Krispy Kreme Doughnuts 10Q 2006 Q3 Quarterly report

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

(Mark one)


þ		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended October 30, 2005


o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from to

Commission file number 001-16485

KRISPY KREME DOUGHNUTS, INC.

(Exact name of registrant as specified in its charter)


North Carolina (State or other jurisdiction of incorporation or organization) 370 Knollwood Street, Winston-Salem, North Carolina (Address of principal executive offices)		56-2169715 (I.R.S. Employer Identification No.) 27103 (Zip Code)

Registrant’s telephone number, including area code:
(336) 725-2981

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yeso Noþ

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filero Accelerated filerþ Non-accelerated filero

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yeso Noþ

Number of shares of Common Stock, no par value, outstanding as of September 29, 2006: 61,838,994.

TABLE OF CONTENTS


	Page
EXPLANATORY NOTE		3
FORWARD-LOOKING STATEMENTS		3

PART I — FINANCIAL INFORMATION		5

Item 1. FINANCIAL STATEMENTS		5
Item 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS		30
Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK		43
Item 4. CONTROLS AND PROCEDURES		44

PART II — OTHER INFORMATION		49

Item 1. LEGAL PROCEEDINGS		49
Item 1A. RISK FACTORS		52
Item 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS		52
Item 3. DEFAULTS UPON SENIOR SECURITIES		53
Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS		53
Item 5. OTHER INFORMATION		53
Item 6. EXHIBITS		53

SIGNATURES		55
EX-31.1: CERTIFICATION
EX-31.2: CERTIFICATION
EX-32.1: CERTIFICATION
EX-32.2: CERTIFICATION

As used herein, unless the context otherwise requires, “Krispy Kreme,” the “Company,” “we,” “us” and “our” refer to Krispy Kreme Doughnuts, Inc. and its subsidiaries. Fiscal 2006, fiscal 2005 and fiscal 2004 mean the fiscal years ended January 29, 2006, January 30, 2005 and February 1, 2004, respectively.

EXPLANATORY NOTE

The Company filed its Annual Report on Form 10-K for fiscal 2005 (the “2005 Form 10-K”) on April 28, 2006. As more fully described in Note 2 to the consolidated financial statements under Item 8, “Financial Statements and Supplementary Data” in the 2005 Form 10-K, the Company restated its consolidated balance sheet as of February 1, 2004 (the last day of fiscal 2004) and its consolidated statements of operations, of shareholders’ equity and of cash flows for fiscal 2004 and fiscal 2003. Certain restatement adjustments affected periods prior to fiscal 2003. The effect of those restatement adjustments on years prior to fiscal 2003 were reflected in the 2005 Form 10-K as an adjustment to the opening balance of retained earnings as of February 4, 2002, the first day of fiscal 2003.

In addition, as disclosed in the 2005 Form 10-K in Note 25 to the consolidated financial statements, certain restatement adjustments affected interim financial information for fiscal 2005 and fiscal 2004 previously filed on Form 10-Q (with respect to the first and second quarters of fiscal 2005 and the first three quarters of fiscal 2004) and on Form 8-K (with respect to the third quarter of fiscal 2005). Such restatement adjustments were reflected in the unaudited selected quarterly financial data appearing in the 2005 Form 10-K and, with respect to the third quarters of fiscal 2005 and fiscal 2004, will be reflected in the Company’s Quarterly Report on Form 10-Q for the third quarter of fiscal 2005.

The restatement adjustments corrected certain historical accounting policies to conform those policies to generally accepted accounting principles (“GAAP”) and corrected errors made in the application of GAAP. For a discussion of the significant restatement adjustments and the background leading to the adjustments, see Notes 2 and 25 to the consolidated financial statements in the 2005 Form 10-K.

The Company has not amended its Annual Reports on Form 10-K or its Quarterly Reports on Form 10-Q for periods affected by the restatement adjustments, and accordingly the financial statements and related financial information contained in such reports should not be relied upon.

All amounts in this Quarterly Report on Form 10-Q affected by the restatement adjustments reflect such amounts as restated.

The Company filed its Annual Report on Form 10-K for fiscal 2006 (the “2006 Form 10-K”) on October 31, 2006.

