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Krispy Kreme Doughnuts, Inc. (NYSE:KKD)

Q2 2009 Earnings Call

September 11, 2008 4:30 pm ET

Executives

Brian Little - Director, Corporate Communications

James Morgan – President & CEO

Douglas Muir - CFO

Analysts

John Ivankoe – JP Morgan

Analyst – Ramsey Asset Management

Operator

Good day ladies and gentlemen and welcome to the second quarter fiscal 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, Mr. Brian Little, Director of Corporate Communications; please proceed.

Brian Little

Good afternoon everyone. Welcome to the Krispy Kreme fiscal 2009 second quarter earnings conference call. On the call with me today are James Morgan, Krispy Kreme's President and Chief Executive Officer; and Doug Muir, Krispy Kreme’s Chief Financial Officer.

During today’s call, Mr. Morgan will address the company’s performance for the second quarter and Mr. Muir will give an overview of the second quarter results released earlier today. Following our prepared remarks we will ask the Operator to open the lines to take your questions.

I’d like to first remind everyone that a copy of our earnings announcement including financial tables is available in the News Release section under the Investor Relations tab at our website, www.krispykreme.com. This conference call is being webcast and will be archived on our website for one year. A transcript of this conference call will also be available at our 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 email 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 US Securities and Exchange Commission.

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

James Morgan

Thank you Brian and good afternoon everyone. Welcome once more to our second quarter conference call. As we commented to you in our conference call last quarter, we expected that our financial results would be somewhat uneven in the near-term as we continue to make the necessary organizational adjustments and investments to improve and grow the business over the long-term.

July is historically our toughest quarter and a weakening economy, rising fuel and agricultural commodity prices combined and adversely affected us. Nevertheless we believe very strongly that it is our task to operate successfully despite the external challenges that may arise and I continue to believe that we are on right track strategically and I remain confident about the future of Krispy Kreme.

I might note that one reason for my increased confidence over these past few months, one of several reasons, is my getting to know the employee base better and if there’s one thing I’m sure of now, we do have the people in place at all levels of this company, throughout the company that can lead this company’s success.

It’s a committed and dedicated group of individuals. I also believe however that we have to move more rapidly, at the same time thoughtfully, to implement our key strategic initiatives in order to achieve the positive long-term results that we believe are possible. And using that as a lead-in let me outline our strategic initiatives for you in a little bit more detail.

First, small retail shops, we are going to build new small retail concept shops in select company markets in order to bring our signature doughnuts closer to consumers and to establish the economics of the domestic hub and spoke model. We expect the economics of these shops to be very attractive simply because they are less expensive to open and operate then our traditional factory stores.

Moreover, supplying smaller satellite Krispy Kreme stores from Krispy Kreme factory stores improves the utilization of the factory store as well and significantly enhances the return on those stores. As a part of this project we have actively searching in North Carolina and Tennessee for suitable sites for new company satellite store locations.

We began our search in Raleigh, North Carolina and Nashville, Tennessee and we’ll be expanding that search to include the Piedmont Triad and Charlotte, North Caroline markets as well as Memphis, Tennessee.

In addition we expect to meet our previously stated goal of opening the first of these locations during this fiscal year. I might remind you that these type shops have already proven to be successful in our international markets and we believe they will set the stage as a model for future domestic growth.

Point number two, shop operations. We are now bringing intense focus to the basics of shop operations in order to improve both the consumer experience and our financial results. The best example of this was in early June, we hired a QSR veteran with 25 years of QSR operations experience to spearhead our efforts to deliver an outstanding experience at all of our shops, improve our training tools, and ensure that we consistently execute the QSR basics.

Number three, broader menu offerings. We continue to develop, test and deploy new menu offerings in order to give consumers more reasons to visit Krispy Kreme. Probably the most exciting important test in place now is the test of Kool Kreme, a new soft serve ice cream concept.

