Glazed & confused

What happened to Krispy Kreme has investors scratching their heads. Here are some hints from beyond the grave.
By Frank Maley

Vernon Rudolph smoked and drank his way into an early grave. His doctor told him to quit — he’d had two heart attacks. But Rudolph, who founded Krispy Kreme Doughnuts Inc. and built it into a $50 million business, was used to giving orders, not taking them, so he followed his doctor’s advice his own way. He switched from unfiltered Camel to filtered Benson & Hedges and from bourbon to beer. In 1973, when he was 58, his heart quit.

Less than a year earlier, he had written a letter giving advice on how to run his company. Nothing too specific, just common sense: Hire performers, not friends; don’t use the company to do favors; run it with your head, not your heart. Sealing the envelope, he wrote the name of his oldest son, Carver, on it, along with instructions: Don’t open this until I’m dead. He stuck it in the company vault.

After he read the letter, Carver felt disappointed. He had heard most of it before, and it wasn’t exactly the paint-by-numbers manual a 26-year-old novice needed to run a business that stretched from Miami to Philadelphia and west to Memphis, Tenn. He showed it to his two brothers, then lost track of the letter for more than 30 years. It resurfaced last year.

By then, Krispy Kreme had soared to heights Vernon Rudolph could only have imagined. Now a public company, it boasted 357 shops and reported revenue of $666 million in the fiscal year that had just ended. But the first cracks in the company’s facade were starting to appear. In May 2004, it cut its earnings projections for the first quarter and fiscal year. The worst was yet to come. The company had lost its way, and some of Rudolph’s admonitions, while not pithy or poetic, never seemed more apt.

Rudolph was a tough-minded man who didn’t eat the soft pastries he sold. His typewritten letter to his son covered one page, but its flinty pragmatism might have spared Krispy Kreme much of its agony.

Mistakes by a plant manager can be serious. But when an executive makes a mistake, it can produce extremely serious consequences to the entire organization.

It’s July 2005, and the company Rudolph sired lies in intensive care, scorned by shareholders, shunned by Wall Street, haunted by investigators and guided by strangers. The CEO who took it public five years ago has been replaced by a temp, a corporate surgeon who shareholders hope can cut out the cancer and save the company.

Don’t rely on our financial statements, the company has warned, and don’t expect us to produce proper ones right away. Krispy Kreme still hasn’t filed financial statements for the third quarter of the previous fiscal year, due in December, and plans to restate its earnings back to its initial public offering of stock in April 2000. Shares, which once fetched nearly $50, trade for about $7. Its Canadian franchisee, which the company owns 41% of, has declared bankruptcy.

Just a few years earlier, Krispy Kreme seemed to be building stores as fast as it made doughnuts. Between its IPO and the end of 2004, it opened more than 300. Now the company is in retreat. In the first half of 2005, it shuttered about 40 stores, bringing the total to about 400, and some investors weren’t shy about using the “B” word.

“If it turns out they need to close a much larger number of locations and if they have too much debt and/or they have a lot of leases they have to get rid of, a prepackaged bankruptcy is a plausible way to solve those problems,” says Eric Von der Porten, head of Leeward Investments, a California hedge fund that invests in Krispy Kreme options.

Directors and officers have kept mum about how things got so screwed up, leaving analysts and academics around the country to guess. They wouldn’t have been guessing about Krispy Kreme 68 years ago, when Rudolph opened his first bakery in Winston-Salem. They wouldn’t have cared. It took him and his successors almost that long to catch their attention.

Rudolph grew up in the Kentucky countryside. In 1933, he joined an uncle who had just bought a Paducah doughnut shop from a Frenchman originally from New Orleans. The sale included a recipe and a name — Krispy Kreme. When the uncle opened a shop in Nashville, Tenn., Rudolph joined him, selling doughnuts door to door. It was the Depression, and times were hard. They helped make Rudolph that way, too.