FORWARD-LOOKING STATEMENTS

This quarterly report contains statements about future events and expectations, including our business strategy, remediation plans with respect to internal controls and trends in or expectations regarding the Company’s operations, financing abilities and planned capital expenditures that constitute “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements are based on management’s beliefs, assumptions and expectations of our future economic performance, considering the information currently available to management. These statements are not statements of historical fact. Forward-looking statements involve risks and uncertainties that may cause our actual results, performance or financial condition to differ materially from the expectations of future results, performance or financial condition we express or imply in any forward-looking statements. The words “believe,” “may,” “will,” “should,” “anticipate,” “estimate,” “expect,” “intend,” “objective,” “seek,” “strive” or similar words, or the negative of these words, identify forward-looking statements. Factors that could contribute to these differences include, but are not limited to:

	•		the outcome of pending governmental investigations, including by the Securities and Exchange Commission and the United States Attorney’s Office for the Southern District of New York, and a review by the Department of Labor;

	•		the outcome of shareholder derivative and class action litigation;

	•		potential indemnification obligations and limitations of our director and officer liability insurance;

	•		material weaknesses in our internal control over financial reporting;

	•		our ability to implement remedial measures necessary to improve our processes and procedures;

	•		continuing negative publicity;

	•		significant changes in our management;

	•		the quality of franchise store operations;

	•		our ability, and our dependence on the ability of our franchisees, to execute on our and their business plans;

	•		disputes with our franchisees;

	•		our ability to implement our international growth strategy;

	•		currency, economic, political and other risks associated with our international operations;

	•		the price and availability of raw materials needed to produce doughnut mixes and other ingredients;

	•		compliance with government regulations relating to food products and franchising;

	•		our relationships with wholesale customers;

	•		our ability to protect our trademarks;

	•		risks associated with our high levels of indebtedness;

	•		restrictions on our operations contained in our senior secured credit facilities;

	•		our ability to meet our ongoing liquidity needs;

	•		changes in customer preferences and perceptions;

	•		risks associated with competition; and

	•		other factors in Krispy Kreme’s periodic reports and other information filed with the Securities and Exchange Commission, including under Item 1A, “Risk Factors,” in the 2006 Form 10-K.

All such factors are difficult to predict, contain uncertainties that may materially affect actual results and may be beyond our control. New factors emerge from time to time, and it is not possible for management to predict all such factors or to assess the impact of each such factor on the Company. Any forward-looking statement speaks only as of the date on which such statement is made, and we do not undertake any obligation to update any forward-looking statement to reflect events or circumstances after the date on which such statement is made.

We caution you that any forward-looking statements are not guarantees of future performance and involve known and unknown risks, uncertainties and other factors which may cause our actual results, performance or achievements to differ materially from the facts, results, performance or achievements we have anticipated in such forward-looking statements.

PART I — FINANCIAL INFORMATION

Item 1. FINANCIAL STATEMENTS


	Page
Index to Financial Statements
Consolidated balance sheet as of October 30, 2005 and January 30, 2005		6
Consolidated statement of operations for the three months and nine months ended October 30, 2005 and October 31, 2004		7
Consolidated statement of cash flows for the nine months ended October 30, 2005 and October 31, 2004		8
Consolidated statement of changes in shareholders’ equity for the nine months ended October 30, 2005 and October 31, 2004		9
Notes to financial statements		10

KRISPY KREME DOUGHNUTS, INC.

CONSOLIDATED BALANCE SHEET

(Unaudited)


	October 30,			January 30,
	2005			2005
	(In thousands)
ASSETS
CURRENT ASSETS:
Cash and cash equivalents	$	27,894		$	27,686
Receivables		26,547			30,198
Accounts and notes receivable — related parties		18,880			15,510
Inventories		25,366			28,591
Deferred income taxes		3,913			3,913
Other current assets		18,035			13,465

Total current assets		120,635			119,363
Property and equipment		244,508			309,214
Non-current portion of notes receivable — related parties		100			2,120
Investments in unconsolidated franchisees		12,727			5,973
Goodwill and other intangible assets		34,207			34,380
Insurance recovery receivable		34,967			—
Other assets		21,381			9,228