Kool Kreme is truly a delicious proprietary soft serve ice cream and that we pair it with an extraordinary toppings bar which includes a toppings bar of fresh fruit. Our Seattle franchisee developed this Kool Kreme concept and they began initial store testing over a year ago that was originally expanded to include a second location there. We introduced Kool Kreme four weeks ago at one of our company shops in Greensboro, North Carolina and Kool Kreme is also being tested at several franchise locations in the St. Louis area.

I might also note, we’re also—we are working on several other products to expand our menu offerings as well as Kool Kreme but Kool Kreme is the one that’s in the stores in test form and the furthest along.

Point number four, improving off premises economics. We are working to improve how we do business in the off premises channel which is experiencing particular revenue and cost pressures and we went into those pressures in some detail in the most recent quarterly call three months ago.

We are looking at product assortment, shelf life, price points, delivery frequency, as well as fleet management. All of these are strategic or tactical levers that we hope can improve the profitability of the off premises business. We think the Krispy Kreme brand should be represented in the off premises distribution channel and we feel that very strongly and we are working to formulate the best approach going forward in this ever changing marketplace.

Our fifth initiative is international expansion. We are continuing to build on our successes in international franchise development and we are devoting additional resources to that area. Recently we announced two international franchise development agreements; one in the Republic of Turkey for approximately 25 shops and the other in Malaysia for approximately 20 shops.

I might note that the Krispy Kreme’s international franchisees opened 30 stores in the second quarter of this year for a total of 58 stores thus far in fiscal 2009. The majority of these shops are satellite shops that occupy less then 2,000 square feet and as I mentioned in my earlier comments, these should serve as great models for our domestic growth in both company and franchise markets.

We also anticipate announcing additional international development agreements in the months ahead.

My sixth point is it pertains to franchisee operational support. We are continuing to enhance our franchisee operational support both domestically and internationally. Next week we’ll be hosting our domestic franchise conference where company and franchise operators come together to discuss our goals and more importantly to share the best practices that will help us attain those goals.

We have held and plan to continue to hold more international franchise conferences to tap the experiences and learnings of Krispy Kreme operators throughout the world.

I would also like to note that something else I’ve learned in the months that I’ve been here and that is that we have some excellent franchisees and we are deeply committed to delivering to them tools, methods and practices that will improve their shop operations everywhere.

Final point, seventh point, is the supply chain support. We are working to provide increased supply chain support to an increasingly global business and improving franchisee service levels and economics. Among other things we have added additional distribution support staff and dedicated personnel to our international franchisees in order to improve our responsiveness to their needs.

We are also working with a number of international franchisees to increase the level of local sourcing of ingredients and other materials when doing so offers them the superior economics or other competitive advantages.

In conclusion let me say that as we continue to lay the foundation for sustainable growth we want to caution once more that none of our strategic initiatives will gain significant traction overnight. We still face internal and external challenges. Although we have seen what I consider to be notable progress, progress greater then our numbers might imply in fact, it remains our task to overcome the challenges and capitalize on our opportunities in the years ahead and our intent is to do exactly that.

I will now turn the call over to Douglas who will speak to our financial results.

Douglas Muir

Thank you James and good afternoon everyone [break in audio] for the balance of the year. During the quarter franchisees opened 31 new Krispy Kreme shops system wide. Five of those were factories and 26 were satellites. There were seven shops closed in the quarter of which five were factories and two were satellites.

All but one of those 31 openings were international and the closures were principally domestic. This brings the total number of stores system wide at the end of the second quarter to 494 comprised of 286 factory stores and 208 satellites and we crossed a milestone in the second quarter. At the end of the quarter over half the total store count was located outside the United States and over a third of the store count represents non-factory, small retail concepts including [hot] shops, fresh shops, and kiosks.

Now turning to results for the quarter, we filed our quarterly report on Form 10-Q this morning and I’d encourage you to take a read through it at your convenience. We reported a net loss of $1.9 million or $0.03 a share in the second quarter compared to a net loss of $27 million or $0.42 a share in the second quarter last year.

The most significant single reason for the dramatic improvement was that last year’s second quarter included impairment charges and lease termination costs of $22 million or $0.35 a share.

