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Executives

Brian Little - Director of Corporate Communications

Jim Morgan - President and CEO

Doug Muir - CFO

Analysts

Andrew Wolf - BB&T Capital Markets

John Ivankoe - J.P. Morgan

Krispy Kreme Doughnuts Inc. (KKD) F4Q08 (Qtr End 02/03/08) Earnings Call April 17, 2008 4:30 PM ET

Operator

Welcome to the fourth quarter 2008 Krispy Kreme Doughnuts Earnings Call. My name is Erika, and I'll be your coordinator for today. (Operator Instructions)

I would now like to turn the presentation over to your host for today's call, Mr. Brian Little, Director of Corporate Communications. You may proceed, Mr. Little.

Brian Little

Thank you, Erika. Welcome everyone to the Krispy Kreme fourth quarter and fiscal 2008 earnings conference call. Also on the call today are Jim Morgan, Krispy Kreme's President and Chief Executive Officer and Doug Muir, Krispy Kreme's Chief Financial Officer. During today's call Jim will comment on company performance during FY '08 and Doug will review fourth quarter and year-end financial results. As is always the case, we will ask the operator to open the lines and take your questions following their remarks.

I'd like to first remind listeners that a copy of our earnings announcement released this morning including financial tables is available in the "New Release" section under Investor Relations at our website krispykreme.com. This conference call is being webcast and will be archived and available on our website for one year. A transcript of our conference call today will also be available at our company website. All SEC filings and press releases are accessible there as well. Investors and Analysts are directed to these online public resources for the most up-to-date company information. Krispy Kreme Investor Relations can be reached via e-mail at ir@krispykreme.com.

Today's responses as well as prepared remarks should be considered forward looking in nature, and are subject to various risks, uncertainties, and assumptions. Should one or more of these risks or uncertainties materialize or should underlying assumptions prove incorrect, actual results may vary materially from those anticipated, estimated or expected. Key factors that may have a direct bearing on Krispy Kreme's operating results, performance or financial condition are discussed in Krispy Kreme's Form 10-K for fiscal 2008 and other periodic reports filed with US Securities and Exchange Commission.

With that, I will now turn the call over to Jim Morgan, President and Chief Executive Officer, Jim?

Jim Morgan

Thank you, Brian. Good afternoon, everyone. I too would like to welcome each of you to today's conference call. As many of you know this is my first quarterly call since taken over as President and CEO, so I am particularly looking forward to sharing my thoughts with you this afternoon.

I spent my first several months meeting with our management team, employees, franchisees and other parties who are truly interested in the long-term success of Krispy Kreme. One thing that I have learned over the past few months is that there are many others out there who share my belief and excitement about our future and the possibilities that lie ahead for our company.

I've also learned that we do have much more work to do in order to deliver the financial performance we believe is possible, but we are committed to that task. While our fiscal 2008 financial results were not what we would have liked, the year was not without any successes. Doug will address the financial results in more detail in a few minutes.

We are well aware that important challenges still exist in key areas of our business, but we believe over time there are many more opportunities than there are challenges. Our goal is to successfully address the challenges without sacrificing any of the opportunities, while at the same time becoming a leaner, stronger, more profitable organization.

Let me now make specific comments on each of our major business segments.

Our wholesale, our off-premises business; it's particularly vulnerable to the rising fuel costs, the increase in the cost of agricultural commodities and the shrinking margins that our off-premise customers are facing. Nevertheless, we are committed to revitalizing our off-premise business. Even though we may approach it in a very different manner long-term, it remains our goal to have more Krispy Kreme branded products in even more retail locations nationwide over the long-term.

As far as our company stores are concerned, because many of our stores are also sort of wholesale customers, they too are being negatively impacted by the pressures affecting the off-premises business. However, our goal for company stores is very simple and clear to improve them. We are currently addressing everything from physical appearance to increase the change from the details that enhance service and that enhance the overall customer experience.

Also we are talking on already successful international hub and spoke model and applying its principles in our company store markets. Early results from three factory stores recently converted to hot shops satellites are very encouraging. Hot shops satellites still provide the Hot Original Glazed doughnut experience by using our tunnel over technology.

