   $ -
 
    Six Months Ended July 31, 2011
    Level 1   Level 2   Level 3   Total gain (loss)
    (In thousands)
Long-lived assets   $             -   $             -   $             -   $ -
Lease termination liabilities   $ -   $ -   $ -   $ -

19
 

 

    Three Months Ended August 1, 2010
        Level 1       Level 2       Level 3       Total gain (loss)
    (In thousands)
Long-lived assets   $ -   $ 1,500   $ -   $ (50 )
Lease termination liabilities   $ -   $ 394   $ -   $ 250  
 
    Six Months Ended August 1, 2010
    Level 1   Level 2   Level 3   Total gain (loss)
    (In thousands)
Long-lived assets   $               -   $        3,638   $               -   $               (899 )
Lease termination liabilities   $ -   $ 394   $ -   $ 250  

   Long-Lived Assets
 
     During the three and six months ended August 1, 2010, long-lived assets having an aggregate carrying value of $1.6 million and $4.5 million, respectively, were written down to their estimated fair values of $1.5 million and $3.6 million, respectively, resulting in recorded impairment charges of $50,000 and $899,000, respectively. Substantially all of such long-lived assets were real properties, the fair values of which were estimated based on independent appraisals or, in the case of properties which the Company was negotiating to sell, based on the Company’s negotiations with unrelated third-party buyers. These inputs are classified as Level 2 within the valuation hierarchy.
 
   Lease Termination Liabilities
 
     During the three and six months ended August 1, 2010, the Company recorded provisions for lease termination costs related to closed stores based upon the estimated fair values of the liabilities under unexpired leases as described in Note 6; such provisions were reduced by previously recorded accrued rent expense related to those stores. The fair value of these liabilities was computed as the excess, if any, of the contractual payments required under the unexpired leases over the current market lease rates for the properties, discounted at a credit-adjusted risk-free rate over the remaining term of the leases. These inputs are classified as Level 2 within the valuation hierarchy. For the three and six months ended August 1, 2010, $644,000 of previously recorded accrued rent expense related to a store closure and a store relocation exceeded the $394,000 fair value of lease termination liabilities related to such stores, and such excess has been reflected as a credit to lease termination costs during the period.
 
Fair Values of Financial Instruments at the Balance Sheet Dates
 
     The carrying values and approximate fair values of certain financial instruments as of July 31, 2011 and January 30, 2011 were as follows:
 
    July 31, 2011   January 30, 2011
    Carrying   Fair   Carrying   Fair
        Value       Value       Value       Value
    (In thousands)
Assets:                        
       Cash and cash equivalents   $        32,324   $        32,324   $        21,970   $        21,970
       Receivables     20,569     20,569     20,261     20,261
       Interest rate derivatives     220     220     -     -
       Receivables from Equity Method Franchisees     582     582     586     586
       Agricultural commodity futures contracts     25     25     144     144
 
Liabilities:                        
       Accounts payable     11,860     11,860     9,954     9,954
       Gasoline commodity futures contracts     13     13     -     -
       Long-term debt (including current maturities)     27,671     27,671     35,387     35,387

20
 

 

Note 11 — Derivative Instruments
 
     The Company is exposed to certain risks relating to its ongoing business operations. The primary risks managed by using derivative instruments are commodity price risk and interest rate risk. The Company does not hold or issue derivative instruments for trading purposes.
 
     The Company is exposed to credit-related losses in the event of non-performance by the counterparties to its over-the-counter interest rate derivative instruments. The Company mitigates this risk of nonperformance by dealing with highly rated counterparties.
 
     Additional disclosure about the fair value of derivative instruments is included in Note 10.
 
Commodity Price Risk
 
     The Company is exposed to the effects of commodity price fluctuations in the cost of ingredients of its products, of which flour, sugar and shortening are the most significant. In order to bring greater stability to the cost of ingredients, from time to time the Company purchases exchange-traded commodity futures contracts, and options on such contracts, for raw materials which are ingredients of its products or which are components of such ingredients, including wheat and soybean oil. The Company is also exposed to the effects of commodity price fluctuations in the cost of gasoline used by its delivery vehicles. To mitigate the risk of fluctuations in the price of its gasoline purchases, the Company may purchase exchange-traded commodity futures contracts and options on such contracts. The difference between the cost, if any, and the fair value of commodity derivatives is reflected in earnings because the Company has not designated any of these instruments as hedges. Gains and losses on these contracts are intended to offset losses and gains on the hedged transactions in an effort to reduce the earnings volatility resulting from fluctuating commodity prices. The settlement of commodity derivative contracts is reported in the consolidated statement of cash flows as a cash flow from operating activities. At July 31, 2011, the Company had commodity derivatives with an aggregate contract volume of 90,000 bushels of wheat and 126,000 gallons of gasoline. Other than the requirement to meet minimum margin requirements with respect to the commodity derivatives, there are no collateral requirements related to such contracts.
 
Interest Rate Risk
 
     All of the borrowings under the Company’s secured credit facilities bear interest at variable rates based upon either the Fed funds rate, the lenders’ prime rate or LIBOR. The interest cost of the Company’s debt may be affected by changes in these short-term interest rates and increases in those rates may adversely affect the Company’s results of operations.
 
     On March 3, 2011, the Company entered into an interest rate derivative contract having an aggregate notional principal amount of $17.5 million. The derivative contract entitles the Company to receive from the counterparty the excess, if any, of the three-month LIBOR rate over 3.00% for each of the calendar quarters in the period beginning April 2012 and ending December 2015. The Company is accounting for this derivative contract as a cash flow hedge.
 
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 July 31, 2011 and January 30, 2011:
 
21
 

 

        Fair Value
        July 31,   January 30,
Derivatives Not Designated as Hedging Instruments       Balance Sheet Location       2011       2011
        (In thousands)
Asset Derivatives                
Agricultural commodity futures contracts   Other current assets   $       25   $       144
                 
Liability Derivatives                
Gasoline commodity futures contracts   Accrued liabilities   $ 13   $ -
         
        Asset Derivatives
        Fair Value
        July 31,   January 30,
Derivatives Designated as a Cash Flow Hedge   Balance Sheet Location   2011   2011
        (In thousands)
Interest rate derivative   Other assets   $ 220   $ -
                 
     The effect of derivative instruments on the consolidated statement of operations for the three and six months ended July 31, 2011 and August 1, 2010, was as follows:
 
        Amount of Derivative Gain or (Loss)
        Recognized in Income
           Three Months Ended   Six Months Ended
Derivatives Not Designated as Hedging   Location of Derivative Gain or (Loss)   July 31,   August 1,   July 31,   August 1,
Instruments   Recognized in Income      2011      2010      2011      2010
        (In thousands)
Agricultural commodity futures contracts   Direct operating expenses   $      (129 )   $      170     $      (598 )   $      241
Gasoline commodity futures contracts   Direct operating expenses     (22 )     (151 )     (9 )     130
Total       $ (151 )   $ 19     $ (607 )   $ 371
         
        Amount of Derivative Gain or (Loss)
        Recognized in Income
        Three Months Ended   Six Months Ended
Derivatives Designated as a Cash Flow   Location of Derivative Gain or (Loss)   July 31,   August 1,   July 31,   August 1,
Hedge   Recognized in OCI   2011   2010   2011   2010
        (In thousands)
Interest rate derivative   Change in fair value of derivative   $ (183 )   $ -     $ (381 )   $ -
    Less - income tax effect     73       -       151       -
    Net change in amount recognized in OCI   $ (110 )   $ -     $ (230 )   $ -
                                   
22
 

 

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

     The following discussion of the Company’s financial condition and results of operations should be read in conjunction with the consolidated financial statements and notes thereto appearing elsewhere herein.
 
Results of Operations
 
     The following table sets forth operating metrics for the three and six months ended July 31, 2011 and August 1, 2010.
 
23
 

 

    Three Months Ended   Six Months Ended
    July 31,   August 1,   July 31,   August 1,
       2011      2010      2011       2010
Change in Same Store Sales (on-premises sales only):                                        
       Company stores     2.5   %     5.7   %     4.2   %     4.5   %
       Domestic Franchise stores     6.3         5.0         5.4         3.8    
       International Franchise stores     (3.1 )       (11.4 )       (3.7 )       (9.5 )  
       International Franchise stores, in constant dollars(1)     (11.7 )       (14.3 )       (10.7 )       (16.0 )  
                                     
Change in Same Store Customer Count - Company stores (retail                                    
sales only)     (2.9 ) %     4.7   %     0.0   %     3.4   %
                                         
Off-Premises Metrics (Company stores only):                                        
       Average weekly number of doors served:                                        
              Grocers/mass merchants     5,876         5,695         5,871         5,597    
              Convenience stores     4,846         5,139         4,996         5,095    
                                         
       Average weekly sales per door:                                        
              Grocers/mass merchants   $       297       $       263       $       294       $       263    
              Convenience stores     227         206         221         207    
                                         
Systemwide Sales (in thousands):(2)                                        
       Company stores   $ 65,476       $ 59,602       $ 134,503       $ 121,790    
       Domestic Franchise stores     64,829         58,797         131,526         121,275    
       International Franchise stores     95,669         77,237         187,260         151,811    
       International Franchise stores, in constant dollars(3)     95,669         84,120         187,260         162,793    
                                         
Average Weekly Sales Per Store (in thousands):(4) (5)                                        
       Company stores:                                        
              Factory stores:                                        
                     Commissaries — off-premises   $ 203.2       $ 169.5       $ 200.8       $ 171.5    
                     Dual-channel stores:                                        
                            On-premises     28.9         27.1         31.9         29.3    
                            Off-premises     46.7         39.2         46.6         38.9    
                                   Total     75.6         66.3         78.5         68.2    
                     On-premises only stores     30.1         31.1         32.0         32.5    
                     All factory stores     67.8         63.1         69.8         64.6    
              Satellite stores     19.3         17.7         19.8         18.2    
              All stores     58.1         55.6         60.3         57.0    
                                         
       Domestic Franchise stores:                                        
              Factory stores   $ 43.0       $ 40.0       $ 43.9       $ 40.8    
              Satellite stores     15.3         12.2         15.0         12.6    
                                         
       International Franchise stores:                                        
              Factory stores   $ 44.0       $ 39.6       $ 45.0       $ 39.7    
              Satellite stores     11.0         8.6         10.4         8.8    

(1)        Represents the change in International Franchise same store sales computed by reconverting franchise store sales in each foreign currency to U.S. dollars at a constant rate of exchange for each period.
(2)   Excludes sales among Company and franchise stores.
(3)   Represents International Franchise store sales computed by reconverting International Franchise store sales for the three and six months ended August 1, 2010 to U.S. dollars based upon the weighted average of the exchange rates prevailing in the three and six months ended July 31, 2011.
(4)   Includes sales between Company and franchise stores.
(5)   Metrics for the three and six months ended July 31, 2011 include only stores open at July 31, 2011 and metrics for the three and six months ended August 1, 2010 include only stores open at August 1, 2010.
 
24
 

 

     The change in “same store sales” is computed by dividing the aggregate on-premises sales (including fundraising sales) during the current year period for all stores which had been open for more than 56 consecutive weeks during the current year (but only to the extent such sales occurred in the 57th or later week of each store’s operation) by the aggregate on-premises sales of such stores for the comparable weeks in the preceding year. Once a store has been open for at least 57 consecutive weeks, its sales are included in the computation of same store sales for all subsequent periods. In the event a store is closed temporarily (for example, for remodeling) and has no sales during one or more weeks, such store’s sales for the comparable weeks during the earlier or subsequent period are excluded from the same store sales computation. The change in same store customer count is similarly computed, but is based upon the number of retail transactions reported in the Company’s point-of-sale system.
 
