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Krispy Kreme Doughnuts (NYSE:KKD)

F1Q09 Earnings Call

June 9, 2008 4:30 pm ET

Executives

Brian K. Little - Director, Corporate Communications

James H. Morgan - Chairman of the Board, President, Chief Executive Officer

Douglas R. Muir - Chief Financial Officer, Executive Vice President

Analysts

John Ivankoe - J.P. Morgan

Pat Gailor

Operator

Good day, ladies and gentlemen, and welcome to the first quarter 2009 Krispy Kreme Doughnuts earnings conference call. (Operator Instructions) I would now like to turn the presentation over to your host for today’s call, the Director of Corporate Communications, Mr. Brian Little. Please proceed.

Brian K. Little

Thank you, Operator. Welcome, everyone. As the Operator mentioned, I’m Brian Little, Director of Corporate Communications for Krispy Kreme. Thank you for joining us for our 2009 first quarter earnings conference call. On the call with me today are Jim Morgan, Krispy Kreme's President and Chief Executive Officer; and Doug Muir, our Chief Financial Officer.

During our time together this afternoon, Jim will comment on company performance for the quarter and Doug will review first quarter results. As is always the case, we will ask the Operator to open the lines and take your questions following our prepared remarks.

First, however, I would like to remind everyone that a copy of our earnings announcement released this morning, including financial tables, is available in the news 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 this conference call 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.

Our responses today, as well as our 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 the U.S. Securities and Exchange Commission.

I will now turn the call over to Jim Morgan. Jim.

James H. Morgan

Thank you, Brian. Good afternoon, everyone and welcome to today’s conference call. I hope all of you have had an opportunity to review our 2009 first quarter earnings release. While we are certainly pleased that the hard work of our employees has resulted in improved performance during the most recent quarter, we do caution against drawing overly optimistic conclusions about future quarters. The majority of our strategic initiatives will not gain meaningful traction for another 12 to 24 months. Therefore, despite our belief that we are laying the appropriate groundwork for long-term success, near-term corporate performance could be somewhat uneven as we continue to address both the internal and external challenges that have faced the company for the past several years, as well as the more recent challenge of rising commodity prices.

We do believe over time there will be many more opportunities than there are challenges, however. We still have plenty of work to do.

We are confident in the strategic plan we are executing and we are moving at what I consider to be an appropriate pace to achieve the outcomes our stakeholders expect.

You might remember that during our last conference call, for those of you that were on that call, I stated that our goal is to successfully address our challenges without sacrificing any of our opportunities, while at the same time becoming a leaner, stronger, more profitable organization. That continues to be our goal.

I’d also like to reemphasize something else I said during that same call -- Krispy Kreme remains committed to delivering positive financial performance on a consistent basis. I am now more convinced than ever that this organization has a bright future and that by working closely with our franchisees, as well as our employees, we will strive to continue to improve every aspect of our company’s performance.

Today, I’ll speak briefly about our major business segment and in just a few minutes, Doug Muir will address our financial results.

I’ll begin with our off-premises business. We continue to be negatively impacted by the rising cost of agricultural commodities in what appears to be an unending rise in the cost of fuel. Like many other organizations, we have had to pass along some of these cost increases to our customers. The skyrocketing cost of fuel has a particularly negative impact on our off-premises business as we do maintain a fleet of vehicles that deliver our products to stores across the country. However, we continue to search for and find strategic ways to address these rising costs while always remaining aware of the impact on and the needs of our franchisees.

While we do anticipate that these challenges associated with rising fuel and agricultural commodity costs will have an effect on our off-premises business for the foreseeable future, we believe we have identified a couple of opportunities that allow us to meet our customers’ needs, provide additional sales potential for our partners, and buffer some portion of the burden.

Currently, we are testing three varieties of a new packaged snack product in our grocery store channel. Our new Krispy Kreme mini snack packs are individually packaged mini versions of our crullers, doughnut holes, and Krispy Juniors. These new products are being test marketed at a number of grocery and mass merchant stores across North Carolina. It’s too early to gauge the ultimate success of these products but the initial feedback we’ve received is encouraging.