He wasn’t quite 22 when he opened his first store in 1937, the year Krispy Kreme claims as its birth. He had looked at several places in the South and Midwest and was standing on a corner in Peoria, Ill., wondering what his next move would be. Pulling a pack of Camel cigarettes from his pocket, he noticed they were made in Winston-Salem and decided a town with a famous company making a nationally advertised product would be a good place for his business.

He rented a building and began selling doughnuts to grocery stores. People started asking if they could buy hot doughnuts, so he cut a hole in a wall and sold them directly to customers. Within a year, he opened a shop in Charlotte. As the company grew, Rudolph came to believe that Krispy Kreme should franchise stores only when it didn’t have enough manpower or capital to open them itself. Franchises went only to managers who had worked for the company long enough to prove themselves. Millionaires interested in a quick return on investment needn’t apply.

Though he started by selling doughnuts to grocery stores, Rudolph on at least one occasion threatened to shut down that part of the business. “My father hated grocery stores,” his son says. “They only make it worthwhile on Thursday, Friday and Saturday. And you had to sell at rock-bottom, super-discounted prices. You end up bringing back huge amounts of stales.”

Krispy Kreme quickly became an institution in Winston-Salem, partly because Rudolph learned to tap his product’s fundraising potential. Ric Marshall is chief analyst for The Corporate Library, a Portland, Maine-based research company that focuses on corporate governance. He grew up in Winston-Salem and sold Krispy Kremes to buy bats and balls for his Little League team in the 1960s. “You always sold all of them. The trick was not eating them.”

As a father, Rudolph could be hard on his kids. If crossed, he’d whip them with his belt. But he also provided them with money, sent them to private schools and rearranged his schedule to attend important events in their lives. He didn’t say much more than he had to. About a year before his death, for the only time in his life, he told Carver how much he loved him.

Carver never got to test his father’s advice — at least not at Krispy Kreme. For three years after Rudolph’s death, the executor of his estate ran the company. The family sold the company to Chicago-based Beatrice Foods in 1976. Beatrice broadened the menu, adding delicatessen-style sandwiches, but they didn’t fit. After a group of franchisees led by Joe McAleer of Mobile, Ala., bought the company in 1982, sandwiches were scratched.

Doughnuts, after all, were how Krispy Kreme had woven itself into the fabric of life, particularly in the South. Typical of its early stores was one on U.S. 74 in east Charlotte. Open 24 hours a day on a busy route between points west and the beach, its “hot doughnuts now” light and rotating sign atop the building became a local landmark. A community of late-night denizens would call it home — red-eyed cops, midnight truckers, cabbies, early risers and late workers. When it closed for a road widening in 1994, they passed around empty doughnut boxes and the company’s paper hats for autographs. Some cried.

The franchisees had borrowed heavily to buy the company. “We were staring a 20% interest rate in the face,” says Bob West, vice president of finance from 1982 to 1992. “And so any excess cash didn’t go to building doughnut shops. It went to pay off debt. But we beat all of our projections, got ahead on our debt, and by 1992 the company was in great financial shape.”

McAleer’s namesake, known as Mack, became president in 1988 and CEO in 1995. He wanted the company to grow quickly, which clashed with the approach of West and his father. “I didn’t fit his mode of operations,” West says. “I’m the old-time conservative. Things have got to make sense. They’ve got to be justified. And he’s the young son that’s ready to let the wheels roll. He was wanting to open 10 and 20 doughnut shops a year back when we could probably only handle maybe two or three a year.”

Mack McAleer was succeeded by Scott Livengood as president in 1992 and CEO in 1998. “Scott was his confidant all along,” Carver Rudolph says. “They were good, close friends. You’d see them at football games together, out to dinner together, playing golf together, traveling together. They were joined at the hip.”

Livengood had grown up in Winston-Salem, the son of a hosiery-mill manager, and married his high-school sweetheart. He joined the company in 1978, worked his way up through the human-resources department and took the company public five years ago. On opening day, shares soared 83%, and the company netted $58.6 million to pay off debt and expand. Its stock became one of the hottest on Wall Street, reaching nearly $110, splitting twice and peaking at a split-adjusted $49.74 in August 2003.