     For off-premises sales, “average weekly number of doors” represents the average number of customer locations to which product deliveries were made during a week, and “average weekly sales per door” represents the average weekly sales to each such location.
 
     Systemwide sales, a non-GAAP financial measure, include sales by both Company and franchise stores. The Company believes systemwide sales data are useful in assessing the overall performance of the Krispy Kreme brand and, ultimately, the performance of the Company. The Company’s consolidated financial statements appearing elsewhere herein include sales by Company stores, sales to franchisees by the KK Supply Chain business segment, and royalties and fees received from franchise stores based on their sales, but exclude sales by franchise stores to their customers.
 
     The following table sets forth data about the number of systemwide stores as of July 31, 2011 and August 1, 2010.
 
    July 31,   August 1,
        2011       2010
Number of Stores Open At Period End:        
       Company stores:        
              Factory:        
                     Commissaries   6   6
                     Dual-channel stores   35   38
                     On-premises only stores   29   25
              Satellite stores   18   15
                            Total Company stores   88   84
         
       Domestic Franchise stores:        
              Factory stores   103   102
              Satellite stores   45   38
                     Total Domestic Franchise stores   148   140
         
       International Franchise stores:        
              Factory stores   111   103
              Satellite stores   322   306
                     Total International Franchise stores   433   409
         
                            Total systemwide stores              669              633
         
25
 

 

     The following table sets forth data about the number of store operating weeks for the three and six months ended July 31, 2011 and August 1, 2010.
 
    Three Months Ended   Six Months Ended
    July 31,   August 1,   July 31,   August 1,
        2011       2010       2011       2010
Store Operating Weeks:                
       Company stores:                
              Factory stores:                
                     Commissaries   78   82   156   160
                     Dual-channel stores   455   494   910   988
                     On-premises only stores   377   325   754   650
              Satellite stores   226   182   425   364
                 
       Domestic Franchise stores:(1)                
              Factory stores   1,321   1,330   2,634   2,669
              Satellite stores   542   463   1,063   918
                 
       International Franchise stores:(1)                
              Factory stores   1,157   1,108   2,302   2,164
              Satellite stores           4,043           3,894           7,897           7,493

(1)         Metrics for the three and six months ended July 31, 2011 include only stores open at July 31, 2011 and metrics for the three and six months ended August 1, 2010 include only stores open at August 1, 2010.
 
     The following table sets forth the types and locations of Company stores as of July 31, 2011.
 
    Number of Company Stores
    Factory            
State       Stores       Hot Shops       Fresh Shops       Total
Alabama   3   -   -   3
District of Columbia   -   1   -   1
Florida   4   -   -   4
Georgia   6   4   -   10
Indiana   3   1   -   4
Kansas   3   -   -   3
Kentucky   3   1   -   4
Louisiana   1   -   -   1
Maryland   2   -   -   2
Michigan   3   -   -   3
Mississippi   1   -   -   1
Missouri   4   -   -   4
New York   -   -   1   1
North Carolina   11   4   -   15
Ohio   6   -   -   6
South Carolina   2   3   -   5
Tennessee   8   3   -   11
Texas   3   -   -   3
Virginia   6   -   -   6
West Virginia   1   -   -   1
Total            70            17            1            88
                 
26
 

 

     Changes in the number of Company stores during the three and six months ended July 31, 2011 and August 1, 2010 are summarized in the table below.
 
    Number of Company Stores
    Factory                
        Stores       Hot Shops       Fresh Shops       Total
Three months ended July 31, 2011                    
May 1, 2011   69   16     1   86  
Opened   -   2     -   2  
Closed   -   -     -   -  
Change in store type   1   (1 )   -   -  
July 31, 2011   70   17     1   88  
                     
Six months ended July 31, 2011                    
January 30, 2011   69   15     1   85  
Opened   -   3     -   3  
Closed   -   -     -   -  
Change in store type   1   (1 )   -   -  
July 31, 2011   70   17     1   88  
                     
Three months ended August 1, 2010                    
May 2, 2010   69   12     2   83  
Opened   -   2     -   2  
Closed   -   (1 )   -   (1 )
August 1, 2010   69   13     2   84  
                     
Six months ended August 1, 2010                    
January 31, 2010   69   12     2   83  
Opened   -   2     -   2  
Closed   -   (1 )   -   (1 )
August 1, 2010              69              13                2              84  
                     
27
 

 

     The following table sets forth the types and locations of domestic franchise stores as of July 31, 2011.
 
    Number of Domestic Franchise Stores
    Factory            
State       Stores       Hot Shops       Fresh Shops       Total
Alabama   6   3   -   9
Arizona   2   -   6   8
Arkansas   2   -   -   2
California   12   -   4   16
Colorado   2   -   -   2
Connecticut   1   -   3   4
Florida   11   6   1   18
Georgia   7   4   -   11
Hawaii   1   -   -   1
Idaho   1   -   -   1
Illinois   4   -   -   4
Iowa   1   -   -   1
Louisiana   3   -   -   3
Mississippi   2   1   -   3
Missouri   2   1   -   3
Nebraska   1   -   1   2
Nevada   3   1   3   7
New Mexico   1   -   1   2
North Carolina   7   1   -   8
Oklahoma   3   -   1   4
Oregon   2   -   -   2
Pennsylvania   4   2   1   7
South Carolina   6   2   1   9
Tennessee   1   -   -   1
Texas   7   1   1   9
Utah   2   -   -   2
Washington   8   -   -   8
Wisconsin   1   -   -   1
Total           103           22           23           148
                 
28
 

 

     Changes in the number of domestic franchise stores during the three and six months ended July 31, 2011 and August 1, 2010 are summarized in the table below.
 
    Number of Domestic Franchise Stores
    Factory                  
        Stores       Hot Shops       Fresh Shops       Total
Three months ended July 31, 2011                        
May 1, 2011   101     19     25     145  
Opened   2     3     -     5  
Closed   -     -     (2 )   (2 )
July 31, 2011   103     22     23     148  
                         
Six months ended July 31, 2011                        
January 30, 2011   102     17     25     144  
Opened   2     6     1     9  
Closed   (1 )   (1 )   (3 )   (5 )
July 31, 2011   103     22     23     148  
                         
Three months ended August 1, 2010                        
May 2, 2010   103     14     23     140  
Opened   -     1     1     2  
Closed   (1 )   -     (1 )   (2 )
August 1, 2010   102     15     23     140  
                         
Six months ended August 1, 2010                        
January 31, 2010   104     14     23     141  
Opened   -     1     1     2  
Closed   (2 )   -     (1 )   (3 )
August 1, 2010           102                  15                  23             140  
                         
29
 

 

     The types and locations of international franchise stores as of July 31, 2011 are summarized in the table below.
 
    Number of International Franchise Stores
    Fiscal                    
    Year First   Factory                
Country       Store Opened       Stores       Hot Shops       Fresh Shops       Kiosks       Total
Australia   2004   6   1   11   10   28
Bahrain   2009   1   -   2   4   7
Canada   2002   4   -   1   -   5
China   2010   1   -   -   -   1
Dominican Republic   2011   1   -   -   -   1
Indonesia   2007   2   -   3   6   11
Japan   2007   15   -   13   -   28
Kuwait   2007   3   -   22   2   27
Lebanon   2009   2   -   6   2   10
Malaysia   2010   2   1   1   1   5
Mexico   2004   5   1   26   31   63
Philippines   2007   4   3   14   2   23
Puerto Rico   2009   5   -   -   -   5
Qatar   2008   2   -   3   1   6
Saudi Arabia   2008   8   -   64   12   84
South Korea   2005   33   1   14   -   48
Thailand   2011   2   -   -   -   2
Turkey   2010   1   -   10   2   13
United Arab Emirates   2008   2   -   18   1   21
United Kingdom   2004   12   4   21   8   45
Total                 111             11             229             82             433
                         
30
 

 

     Changes in the number of international franchise stores during the three and six months ended July 31, 2011 and August 1, 2010 are summarized in the table below.
 
    Number of International Franchise Stores
    Factory                      
        Stores       Hot Shops       Fresh Shops       Kiosks       Total
Three months ended July 31, 2011                            
May 1, 2011   109     11   223     78     421  
Opened   3     -   9     5     17  
Closed   (1 )   -   (3 )   (1 )   (5 )
July 31, 2011   111     11   229     82     433  
 
Six months ended July 31, 2011                            
January 30, 2011   106     11   222     78     417  
Opened   7     -   16     10     33  
Closed   (2 )   -   (9 )   (6 )   (17 )
July 31, 2011   111     11   229     82     433  
 
Three months ended August 1, 2010                            
May 2, 2010   100     14   201     78     393  
Opened   4     -   14     -     18  
Closed   (1 )   -   (1 )   -     (2 )
August 1, 2010   103     14   214     78     409  
 
Six months ended August 1, 2010                            
January 31, 2010   95     14   180     69     358  
Opened   11     -   38     10     59  
Closed   (3 )   -   (4 )   (1 )   (8 )
August 1, 2010         103           14             214           78           409  
                             
Three months ended July 31, 2011 compared to three months ended August 1, 2010
 
   Overview
 
     Total revenues rose by 11.4% to $98.0 million for the three months ended July 31, 2011 compared to $87.9 million for the three months ended August 1, 2010.
 
     Consolidated operating income increased to $4.9 million in the three months ended July 31, 2011 from $4.2 million in the three months ended August 1, 2010. Consolidated net income was $8.8 million in the three months ended July 31, 2011 compared to $2.2 million in the three months ended August 1, 2010.
 
     Revenues by business segment (expressed in dollars and as a percentage of total revenues) are set forth in the table below (percentage amounts may not add to totals due to rounding).
 
31
 

 

    Three Months Ended
    July 31,   August 1,
        2011       2010
    (Dollars in thousands)
Revenues by business segment:                    
       Company Stores   $ 65,992       $ 59,970    
       Domestic Franchise     2,349         2,074    
       International Franchise     5,352         4,009    
       KK Supply Chain:                    
              Total revenues     50,341         44,892    
              Less - intersegment sales elimination     (26,082 )       (23,013 )  
                     External KK Supply Chain revenues
    24,259         21,879    
                            Total revenues   $ 97,952       $ 87,932    
   
Segment revenues as a percentage of total revenues:                    
       Company Stores     67.4   %     68.2   %
       Domestic Franchise     2.4         2.4    
       International Franchise     5.5         4.6    
       KK Supply Chain (external sales)     24.8         24.9    
      100.0   %     100.0   %
   
Operating income (loss):                    
       Company Stores   $ (1,049 )     $ (1,734 )  
       Domestic Franchise     216         1,041    
       International Franchise     3,409         2,500    
       KK Supply Chain     7,745         7,329    
              Total segment operating income     10,321         9,136    
       Unallocated general and administrative expenses     (5,083 )       (5,197 )  
       Impairment charges and lease termination costs     (301 )       216    
                     Consolidated operating income
  $      4,937       $      4,155    
                     
     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).
 
