Note to Reader: All New Comments Since Last Report Are Highlighted

April 11, 2005

Research Digest Editor: Ian Madsen, MBA, CFA [email protected] Tel:1-800-767-3771, ext.417

www.zackspro.com 155 North Wacker Drive Chicago, IL 60606

Krispy Kreme Doughnuts, Inc. (KKD-NYSE) $7.59 Note to reader: All new comments since last report are highlighted.

Overview

Krispy Kreme Doughnuts, Inc. is a leading branded specialty retailer of doughnuts. The company sells its doughnuts in its own or franchised Krispy Kreme stores (432 units) as well as in supermarkets and other retail outlets spanning 45 U.S. states as well as Australia, Canada, Mexico, and the United Kingdom. Its website is www.krispykreme.com.

Nothing seems to be going right with KKD at this moment with both its top and bottom line under severe pressure. The company continues to post disappointing same-store sales, one of the key metrics to judge its top-line performance. The comps at company-operated stores are suffering from a significant decline in retail sales, cannibalization effect, as well as heightened competition. Franchisee operations are sluggish as well and the company’s decision to go for consolidation and writing off doubtful accounts are even more worrisome. Analysts believe the company’s initiatives to drive top-line momentum will bear fruit after 1Q06. Weak sales have led to contraction in operating margins. Analysts believe the sales and margin pressure in the near-term making is challenging the earnings visibility. As a result of this, most of them have lowered their forward EPS estimates. The ongoing SEC probe has also created a potential overhang on KKD shares.

Key Positive Arguments Key Negative Arguments  KKD has adopted several initiatives to  Systemwide comparable-store sales declined reaccelerate the top-line momentum. 6.4% in Q3 with a 6.2% at company-operated  The company continues to pursue its unit stores. expansion plans.  Significant decline in retail sales, cannibalization, and heightened competition negatively impacted comps at company- operated stores.  Franchisee operations are not doing well. Analysts believe consolidation and write-offs signify the financial distress of the franchisees.  Operating margins contracted in the third quarter.  Earnings visibility clouded. All analysts have lowered their forward EPS estimates.  Analysts believe SEC probe will create an overhang on shares.

KKD’s fiscal year ends January; all calendar references are to the fiscal year

Revenue

Analysts (BB&T, CIBC, J.P. Morgan, Legg Mason, and RBC Capital) expect sales to increase 6.3% in 2005, -3.9% in 2006, and 1.8% in 2007.

2003A 2004A 2005E 2006E Net Sales $492 $659 $700 $673 Same-Store Sales 12.8% 13.6% 0.2% 1.7% Store Growth - 29.3% 11.4% 6.6%

Q3 Summary: Third quarter systemwide sales, including sales of company and franchise stores, increased 4.7% Systemwide average sales per week decreased 16.7% year-over-year to $52,200 per store, and company store average sales per week decreased 19.9% to approximately $58,400 per store. On a comparable store basis, systemwide sales and company store sales decreased 6.4% and 6.2%, respectively. Management has not provided any sales guidance for the fourth quarter or full fiscal year 2005.

“The (6.2%) same-store sales decrease included a double-digit decline in retail sales, somewhat offset by a modest increase in off-premise sales. In its Heritage markets, which represent approximately 50% of its company sales, retail sales decreased in the high single-digits, driven by a decrease in traffic, while off-premise sales decreased in the low double-digits, reflecting a mid to high single-digit per door productivity decline, somewhat offset by a low to mid single-digit increase in the number of doors. In addition to the popular dieting trends, at least two other key issues continue to adversely impact sales trends, in our opinion. After a three-year period of aggressive retail and wholesale expansion, cannibalization of comp stores is impacting sales trends. Also related to its expansion in consumer availability, many new markets that it entered in recent years are likely becoming more accustomed to the product and stores in these markets are settling into more sustainable levels. Other factors also include an evolving grocery-store landscape with fewer successful players due to Wal-Mart's growing presence, with whom the company's relationship is not as developed as with traditional grocery store players, and a continuation of inflationary cost pressures on the consumer. While the company has discussed several sales-building initiatives that are in various stages of testing and being rolled-out, we have assumed little incremental benefit and expect that sales trends will remain under pressure over coming quarters and begin to improve during F2006,” (RBC Capital).

Analysts are concerned with declining average weekly sales as well as lackluster comps. One analyst (CIBC) expects sales erosion to continue. The analyst also believes new products like doughnut holes, flavored glazes, and sugar free doughnuts are still in test and are unlikely to impact results prior to F1Q06, at the earliest.