Total assets	$	468,525		$	480,278


LIABILITIES AND SHAREHOLDERS’ EQUITY
CURRENT LIABILITIES:
Short-term borrowings	$	1,144		$	—
Current maturities of long-term debt		27,516			48,097
Book overdraft		—			8,480
Accounts payable		16,652			17,436
Accrued liabilities		48,044			43,622

Total current liabilities		93,356			117,635
Long-term debt, less current maturities		119,299			90,950
Deferred income taxes		3,913			3,913
Accrued litigation settlement		70,800			—
Other long-term obligations		33,020			26,447
Minority interests in consolidated franchisees		1,723			390

Commitments and contingencies

SHAREHOLDERS’ EQUITY:
Preferred stock, no par value		—			—
Common stock, no par value		298,255			295,611
Unearned compensation		—			(17	)
Notes receivable secured by common stock		(197	)		(197	)
Accumulated other comprehensive income		1,639			796
Accumulated deficit		(153,283	)		(55,250	)

Total shareholders’ equity		146,414			240,943

Total liabilities and shareholders’ equity	$	468,525		$	480,278

The accompanying notes are an integral part of the financial statements.

KRISPY KREME DOUGHNUTS, INC.

CONSOLIDATED STATEMENT OF OPERATIONS

(Unaudited)


	Three Months Ended						Nine Months Ended
	October 30,			October 31,			October 30,			October 31,
	2005			2004			2005			2004
	(In thousands, except per share amounts)
				(restated)						(restated)
Revenues	$	128,818		$	174,393		$	421,115		$	546,060
Operating expenses:
Direct operating expenses		115,995			149,194			365,742			446,922
General and administrative expenses		15,206			12,518			50,667			35,566
Depreciation and amortization expense		6,915			8,554			22,400			23,325
Impairment charges and lease termination costs		15,695			142,657			29,718			150,256
Settlement of litigation		—			—			35,833			—

Operating (loss)		(24,993	)		(138,530	)		(83,245	)		(110,009	)
Interest income		211			174			811			583
Interest expense		(4,681	)		(1,731	)		(15,225	)		(4,838	)
Equity in income (losses) of equity method franchisees		(488	)		190			(3,759	)		(675	)
Minority interests in results of consolidated franchisees		563			4,188			1,485			4,829
Other income and (expense), net		(39	)		(1,867	)		754			(1,406	)

(Loss) from continuing operations before income taxes		(29,427	)		(137,576	)		(99,179	)		(111,516	)
Provision for income taxes (benefit)		308			(133	)		(1,146	)		9,674

(Loss) from continuing operations		(29,735	)		(137,443	)		(98,033	)		(121,190	)
Discontinued operations, including income tax effects		—			(5,076	)		—			(39,833	)

(Loss) before cumulative effect of change in accounting principle		(29,735	)		(142,519	)		(98,033	)		(161,023	)
Cumulative effect of change in accounting principle, net of income taxes		—			—			—			(1,231	)

Net (loss)	$	(29,735	)	$	(142,519	)	$	(98,033	)	$	(162,254	)


(Loss) per common share — basic:
(Loss) from continuing operations	$	(.48	)	$	(2.23	)	$	(1.59	)	$	(1.97	)
Discontinued operations		—			(.08	)		—			(.64	)
Cumulative effect of change in accounting principle		—			—			—			(.02	)

Net (loss)	$	(.48	)	$	(2.31	)	$	(1.59	)	$	(2.63	)


(Loss) per common share — diluted:
(Loss) from continuing operations	$	(.48	)	$	(2.23	)	$	(1.59	)	$	(1.97	)
Discontinued operations		—			(.08	)		—			(.64	)
Cumulative effect of change in accounting principle		—			—			—			(.02	)

Net (loss)	$	(.48	)	$	(2.31	)	$	(1.59	)	$	(2.63	)

The accompanying notes are an integral part of the financial statements.

KRISPY KREME DOUGHNUTS, INC.