We are committed to revamping our off-premises business with a long-term goal of increasing profitability and we believe that longer shelf life products could be one of the keys to this future.

We have recently taken steps to improve the efficiency of our supply chain operations. By not renewing the lease on our California distribution facility and contracting with BakeMark, USA to distribute doughnut mix and supplies to Krispy Kreme stores west of the Mississippi River, we believe we will reduce costs in our supply chain and improve speed of service to many of our franchisees.

We also continued to implement delivering improvements in our company stores with the goal of making them among the best QSRs anywhere. We are focusing our efforts carefully on the details of improving customer service and enhancing the Krispy Kreme consumer experience. We are increasing customer service training and we are emphasizing the basics of maintaining clean, inviting, and family friendly environments for our customers.

We have been introducing our plan to improve company stores now for several weeks and although we still have much to accomplish, we do believe we are making progress. The company factory stores that have recently converted to smaller shops as part of our small retail store expansion strategy continues to produce encouraging results. As you know, the smaller satellite Krispy Kreme stores provide the hot original glazed doughnut experience by using our tunnel oven technology. They also improve the utilization of the factory store that delivers freshly made doughnuts several times a day to these smaller shops for glazing and finishing. This strategy allows us to make our one-of-a-kind signature products more accessible to consumers and these smaller shops are simple to operate and less costly to build, staff, and run.

During our fourth quarter call, I stated that we plan to begin construction of new company satellite stores this year. We are actively looking at real estate in North Carolina and Tennessee to identify suitable locations for company satellite stores that are close to existing factory store hubs. Obtaining store sites is a time-consuming process often dependent on market factors outside our control and while we have not yet secured locations for any new satellites, we have identified several potential suitable sites with the objective of starting construction this fiscal year.

In our franchise business, international franchisees continue to grow and add stores. In fact, 28 international stores were opened in the first quarter. Additionally during the first quarter, Krispy Kreme reopened in Arizona, where we refranchised the store in Mesa that opened on May 13th. Going forward, we will continue to consider refranchising opportunities in other parts of the country as we focus our company store operations in our traditional base in the Southeast. This refranchising process will be a multi-year effort but over time, we expect the percentage of domestic stores operated by franchisees to increase significantly.

A very important part of the transformation of Krispy Kreme is our renewed focus on franchise relations. Although we do expect to maintain a limited company store footprint going forward, it’s our goal to be a world-class franchisor as we strive to support our franchisees better than ever before.

I will conclude now with a shot that I share previously with many of you. Krispy Kreme products are by and large an indulgence and we quite frankly do not intend to shy away from that reality. I firmly believe that we can and should be an indulgence of choice worldwide and that we should therefore succeed corporately and financially regardless of the macroeconomic environment that surrounds us.

I will now turn the call over to Doug Muir. Doug.

Douglas R. Muir

Thank you and good afternoon, everyone. First I’ll review some highlights of the quarter and then touch on our financial position and cash flows.

On the new store front, we had a big quarter. During the first quarter, 28 new Krispy Kreme stores opened system-wide, of which four were factories and 24 were satellites. Seven stores closed system-wide in the quarter, six of which were factory stores. The new stores were all located internationally and the store closures were principally domestic. This brings the total number of stores system-wide at the end of the quarter to 470, comprised of 289 factories and 181 small retail concept satellites. Of the total stores, almost half are located outside the U.S. and over a third are non-factory, small retail concepts, including hot shots, fresh shops, and kiosks.

Now turning to results for the quarter, we filed our quarterly report on 10-Q this morning and I would encourage you to read through it when you have a chance, as there’s no way we can cover all of its contents on a conference call of reasonable length.

We reported net income of $4 million in the first quarter, compared to a net loss of $7.4 million in the first quarter last year. The most significant reason for the dramatic improvement was that last year’s first quarter included a charge of $9.6 million related to a refinancing of our credit facilities.

But there were a few other unusual items that affected earnings in the quarter, some of which you might term as non-recurring in nature and I would like to mention them and just walk through them very briefly.