32
 

 

                    Percentage of Total Revenues
    Three Months Ended   Three Months Ended
    July 31,   August 1,   July 31,   August 1,
        2011       2010       2011       2010
    (In thousands)                
Revenues:                                
       On-premises sales:                                
              Retail sales   $ 26,374     $ 24,023     40.0   %   40.1   %
              Fundraising sales     2,569       2,707     3.9       4.5    
                     Total on-premises sales     28,943       26,730     43.9       44.6    
       Off-premises sales:                                
              Grocers/mass merchants
    22,468       19,361     34.0       32.3    
              Convenience stores
    13,800       13,232     20.9       22.1    
              Other off-premises
    781       647     1.2       1.1    
                     Total off-premises sales     37,049       33,240     56.1       55.4    
                            Total revenues     65,992       59,970     100.0       100.0    
   
Operating expenses:                                
       Cost of sales:                                
              Food, beverage and packaging     25,680       22,440     38.9       37.4    
              Shop labor     12,484       12,261     18.9       20.4    
              Delivery labor     5,797       5,305     8.8       8.8    
              Employee benefits     4,567       4,185     6.9       7.0    
                     Total cost of sales     48,528       44,191     73.5       73.7    
              Vehicle costs(1)     4,426       3,526     6.7       5.9    
              Occupancy(2)     2,323       2,365     3.5       3.9    
              Utilities expense          1,500       1,500     2.3       2.5    
              Depreciation expense     1,689       1,459     2.6       2.4    
              Other operating expenses     4,268       4,413     6.5       7.4    
                     Total store level costs     62,734       57,454     95.1       95.8    
       Store operating income     3,258       2,516     4.9       4.2    
       Other segment operating costs(3)     3,182       3,125     4.8       5.2    
       Allocated corporate overhead     1,125       1,125     1.7       1.9    
Segment operating income (loss)   $      (1,049 )   $      (1,734 )           (1.6 ) %           (2.9 ) %
                                 
(1)       Includes fuel, maintenance and repairs, rent, taxes and other costs of operating the delivery fleet, exclusive of depreciation.
(2)       Includes rent, property taxes, common area maintenance charges, insurance, building maintenance and other occupancy costs, exclusive of utilities and depreciation.
(3)       Includes marketing costs not charged to stores, segment management costs, off-premises selling expenses and support functions.
 
     A reconciliation of Company Stores segment sales from the second quarter of fiscal 2011 to the second quarter of fiscal 2012 follows:
 
        On-Premises       Off-Premises       Total
    (In thousands)
Sales for the three months ended August 1, 2010   $ 26,730     $ 33,240   $ 59,970  
Fiscal 2011 sales at closed stores     (227 )     -     (227 )
Increase in sales at mature stores (open stores only)     839       3,809     4,648  
Increase in sales at stores opened in fiscal 2011     522       -     522  
Sales at stores opened in fiscal 2012     1,079       -     1,079  
Sales for the three months ended July 31, 2011   $      28,943     $      37,049   $      65,992  
                       
     Sales at Company Stores increased 10.0% in the second quarter of fiscal 2012 from the second quarter of fiscal 2011 due to an increase in sales from existing stores and stores opened in fiscal 2011 and 2012. Selling price increases in the on-premises and off-premises distribution channels accounted for approximately 7.5 percentage points of the increase in sales, exclusive of the effects of higher pricing on unit volumes; such effects are difficult to measure reliably.
 
33
 

 

     The following table presents sales metrics for Company stores:
 
    Three Months Ended
    July 31,   August 1,
        2011       2010
On-premises:                
              Change in same store sales   2.5   %   5.7   %
              Change in same store customer count (retail sales only)   (2.9 ) %   4.7   %
Off-premises:                
       Grocers/mass merchants:                
              Change in average weekly number of doors   3.2   %   1.7   %
              Change in average weekly sales per door   12.9   %   6.9   %
       Convenience stores:                
              Change in average weekly number of doors   (5.7 ) %   (2.4 ) %
              Change in average weekly sales per door          10.2   %          (1.0 ) %

   On-premises sales
 
     The components of the change in same store sales at Company stores are as follows:
 
    Three Months Ended
    July 31,   August 1,
        2011       2010
Change in same store sales:                
       Pricing   8.3   %   3.5   %
       Guest check average (exclusive of the effects of pricing)   (2.7 )     (2.4 )  
       Customer count   (2.6 )     4.2    
       Other   (0.5 )     0.4    
              Total          2.5   %          5.7   %
                 
     On March 7, 2011, the Company implemented price increases at substantially all its stores designed to help offset the rising costs of doughnut mixes, other ingredients and fuel resulting from higher commodity prices. The price increases, which affect approximately 60% of on-premises sales, averaged approximately 14%.
 
     The Company believes that the expected cannibalization effect of new stores in expansion markets adversely affected same store customer count in the second quarter of fiscal 2012. “Cannibalization effect” means the tendency for new stores to become successful, in part or in whole, by “stealing” sales from existing stores in the same market.
 
     The Company continues to implement programs intended to improve on-premises sales, including increased focus on local store marketing efforts, improved employee training, store refurbishment efforts and the introduction of new products.
 
   Off-premises sales
 
     Off-premises sales increased 11.5% to $37.0 million in the second quarter of fiscal 2012 from $33.2 million in the second quarter of fiscal 2011. Approximately 7.0 percentage points of the sales increase reflects price increases, including not only increases implemented in the first quarter of fiscal 2012 but also price increases implemented in fiscal 2011. The Company’s sales increase was greater than that of the doughnut industry as a whole, according to industry data. The Company started implementing price increases for some products offered in the off-premises channel mid-April 2011, and substantially completed implementing the increases during the second quarter. Those price increases affect products comprising approximately 60% of off-premises sales, and the average price increase on those products was approximately 11%.
 
     Sales to grocers and mass merchants increased 16.0% to $22.5 million, with a 12.9% increase in average weekly sales per door and a 3.2% increase in the average number of doors served. In addition to pricing, the Company believes that average weekly sales per door in the grocer/mass merchant channel have grown as a result of, among other things, improved customer service, introduction of additional price points, a redesign of product packaging to improve its shelf appeal, and the addition of new relatively higher volume doors. Convenience store sales rose 4.3% to $13.8 million, reflecting a 10.2% increase in the average weekly sales per door partially offset by a 5.7% decline in the average number of doors served. The decline in the average number of doors served in the convenience store channel in the second quarter reflects route management efforts to eliminate deliveries to relatively low volume doors.
 
34
 

 

     The Company is implementing strategies designed to improve sales through convenience stores, including offering additional price points and increasing the quantity and assortment of packaged products offered in this channel. In addition, the Company is seeking to shift customers in the convenience store channel to sales agreements which provide that the Company will absorb unsold product rather than the retailer. While this strategy will increase the cost of product returns, the Company believes that the increase will be more than offset by higher unit pricing and, because the Company will have much greater control over product assortment and quantities merchandised, increased unit sales from both existing products and packaged products not traditionally offered through convenience stores.
 
   Costs and expenses
 
     Cost of sales as a percentage of revenues declined by 0.2 percentage points from the second quarter of fiscal 2011 to 73.5% of revenues in the second quarter of fiscal 2012.
 
     Before considering the potential loss of unit volume as a result of on-premises and off-premises selling price increases, those increases more than offset higher costs of food, beverages and packaging in the second quarter of fiscal 2012. The effects of price increases on unit volumes are difficult to measure reliably. The Company currently estimates that input costs, excluding fuel and sugar, for the remainder of fiscal 2012 will be modestly higher than the levels of the first half of the year. As previously disclosed, sugar costs, however, are expected to rise approximately $2 million over the balance of fiscal 2012. Sugar costs are expected to decline modestly in fiscal 2013; the Company’s existing sugar contracts cover volume expected to last through approximately the end of the second quarter of fiscal 2013.
 
     Shop labor as a percentage of revenues declined by 1.5 percentage points from the second quarter of fiscal 2011 to 18.9% of revenues in the second quarter of fiscal 2012, principally due to higher sales resulting from price increases.
 
     Vehicle costs as a percentage of revenues increased from 5.9% of revenues in the second quarter of fiscal 2011 to 6.7% of revenues in the second quarter of fiscal 2012, principally as a result of higher fuel costs and higher expense of leased delivery trucks in the second quarter of fiscal 2012 compared to the second quarter of fiscal 2011. This increase was partially offset by a decrease in repairs and maintenance expense in the second quarter of fiscal 2012 as a result of the Company replacing a portion of its aging delivery fleet.
 
     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 the 2011 Form 10-K, and periodically updates actuarial valuations of its self-insurance reserves. 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. As a result of the Company’s periodic update of its actuarial valuation, during the second quarter of both fiscal 2012 and fiscal 2011, the Company recorded favorable adjustments to its self-insurance claims liabilities related to prior policy years of approximately $500,000 in the second quarter of fiscal 2012 and $690,000 in the second quarter of fiscal 2011. Substantially all of the $500,000 in favorable adjustments recorded in the second quarter of fiscal 2012 relates to workers’ compensation liability claims and is included in employee benefits in the table above. Of the $690,000 in favorable adjustments recorded in the second quarter of fiscal 2011, approximately $640,000 relates to workers’ compensation liability claims and approximately $50,000 relates to vehicle liability claims included in vehicle costs in the table above.
 
     The Company continues to implement 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.
 
     The Company Stores segment closed two stores since the end of fiscal 2010, neither of which was accounted for as discontinued operations because the Company continues to have significant continuing involvement in the markets in which the stores were located, through either continuing operations of other stores in or serving the market or through its role 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 July 31, 2011, and excludes the revenues and expenses for stores closed prior to that date. Percentage amounts may not add to totals due to rounding.
 
35
 

 

    Stores in Operation at July 31, 2011
                    Percentage of Total Revenues
    Three Months Ended   Three Months Ended
    July 31,   August 1,   July 31,   August 1,
        2011       2010       2011       2010
    (In thousands)            
Revenues:                            
       On-premises sales:                            
              Retail sales
  $ 26,374     $ 23,845     40.0 %   39.9 %
              Fundraising sales
    2,569       2,658     3.9     4.4  
                     Total on-premises sales     28,943       26,503     43.9     44.4  
       Off-premises sales:                            
              Grocers/mass merchants
    22,468       19,361     34.0     32.4  
              Convenience stores
    13,800       13,232     20.9     22.1  
              Other off-premises
    781       647     1.2     1.1  
                     Total off-premises sales     37,049       33,240     56.1     55.6  
                            Total revenues     65,992       59,743     100.0     100.0  
 
Operating expenses:                            
       Cost of sales:                            
              Food, beverage and packaging
    25,680       22,336     38.9     37.4  
              Shop labor
    12,484       12,189     18.9     20.4  
              Delivery labor
    5,797       5,305     8.8     8.9  
              Employee benefits
    4,567       4,163     6.9     7.0  
                     Total cost of sales     48,528       43,993     73.5     73.6  
              Vehicle costs
    4,426       3,515     6.7     5.9  
              Occupancy
    2,314       2,226     3.5     3.7  
              Utilities expense
    1,499       1,482     2.3     2.5  
              Depreciation expense
    1,689       1,448     2.6     2.4  
              Other operating expenses
    4,266       4,375     6.5     7.3  
                     Total store level costs     62,722       57,039     95.0     95.5  
              Store operating income - ongoing stores
    3,270       2,704                 5.0 %               4.5 %
              Store operating loss - closed stores
    (12 )     (188 )            
Store operating income   $      3,258     $      2,516              
                             
   Domestic Franchise
 
    Three Months Ended
    July 31,   August 1,
        2011       2010
    (In thousands)
Revenues:            
       Royalties   $ 2,136   $ 1,945
       Development and franchise fees     105     20
       Other     108     109
              Total revenues     2,349     2,074
 
Operating expenses:            
       Segment operating expenses     1,978     878
       Depreciation expense     55     55
       Allocated corporate overhead     100     100
              Total operating expenses     2,133     1,033
Segment operating income   $      216   $      1,041
             
36
 

 

     Domestic Franchise revenues increased 13.3% to $2.3 million in the second quarter of fiscal 2012 from $2.1 million in the second quarter of fiscal 2011. The increase reflects higher domestic royalty revenues resulting from an increase in sales by domestic franchise stores from $59 million in the second quarter of fiscal 2011 to $65 million in the second quarter of fiscal 2012. Domestic Franchise same store sales rose 6.3% in the second quarter of fiscal 2012.
 