One analyst (JP Morgan) has expressed concern about the franchisee operations. The analyst believes franchisee level economics is much worse than company economics. The analyst also believes that there is overcapacity in many markets and evidenced by the forced consolidation of KremKo in 3Q. During the third quarter, the company recorded a $2 million allowance for doubtful accounts with respect to accounts receivable from two franchisees as an estimate of potential exposure. At the end of the third quarter, KKD consolidated KremKo, Inc., its area developer for Central and Eastern Canada, pursuant to FIN 46-R. The company owns approximately 40% of this entity but has recently provided KremKo, Inc. additional subordinated financial support, which triggered the consolidation. Analysts (CIBC and JP Morgan) believe this is the first explicit sign of financial distress of the franchisees. Another analyst (RBC Capital)

Zacks Investment Research Page 2 www.Zackspro.com believes the company may have more difficulty collecting full royalties from franchisees whose businesses are under pressure.

See the KKD consensus earnings model for more detail on the analysts’ sales estimates.

Margins

Analysts (BB&T, CIBC, JP Morgan, Legg Mason, and RBC Capital) expect margins to remain under pressure in 2005 and 2006.

Margins 2003A 2004A 2005E 2006E Restaurant Level 22.4% 23.0% 17.6% 14.6% Operating 14.0% 15.4% 7.1% 4.9% Net 8.0% 8.6% 3.5% 1.9%

Q3 Summary – Gross margin dropped 740 bps to 15.6% compared to 23% in the year-ago quarter. Overall operating margins declined approximately 1130 bps to 4.2%, compared to 15.5% in the year- earlier quarter.

“Overall operating profit margin contracted 1,119 bps to 4.16% from 15.35% in the similar year-earlier period, while associated profit dollars fell 72.8% to $7.1MM from $26MM. Company-store operating margin contracted 1,046 bps to 7.91% from 18.37%, and the profit dollars sank 52.8% to $9.6MM from $20.3MM. Management stated that a major source of the profit drain was attributable to stores in established markets where off-premise sales were down by double digits and retail sales were off high- single digits. Franchise operations EBIT margin contracted 1,055 bps to 70.91% versus 81.46% in the year-earlier period, and the related profit dollars fell 17.6% to $4.4MM. KKM&D operating margin contracted 760 bps to 14% from 21.6% in the year-ago period, and the related profit contribution declined 45.3% to $6MM. In addition to the far lower equipment sales in the quarter, higher transportation costs also impacted profits at KKM&D,” (BB&T).

One analyst (CIBC) believes operating margin has begun stabilizing. The analyst also assumes that the incremental costs that hurt the Q3 results will persist for at least two more quarters. The analyst believes given its factory store model KKD has far more fixed cost leverage than a typical restaurant or retailer.

KKD’s new management announced an aggressive cost cutting program that will save the company $10.40 M, or approximately $0.10 per share. The savings include a 25% headcount reduction in corporate and related functions and selling the corporate jet.

See the KKD consensus earnings model for more detail on the analysts’ profit margin estimates.

Earnings Per Share

The Digest EPS averages are $0.37 in 2005, $0.16 in 2006, and $0.24 in 2007.

FY ends January 3QA 4QE 2005E 1QE 2006E 2007E Digest High $0.04 $0.07 $0.45 $0.06 $0.35 $0.29 Digest Low $0.04 ($0.06) $0.33 ($0.06) $0.03 $0.18 Digest Avg. $0.04 $0.00 $0.37 $0.00 $0.16 $0.24 Digest YoY growth -82.6% -99.2% -59.2% -100.0% -57.4% 51.6% Mgmt Guidance nf nf nf nf nf nf

Zacks Investment Research Page 3 www.Zackspro.com Third quarter EPS from continuing operations were $0.04, before impairment and store closing costs. This compared to an EPS of $0.23 in the year-earlier quarter and the consensus of $0.13. Analysts believe higher general and administrative expenses (higher legal/accounting expenses), tax rate, and write down of receivables have hurt EPS to the extent of $0.05. Management has not provided any earnings guidance for the fourth quarter of full fiscal year 2005. All analysts have lowered their EPS estimates for FY05 and FY06 due to weak sales trends, lackluster new store productivity, higher costs, and margin pressure.

See the EPS and Recent Revisions tabs in the KKD consensus earnings model for more detail.