As James noted, the July quarter is traditionally a seasonally slow quarter and the July quarter this year was no exception. We incurred an operating loss of $1 million in the quarter this year compared to an operating loss of $2.3 million last year. That last year’s number is excluding the affect of that $22 million of impairment charges.

We did not produce the financial results in the quarter that our plan called for but we did not miss our number by a huge margin. There were a handful of unusual or one-off items in the quarter all of which are described in the 10-Q but on balance they largely offset each other.

Thanks to significant outperformance last quarter for the year-to-date our results are ahead of plan. Let me take a minute to talk about cash flow and what the balance sheet looks like.

We generated $3 million of cash flow from operating activities in the second quarter compared to about $600,000 in the second quarter last year. We ended the quarter with about $33 million of cash and we have about $12 million of unused credit availability under our bank revolver.

Our total outstanding debt at the end of the quarter was just over $75 million. Now if I may, I’ll take a look at the balance of the year.

As you know wheat and soybean oil are the primary components of flour and shortening which are our two most significant ingredients and gasoline is a significant expense item in the company’s store segment and gasoline influences freight costs in the supply chain segment.

There recently has been some abatement in what for a long time was looking like a constantly rising cost environment and in some cases; there has been significant price retrenchment. This cost relief could have a positive affect on the second half of the year particularly in the case of gasoline but we are not counting on it.

On balance our shortfall to planned results in the second quarter makes our point estimate of our results for the full year somewhat less then it was three months ago. There are a number of uncertainties that could affect us, not the least of which are the state of the economy, gas prices and consumers’ ability and willingness to spend and these uncertainties lead to a relatively wide range of possible financial outcomes for the year.

But our expectation at this time is that our results for the year will not be significantly different from our original plan. Our major focus is to execute the initiatives James described a few minutes ago. If we can do that then I think we can begin to produce not only better financial results but also results that are more consistent and more predictable.

We are ready to go to Q&A.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of John Ivankoe – JP Morgan

John Ivankoe – JP Morgan

I was hoping you could maybe give us some more specificity around the smaller shops, satellite shops economics as you’re currently planning for company markets, just a sense in terms of what your [all-in] capital investment is what kind of sales per unit you’re expecting and if it’s fair at this point to give some margin expectation per box. And if possible, to apply that relative to what franchisees have been doing.

James Morgan

I think we will be able to do that at some point in the not-to-distant future. It’s a little early—we’ve done some modeling, we’re just now getting the shops up, we’re not real sure whether the international experience is going to reflect on the domestic experience because they’ve gone largely toward fresh shops and we’re probably going to go largely to hot shops so I think the answer is, we’re not quite prepared to do that yet.

John Ivankoe – JP Morgan

I know in the past you’ve discussed various operational initiatives that you’re trying at the store level in terms of labor cost savings, going from salary to hourly employees, could you give us an update, at the store level where you are in terms of cost controls, whether things have been done or if there’s anything that we should be looking forward to in the future?

Douglas Muir

We are beginning to see a little headway we think in shop labor. We’re not where we need to be but we think directionally we’re headed in the right direction and making some progress. Generally we are experiencing operating expenses at shop level running a little favorable to plan and that’s been one of the reasons we’ve been able to overcome to some extent higher gasoline and certain commodity costs.

James Morgan

When we mentioned that in June and I do think that’s a significant—could be potentially a significant factor, it was only about a month later that we were fortunate enough to be able to bring in a new head of company store operations and with her experience, 25-26 years with a major in well thought of QSR operation, we really—we didn’t stop it by any means but we really decided it was too valuable an input for us not to get more of her input. Give her a chance to be on the ground for a little while before we continued to push forward on that. So we didn’t stop it but we slowed it down a little bit in order to make sure that it was in sync with what she saw as most opportune without sacrificing the operational quality that we were trying to generate.

John Ivankoe – JP Morgan

I know the press likes to focus on things like growth of Dunkin Donuts maybe in some of your markets, as one of the reasons that you might not be doing as well as people would have thought a couple of years ago, is there any way to even anecdotally apply increased competition to some of your sales weakness?