     Domestic Franchise operating expenses include costs to recruit new domestic franchisees, to assist in domestic store openings, and to monitor and aid in the performance of domestic franchise stores, as well as allocated corporate costs. The increase     in Domestic Franchise operating expenses reflects a provision of $820,000 recorded in the second quarter of fiscal 2012 for payments under a lease guarantee associated with a franchisee whose franchise agreements the Company terminated during the quarter, as well as an increase in franchisee support costs.
 
     Domestic franchisees opened five stores and closed two stores in the second quarter of fiscal 2012. As of August 24, 2011, existing development and franchise agreements for territories in the United States provide for the development of approximately 30 additional stores in the remainder of fiscal 2012 and thereafter. Royalty revenues are directly related to sales by franchise stores and, accordingly, the success of franchisees’ operations has a direct effect on the Company’s revenues, results of operations and cash flows.
 
   International Franchise
 
    Three Months Ended
    July 31,   August 1,
        2011       2010
    (In thousands)
Revenues:            
       Royalties   $ 5,129   $ 3,687
       Development and franchise fees     223     322
              Total revenues     5,352     4,009
 
Operating expenses:            
       Segment operating expenses     1,616     1,182
       Depreciation expense     2     2
       Allocated corporate overhead     325     325
              Total operating expenses     1,943     1,509
Segment operating income   $      3,409   $      2,500
             
     International Franchise royalties increased 39.1%, driven by an increase in sales by international franchise stores from $77 million in the second quarter of fiscal 2011 to $96 million in the second quarter of fiscal 2012. Changes in the rates of exchange between the U.S. dollar and the foreign currencies in which the Company’s international franchisees do business increased sales by international franchisees measured in U.S. dollars by approximately $7.8 million in the second quarter of fiscal 2012 compared to the second quarter of fiscal 2011, which positively affected international royalty revenues by approximately $470,000. The Company did not recognize as revenue approximately $600,000 of uncollected royalties which accrued during the second quarter of fiscal 2011 because the Company did not believe collection of these royalties was reasonably assured. Substantially all of the unrecognized royalties in the first six months of fiscal 2011 related to the Company’s Australian franchisee, which commenced a voluntary administration process (similar to a bankruptcy filing in the U.S.) in October 2010. In connection with that process, in November 2010, the franchisee closed 24 of the 53 shops the franchisee operated prior to the reorganization.
 
     International Franchise same store sales, measured on a constant currency basis to remove the effects of changing exchange rates between foreign currencies and the U.S. dollar (“constant dollar same store sales”), fell 11.7%. The decline in International Franchise same store sales reflects, among other things, waning honeymoon effects from the large number of new stores opened internationally in recent years and the cannibalization effects on initial stores in new markets of additional store openings in those markets. “Honeymoon effect” means the common pattern for many start-up restaurants in which a flurry of activity due to start-up publicity and natural curiosity is followed by a decline during which a steady repeat customer base develops.
 
     Constant dollar same store sales in established markets increased 1.0% in the second quarter of fiscal 2012 and fell 22.9% in new markets. “Established markets” means countries in which the first Krispy Kreme store opened before fiscal 2006. Sales at stores in established markets comprised approximately 53% of aggregate constant dollar same store sales for the second quarter of fiscal 2012. While the Company considers countries in which Krispy Kreme first opened in fiscal 2005 and earlier to be established markets, franchisees in those markets continue to develop their business; these franchisees opened 220 of the 507 international stores opened since the beginning of fiscal 2006.
 
37
 

 

     International franchise sales for the three months ended July 31, 2011 were adversely affected by the aftereffects of the March 2011 tsunami in Japan.
 
     International Franchise operating expenses include costs to recruit new international franchisees, to assist in international store openings, and to monitor and aid in the performance of international franchise stores, as well as allocated corporate costs. International Franchise operating expenses increased in the second quarter of fiscal 2012 compared to the second quarter of fiscal 2011 primarily due to an increase in legal fees and an increase in share based compensation expense. The increase also includes a $90,000 increase in the provision for incentive compensation in the second quarter of fiscal 2012 compared to the second quarter of fiscal 2011.
 
     International franchisees opened 17 stores and closed five stores in the second quarter of fiscal 2012. As of August 24, 2011, existing development and franchise agreements for territories outside the United States provide for the development of approximately 230 additional stores in the remainder of fiscal 2012 and thereafter. Royalty revenues are directly related to sales by franchise stores and, accordingly, the success of franchisees’ operations has a direct effect on the Company’s revenues, results of operations and cash flows.
 
   KK Supply Chain
 
     The components of KK Supply Chain revenues and expenses (expressed in dollars and as a percentage of total revenues before intersegment sales elimination) are set forth in the table below (percentage amounts may not add to totals due to rounding).
 
                  Percentage of Total Revenues
                  Before Intersegment
                  Sales Elimination
    Three Months Ended   Three Months Ended
    July 31,   August 1,   July 31,   August 1,
        2011       2010       2011       2010
    (In thousands)              
Revenues:                            
       Doughnut mixes
  $ 16,562   $ 15,147     32.9 %   33.7   %
       Other ingredients, packaging and supplies
    30,795     28,223     61.2     62.9    
       Equipment
    2,356     1,333     4.7     3.0    
       Fuel surcharge
    628     189     1.2     0.4    
              Total revenues before intersegment sales elimination
    50,341     44,892     100.0     100.0    
   
Operating expenses:                            
       Cost of sales:
                           
              Cost of goods produced and purchased
    34,379     30,295     68.3     67.5    
              (Gain) loss on agricultural derivatives
    129     (170 )   0.3     (0.4 )  
              Inbound freight
    1,043     902     2.1     2.0    
                     Total cost of sales     35,551     31,027     70.6     69.1    
       Distribution costs:
                           
              Outbound freight
    2,756     2,611     5.5     5.8    
              Other distribution costs
    964     883     1.9     2.0    
                     Total distribution costs     3,720     3,494     7.4     7.8    
       Other segment operating costs
    2,862     2,562     5.7     5.7    
       Depreciation expense
    188     205     0.4     0.5    
       Allocated corporate overhead
    275     275     0.5     0.6    
              Total operating costs
    42,596     37,563     84.6     83.7    
Segment operating income   $      7,745   $      7,329               15.4 %             16.3   %
                             
     KK Supply Chain revenues before intersegment sales elimination increased $5.4 million, or 12.1%, in the second quarter of fiscal 2012 compared to the second quarter of fiscal 2011. The increase reflects selling price increases for doughnut mix, sugar, shortening and certain other ingredients instituted by KK Supply Chain in order to pass along to Company and franchise stores increases in KK Supply Chain’s cost of sugar, flour and shortening.
 
     The Company utilizes a fuel surcharge program to recoup additional freight costs resulting from increases in fuel costs. Charges under the program are based upon the price of diesel fuel, with the price benchmark reset each fiscal year.
 
38
 

 

     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.
 
     The increase in cost of goods produced and purchased as a percentage of sales in the second quarter of fiscal 2012 compared to the second quarter of fiscal 2011 reflects, among other things, an increase in the cost of agricultural commodities used in the production of doughnut mix and of other goods sold to Company and franchise stores. In particular, the prices of flour, shortening and sugar and the products from which they are made were significantly higher in the second quarter of fiscal 2012 compared to the second quarter of fiscal 2011. KK Supply Chain increased the prices charged to Company and franchise stores for doughnut mix, shortening, sugar and other goods in order to mitigate increases in the cost of certain raw materials. However, KK Supply Chain margins were adversely affected because, while the Company increased prices to cover higher costs, the Company did not raise prices to earn a proportionate gross profit on all of its higher costs.
 
     Other segment operating costs include segment management, purchasing, customer service and support, laboratory and quality control costs, and research and development expenses.
 
     Franchisees opened 22 stores and closed seven stores in the second quarter of fiscal 2012. A substantial portion of KK Supply Chain’s revenues are directly related to sales by franchise stores and, accordingly, the success of franchisees’ operations has a direct effect on the Company’s revenues, results of operations and cash flows.
 
   General and Administrative Expenses
 
     General and administrative expenses remained relatively unchanged at $4.9 million, or 5.0% of total revenues, in the second quarter of fiscal 2012 compared to $5.0 million, or 5.7% of total revenues in the second quarter of fiscal 2011. The Company is seeking to minimize general and administrative expenses in order to gain operating leverage as its revenues rise.
 
   Impairment Charges and Lease Termination Costs
 
     Impairment charges and lease termination costs were $301,000 in the second quarter of fiscal 2012 compared to a credit of $216,000 in the second quarter of fiscal 2011. The components of these charges are set forth in the following table:
 
    Three Months Ended
    July 31,   August 1,
    2011   2010
        (In thousands)
Impairment of long-lived assets:                  
       Current period charges   $ -   $ 50  
       Adjustments to previously recorded estimates     -     (190 )
              Total impairment of long-lived assets     -     (140 )
Lease termination costs     301     (76 )
    $      301   $      (216 )
               
     Impairment charges relate to the Company Stores segment. The Company tests long-lived assets for impairment when events or changes in circumstances indicate that their carrying value may not be recoverable. These events and changes in circumstances include store closing and refranchising decisions, the effects of changing costs on current results of operations, observed trends in operating results, and evidence of changed circumstances observed as a part of periodic reforecasts of future operating results and as part of the Company’s annual budgeting process. Impairment charges generally relate to stores expected to be closed or refranchised, as well as to stores management believes will not generate sufficient future cash flows to enable the Company to recover the carrying value of the stores’ assets, but which management has not yet decided to close. When the Company concludes that the carrying value of long-lived assets is not recoverable (based on future projected undiscounted cash flows), the Company records impairment charges to reduce the carrying value of those assets to their estimated fair values. The fair values of these assets are estimated based on the present value of estimated future cash flows, on independent appraisals and, in the case of assets the Company currently is negotiating to sell, based on the Company’s negotiations with unrelated third-party buyers. During the second quarter of fiscal 2011, a long-lived asset that had been previously written down to a carrying value of $1.0 million was sold for $1.2 million, resulting in a gain of $190,000 that was recorded as a credit to impairment charges.
 
     Lease termination costs represent the estimated fair value of liabilities related to unexpired leases, after reduction by the amount of accrued rent expense, if any, related to the leases, and are recorded when the lease contracts are terminated or, if earlier, the date on which the Company ceases use of the leased property. The fair value of these liabilities were estimated as the excess, if any, of the contractual payments required under the unexpired leases over the current market lease rates for the properties, discounted at a credit-adjusted risk-free rate over the remaining term of the leases. The provision for lease termination costs also includes adjustments to liabilities recorded in prior periods arising from changes in estimated sublease rentals and from settlements with landlords.
 
39
 

 

     In the second quarter of fiscal 2012, the Company recorded lease termination charges of $301,000, principally reflecting a change in estimated sublease rentals and settlements with landlords on stores previously closed. In the second quarter of fiscal 2011, the Company recorded a net credit to lease termination costs of $76,000, reflecting charges related to a store closure and a store relocation, offset by the reversal of previously recorded accrued rent related to those stores.
 
     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.
 
