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Kremed!

The rise and fall of Krispy Kreme is a cautionary tale of ambition, greed, and inexperience.

Aggressive Growth

From its humble beginnings in 1937 as a family-owned business, Krispy Kreme slowly enlarged its footprint in the Southeast. In 1976, three years after founder Vernon Rudolph died, the company was sold to Beatrice Foods Co.; in 1982, a group of franchisees bought it back. In 1996, the company began to stake its claim as a national franchise.

But once Krispy Kreme went public, “there was enormous pressure, as there is for all companies, to grow very quickly and sustain growth quarter after quarter after quarter,” comments Steven P. Clark, an assistant professor of finance at Belk College of Business at the University of North Carolina at Charlotte. Unfortunately, adds Clark, “this was not the sort of business that was going to have that kind of unending growth.”

McDonald’s Corp. is the gold standard in franchising, driving such profitability to individual restaurants that franchisees are eager to join the system and follow the company’s stringent operating guidelines. But Krispy Kreme concentrated on growing revenues and profits at the parent-company level, while its outlets struggled. “You can often get a system to grow really large even when particular outlets aren’t really profitable,” notes Scott Shane, SBC Professor of Economics at Case Western Reserve University’s Weatherhead School of Management and an expert on franchising. Franchises, he explains, suffer from “goal conflict”: while the franchisor aims to maximize sales, and thus boost royalty payments, the franchisee needs to maximize profits. If a franchisor packs a market with outlets to boost its own growth, it hurts the system in the long run by forcing units to compete with one another.

“You might add another outlet in a market and increase your sales by 50 percent, but you might have turned franchisees in that market from profitable to unprofitable,” says Shane. Thus Krispy Kreme reported nearly a 15 percent increase in second-quarter revenues from fiscal 2003 to fiscal 2004, but same-store sales were up just a tenth of a percent during that time. The waning of a fad? Perhaps. But citing the issue of “significantly declining new unit returns” in August 2004, J.P. Morgan analyst John Ivankoe wrote: “These returns declined as [the] incremental appeal of each new retail store fell upon market penetration.” A year earlier, Ivankoe had downgraded the stock from “neutral” to “underweight,” the equivalent of a “sell” rating.

Getting Greedy?

Having to share markets with other outlets isn’t the only handicap for franchisees. In addition to the standard franchise fee and royalty payments, Krispy Kreme requires franchisees to buy equipment and ingredients from headquarters at marked-up prices. This strategy, while not unheard of, can hurt franchisees in the long run.

“There are a couple of ways that franchise companies can look at the selling of equipment and formula,” says Steve Hockett, president of FranChoice Inc., a company that matches potential franchisees with franchisors. “One is that it’s a true profit center, even to the point where companies can be aggressive on pricing. But most successful franchise companies build their business around the royalty payment; they don’t build it around equipment sales.” Over time, says Hockett, “the franchisor is more likely to succeed by building profitable franchisees that can make royalty payments.”

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