James Morgan

I cannot give you statistically on that but I can tell you that so far we have not seen any marriageable affect in any of the markets where they opened one store or 20 stores. Those stores that have been in the same area of ours do not look any different on a relative basis then stores in areas where Dunkin does not exist.

So I really don’t feel like there’s a direct relationship there. The great thing and this is part of why I was attracted to this company, I really do—I know this sounds strange, but the product is so unique I’m not sure that we have a lot of direct competition. I think the greatest competition is ourselves.

Operator

Your final question comes from the line of Analyst – Ramsey Asset Management

Analyst – Ramsey Asset Management

It was noted in the 10-Q the $500,000 decline in stock comp expense due to increased executive officer turnover, could you comment on that? Was that like just in terms of how many or any detail you can provide there?

Douglas Muir

The big drivers of that are the departure of [Daryl Brewster, Mike Faylan and Jeff Jurvic] each of whom had some equity awards, particularly in the case of [Mike Faylan and Daryl Brewster] that dated back to a higher stock price then we have today. And when they left they forfeited those awards so we don’t have the current P&L hit because candidly the equity is lower today then it was when those forfeited awards were granted.

Analyst – Ramsey Asset Management

There was $440,000 of royalty income not recognized in the quarter principally related to international franchisees, any color you could provide there in terms of whether it was one particular franchisee or which region of the world that was?

Douglas Muir

The royalty revenue is related principally to a single franchisee. There is also a charge of about $1 million in the franchise segment in the quarter related to the same franchisee. What we are seeing here we think is the fact that the credit market situation that we see domestically is also prevalent in other parts of the world. This franchisee is basically in a situation not too dissimilar from the one we were in a couple of quarters ago in which we were having some trouble complying with financial covenants in a credit agreement that had been negotiated some time earlier.

The franchisee is profitable, the cash flow looks good but they are going through the same experience we went through a couple of quarters ago of renegotiating in a very difficult credit environment. Its been our practice I think in the past year since I’ve been here is that when in doubt of whether we need to take a charge, we like to try and take them sooner rather then later. But we don’t see this as a long-term problem for this franchisee or for the international community generally.

Analyst – Ramsey Asset Management

Was that $440,000 the full amount of royalty that would be owed by that franchisee for the quarter or was it a portion of it?

Douglas Muir

It was a portion of it.

Analyst – Ramsey Asset Management

Majority?

Douglas Muir

Yes.

Analyst – Ramsey Asset Management

Would you expect that there would be additional revenue amounts not recognized in future quarters or this is just maybe a one quarter type of thing?

Douglas Muir

It is possible but that is not my expectation.

Analyst – Ramsey Asset Management

On the system wide comp or same store sales on premise growth rate of negative 9.2 for the quarter I heard you talk about the strategic initiatives and new products one of which being the soft serve, just in terms of the rest of the year outlook, is there anything that would—what do you see—are there any initiatives that could materially help drive improvement in that number in the back half of the year?

Douglas Muir

I don’t expect that number to change terribly dramatically in the next six months. A big thing that we are seeing that’s influencing that number is in the international community because what we’re tending to see is not unexpectedly as you open the second and third store in a market, you do tend to have some cannibalization occurring in the revenue of the first store. That tends to occur more or less at about the same time the honeymoon on the first store ends and that is some of the pressure that we’re seeing in the system wide same store number, is just the effect of expansion by franchisees in existing markets.

Analyst – Ramsey Asset Management

Could you tell us if the international franchise same store sales is better or worse then the domestic franchisee same store sales?

Douglas Muir

I don’t have that right in front of me but I’ll be glad to circle back with you on that.

Operator

There are no additional questions at this time; I would like to turn it back over to management for any additional or closing comments.

Douglas Muir

Somebody was kind enough to look up the number so we’ll answer the previous question now; international same store sales in the quarter were off about 18%, that’s your driver and that’s principally we think cannibalization going on as international franchisees penetrate these markets.

Thank you for joining us today and we look forward to speaking with you again.

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