     Since the beginning of fiscal 2009, the Company has refranchised a total of 11 stores and received consideration totaling $2.5 million in connection with those transactions. During this period, the Company recorded impairment charges totaling approximately $490,000 related to completed and anticipated refranchisings. The Company cannot predict the likelihood of refranchising any additional stores or markets or the amount of proceeds, if any, which might be received therefrom, including the amounts which might be realized from the sale of store assets and the execution of any related franchise agreements. Refranchising could result in the recognition of additional impairment losses on the related assets.
 
   Interest Expense
 
     The components of interest expense are as follows:
 
    Three Months Ended
    July 31,   August 1,
        2011       2010
    (In thousands)
Interest accruing on outstanding indebtedness   $ 202   $ 1,238  
Letter of credit and unused revolver fees     89     185  
Amortization of deferred financing costs     116     164  
Other     7     (20 )
    $      414   $      1,567  
               
     The decrease in interest accruing on outstanding indebtedness and in letter of credit and unused revolver fees reflects the substantial reduction in lender margin on the Company’s credit facilities resulting from the refinancing of those facilities in January 2011, as more fully described in Note 4 to the consolidated financial statements appearing elsewhere herein, as well as the reduction in the principal outstanding under the Company’s term loan. The lender margin on outstanding term debt and on outstanding letters of credit was reduced from 750 basis points to 250 basis points as a result of the refinancing.
 
   Equity in Income (Losses) of Equity Method Franchisees
 
     The Company recorded equity in the earnings of equity method franchisees of $12,000 in the second quarter of fiscal 2012 compared to losses of $165,000 in the second quarter of fiscal 2011. This caption represents the Company’s share of operating results of equity method franchisees which develop and operate Krispy Kreme stores. On May 5, 2011, the Company sold its 30% equity interest in Krispy Kreme Mexico, S. de R.L. de C.V. (“KK Mexico”), the Company’s franchisee in Mexico, to KK Mexico’s majority shareholder, as more fully described in Note 8 to the consolidated financial statements appearing elsewhere herein. The Company’s equity in earnings of KK Mexico was approximately $70,000 for the three months ended July 31, 2011 compared to losses of $110,000 for the three months ended August 1, 2010.
 
   Gain on Sale of Interest in Equity Method Franchisee
 
     In the second quarter of fiscal 2012, the Company recorded a gain of approximately $6.2 million arising from the sale of the Company’s investment in KK Mexico as more fully described in Note 8 to the consolidated financial statements appearing elsewhere herein.
 
40
 

 

   Provision for Income Taxes
 
     The provision for income taxes was $2.0 million in the second quarter of fiscal 2012 compared to $379,000 in the second quarter of fiscal 2011. Each of these amounts includes, among other things, adjustments to the valuation allowance for deferred income tax assets to maintain such allowance at an amount sufficient to reduce the Company’s aggregate net deferred income tax assets to zero, and a provision for income taxes estimated to be payable or refundable currently, the majority of which represents foreign tax withholdings. The current income tax provision for the second quarter of fiscal 2012 also includes a provision for payment of Mexican income taxes of approximately $1.5 million related to the Company’s sale of its 30% equity interest in KK Mexico as more fully described in Note 8 to the consolidated financial statements appearing elsewhere herein.
 
     The Company has maintained a valuation allowance on deferred income tax assets equal to the entire excess of those assets over the Company’s deferred income tax liabilities since fiscal 2005 because of the uncertainty surrounding the realization of those assets. Such valuation allowance totaled $159 million as of January 30, 2011. Such uncertainty reflects the substantial cumulative losses incurred by the Company since fiscal 2005. However, the Company earned a cumulative pretax profit of $5.7 million during the three most recent fiscal years, including a pretax profit of $8.9 million in fiscal 2011. If the Company again generates significant core earnings (generally meaning pretax earnings adjusted for non-recurring items) in fiscal 2012, then, absent other factors indicating a contrary conclusion, it is likely the Company will conclude it is appropriate to reverse a portion of the valuation allowance to earnings in the fourth quarter of fiscal 2012. If such a reversal is recorded, it appears unlikely that the reversal will equal the entire $159 million valuation allowance recorded as of January 30, 2011, although it is likely the amount will be material to the Company’s results of operations. Any reversal will have no effect on the Company’s cash flows.
 
     While any reversal of a portion of the valuation allowance will have a positive effect on the Company’s results of operations in the period in which any reversal is recorded, any reversal will most likely have the effect of reducing the Company’s earnings in subsequent periods as a result of an increase in the provision for income taxes in such periods. This negative effect on earnings in subsequent periods occurs because the reversal of the valuation allowance will reflect the recognition of future income tax benefits in the period in which the reversal is recorded; absent the reversal of the valuation allowance, such tax benefits would be recognized in the future periods in which their realization occurs upon the generation of taxable income. Accordingly, subsequent to any reversal of a portion of the valuation allowance, the Company’s effective income tax rate, which currently bears no relationship to pretax income, is likely to more closely reflect the blended federal and state income tax rates to which the Company’s earnings are subject.
 
   Net Income
 
     The Company reported net income of $8.8 million for the three months ended July 31, 2011 and $2.2 million for the three months ended August 1, 2010.
 
Six months ended July 31, 2011 compared to six months ended August 1, 2010
 
   Overview
 
     Total revenues rose by 12.5% to $202.6 million for the six months ended July 31, 2011 compared to $180.0 million for the six months ended August 1, 2010.
 
     Consolidated operating income increased to $14.7 million in the six months ended July 31, 2011 from $10.2 million in the six months ended August 1, 2010. Consolidated net income was $18.0 million in the six months ended July 31, 2011 compared to $6.7 million in the six months ended August 1, 2010.
 
     Revenues by business segment (expressed in dollars and as a percentage of total revenues) are set forth in the table below (percentage amounts may not add to totals due to rounding).
 
41
 

 

    Six Months Ended
    July 31,   August 1,
        2011       2010
    (Dollars in thousands)
Revenues by business segment:                    
       Company Stores   $      135,467       $      122,504    
       Domestic Franchise     4,718         4,274    
       International Franchise     10,988         8,769    
       KK Supply Chain:                    
              Total revenues     104,224         90,797    
              Less - intersegment sales elimination     (52,845 )       (46,295 )  
                     External KK Supply Chain revenues     51,379         44,502    
                            Total revenues   $ 202,552       $ 180,049    
                     
Segment revenues as a percentage of total revenues:                    
       Company Stores     66.9   %     68.0   %
       Domestic Franchise     2.3         2.4    
       International Franchise     5.4         4.9    
       KK Supply Chain (external sales)     25.4         24.7    
      100.0   %     100.0   %
                     
Operating income (loss):                    
       Company Stores   $ 1,125       $ (1,765 )  
       Domestic Franchise     1,363         2,195    
       International Franchise     7,580         5,986    
       KK Supply Chain     16,087         16,019    
              Total segment operating income     26,155         22,435    
       Unallocated general and administrative expenses     (10,882 )       (11,142 )  
       Impairment charges and lease termination costs     (545 )       (1,083 )  
                     Consolidated operating income   $ 14,728       $ 10,210    
                     

     A discussion of the revenues and operating results of each of the Company’s four business segments follows, together with a discussion of income statement line items not associated with specific segments.
 
   Company Stores
 
     The components of Company Stores revenues and expenses (expressed in dollars and as a percentage of total revenues) are set forth in the table below (percentage amounts may not add to totals due to rounding).
 
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                  Percentage of Total Revenues
    Six Months Ended   Six Months Ended
    July 31,   August 1,   July 31,   August 1,
        2011       2010       2011       2010
    (In thousands)              
Revenues:                            
       On-premises sales:                            
              Retail sales   $      54,530   $      49,429     40.3 %   40.3   %
              Fundraising sales     7,274     7,354     5.4     6.0    
                     Total on-premises sales     61,804     56,783     45.6     46.4    
       Off-premises sales:                            
              Grocers/mass merchants     44,481     38,012     32.8     31.0    
              Convenience stores     27,679     26,396     20.4     21.5    
              Other off-premises     1,503     1,313     1.1     1.1    
                     Total off-premises sales     73,663     65,721     54.4     53.6    
                            Total revenues     135,467     122,504            100.0            100.0    
                             
Operating expenses:                            
       Cost of sales:                            
              Food, beverage and packaging     51,975     45,419     38.4     37.1    
              Shop labor     25,085     24,475     18.5     20.0    
              Delivery labor     11,651     10,566     8.6     8.6    
              Employee benefits     9,173     8,917     6.8     7.3    
                     Total cost of sales     97,884     89,377     72.3     73.0    
              Vehicle costs(1)     8,807     6,580     6.5     5.4    
              Occupancy(2)     4,585     4,791     3.4     3.9    
              Utilities expense     2,839     2,910     2.1     2.4    
              Depreciation expense     3,226     2,854     2.4     2.3    
              Other operating expenses     8,812     9,238     6.5     7.5    
                     Total store level costs     126,153     115,750     93.1     94.5    
       Store operating income     9,314     6,754     6.9     5.5    
       Other segment operating costs (3)     5,939     6,269     4.4     5.1    
       Allocated corporate overhead     2,250     2,250     1.7     1.8    
Segment operating income (loss)   $ 1,125   $ (1,765 )   0.8 %   (1.4 ) %
                             

(1)         Includes fuel, maintenance and repairs, rent, taxes and other costs of operating the delivery fleet, exclusive of depreciation.
(2)         Includes rent, property taxes, common area maintenance charges, insurance, building maintenance and other occupancy costs, exclusive of utilities and depreciation.
(3)         Includes marketing costs not charged to stores, segment management costs, off-premises selling expenses and support functions.

     A reconciliation of Company Stores segment sales from the six months ended August 1, 2010 to the six months ended July 31, 2011 follows:
 
        On-Premises       Off-Premises       Total
    (In thousands)
Sales for the six months ended August 1, 2010   $       56,783     $      65,721   $      122,504  
Fiscal 2011 sales at closed stores     (523 )     -     (523 )
Increase in sales at mature stores (open stores only)     2,717       7,942     10,659  
Increase in sales at stores opened in fiscal 2011     1,537       -     1,537  
Sales at stores opened in fiscal 2012     1,290       -     1,290  
Sales for the six months ended July 31, 2011   $ 61,804     $ 73,663   $ 135,467  
                       

     Sales at Company Stores increased 10.6% in the first six months of fiscal 2012 from the first six months of fiscal 2011 due to an increase in sales from existing stores and stores opened in fiscal 2011 and 2012. Selling price increases in the on-premises and off-premises distribution channels accounted for approximately 6.1 percentage points of the increase in sales, exclusive of the effects of higher pricing on unit volumes; such effects are difficult to measure reliably.
 
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     The following table presents sales metrics for Company stores:
 
    Six Months Ended
    July 31,   August 1,
        2011       2010
On-premises:                
              Change in same store sales   4.2   %   4.5   %
              Change in same store customer count (retail sales only)   0.0   %   3.4    
Off-premises:                
       Grocers/mass merchants:                
              Change in average weekly number of doors   4.9   %   (2.3 ) %
              Change in average weekly sales per door   11.8   %   9.1   %
       Convenience stores:                
              Change in average weekly number of doors         (1.9 ) %   (6.4 ) %
              Change in average weekly sales per door   6.8   %         (1.4 ) %

   On-premises sales
 
     The components of the change in same store sales at Company stores are as follows:
 
    Six Months Ended
    July 31,   August 1,
        2011       2010
Change in same store sales:                
              Pricing
  7.0   %   5.5   %
              Guest check average (exclusive of the effects of pricing)
         (2.5 )            (3.9 )  
              Customer count
  0.0       2.9    
              Other
  (0.3 )     0.0    
                     Total
  4.2   %   4.5   %
                 
 
     On March 7, 2011, the Company implemented price increases at substantially all its stores designed to help offset the rising costs of doughnut mixes, other ingredients and fuel resulting from higher commodity prices. The price increases, which affect approximately 60% of on-premises sales, averaged approximately 14%. These price increases are not fully reflected in the same store sales metrics because they were in effect for only 21 of the 26 weeks of the first six months of fiscal 2012.
 