Supplying the smaller satellite Krispy Kreme stores from Krispy Kreme factory stores improves the utilization of the factory store and significantly enhances the return on the satellite shop which is smaller, simpler to operate and less costly to build, stay up and run than a factory store. We plan to begin construction of new satellite stores during the course of this year.

We are committed to being a world-class franchisor with a limited company store footprint. As a result of this vision, the opportunity exists to re-franchise many of our company stores that lay outside of our traditional base in the southeast. This should in time increase the portion of our revenues derived from mix sales and royalty. Two such refranchising opportunities are currently underway, but this in essence will be a multi-year process.

As we look at our Franchise segment, our associates who operate primarily in the southeast are doing okay, but they are also suffering from the same off-premises pressure as we are. Some of our area developers who operate in the remaining of the US continue to struggle, although some others have made a great deal of progress on a number of fronts this year. Most of our international franchises are doing well. We expect that our international franchisees will open at least 50 additional stores in this fiscal year and by the end of this next year, over half of all Krispy Kreme shops will be located outside of United States.

We are focused intently on working with all of our franchisees to provide them with the two that will assist them in their long-term success. As most of you know, our mix sales are a significant source of revenue. This product is our equivalent of Coca-Cola syrup. These sales, these mixed sales depend upon the success of our company stores and our franchisee and we are currently undertaking a couple of initiatives in that area that should result in more efficient and effective delivery of this product.

To summarize, I would say that Krispy Kreme is the company that is clearly in transition. We are transitioning from a complex model in which we owned interest in many franchisees to a more transitional franchise overall in the process. We have reduced our guarantee to franchisee obligations from over $70 million to less than $15 million. We're also transitioning from off-premises being the dominate source of revenue to retail sales being the key driver. We are transitioning from being company's store focused to being the world-class franchisor with more limited company store footprint. We are transitioning from the large factory store operations to our hub and spoke strategy, a smaller more economical model that brings our signature products closer to consumers.

And finally, we're transitioning from shrinking the store base to slowly growing the total number of Krispy Kreme stores worldwide.

As I mentioned earlier in my comments, Krispy Kreme still faces challenges. We are not naïve in our approach, but we are optimistic that we will emerge from these past few years as a wiser, more efficient and more focused company. Krispy Kreme products are by and large indulgence. We believe that we can and should be the indulgence of choice among a great portion of the world's population. We also believe that even in difficult economic times, families can still enjoy treating themselves to the joy that is at Krispy Kreme Doughnuts.

Now I will turn the call over to Doug who will outline our financial performance for the quarter and year end. Doug?

Doug Muir

Thank you, Jim, and good afternoon, everyone. First, I'll review our results for the quarter and then touch on our financial position. We filed our Annual Report on Form 10-K with the SEC this morning. If you would take some time to review it since we can't begin to cover on this call everything that is discussed in the 10-K, and as you review the annual report, please remember that fiscal 2008 that we just completed was a 53-week year and the fourth quarter had 14 weeks instead of 13. To enhance comparability between fiscal 2008 and last year, we included in the 10-K since supplemental disclosure of many of the year-over-year comparisons on a 52 week basis.

Turning now to results for the quarter, we reported a net loss of $31.8 million in the fourth quarter which ended February 3. There were some special charges that reduced earnings in the quarter and I'll walk through them briefly. The loss reflects asset impairment charges and lease termination costs of $27.6 million, virtually all of which is non-cash. That $27.6 million consists principally of $22.7 million of write-downs of long-lived assets and $4.6 million of goodwill impairment.

We also took a $3 million charge in the fourth quarter for potential payments under our guarantees of certain debt and leases of a franchisee in which we own an interest. That $3 million is composed of $2.1 million, representing 100% of our exposure to guarantees of the franchisees funded debt and $900,000, representing approximately 1 year of gross lease payments.

Finally, we took a charge of $2.7 million in the quarter for cost related to the resignation of our former Chief Executive Officer and that total $1.1 million is cash.