First off, impairment charges and lease termination costs in the first quarter was actually a credit. This caption normally is an expense item. The credit arose principally from cash proceeds we received on the assignment of a lease for our closed store. Second, other non-operating income for the quarter includes a non-cash gain of about $930,000 on the disposal of our equity interest in two franchisees. As a result of this transaction, we were released from all our guarantees of debt and leases of those franchisees, and it’s the guarantee reductions that resulted in the non-cash gain.

Our total guarantee of franchisee debt and leases, the bulk of which is leases, was about $14 million at the end of the quarter.

Interest expense declined from the first quarter last year, principally because we had substantially reduced our long-term debt over the past year. There are two other items that affected interest expense in the quarter. While these items offset each other, they are worth taking not of because they may show up somewhere down the road.

First, interest expense for the quarter reflects a non-cash credit of about $600,000, resulting from marking to market the liabilities related to our interest rate derivatives. We discontinued hedge accounting for these derivatives as a results of amendments to our credit facilities and subsequent to April the 9th when the amendments went into effect, changes in the fair value of the derivative contracts will be reflected in earnings as they occur. This may lead to some volatility going forward if market expectations about short-term interest rates change between now and the expiration of the derivatives in April of 2010.

Going the other way in interest expense, interest for the first quarter reflects a write-off of deferred financing costs and other costs and expenses related to the credit facility amendment and those totaled about $550,000 in the aggregate.

Looking down field a little bit, as you know 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 cost of these key ingredients will continue to be higher during fiscal 2009 compared to last year.

Another commodity that we are keeping our eye on is oil. We are a large consumer of gasoline in our off-premises business and continued high gas prices have an adverse effect on our results of operations.

I’ll take up just a minute to talk about the balance sheet. We ended the first quarter of fiscal 2009 with about $29 million of cash on the balance sheet, and we had about $12 million of unused credit availability under our bank revolver. So the liquidity picture right now looks pretty good. As a reminder, we have never made any draws at all on the revolving credit facility.

Let me touch briefly last on cash provided by operating activities. The business generated $6.5 million of cash provided by operating activities in the first quarter, compared to $1.3 million in the first quarter of last year.

Now, last year’s number reflects a $4.1 million outflow or a pre-payment penalty on that debt we refinanced, but even adding back that $4.1 million to last year’s number, cash provided by operating activities increased year over year in the first quarter.

Looking forward, as we disclosed back in April, we amended our credit facilities in the first quarter to, among other things, relax the financial covenants in those facilities for both this fiscal year and for next year. The cost of the amendments included a 200 basis point increase in the interest rate which, all things being equal, will increase our interest costs in coming quarters. But we are glad to have the amendments behind us and the good news is we have about $26 million less debt outstanding today than we did a year ago.

That concludes our prepared remarks and Operator, we’re now ready to go to Q&A.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of John Ivankoe with J.P. Morgan.

John Ivankoe - J.P. Morgan

I was hoping that you could update us on some of the things you talked about last quarter, such as changing employees from full-time to hourly and if there’s anything else that may have affected either the first quarter or might affect 2009 from a margin perspective to allow you to offset some of the other headwinds.

James H. Morgan

We have begun the process of that employee change, getting a high percentage of the employees to part-time and so that process has begun. It’s not nearly complete and I think -- was part of your question what affect that may or may not have had on us financially this quarter?

John Ivankoe - J.P. Morgan

Yes, and -- that and if there’s anything else that you are doing from a margin perspective to allow you to offset what are some obviously inflationary aspects of your business. So did that help the first quarter and is that going to be something measurable in 2009?

James H. Morgan

It did not have any material affect on the first quarter. I would certainly think it’s going to help us by the time 2009’s over in two ways; one, it should help us on a direct basis. I mean, our overall labor expense should be down historically. Secondly, I think it’s going to increase efficiency within the shops themselves, and that’s yet to be determined how much we truly benefit from that, but we probably would not be doing it with this strong a commitment as we have toward it if we didn’t think we were going to get both benefits over time.

John Ivankoe - J.P. Morgan

Okay. Also a question, if I may, regarding the off-premise business, which is obviously for company stores, they were have of your sales. If the numbers I have are right, not only -- on the average weekly sales per door was down something like 6.7% and then your actual number of doors I think was down 8.6%. Do I have those numbers written down right?