CONSOLIDATED STATEMENT OF CASH FLOWS

(Unaudited)


	Nine Months Ended
	October 30,			October 31,
	2005			2004
	(In thousands)
				(restated)
CASH FLOW FROM OPERATING ACTIVITIES:
Net (loss)	$	(98,033	)	$	(162,254	)
Items not requiring cash:
Depreciation and amortization		22,400			23,373
Deferred income taxes		(2,003	)		4,337
Impairment charges, including $35,119 related to discontinued operations for the nine months ended October 31, 2004		28,453			182,914
Settlement of litigation		35,833			—
Cumulative effect of change in accounting principle		—			1,231
Deferred rent expense		952			1,007
(Gain) on disposal of property and equipment		(1,036	)		(587	)
Share-based compensation		5,816			41
Provision for doubtful accounts, net of chargeoffs		4,077			2,940
Amortization of deferred financing costs		1,989			175
Minority interests in results of consolidated franchisees		(1,485	)		(4,829	)
Equity in losses of equity method franchisees		3,759			675
Cash distributions from equity method franchisees		453			1,497
Other		270			(674	)
Change in assets and liabilities:
Receivables		(3,120	)		(9,920	)
Inventories		2,806			(2,762	)
Other current assets		(1,869	)		269
Income taxes		—			6,826
Accounts payable and accrued expenses		7,268			16,438
Other long-term obligations		2,750			4,573

Net cash provided by operating activities		9,280			65,270

CASH FLOW FROM INVESTING ACTIVITIES:
Purchase of property and equipment		(8,989	)		(61,136	)
Proceeds from sales of assets leased back		—			16,698
Proceeds from other disposals of property and equipment		4,570			1,684
Acquisition of franchisees and interests therein, net of cash acquired		—			(3,618	)
Investments in and advances to equity method franchisees		(10,388	)		(2,401	)
Issuance of notes receivable		—			(724	)
Collection of notes receivable		—			4,139
(Increase) decrease in other assets		(1,077	)		212

Net cash used for investing activities		(15,884	)		(45,146	)

CASH FLOW FROM FINANCING ACTIVITIES:
Issuance of short-term debt		2,274			—
Repayment of short-term debt		(1,130	)		—
Issuance of long-term debt		120,000			12,164
Repayment of long-term debt		(97,237	)		(43,368	)
Net borrowings (repayments) under revolving credit lines		(1,606	)		1,092
Deferred financing costs		(8,761	)		(97	)
Proceeds from exercise of stock options		154			1,172
Net change in book overdraft		(8,480	)		1,845
Cash received from minority interests		2,620			22

Net cash provided by (used for) financing activities		7,834			(27,170	)

Effect of exchange rate changes on cash		(11	)		135

Cash balances of subsidiaries at date of consolidation		—			3,217

Cash balances of subsidiaries at date of deconsolidation		(1,011	)		—

Net increase (decrease) in cash and cash equivalents		208			(3,694	)
Cash and cash equivalents at beginning of period		27,686			21,029

Cash and cash equivalents at end of period	$	27,894		$	17,335

Supplemental schedule of non-cash investing and financing activities:
Assets acquired under capital leases	$	—		$	3,811

The accompanying notes are an integral part of the financial statements.

KRISPY KREME DOUGHNUTS, INC.

CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS’ EQUITY

(Unaudited)


													Accumulated
													other			Retained
													comprehensive			earnings
	Common			Common			Unearned			Notes			income			(accumulated
	shares			stock			compensation			receivable			(loss)			(deficit)			Total
	(In thousands)
BALANCE AT JANUARY 30, 2005		61,756		$	295,611		$	(17	)	$	(197	)	$	796		$	(55,250	)	$	240,943
Comprehensive income (loss):
Net loss for the nine months ended October 30, 2005																	(98,033	)		(98,033	)
Foreign currency translation adjustment, net of income tax benefit of $105														(88	)					(88	)
Unrealized gain from cash flow hedge, net of income taxes of $582														931						931

Total comprehensive (loss)																				(97,190	)
Correction of errors in accounting for stock-based compensation (Note 1)					2,508															2,508
Exercise of stock options		86			154															154
Amortization of restricted shares								5												5
Cancellation of restricted shares		(1	)		(18	)		12												(6	)