Looking ahead to next year, as you know there has been a significant increase in the price of wheat and soybean oil in recent quarters. Wheat and soybean oil are the primary components of flour and shortening which are our two most significant ingredients. While prices have been volatile, the overall trend of these prices has been up.

We currently anticipate that the costs of these ingredients will be higher in fiscal 2009 than in fiscal 2008 and we have factored that into our plans. We raised the price of doughnut mix and shortening to our company and franchise stores in fiscal 2008, and again in the first quarter of fiscal 2009, in order to recover some of our increased materials costs, but we are also working to find and achieve some offsetting cost productions wherever we can.

Take a minute to talk about the balance sheet as we head into fiscal 2009. We ended fiscal 2008 in the beginning of February with about $25 million of cash on the balance sheet. During the fourth quarter, we repaid about $11 million of our term loan principal using the proceeds of the sale of our mix manufacturing and distribution facility in Illinois. That payment brought the total term loan prepayments this year to $32 million and the term loan balance has been reduced 30% to $77 at year end.

Last week we reached an agreement with our lenders on some amendments to our credit facilities, which among other things relaxed the financial covenants in those facilities both for fiscal 2009 and fiscal 2010. The amendments also gave us some flexibility to execute some elements of our business plans that we didn't previously have. We also reduced the size of the revolving facility from $50 million to $30 million which candidly we were planning to do anyway because it was bigger than it needed to be. The revolvers only function is to support about $20 million of insurance-related letters of credit we have never drawn on the revolver. The cost to the amendment included a 200 basis points increase in the interest rate, the addition of 3.25% LIBOR floor and a 35% basis amendment paid to the lenders. That the amendments warranty that in the credit market we are in seem to us to be a workable outcome and is very nice to be squared away with our lenders as we move into fiscal 2009.

There is one more thing I would like to highlight just briefly and that is our internal control over financial reporting. 18 months ago we had identified about 17 material weaknesses in our internal control with financial reporting. One year ago we had reduced that number to 11. As of February 3, we had remediated all 11 of the remaining material weaknesses and now we have none at all. And just going forward, it's our intention to stay that way.

Erika, I think at this time we are ready to take some questions if you would open the queue.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Andrew Wolf from BB&T Capital Markets. You may proceed.

Andrew Wolf - BB&T Capital Markets

Good afternoon.

Jim Morgan

Good afternoon.

Andrew Wolf - BB&T Capital Markets

Couple of different questions. To create a product you know that ingredient inflation is going into pricing eventually at retail. Given the economic climate, what kind of expectations have experienced and other recessions and so on touch you and rising prices as obviously you have to do if you are going to maintain some margins. What do you expect to be the impact on volumes at the retail stores and those off-premise locations where you saw a good business?

Jim Morgan

Andrew, this is Jim. Let me give you a ranch on that. We do not have detailed studies on that. We have got some subjective evidence that tells us that we have got room to pass on and the tougher the times, all the more room we got to pass it on simply because every one around us is doing the same thing and it appears that we kind of take a step down benefit that people will still go out and indulge and their families bought a McDonald and hot doughnuts. May be more likely to do that than going out to dinner and a movie and so to more likely that than going to Disney world.

So it looks like right now we fail to meet, we didn't. We have been watching the reaction of the two price increases that we put in and we see a slight decrease in customer count. Although that was already taking place before the price increases gain and yet we see ticket average is up and we are seeing same store sales that appear to be not only stabilized but may be slightly picking up a little bit. So that's the best answer we can give you right now.

Andrew Wolf - BB&T Capital Markets

Okay. Well, that's pretty helpful. And the other thing is I think you mentioned 50 international store openings. Two things, first of all, do you plan, do you expect some closures either domestically or any of those 50 stores internationally going to be replacements. I mean, are you actually going to be up 50 stores or close to that without a lot of domestic closures, number one, so is that 50 stores a net number, gross number or net number?

Secondly, could you just give us some flavor for those stores, they are mainly kiosks or fresh stores as opposed to factory stores that kind of mix the store types and if there is no confidential or other reason. Could you tell us about the geographies which are part of the worlds it's going to be?