Target Price/Valuation

Target prices for KKD range from $7 (CIBC) to $16 (RBC Capital). The analyst with the lowest target price has valued it by a applying a P/E multiple 15x to CY05 EPS estimate, while the analyst with the highest one has valued it by applying a multiple of 1.4x applied to CY05 revenue estimate of $11.24 per share. While CIBC has a negative rating on the stock, RBC Capital rates the stock as neutral. Average target price is $11.50.

Rating Distribution Positive 17% Neutral 33% Negative 50% Avg. Target Price $11.50 Digest High $16.00 Digest Low $7.00

Go to the valuation tab of the KKD earnings model spreadsheet for more detail on the brokers’ valuation methodologies and individual price targets.

Long-Term Growth

Long-term growth rates for KKD ranges from 10% (CIBC) to 20% (RBC Capital). Digest average long- term growth rate is 15.6%.

During the third quarter, 15 new Krispy Kreme stores, comprising 13 factory stores and two satellites, were opened, and nine stores comprising seven factory stores and two satellites were closed. The company thus ended the third quarter with 429 stores systemwide, consisting of 393 factory stores and 36 satellites. The company intends to open approximately ten new stores systemwide in the fourth quarter. One analyst (RBC Capital) believes new store development will largely offset the closure of underperforming stores, and the company will continue to test its smaller retail-only prototype.

Additional Discussion

“Krispy Kreme also reported that the special committee formed by the board of directors to investigate matters related to the SEC’s formal investigation of the company, shareholder lawsuits, and issues raised by its auditors would not be completing its report prior to the required date for the company to issue its third-quarter 10-Q. Further, Krispy Kreme’s auditors informed the company that they would not complete their reviews of financial statements contained in the Q2 and Q3 10-Qs prior to the completion of the special committee’s investigation. These issues should create an overhang on the stock in the near term, in our opinion,” (BB&T).

Zacks Investment Research Page 4 www.Zackspro.com “Krispy Kreme' s CEO Scott Livengood has retired, and a restructuring outfit has taken the helm. We view this news as positive for the company, as the previous management team's credibility was very low, in our opinion. All three of the responsible parties for KKD's current situation (previous CFO, COO and CEO) are no longer with the firm.”(Legg Mason)

“News of CEO's departure welcomed, all things considered, though choice of replacement, Stephen Cooper, interim CEO at Enron, a mixed blessing. His hiring suggests to us that there's a greater sense of urgency to stanch mounting sales declines and stave off greater financial distress.”(CIBC)

KKD announced that it has finalized $225M of secured credit facility. A $120 million second lien senior secured term loan will be used to repay approximately $90 M outstanding existing unsecured credit facility, financing fees/expenses, and to provide cash on the balance sheet.

Individual Analyst Opinions

POSITIVE RATINGS RBC Capital – Outperform ($16) – report date 02/09/05 0.“We expect long-term investors will be rewarded for building positions at current levels with a multi-year turnaround effort that includes closing underperform stores, rebuilding store execution and profitability levels, refining its market development strategy, and strengthening the management team.” Lowered price target from $18 to $16.

NEUTRAL RATINGS Key Banc – Hold – report date 02/11/05 Key Banc maintains its Hold rating on KKD shares based on its valuation and declining Average Weekly Sales (AWS).

NEGATIVE RATINGS BB&T – Underweight – report date 02/09/05 “ In our view, Krispy Kreme shares are overvalued given the difficult fundamental trends and legal/regulatory challenges.”

CIBC – Sector Underperformer ($7) - report date 02/09/05 “While many issues dog the company—SEC investigations, questions about franchisees’ debts and legal issues— we contend that the single largest obstacle facing the company is arresting the current slide in sales, and there is little indication that the company has any near-term strategy to do so, in our view. Exacerbating this, Krispy Kreme’s refusal to take questions on its recent conference call decreases our confidence level in these shares and leaves many questions unanswered. Moreover, the first hints of financial distress for the franchise system appeared in the form of a $2 million doubtful account write off. More are likely to follow, in our view.” Lowered price target from $8 to $6.

JP Morgan – Underweight – report date 04/04/05 “Continue to avoid shares and believe significant downside remains likely. We don’t view current earnings or cash valuation as compelling from either a public or private investor perspective. We reiterate our Underweight rating.

NOT RATED

Legg Mason –report date 03/01/05 “We are dropping coverage of Krispy Kreme due to a lack of analyst coverage.”

Zacks Investment Research Page 5 www.Zackspro.com