James H. Morgan

Doug’s checking, John, but I think that’s correct.

John Ivankoe - J.P. Morgan

Okay, and I guess the point is what do you think is happening at the off-premise channel? And what I’m really trying to get at is, is some of the accounts being down -- I mean, is it your decision, is it them saying it’s, you know, selling Krispy Kreme is no longer profitable? And at the individual count level, I mean, is it -- I mean, have you taken pricing up such that consumers aren’t buying? I mean, can you give us a little bit more clarity as to what’s happening in terms of why your accounts are down? Is it you or is it them? And then secondly, why you think your sales are down at the individual accounts?

Douglas R. Muir

John, this is Doug. Just a couple of things -- the total door count number, just for information, is not a same-store number and so you do have the effects of store closures affecting the count year over year. Jim I think will want to add to this but there’s I think several things going on in the grocery mass channel. These stores in particular, I’ve read about this in the press, you have too -- I think the average non-gas ring, average check, if you will, in the C-store world is off fairly substantially. Customers are finding that when they fill up the car, there’s less left of that -- I was going to say that 20. It probably should be less left of that $100 to buy Cokes, coffee, and doughnuts.

While there’s several things going on, I think just the economy is probably getting us here at least in the short-term as much as anything. I think Jim has mentioned before, we’ve also candidly got some product issues that we need to work on in the wholesale channel. The consistency and freshness of the product when it hits the shelf is in all circumstances not what it should be and something that the operators in the company stores are working pretty hard on.

James H. Morgan

Doug’s covered nearly most of the reasons but I just want to be emphatic on that last one that he said. I would love to tell you that it’s all part of the perfect storm and I think that is in effect. I think the consumer and the gasoline prices -- I really -- I don’t believe that’s our biggest enemy. I think our biggest enemy has been ourselves and I think that that last statement Doug made that we are spending a lot of time internally on making sure we product a higher quality product, get it to the stores in a fresh and appealing manner, we keep the display fresh and appealing and we go back to cultivate the partners that we have in the off-premise business the way we did when we first tried to gain them, because I think we had quite frankly backed away from that to some degree.

So I think that you are going to continue to see challenging numbers but I believe that we have the answer to it within our hands that we cannot blame much longer all the external conditions about why that’s fading away on us.

John Ivankoe - J.P. Morgan

Okay, fair enough. And the final question for me is related to your language about anticipating future store closures and obviously that’s probably just in the United States now. I mean, I think that language has been in your documents for years now and the sense that I’m trying to get is how closely are we to being done with that and if it’s possible to answer this question, especially looking at your franchise base, I mean, what percentage of your stores are at the franchisee level at least cash flow break-even versus some improvement has to happen to allow them to stay open? I mean, do you have like a real sense in terms of just -- especially just for modeling and expectations purposes, just kind of giving us a sense how many stores might close in the U.S. over the next year?

Douglas R. Muir

John, I don’t think we have put a number out there. In fact, I know we haven’t put a number down there. Obviously every quarter we go on we get closer to the end, wherever that is. I wish I could give it to you.

The number may be significant going forward. I’m not saying it will be but it may be. I do think that most franchisees have closed -- to the extent they have obviously losers, I think they have dealt with them. I think -- but I still think people probably continue to evaluate virtually all of their locations in a very fluid environment.

We do not have store level profitability information on virtually any of our franchise locations. We can get a sense of kind of what the top line looks like and from that we can make some inferences but I wouldn’t want to quote any percentages of stores that are positive or negative cash flow, except to say I think franchisees have done generally what we have and that’s try and get rid of your bleeders.

John Ivankoe - J.P. Morgan

Right. Okay, all right. Fair enough. Thank you.

Operator

Your next question comes from the line of Pat [Gailor]. Please proceed.

Pat Gailor

Thanks for taking the call. Two questions, I guess; first would be the real estate. Is it all encumbered by your bank debt and if so, do you have some kind of a valuation for it? And the next question would be kind of a run-rate for interest expense that you might expect?