Doug Muir

Sure, Andy, it's Doug. The 50 is a gross number. We expect the international franchisees will open at least 50 locations this fiscal year and they're up off to a good start even two months into the year. As far as closures go, there are inevitably closures in the restaurant business. So yeah, I think there will be some. I think my expectation is, we have closures, we would have more of them domestically than we would internationally and we have factored that into that possibility into our plans and budgets for next year.

In terms of what's going to be opened internationally, we think it's going to be, because we've talked to the franchisees and we know what equipment orders are. These are going to be mostly satellite spoke locations. The bulk of the factory stores have been built at least in the short term; they will be I think a handful next year. But most are more going to be spokes and they tend to be fresh shops principally are predominating in the international community right now in terms of what's currently in the pipeline.

In terms of geography, it's all over. As you know, we signed six or seven international development franchise agreements in 2007. All of those franchisees by March are working away and are in where they expected to be. So it's not really concentrated anywhere; it's Korea, Indonesia, the Philippines, all the usual places.

Andrew Wolf - BB&T Capital Markets

Okay. And just an unrelated follow-up on the support operations. The profit dollars sequentially now have gone down close to franchise operations, it's pretty obvious why they are going up. You are getting some foreign franchisees or opening stores. But is this support operations profit dollars a decrease there or a function of not making money any longer on the equipment sales? Or is it more just sort of a negative mix shift than it's more expensive to produce and I guess you got shipping cost probably substantial to ship ingredients outside the United States? Could you give us some flavor on what's going on with the profit in that business?

Doug Muir

Sure, I'll be glad to. The equipment sales have been less than 15% of the supply chain revenues for about three years. They are not a big contributor to profit because candidly the company dialed back the margins on those roughly at, I think, it was in fiscal 2006, if I recall correctly. What do you see going in the supply chain, a big driver of supply chain is volume, it's a very volume sensitive business. And so we have adversely affected in the supply chain to the extent that domestic franchisees had some store closings and that has reduced our mix volume.

We currently don't ship a tremendous amount of mix across the ocean. We do some of it, but we are increasingly moving to late models in which we ship a concentrate, if you will, overseas and then that concentrate is mixed with flour and the other ingredients by packers outside the US.

In terms of costs, we have in the recent past, recent years had I guess an understanding perhaps with franchisees that mix pricing would be set once a year. So even though costs went up fairly dramatically during fiscal 2008, we held the line on mix pricing and that did adversely affect our gross profit margin and the supply chain. That effect was most pronounced in the fourth quarter because that's when goods we had purchased earlier at lower prices ran out on us and we began starting to have to pay a little bit closer to the market rate for flour.

Andrew Wolf - BB&T Capital Markets

Okay. Just a follow-up on your last point, that's interesting. Given all the volatility in the ingredient costs flour and now the cooking fats too, is that the arrangement you are going to have going forward to fix price for a year or you are going try to get a more flexible arrangement?

Doug Muir

Thanks for the (inaudible). We have a discussion with the franchisees where our current plan is to adjust pricing of mix quarterly. We were candid with the franchisees about it. We can fix the price if we want to go out and hedge flour for the entire year and the feedback we got from the franchisees is we think we like the quarterly adjustment plan. We have announced to the franchisees group that there is not going to be a mix pricing increase in the second quarter.

Andrew Wolf - BB&T Capital Markets

And just lastly sort of housekeeping gear, where in the P&L, where the two charges one for the severance arrangement with Daryl and the other one for the franchise liability, where should we if we want to exclude that?

Doug Muir

Sure. The $2.7 million related to Daryl is in the general and administrative expenses line. The $3 million for the guarantees is in the other non-operating income line.

Andrew Wolf - BB&T Capital Markets

Okay. That's it for me. Thank you.

Doug Muir

Thank you.

Operator

(Operator Instructions) Your next question comes from the line of John Ivankoe from J.P. Morgan. You may proceed.

John Ivankoe - J.P. Morgan

Hi, thanks. I have some modeling questions and I just want to see if I understand these things right, if I am looking at them right. It seems like on the company store side, the store that you closed actually may have been higher volume stores in the average given the fact by our calculation that average would be sales decline while comps were up, is that true?