The news was so good for so long that many shareholders were caught by surprise when the company revised its earnings outlook in early 2004. Later that year, it said it would be late with its third-quarter earnings statement. As shares dropped, some investors started calling for Livengood’s ouster, and in January, they got their wish.

He retired — that’s how the company put it — at age 52 and was replaced by turnaround specialist Steve Cooper, chairman of New York-based Kroll Zolfo Cooper. Cooper is capable of reviving the company, as he did Laidlaw International, a Naperville, Ill.-based bus operator, or selling its assets, as he has at Houston-based energy trader Enron, which he still heads.

Let me warn you of one area where mistakes can be fatal and not easily corrected, because they are the result of letting your personal feelings override your executive responsibilities.

Rudolph was talking about the mistake of hiring friends. But his son understood that to mean friendship should never taint his judgment about what was best for Krispy Kreme.

At the heart of the allegations against Livengood’s team are complaints that the company padded revenue through a practice called channel stuffing — shipping double the number of doughnuts actually ordered just before a quarter ended — and paid too much to buy back struggling franchises, particularly those owned by favored franchisors. Essentially, its detractors contend that Krispy Kreme executives lost the faith of Wall Street by being too good to friends and not good enough to — or honest enough with — shareholders.

In October 2003, Krispy Kreme bought five stores in the Michigan market from Dough-Re-Mi Inc., paying $32.1 million. One shareholder lawsuit claims Dough-Re-Mi was doing poorly and owed Krispy Kreme several million dollars, so Krispy Kreme inflated the purchase price, overpaid, then collected the debt with the same money, thereby paying itself and boosting earnings.

Livengood and other company officers, past and present, declined to be interviewed for this story or did not return phone calls seeking comment. But in January, two weeks before Livengood’s departure, the company issued a statement admitting it had handled the Dough-Re-Mi purchase badly. It said it would restate earnings and change the way it accounted for the purchase, projecting “a pre-tax adjustment of $3.4 million to $4.8 million to record as compensation expense, rather than purchase price, some or all of the disproportionate consideration paid.”

That wasn’t the only deal that raised eyebrows. In June 2003, Krispy Kreme agreed to buy back franchises for the Dallas, Texas, and Shreveport, La., markets — six stores — for $67 million, almost all of it cash. It later revealed that one of the franchisees was none other than Mack McAleer. Another was former board member Steven D. Smith. About the same time, Great Circle Family Foods, Krispy Kreme’s franchisee in Southern California, reportedly was willing to sell 22 stores and a commissary for $80 million. Great Foods executives wouldn’t verify that price. It still hadn’t sold them in early July.

In February 2004, Krispy Kreme bought what it didn’t own of Golden Gate Doughnuts, its Northern California franchisee, for an undisclosed amount. Livengood’s former wife, Adrienne Livengood-Baker, owned 3% of Golden Gate and received about $1.5 million, but it’s unlikely the purchase was made for her benefit. Livengood had bought 6% of the franchise in 2000, and his ex-wife got half in their divorce. He sold his 3% in 2002, right after the divorce. Even so, the company in its restatements expects to adjust its accounting for that purchase in ways similar to Dough-Re-Mi, even using the phrase “disproportionate consideration paid.”

There’s even a whiff of incest in one of the company’s costliest failures. In April 2003, it bought Montana Mills Bread Co., a Rochester, N.Y.-bakery chain whose board included Krispy Kreme Chief Operating Officer John Tate. About a year later, Krispy Kreme said it would divest itself of Montana Mills and close most of the stores. It later recorded a loss from discontinued operations of $34 million. Three months later, Tate left to become COO of Corte Madera, Calif.-based Restoration Hardware.