James H. Morgan

Pat, you were breaking up. Could you -- I hate to ask you to repeat that, but --

Douglas R. Muir

Well, I heard the first question, I think, so maybe I’ll try and answer that one and you can come back. The answer is yes, all of our real estate fee owned properties and leasehold interest, for that matter, are within the scope of the lien, the credit facility. The credit facility is secured by substantially all of the company’s assets.

In terms of the valuation of all of that real estate, we have not put out in public any numbers on appraised values of any of that real estate.

Pat Gailor

Okay. How old is the plant?

Douglas R. Muir

I think you are referring probably to the plant at Ivey Avenue in Winston Salem where we manufacture our mix and we have a distribution center. That plant was built by Mr. Rudolph in its original form I believe in -- right around the second World War. We have done a fair amount of maintenance on it and the equipment has been upgraded. In fact, we are putting in a new bagging and packaging line in the mix plant over the summer, so it is old. It is in good repair. The machinery is considerably younger than the building is in most cases.

Pat Gailor

Okay, and the distribution facility, is that the same age?

Douglas R. Muir

It’s considerably younger but a distribution center is really nothing but a big -- it’s an overgrown metal shed, if you will. It is not an elegant fancy piece of real estate. It doesn’t have a whole lot in it except shelving where you can move palettes of materials around.

Pat Gailor

Okay, and my second question was the run-rate that you kind of expect for interest expense going forward.

Douglas R. Muir

If you take the -- here’s how I might estimate it if I were the analyst, and I’m not the analyst but here’s how you might want to approach it -- if you look at where we are in the first quarter, the one-off items kind of pretty much push -- they’re a push one way or the other, offsetting each other.

We have basically one month in the quarter reflects the higher interest rates of the credit facilities. If you wanted to ballpark going forward, you know you are missing two quarters that don’t reflect the credit facility amendments. The higher interest cost on the facility applies to about $75 million of outstanding indebtedness. That’s funded debt. The 200 basis point increase also applies to the fees we pay to lenders to back-stop outstanding letters of credit. In the first quarter, there was $20 million of LCs outstanding the entire quarter. Just recently we have been able to reduce those outstanding LCs to $18 million, so I think with the 12 you can kind of do the math from there.

Pat Gailor

Sure. Thank you so much.

Operator

(Operator Instructions) You have a follow-up question from the line of Pat [Gailor]. Please proceed.

Pat Gailor

The last question I had was if you could talk about the popularity and growth of your product on the international side and maybe what countries and regions that you are perhaps more optimistic about? I’m trying to get a feeling on what kind of growth we might expect going forward with those international operations.

Douglas R. Muir

The rate of growth internationally in percentage terms is going to fall because it’s kind of just on a rocket and happiness is a small base. The international appeal of the product appears to be pretty broad. If you look at the older markets, you’ve got Mexico, Australia, and the U.K. where the brand appears to be pretty well-established and where each of those franchisees continue to open additional outlets.

The most rapid area of growth after you take out those three is originally in Korea and that has been followed by other development by franchisees in the Pacific Rim area, including the Philippines, Tokyo, Indonesia, and American brands are pretty hot in Southeast Asia and the Pacific right now. We have I think interest in a number of other geographies in that general area of the world. It’s premature for me to talk about where and how many.

We see it as a very, very exciting opportunity. Again, right now mostly in the Pacific but I wouldn’t rule out more in the Middle East. I think Western Europe may be a little bit further down the road.

Pat Gailor

Thank you.

Operator

You have no further questions at this time.

Brian K. Little

Okay. Thank you, Operator.

Operator

Ladies and gentlemen, thank you for --

Brian K. Little

I’m sorry. Before we end the call today, I’d like to remind everyone that this conference call has been webcast and will be archived and available on our website. There will also be an archived audio replay available shortly following the conclusion of our call. You will find dial-in numbers and access pass-codes in our earnings release. We appreciate you joining us this afternoon. I hope you have a good evening. Good night.

Operator

Ladies and gentlemen, thank you for your patience. Your conference call has now concluded.

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Source: Krispy Kreme F1Q09 (Qtr End 5/4/08) Earnings Call Transcript
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