Doug Muir

John, I don't have that statistic in front of me, I can't tell you the answer to that question.

John Ivankoe - J.P. Morgan

Okay. That is the way I think there could be reasons why we are kind of seeing that, that's not necessarily true with operating results, just curious. Secondly, again I don't think this is exactly the way that you look at it but this is the way that we look at. Company segment EBIT I mean I guess it primarily related to the stores actually up fourth quarter 2008 versus fourth quarter 2007.

And obviously when we talked about commodity costs and you presumed that labor costs and some other factors being higher. I mean could you walk through how much cost savings at the store as might have been one time in the fourth quarter or if it's something that actually might be recurring throughout 2009 that we actually, I mean the next fiscal year that we might actually be expecting to see margin improvement at the company store level, even if comps don't accelerate materially?

Doug Muir

Let me come out of that this way John. I am trying to think of one-off items that would have affected the company store segment. I believe if I am correct in the fourth quarter last year there was a charge of about $1.3 million related to the settlement of purported wage and hour class action out in California.

John Ivankoe - J.P. Morgan

Okay.

Doug Muir

In terms of going into fiscal 2009, the answer is yes. We do currently plan and expect in budget that the operating margin in the company store segment will improve over 2008.

John Ivankoe - J.P. Morgan

And how was that especially with commodities are where they are in a consumer environment spending] s not great. Why is it that that happens, I mean it seems like when we talk about improving the customer experience that typically requires investment at the store level, not savings at the store level. So could you may be provide a little bit more color in terms of what you are actually doing to allow for improved margins to the company store level?

Doug Muir

I think I can do maybe a couple of them.

John Ivankoe - J.P. Morgan

Okay.

Doug Muir

Number one is we have taken a little bit of retail pricing that we took in the first of November if I recall correctly, so we will get some benefit from that next year. We have not taken a wholesale price increase into the grocery mass channel gosh years. And so we are finally but with the cost of commodities we have been forced to go in end of the g mass market and take some pricing increase, and if there is volume run off from that which there may be we have factored that into out plants.

One of the big things that's going on in terms of costs in the stores is a real focus on labor, I think candidly labor got away from us last year among the things we've done to attack it, we have put in a Chronos timekeeping system, which a lot of the restaurant guys use will be putting in the second phase of that this year which is a scheduling module. The other thing we're doing on the store side is historically Krispy Kreme and the store system largely a full-time employer, it's the only restaurant and kind of concept knowing around it, that doesn't use much part-time labor, that is something that we expect to be a big change as we move to part-time labor as a much bigger part of our workforce going forward.

Jim Morgan

And John, this is Jim, and that's in the end, that will not be a smaller factor, I mean our business and you understand the searches we have to shorten hours and we're 80% plus full-time as there are 100% employee based and I don't know whether it should be all the way to 2080 but 2080 is way off where we should be and I think over the next year or two that's going to make a big difference in the efficiency that we have in our stores.

John Ivankoe - J.P. Morgan

And Krispy, I never knew that, I didn't know that in terms of what your total of what the hours at the store level that was close to 80% full-time, that wasn't very high. And how much do you think just that in and of itself, I mean, if you could kind of reverse the clock calendar 2007. How much do you think that could have helped relative to like what maybe the potential of full-time or part-time, if you gone to that exercise?

Doug Muir

Not to a level of granularity we want to talk about. I'm sorry.

John Ivankoe - J.P. Morgan

Okay. No, but that's helpful though. I appreciate it. Thank you.

Doug Muir

Thank you.

Operator

(Operator Instructions) This concludes the Q&A portion of the call. I would now like to hand the call over to Mr. Brian Little for closing remarks.

Brian Little

Thank you, Erica. Before we end the call today I would like to remind everyone that this conference call webcast will be archived and available on our website. There will also be an archive audio replay available shortly following the conclusion of our call. You will find dial-in numbers and the access passcode in our earnings release. We appreciate you joining us this afternoon. Have a good evening.

Operator

Thank you for your participation in today's conference. This concludes our presentation. You may now disconnect and have a wonderful day.

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