US doughnut empire hits sticky patch

At the Krispy Kreme shop in Washington's Dupont Circle, a steady stream of customers was making its way in out of the grey dampness to get their hands on the shop's freshly cooked doughnuts.

"I come here every morning for two of them," admitted accountant Maneda Harrington, 28. "They're delicious."

To their fans, Krispy Kreme's sweet and airy doughnuts may still be the ultimate snack.

But while there may be nothing wrong with its product, Krispy Kreme has found itself in unprecedented financial and legal problems less than two years after riding a tide of investor confidence and breathless publicity.

On Tuesday, the North Carolina-based company said it was restating its earnings for the 2004 financial year, citing accounting errors. It said profits would have to be reduced by anywhere between 6 and 8 per cent or US$3.8 million ($5.4 million) to US$4.9 million.

It also warned that it may have to default on almost US$91 million in loans. Its shares fell 10 per cent as investors learned of the news.

That is not all. A class-action lawsuit filed last month on behalf of hundreds of thousands of Krispy Kreme investors accused the company of issuing false statements about its earnings for more than a year, and of and deliberately sending out double the number of doughnuts ordered by wholesales in order to boost its sales.

Three senior executives in the company were also accused of dumping 75,000 of their own shares for US$19.8 million in alleged insider trading.

Even that was not enough. The company was also forced to admit that it was being formally investigated by the federal Securities and Exchange Commission.

So what went wrong? Little more than a year ago, Krispy Kreme, which was founded in 1933, had just opened its first British outlet in the Harrods' food hall and was enjoying a wave of free publicity and product placement.

You could barely turn on the television, it seemed, without the doughnuts being plugged by either President Bill Clinton, the cast of NYPD Blue, Madonna, Jim Carey or Nicole Kidman.

It was estimated that 7.5 million of them were being sold in the US every day.

Between April 2000 when the company started public trading and August 2003, the stock rose by 625 per cent.

Much of the US economy was in recession during this period and Krispy Kreme was the darling of investors.

It appeared the company could do no wrong.

Analysts say the company - whose founder Vernon Rudolph claimed to have obtained his doughnut recipe from a French chef in New Orleans - has suffered from two factors.

One has been the growing obsession with low-carbohydrate diets such as Atkins, which hardly favours doughnuts that can pack up to 400 calories each.

The other problem may have been the company's rapid expansion and saturation of the marketplace, something it achieved by making its doughnuts available at grocery stores and petrol stations.

In a note to clients this week, analyst John Ivankoe of JP Morgan Securities, said: "There are many more questions than answers, especially given increased concerns regarding company liquidity."

Last May, the company posted its first losses since it went public and said it was cutting back on the number of stores it planned to open. At the time it blamed its difficulties on the growing popularity of low carbohydrate diets.

Some allege the problems existed long before then and that the company had been trying to hide them from investors.

In the group lawsuit filed in December, it was alleged that between January 2003 and May 2004 the company "issued false and misleading statements including false financial results [and] repeatedly ratcheted upward its public quarterly and fiscal year revenue and earning projections ... all in the face of slowing sales and market saturation".

The lawsuit claimed two witnesses had seen Krispy Kreme ship double the amount of doughnuts to boost sales.

One witness, a former Krispy Kreme sales manager at a store in Ravenna, Ohio, said the regional manager ordered that customers be sent double orders on the last Friday and Saturday of the 2004 fiscal year because "Krispy Kreme wanted to boost the sales for the fiscal year in order to meet Wall Street projections".

The extra doughnuts would be returned but go on the books of the 2005 fiscal year, the witness said.

Krispy Kreme failed to return calls seeking comment about both its restatement of earnings and the allegations of misconduct levelled at the company and its senior executives.

Last month, when it missed a deadline for filing a quarterly report with the SEC, it said it was carrying out analysis "related to the accounting treatment of certain franchise matters in the company's third quarter".

In a statement on Tuesday the firm said it had concluded that previously issued statements regarding its 2004 earning would have to be restated to "correct certain errors". It added: "Such statements should no longer be relied upon."

- INDEPENDENT