     The Company believes that the expected cannibalization effect of new stores in expansion markets adversely affected same store customer count in the first six months of fiscal 2012.
 
     The Company continues to implement programs intended to improve on-premises sales, including increased focus on local store marketing efforts, improved employee training, store refurbishment efforts and the introduction of new products.
 
   Off-premises sales
 
     Off-premises sales increased 12.1% to $73.7 million in the first six months of fiscal 2012 from $65.7 million in the first six months of fiscal 2011. Approximately 5.5 percentage points of the sales increase reflects price increases, including not only increases implemented in the first quarter of fiscal 2012 but also price increases implemented in fiscal 2011. The Company’s sales increase was greater than that of the doughnut industry as a whole, according to industry data. The Company started implementing price increases for some products offered in the off-premises channel mid-April 2011, and substantially completed implementing the increases during the second quarter. Those price increases affect products comprising approximately 60% of off-premises sales, and the average price increase on those products was approximately 11%.
 
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     Sales to grocers and mass merchants increased 17.0% to $44.5 million, with an 11.8% increase in average weekly sales per door and a 4.9% increase in the average number of doors served. In addition to pricing, the Company believes that average weekly sales per door in the grocer/mass merchant channel have grown as a result of, among other things, improved customer service, introduction of additional price points, a redesign of product packaging to improve its shelf appeal and the addition of new relatively higher volume doors. Convenience store sales increased 4.9%, reflecting a 6.8% increase in the average weekly sales per door, partially offset by a 1.9% decline in the average number of doors served. The Company is implementing strategies designed to improve sales through convenience stores, including offering additional price points and increasing the quantity and assortment of packaged products offered in this channel. In addition, the Company is seeking to shift customers in the convenience store channel to sales agreements which provide that the Company will absorb unsold product rather than the retailer. While this strategy will increase the cost of product returns, the Company believes that the increase will be more than offset by higher unit pricing and, because the Company will have much greater control over product assortment and quantities merchandised, increased unit sales from both existing products and packaged products not traditionally offered through convenience stores.
 
   Costs and expenses
 
     Cost of sales as a percentage of revenues declined by 0.7 percentage points from the first six months of fiscal 2011 to 72.3% of revenues in the first six months of fiscal 2012.
 
     Before considering the potential loss of unit volume as a result of on-premises and off-premises selling price increases, those increases more than offset higher costs of food, beverages and packaging in the first six months of fiscal 2012. The effects of price increases on unit volumes are difficult to measure reliably. The Company currently estimates that input costs, excluding fuel and sugar, for the remainder of fiscal 2012 will be modestly higher than the levels of the first half of the year. As previously disclosed, sugar costs, however, are expected to rise approximately $2 million over the balance of fiscal 2012. Sugar costs are expected to decline modestly in fiscal 2013; the Company’s existing sugar contracts cover volume expected to last through approximately the end of the second quarter of fiscal 2013.
 
     Shop labor as a percentage of revenues declined by 1.5 percentage points from the first six months of fiscal 2011 to 18.5% of revenues in the first six months of fiscal 2012, principally due to higher sales resulting from price increases.
 
     Vehicle costs as a percentage of revenues increased from 5.4% of revenues in the first six months of fiscal 2011 to 6.5% of revenues in the first six months of fiscal 2012, principally as a result of higher fuel costs and higher expense of leased delivery trucks in the first six months of fiscal 2012 compared to the first six months of fiscal 2011. This increase was partially offset by a decrease in repairs and maintenance expense in the first six months of fiscal 2012 as a result of the Company replacing a portion of its aging delivery fleet.
 
     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 the 2011 Form 10-K, and periodically updates actuarial valuations of its self-insurance reserves. 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. As a result of the Company’s periodic update of its actuarial valuation, during the second quarter of both fiscal 2012 and fiscal 2011, the Company recorded favorable adjustments to its self-insurance claims liabilities related to prior policy years of approximately $500,000 in the second quarter of fiscal 2012 and $690,000 in the second quarter of fiscal 2011. Substantially all of the $500,000 in favorable adjustments recorded in the second quarter of fiscal 2012 relates to workers’ compensation liability claims and is included in employee benefits in the table above. Of the $690,000 in favorable adjustments recorded in the second quarter of fiscal 2011, approximately $640,000 relates to workers’ compensation liability claims and approximately $50,000 relates to vehicle liability claims included in vehicle costs in the table above.
 
     The Company continues to implement 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.
 
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     Other operating expenses as a percentage of revenues declined by 1.0 percentage point from the first six months of fiscal 2011 to 6.5% of revenues in the first six months of fiscal 2012 reflecting, among other things, lower store-level marketing expense.
 
     Other segment operating costs as a percentage of revenues declined by 0.7 percentage points from the first six months of fiscal 2011 to 4.4% of revenues in the first six months of fiscal 2012 reflecting, among other things, a decrease in spending on off-premises selling and support expenses.
 
     The Company Stores segment closed two stores since the end of fiscal 2010, neither 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 located, through either continuing operations of other stores in or serving the market or through its role 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 July 31, 2011, and excludes the revenues and expenses for stores closed prior to that date. Percentage amounts may not add to totals due to rounding.
 
    Stores in Operation at July 31, 2011
                    Percentage of Total Revenues
    Six Months Ended   Six Months Ended
    July 31,   August 1,   July 31,   August 1,
        2011       2010       2011       2010
    (In thousands)            
Revenues:                            
       On-premises sales:                            
              Retail sales   $      54,530     $      48,982     40.3 %   40.2 %
              Fundraising sales     7,274       7,278     5.4     6.0  
                     Total on-premises sales     61,804       56,260     45.6     46.1  
       Off-premises sales:                            
              Grocers/mass merchants
    44,481       38,012     32.8     31.2  
              Convenience stores
    27,679       26,396     20.4     21.6  
              Other off-premises
    1,503       1,313     1.1     1.1  
                     Total off-premises sales     73,663       65,721     54.4     53.9  
                            Total revenues     135,467       121,981            100.0            100.0  
                             
Operating expenses:                            
       Cost of sales:                            
              Food, beverage and packaging
    51,975       45,187     38.4     37.0  
              Shop labor
    25,085       24,312     18.5     19.9  
              Delivery labor
    11,651       10,565     8.6     8.7  
              Employee benefits
    9,173       8,871     6.8     7.3  
                     Total cost of sales     97,884       88,935     72.3     72.9  
              Vehicle costs
    8,807       6,563     6.5     5.4  
              Occupancy
    4,522       4,525     3.3     3.7  
              Utilities expense
    2,833       2,871     2.1     2.4  
              Depreciation expense
    3,226       2,822     2.4     2.3  
              Other operating expenses
    8,807       9,147     6.5     7.5  
                     Total store level costs     126,079       114,863     93.1     94.2  
              Store operating income - ongoing stores
    9,388       7,118     6.9 %   5.8 %
              Store operating loss - closed stores
    (74 )     (364 )            
Store operating income   $ 9,314     $ 6,754              
                             

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   Domestic Franchise
 
    Six Months Ended
    July 31,   August 1,
        2011       2010
    (In thousands)
Revenues:            
       Royalties   $      4,322   $      4,008
       Development and franchise fees     180     20
       Other     216     246
              Total revenues     4,718     4,274
             
Operating expenses:            
       Segment operating expenses     3,045     1,769
       Depreciation expense     110     110
       Allocated corporate overhead     200     200
              Total operating expenses     3,355     2,079
Segment operating income   $ 1,363   $ 2,195
             

     Domestic Franchise revenues increased 10.4% to $4.7 million in the first six months of fiscal 2012 from $4.3 million in the first six months of fiscal 2011. The increase reflects higher domestic royalty revenues resulting from an increase in sales by domestic franchise stores from approximately $121 million in the first six months of fiscal 2011 to $132 million in the first six months of fiscal 2012. Domestic Franchise same store sales rose 5.4% in the first six months of fiscal 2012.
 
     Domestic Franchise operating expenses include costs to recruit new domestic franchisees, to assist in domestic store openings, and to monitor and aid in the performance of domestic franchise stores, as well as allocated corporate costs. The increase in Domestic Franchise operating expenses reflects a provision of $820,000 recorded in the second quarter of fiscal 2012 for payments under a lease guarantee associated with a franchisee whose franchise agreements the Company terminated during the second quarter, as well as an increase in franchisee support costs.
 
     Domestic franchisees opened nine stores and closed five stores in the first six months of fiscal 2012. As of August 24, 2011, existing development and franchise agreements for territories in the United States provide for the development of approximately 30 additional stores in the remainder of fiscal 2012 and thereafter. Royalty revenues are directly related to sales by franchise stores and, accordingly, the success of franchisees’ operations has a direct effect on the Company’s revenues, results of operations and cash flows.
 
   International Franchise
 
    Six Months Ended
    July 31,   August 1,
        2011       2010
    (In thousands)
Revenues:            
       Royalties   $      10,417   $      7,571
       Development and franchise fees     571     1,198
              Total revenues     10,988     8,769
             
Operating expenses:            
       Segment operating expenses     2,754     2,130
       Depreciation expense     4     3
       Allocated corporate overhead     650     650
              Total operating expenses     3,408     2,783
Segment operating income   $ 7,580   $ 5,986
             

47
 

 

     International Franchise royalties increased 37.6% driven by an increase in sales by international franchise stores from $152 million in the first six months of fiscal 2011 to $187 million in the first six months of fiscal 2012. Changes in the rates of exchange between the U.S. dollar and the foreign currencies in which the Company’s international franchisees do business increased sales by international franchisees measured in U.S. dollars by approximately $12.6 million in the first six months of fiscal 2012 compared to the first six months of fiscal 2011, which positively affected international royalty revenues by approximately $760,000. In the first six months of fiscal 2012, the Company recognized $280,000 of royalty revenue from the Company’s Mexican franchisee discussed in the second succeeding paragraph below. The Company did not recognize as revenue approximately $960,000 of uncollected royalties which accrued during the first six months of fiscal 2011 because the Company did not believe collection of these royalties was reasonably assured. Substantially all of the unrecognized royalties in the first six months of fiscal 2011 related to the Company’s Australian franchisee, which commenced a voluntary administration process (similar to a bankruptcy filing in the U.S.) in October 2010. In connection with that process, in November 2010, the franchisee closed 24 of the 53 shops the franchisee operated prior to the reorganization.
 
     International development and franchise fees decreased $627,000 in the first six months of fiscal 2012, primarily as a result of a decline in the number of store openings from 59 in the first six months of fiscal 2011 to 33 in the first six months of fiscal 2012. This reduction in fees was partially offset by the recognition of approximately $95,000 of franchise fees related to the Company’s Mexican franchisee described in the following paragraph.
 
     Royalties and franchise fees for the first six months of fiscal 2012 include approximately $280,000 and $95,000, respectively, of amounts relating to the Company’s franchisee in Mexico which accrued in prior periods but which had not previously been reported as revenue because of uncertainty surrounding their collection. Such amounts were reported as revenue in recognition of the payment of such amounts to the Company on May 5, 2011, in connection with the Company’s sale of its 30% equity interest in the franchisee, as more fully described in Note 8 to the consolidated financial statements appearing elsewhere herein
 
     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 10.7%. The decline in International Franchise same store sales reflects, among other things, waning honeymoon effects from the large number of new stores opened internationally in recent years and the cannibalization effects on initial stores in new markets of additional store openings in those markets.
 