Making decisions is the first responsibility of an executive. So you cannot let fear of making a mistake paralyze your decision-making process. When you become the chief executive officer of a corporation, the “buck does stay” on your desk — and you’ll find that making decisions can be a lonely job.

While Krispy Kreme was paying big money for franchises and moribund companies, growth in comparable-store sales — for stores open longer than 18 months — was slowing. Even its cheerful earnings statements, which it has since disavowed, showed comparable-store sales growing 13% in fiscal 2002 and 10% in the fiscal year ended in February 2004. Sales growth continued to slow in the two quarters that followed. Late last year, a press release on third-quarter earnings said comparable-store sales had slipped 6.4% compared with the third quarter of 2003, but the company didn’t follow up with a formal earnings statement.

Krispy Kreme was adept at creating hoopla around its store openings, often giving doughnuts to media outlets and following up with tips. “They would call up the radio station and say, ‘Just wanted to let you guys know there’s a traffic backup on this highway because of a Krispy Kreme opening,’” says Carl Sibilski, restaurant analyst with Chicago-based Morningstar. “And then the radio station would say in their traffic report, ‘Avoid this highway because it’s all backed up due to the Krispy Kreme opening.’”

An operator of a Krispy Kreme outlet could expect a burst of revenue the first few months — as much as $500,000 a week. But sales would quickly slide to more realistic levels — about $50,000 to $60,000 a week. “You had these huge openings and so much early demand and excitement about the product when it came into new markets,” says Von der Porten, the California hedge-fund manager. “So maybe part of the problem is that management got intoxicated with the success and just wanted to do more and more and didn’t fully appreciate how quickly the merry-go-round might stop.”

When it did feel the momentum slowing, the company might have passed the buck and papered over weaknesses instead of admitting and correcting them. Shareholder suits contend that the company improperly accounted for revenue and overstated income by unilaterally boosting orders near the end of quarters and booking the additional sales, knowing the doughnuts would be returned early in the next quarter.

“It works in the short run,” Sibilski says. “And if what you have is just a very short-term sales weakness, then you can probably cover it up, but if it’s a long-term issue, which is probably what it turned out to be, then it comes back to haunt you.” Despite the accusations of financial hanky-panky, he says the company did a good job of increasing sales rapidly, though it probably added too many of the grocery-store accounts that Rudolph loathed. They turned unprofitable as sales sagged. “The company was focused way too much on expanding the top line and not enough on the lines in between that and the net-income line.”

It filled some markets with too much doughnut-making capacity, Von der Porten says, and it’s now feeling the effects. Krispy Kreme not only closed stores, it announced in February that it planned to cut employment in its corporate, mix-plant, equipment-manufacturing and distribution operations by 25% to save $7.4 million a year. “It remains to be seen how many franchisees survive, how many get rolled back up into the parent company, how many may get sold or go out of business,” Von der Porten says.

Overseeing the company was a board with too many insiders and too few independent directors asking the right questions, Marshall says. Despite its problems, many of Krispy Kreme’s critics say things will get better now that the company has brought in more out-siders. “These turnaround guys are good,” Marshall says. “They’re hard. They’re ruthless. They make tough decisions.” The buck stays on their desks.

Though Americans might not love Krispy Kreme doughnuts as much as the company claimed, the pastries still have legions of loyal customers. “You can fix an operational problem,” Sibilski says. “You can fix a finance problem. But you can’t really fix a brand problem. The glimmer of hope for Krispy Kreme is that the brand is still valuable.”

For that, the company owes a debt — though it needn’t account for it — to Vernon Rudolph. As a young man, his sons say, he was embarrassed by his station in life. Making doughnuts didn’t have the cachet of practicing medicine or law. But he was good at it. “He wanted to build it up and make it a nationally known name that was well-respected in the industry for doing things right and profitably and giving people opportunities they wouldn’t have otherwise,” his son says.

His modern-day successors achieved part of his dream. The Krispy Kreme name has become known, even beyond the United States. But in some circles, it’s infamous. “He wouldn’t want to be associated with it,” Carver says.