     Constant dollar same store sales in established markets fell 1.3% in the first six of fiscal 2012 and fell 19.6% in new markets. “Established markets” means countries in which the first Krispy Kreme store opened before fiscal 2006. Sales at stores in established markets comprised approximately 54% of aggregate constant dollar same store sales for the first six months of fiscal 2012. While the Company considers countries in which Krispy Kreme first opened in fiscal 2005 and earlier to be established markets, franchisees in those markets continue to develop their business; these franchisees opened 220 of the 507 international stores opened since the beginning of fiscal 2006.
 
     International franchise sales for the six months ended July 31, 2011 were adversely affected by the aftereffects of the March 2011 tsunami in Japan.
 
     International Franchise operating expenses include costs to recruit new international franchisees, to assist in international store openings, and to monitor and aid in the performance of international franchise stores, as well as allocated corporate costs. International Franchise operating expenses increased in the first six months of fiscal 2012 compared to the first six months of fiscal 2011 primarily due to an increase in legal fees and in share based compensation expense. The increase also includes a $130,000 increase in the provision for incentive compensation in the first six months of fiscal 2012 compared to the first six months of fiscal 2011. These increases were partially offset by a decrease in bad debt expense to a credit of $391,000 in the first six months of fiscal 2012 compared to a credit of $70,000 in the first six months of fiscal 2011. The credit recorded to the bad debt provision in the first six months of fiscal 2012 related principally to the Mexican franchisee discussed above. A net credit in bad debt expense should not be expected to recur frequently.
 
     International franchisees opened 33 stores and closed 17 stores in the first six months of fiscal 2012. As of August 24, 2011, existing development and franchise agreements for territories outside the United States provide for the development of approximately 230 additional stores in the remainder of fiscal 2012 and thereafter. Royalty revenues are directly related to sales by franchise stores and, accordingly, the success of franchisees’ operations has a direct effect on the Company’s revenues, results of operations and cash flows.
 
   KK Supply Chain
 
     The components of KK Supply Chain revenues and expenses (expressed in dollars and as a percentage of total revenues before intersegment sales elimination) are set forth in the table below (percentage amounts may not add to totals due to rounding).
 
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                  Percentage of Total Revenues
                  Before Intersegment
                  Sales Elimination
    Six Months Ended   Six Months Ended
    July 31,   August 1,   July 31,   August 1,
        2011       2010       2011       2010
    (In thousands)              
Revenues:                            
       Doughnut mixes   $      34,930   $      31,207     33.5 %   34.4   %
       Other ingredients, packaging and supplies     63,651     56,061     61.1     61.7    
       Equipment     4,427     3,141     4.2     3.5    
       Fuel surcharge     1,216     388     1.2     0.4    
              Total revenues before intersegment sales elimination     104,224     90,797            100.0            100.0    
                             
Operating expenses:                            
       Cost of sales:                            
              Cost of goods produced and purchased     71,160     59,871     68.3     65.9    
              (Gain) loss on agricultural derivatives     598     (241 )   0.6     (0.3 )  
              Inbound freight     2,096     1,772     2.0     2.0    
                     Total cost of sales     73,854     61,402     70.9     67.6    
       Distribution costs:                            
              Outbound freight     5,556     5,150     5.3     5.7    
              Other distribution costs     1,833     1,824     1.8     2.0    
                     Total distribution costs     7,389     6,974     7.1     7.7    
       Other segment operating costs     5,967     5,435     5.7     6.0    
       Depreciation expense     377     417     0.4     0.5    
       Allocated corporate overhead     550     550     0.5     0.6    
              Total operating costs     88,137     74,778     84.6     82.4    
Segment operating income   $ 16,087   $ 16,019     15.4 %   17.6   %
                             

     KK Supply Chain revenues before intersegment sales elimination increased $13.4 million, or 14.8%, in the first six months of fiscal 2012 compared to the first six months of fiscal 2011. The increase principally reflects selling price increases for doughnut mix, sugar, shortening and certain other ingredients instituted by KK Supply Chain in order to pass along to Company and franchise stores increases in KK Supply Chain’s cost of sugar, flour and shortening. The increase also reflects higher unit volumes of most product categories compared to the first six months of last year resulting from higher systemwide sales.
 
     The Company utilizes a fuel surcharge program to recoup additional freight costs resulting from increases in fuel costs. Charges under the program are based upon the price of diesel fuel, with the price benchmark reset each fiscal year.
 
     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.
 
     The increase in cost of goods produced and purchased as a percentage of sales in the first six months of fiscal 2012 compared to the first six months of fiscal 2011 reflects, among other things, an increase in the cost of agricultural commodities used in the production of doughnut mix and of other goods sold to Company and franchise stores. In particular, the prices of flour, shortening and sugar and the products from which they are made were significantly higher in the first six months of fiscal 2012 compared to the first six months of fiscal 2011. KK Supply Chain increased the prices charged to Company and franchise stores for doughnut mix, shortening, sugar and other goods in order to mitigate increases in the cost of certain raw materials. However, KK Supply Chain margins were adversely affected because, while the Company increased prices to cover higher costs, the Company did not raise prices to earn a proportionate gross profit on all of its higher costs.
 
     Other segment operating costs include segment management, purchasing, customer service and support, laboratory and quality control costs, and research and development expenses.
 
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     Franchisees opened 42 stores and closed 22 stores in the first six months of fiscal 2012. A substantial portion of KK Supply Chain’s revenues are directly related to sales by franchise stores and, accordingly, the success of franchisees’ operations has a direct effect on the Company’s revenues, results of operations and cash flows.
 
   General and Administrative Expenses
 
     General and administrative expenses were $10.6 million, or 5.2% of total revenues, in the first six months of fiscal 2012 compared to $10.7 million, or 6.0% of total revenues, in the first six months of fiscal 2011. The Company is seeking to minimize general and administrative expenses in order to gain operating leverage as its revenues rise.
 
   Impairment Charges and Lease Termination Costs
 
     Impairment charges and lease termination costs were $545,000 in the first six months of fiscal 2012 compared to $1.1 million in the first six months of fiscal 2011.
 
    Six Months Ended
    July 31,   August 1,
        2011       2010
    (In thousands)
Impairment of long-lived assets:              
       Current period charges   $        -   $        899  
       Adjustments to previously recorded estimates     -     (190 )
              Total impairment of long-lived assets     -     709  
       Lease termination costs     545     374  
    $ 545   $ 1,083  
               

     Impairment charges relate to the Company Stores segment. The Company tests long-lived assets for impairment when events or changes in circumstances indicate that their carrying value may not be recoverable. These events and changes in circumstances include store closing and refranchising decisions, the effects of changing costs on current results of operations, observed trends in operating results, and evidence of changed circumstances observed as a part of periodic reforecasts of future operating results and as part of the Company’s annual budgeting process. Impairment charges generally relate to stores expected to be closed or refranchised, as well as to stores management believes will not generate sufficient future cash flows to enable the Company to recover the carrying value of the stores’ assets, but which management has not yet decided to close. When the Company concludes that the carrying value of long-lived assets is not recoverable (based on future projected undiscounted cash flows), the Company records impairment charges to reduce the carrying value of those assets to their estimated fair values. The fair values of these assets are estimated based on the present value of estimated future cash flows, on independent appraisals and, in the case of assets the Company currently is negotiating to sell, based on the Company’s negotiations with unrelated third-party buyers. During the first six months of fiscal 2011, a long-lived asset that had been previously written down to a carrying value of $1.0 million was sold for $1.2 million, resulting in a gain of $190,000 that was recorded as a credit to impairment charges.
 
     Lease termination costs represent the estimated fair value of liabilities related to unexpired leases, after reduction by the amount of accrued rent expense, if any, related to the leases, and are recorded when the lease contracts are terminated or, if earlier, the date on which the Company ceases use of the leased property. The fair value of these liabilities were estimated as the excess, if any, of the contractual payments required under the unexpired leases over the current market lease rates for the properties, discounted at a credit-adjusted risk-free rate over the remaining term of the leases. The provision for lease termination costs also includes adjustments to liabilities recorded in prior periods arising from changes in estimated sublease rentals and from settlements with landlords.
 
     In the first six months of fiscal 2012, the Company recorded lease termination charges of $545,000 principally reflecting a change in estimated sublease rentals and settlements with landlords on stores previously closed. In the first six months of fiscal 2011, the Company recorded lease termination charges of $374,000 reflecting a change in estimated sublease rentals on stores previously closed and charges related to a store closure and a store relocation, partially offset by the reversal of previously recorded accrued rent related to those stores.
 
     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.
 
50
 

 

     Since the beginning of fiscal 2009, the Company has refranchised a total of 11 stores and received consideration totaling $2.5 million in connection with those transactions. During this period, the Company recorded impairment charges totaling approximately $490,000 related to completed and anticipated refranchisings. The Company cannot predict the likelihood of refranchising any additional stores or markets or the amount of proceeds, if any, which might be received therefrom, including the amounts which might be realized from the sale of store assets and the execution of any related franchise agreements. Refranchising could result in the recognition of additional impairment losses on the related assets.
 
   Interest Expense
 
     The components of interest expense are as follows:
 
    Six Months Ended
    July 31,   August 1,
    2011   2010
    (In thousands)
Interest accruing on outstanding indebtedness       $        444       $        2,408
Letter of credit and unused revolver fees     203     503
Amortization of deferred financing costs     218     312
Amortization of unrealized losses on interest rate derivatives     -     152
Other     26     63
    $ 891   $ 3,438
             
     The decrease in interest accruing on outstanding indebtedness and in letter of credit and unused revolver fees reflects the substantial reduction in lender margin on the Company’s credit facilities resulting from the refinancing of those facilities in January 2011, as more fully described in Note 4 to the consolidated financial statements appearing elsewhere herein, as well as the reduction in the principal outstanding under the Company’s term loan. The lender margin on outstanding term debt and on outstanding letters of credit was reduced from 750 basis points to 250 basis points as a result of the refinancing. The interest rate derivative contracts which gave rise to the amortization of unrealized losses on interest rate derivatives in the first six months of fiscal 2011 expired in April 2010.
 
   Equity in Income (Losses) of Equity Method Franchisees
 
     The Company recorded equity in the earnings of equity method franchisees of $3,000 in the first six months of fiscal 2012 compared to $181,000 in the first six months of fiscal 2011. This caption represents the Company’s share of operating results of equity method franchisees which develop and operate Krispy Kreme stores. On May 5, 2011, the Company sold its 30% equity interest in KK Mexico, the Company’s franchisee in Mexico, to KK Mexico’s majority shareholder as more fully described in Note 8 to the consolidated financial statements appearing elsewhere herein. The Company’s equity in earnings of KK Mexico was approximately $110,000 and $280,000 for the six months ended July 31, 2011 and August 1, 2010, respectively.
 
   Gain on Sale of Interest in Equity Method Franchisee
 
     In the first six months of fiscal 2012, the Company recorded a gain of approximately $6.2 million arising from the sale of the Company’s investment in KK Mexico as more fully described in Note 8 to the consolidated financial statements appearing elsewhere herein.
 
   Provision for Income Taxes
 
     The provision for income taxes was $2.3 million in the first six months of fiscal 2012 compared to $562,000 in the first six months of fiscal 2011. Each of these amounts includes, among other things, adjustments to the valuation allowance for deferred income tax assets to maintain such allowance at an amount sufficient to reduce the Company’s aggregate net deferred income tax assets to zero, and a provision for income taxes estimated to be currently payable, the majority of which represents foreign tax withholdings. The current income tax provision for the first six months of fiscal 2012 also includes a provision for payment of Mexican income taxes of approximately $1.5 million related to the Company’s sale of its 30% equity interest in KK Mexico as more fully described in Note 8 to the consolidated financial statements appearing elsewhere herein.
 
51
 

 

     The Company has maintained a valuation allowance on deferred income tax assets equal to the entire excess of those assets over the Company’s deferred income tax liabilities since fiscal 2005 because of the uncertainty surrounding the realization of those assets. Such valuation allowance totaled $159 million as of January 30, 2011. Such uncertainty reflects the substantial cumulative losses incurred by the Company since fiscal 2005. However, the Company earned a cumulative pretax profit of $5.7 million during the three most recent fiscal years, including a pretax profit of $8.9 million in fiscal 2011. If the Company again generates significant core earnings (generally meaning pretax earnings adjusted for non-recurring items) in fiscal 2012, then, absent other factors indicating a contrary conclusion, it is likely the Company will conclude it is appropriate to reverse a portion of the valuation allowance to earnings in the fourth quarter of fiscal 2012. If such a reversal is recorded, it appears unlikely that the reversal will equal the entire $159 million valuation allowance recorded as of January 30, 2011, although it is likely the amount will be material to the Company’s results of operations. Any reversal will have no effect on the Company’s cash flows.
 
     While any reversal of a portion of the valuation allowance will have a positive effect on the Company’s results of operations in the period in which any reversal is recorded, any reversal will most likely have the effect of reducing the Company’s earnings in subsequent periods as a result of an increase in the provision for income taxes in such periods. This negative effect on earnings in subsequent periods occurs because the reversal of the valuation allowance will reflect the recognition of future income tax benefits in the period in which the reversal is recorded; absent the reversal of the valuation allowance, such tax benefits would be recognized in the future periods in which their realization occurs upon the generation of taxable income. Accordingly, subsequent to any reversal of a portion of the valuation allowance, the Company’s effective income tax rate, which currently bears no relationship to pretax income, is likely to more closely reflect the blended federal and state income tax rates to which the Company’s earnings are subject.
 
   Net Income
 
     The Company reported net income of $18.0 million for the six months ended July 31, 2011 and $6.7 million for the six months ended August 1, 2010.
 
LIQUIDITY AND CAPITAL RESOURCES
 
     The following table presents a summary of the Company’s cash flows from operating, investing and financing activities for the first six months of fiscal 2012 and fiscal 2011.
 
    Six Months Ended
    July 31,   August 1,
    2011   2010
    (In thousands)
Net cash provided by operating activities       $       12,692         $       5,393  
Net cash provided by (used for) investing activities     4,609       (2,734 )
Net cash used for financing activities     (6,947 )     (1,639 )
       Net increase in cash and cash equivalents   $ 10,354     $ 1,020  
                 
Cash Flows from Operating Activities
 
     Net cash provided by operating activities was $12.7 million and $5.4 million in the first six months of fiscal 2012 and fiscal 2011, respectively.
 
     Cash provided by operating activities in the first six months of fiscal 2012 was adversely affected by a temporary increase in inventories associated with the outsourcing of distribution of doughnut mixes and other KK Supply Chain products for international and certain domestic stores to a third party vendor. The completion of this outsourcing over the balance of fiscal 2012 is expected to result in an overall decrease in inventories. Cash provided by operating activities in the first six months of fiscal 2011 reflects the payment of approximately $2.0 million to a landlord in connection with the renegotiation and renewal of the lease for the Company’s headquarters. The balance in the change in cash flows from operating activities principally reflects normal fluctuations in working capital.
 
Cash Flows from Investing Activities
 
     Net cash provided by investing activities was $4.6 million in the first six months of fiscal 2012 compared to net cash used for investing activities of $2.7 million in the first six months of fiscal 2011.
 
     Cash used for capital expenditures increased to approximately $4.1 million in the first six months of fiscal 2012 from $4.0 million in the first six months of fiscal 2011. The Company currently expects capital expenditures to range from $13 million to $17 million in fiscal 2012, and consist principally of new stores, renovations of and improvements to existing stores, new store equipment, information technology hardware and software, and delivery vehicles. The Company intends to fund these capital expenditures from cash provided by operating activities, from existing cash balances and, to a lesser extent, through leases.
 
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     In the first six months of fiscal 2012, the Company received proceeds of approximately $7.7 million from the sale of the Company’s 30% equity interest in KK Mexico as more fully described in Note 8 to the consolidated financial statements appearing elsewhere herein.
 
     In connection with the refinancing of the Company’s Secured Credit Facilities in January 2011, as more fully described in Note 4 to the consolidated financial statements appearing elsewhere herein, the Company deposited into escrow $1.8 million related to properties with respect to which the Company has agreed to furnish to the lenders certain documentation on or before January 31, 2012, with amounts to be released from escrow upon the Company’s furnishing such documentation. In the first six months of fiscal 2012, $1.0 million was released from escrow. If the Company does not furnish the remaining documentation by January 31, 2012, then the amount remaining in escrow on that date will be used to make a prepayment of principal on the 2011 Term Loan.
 
Cash Flows from Financing Activities
 
     Net cash used by financing activities was $6.9 million in the first six months of fiscal 2012, compared to $1.6 million in the first six months of fiscal 2011.
 
     During the first six months of fiscal 2012, the Company repaid approximately $7.8 million of outstanding term loan and capitalized lease indebtedness, consisting of approximately $1.1 million of scheduled principal amortization, $6.2 million of prepayments from the sale of the Company’s interest in an equity method franchisee as more fully described in Note 8 to the consolidated financial statements appearing elsewhere herein, and $520,000 of prepayments from the proceeds of the exercise of stock options. During the first six months of 2011, the Company repaid $1.6 million of outstanding term loan and capitalized lease indebtedness, consisting of approximately $400,000 of scheduled principal amortization and $1.2 million of prepayments from the sale of assets related to a closed store.
 
Recent Accounting Pronouncements
 
     Effective February 1, 2010, the first day of fiscal 2011, the Company was required to adopt new accounting standards related to the consolidation of variable interest entities (“VIEs”). Those standards require an enterprise to qualitatively assess whether it is the primary beneficiary of a VIE based on whether the enterprise has the power to direct matters that most significantly impact the activities of the VIE and has the obligation to absorb losses of, or the right to receive benefits from, the VIE that could potentially be significant to the VIE. An enterprise must consolidate the financial statements of VIEs of which it is the primary beneficiary. Under the new accounting standards, the Company was no longer the primary beneficiary of its franchisee in northern California, which required the Company to deconsolidate the franchisee and recognize a divestiture of the three stores the Company sold to the franchisee in the third quarter of fiscal 2010. The cumulative effect of adoption of the new standards has been reflected as a $1.3 million credit to the opening balance of retained earnings as of February 1, 2010. Adoption of the standards had no material effect on the Company’s financial position, results of operations or cash flows.
 
     In May 2011, the Financial Accounting Standards Board (the “FASB”) issued an Accounting Standards Update (“ASU”) related to fair value measurements. The ASU clarifies some existing concepts, eliminates wording differences between GAAP and International Financial Reporting Standards (“IFRS”), and in some limited cases, changes some principles to achieve convergence between GAAP and IFRS. The ASU also expands the disclosures for fair value measurements that are estimated using significant unobservable (Level 3) inputs. The ASU is effective for the Company in fiscal 2013. The Company does not expect the adoption of the new accounting standards to have a material effect on the Company’s financial condition or results of operations.
 
     In June 2011, the FASB issued new accounting standards which require an entity to present the total of comprehensive income, the components of net income, and the components of other comprehensive income either in a single continuous statement of comprehensive income, or in two separate but consecutive statements. The new accounting rules eliminate the option to present components of other comprehensive income as part of the statement of changes in shareholders’ equity. The new accounting rules will be effective for the Company in fiscal 2013. The Company does not expect the adoption of the new accounting rules to have a material effect on the Company’s financial condition or results of operations
 
Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
 
     There have been no material changes from the disclosures in Part II, Item 7A, “Quantitative and Qualitative Disclosures About Market Risk,” in the 2011 Form 10-K.
 
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Item 4. CONTROLS AND PROCEDURES.
 
Evaluation of Disclosure Controls and Procedures
 
     As of July 31, 2011, the end of the period covered by this Quarterly Report on Form 10-Q, management performed, under the supervision and with the participation of the Company’s chief executive officer and chief financial officer, an evaluation of the effectiveness of the Company’s disclosure controls and procedures as defined in Rules 13a-15(e) and 15d-15(e) of the Exchange Act. The Company’s disclosure controls and procedures are designed to ensure that information required to be disclosed in the reports the Company files or submits 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 the Company’s chief executive officer and chief financial officer, to allow timely decisions regarding required disclosures. Based on this evaluation, the Company’s chief executive officer and chief financial officer have concluded that, as of July 31, 2011, the Company’s disclosure controls and procedures were effective.
 
Changes in Internal Control Over Financial Reporting
 
     During the quarter ended July 31, 2011, 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.
 
Part II – Other Information
 
Item 1. LEGAL PROCEEDINGS.
 
     There have been no material changes from the disclosures contained in Part 1, Item 3, “Legal Proceedings,” in the 2011 Form 10-K.
 
Item 1A. RISK FACTORS.
 
     There have been no material changes from the risk factors disclosed in Part I, Item 1A, “Risk Factors,” in the 2011 Form 10-K.
 
Item 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS.
 
     None.
 
Item 3. DEFAULTS UPON SENIOR SECURITIES.
 
     None.
 
Item 4. (REMOVED AND RESERVED).
 
Item 5. OTHER INFORMATION.
 
     None.
 
Item 6. EXHIBITS.
 
     The exhibits filed with this Quarterly Report on Form 10-Q are set forth in the Exhibit Index on page 56 and are incorporated herein by reference.
 
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SIGNATURES
 
     Pursuant to the requirements 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.
         
         
Date: September 1, 2011   By: /s/ Douglas R. Muir  
    Name:     Douglas R. Muir
    Title: Chief Financial Officer
      (Duly Authorized Officer and Principal Financial Officer)

55
 

 

Exhibit Index
 
3.1               Amended Articles of Incorporation of the Registrant (incorporated by reference to Exhibit 3.1 to the Registrant’s Annual Report on Form 10-K, filed on April 15, 2010)
         
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 December 15, 2008)
 
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
         
101       The following materials from our Quarterly Report on Form 10-Q for the quarter ended July 31, 2011, formatted in XBRL (eXtensible Business Reporting Language): (i) the Consolidated Statement of Operations for the three and six months ended July 31, 2011 and August 1, 2010; (ii) the Consolidated Balance Sheet as of July 31, 2011 and January 30, 2011; (iii) the Consolidated Statement of Cash Flows for the six months ended July 31, 2011 and August 1, 2010; (iv) the Consolidated Statement of Changes in Shareholders’ Equity for the six months ended July 31, 2011 and August 1, 2010; and (v) the Notes to the Condensed Consolidated Financial Statements, tagged as block text*

* Pursuant to Rule 406T of Regulation S-T, the Interactive Data Files on Exhibit 101 hereto are deemed not filed or part of a registration statement or prospectus for purposes of Sections 11 or 12 of the Securities Act of 1933, as amended, are deemed not filed for purposes of Section 18 of the Securities Exchange Act of 1934, as amended, and otherwise are not subject to liability under those sections.
 
Our SEC file number for documents filed with the SEC pursuant to the Securities Exchange Act of 1934, as amended, is 001-16485
 
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