BALANCE AT OCTOBER 30, 2005		61,841		$	298,255		$	—		$	(197	)	$	1,639		$	(153,283	)	$	146,414


BALANCE AT FEBRUARY 1, 2004 (restated)		61,286		$	294,477		$	(62	)	$	(383	)	$	(712	)	$	143,089		$	436,409
Comprehensive income (loss):
Net loss for the nine months ended October 31, 2004 (restated)																	(162,254	)		(162,254	)
Foreign currency translation adjustment, net of income taxes of $583														854						854
Unrealized gain from cash flow hedge, net of income taxes of $140														213						213

Total comprehensive (loss) (restated)																				(161,187	)
Exercise of stock options		471			1,172															1,172
Amortization of restricted shares								41												41
Cancellation of restricted shares		(2	)		(41	)														(41	)

BALANCE AT OCTOBER 31, 2004 (restated)		61,755		$	295,608		$	(21	)	$	(383	)	$	355		$	(19,165	)	$	276,394

The accompanying notes are an integral part of the financial statements.

KRISPY KREME DOUGHNUTS, INC.

NOTES TO FINANCIAL STATEMENTS

(Unaudited)

Note 1 — Overview

Restatement of financial statements

In its 2005 Form 10-K, the Company restated its consolidated balance sheet as of February 1, 2004 (the last day of fiscal 2004) and its consolidated statements of operations for fiscal 2004, fiscal 2003 and the first three quarters of fiscal 2005. The restatement adjustments corrected certain historical accounting policies to conform those policies to generally accepted accounting principles (“GAAP”) and corrected errors made in the application of GAAP. Amounts set forth herein for the three and nine months ended October 31, 2004 give effect to those restatements. See Notes 2 and 25 to the consolidated financial statements included in the 2005 Form 10-K for a description of the restatement adjustments, together with reconciliations of revenues, operating income and net income for the quarters ended May 2, August 1 and October 31, 2004 as originally reported with the comparable amounts as restated.

Significant Accounting Policies

BASIS OF PRESENTATION.The consolidated financial statements contained herein should be read in conjunction with the Company’s Annual Reports on Form 10-K for the years ended January 29, 2006 and January 30, 2005. The accompanying interim consolidated financial statements are presented in accordance with the requirements of Article 10 of Regulation S-X and, accordingly, do not include all the disclosures required by generally accepted accounting principles with respect to annual financial statements. The interim consolidated financial statements have been prepared in accordance with the Company’s accounting practices described in such Annual Reports, but have not been audited. In management’s opinion, the financial statements include all adjustments which, except as otherwise disclosed in this Quarterly Report on Form 10-Q, consist only of normal recurring adjustments, necessary for a fair statement of the Company’s results of operations for the periods presented. The consolidated balance sheet data as of January 30, 2005 were derived from the Company’s audited financial statements, but do not include all disclosures required by generally accepted accounting principles.

NATURE OF BUSINESS.Krispy Kreme Doughnuts, Inc. (“KKDI”) and its subsidiaries (collectively, the “Company”) are engaged in the sale of doughnuts and related items through Company-owned stores. The Company also derives revenue from franchise and development fees and the collection of royalties from franchisees. Additionally, the Company sells doughnut-making equipment, doughnut mix, coffee and other ingredients and supplies to franchisees.

BASIS OF CONSOLIDATION.The financial statements include the accounts of KKDI and its wholly-owned subsidiaries, the most significant of which is KKDI’s principal operating subsidiary, Krispy Kreme Doughnut Corporation (“KKDC”).

As required by Accounting Research Bulletin No. 51, “Consolidated Financial Statements” (“ARB 51”) and Statement of Financial Accounting Standards No 94, “Consolidation of All Majority-Owned Subsidiaries,” the Company consolidates the financial statements of all entities in which the Company has a controlling financial interest, as defined by ARB 51. As of October 30, 2005, these entities included Glazed Investments, LLC (“Glazed Investments”), a franchisee of the Company, because the Company’s ownership interest in Glazed Investments enables the Company to exercise voting control over it.

Effective May 2, 2004, the Company adopted the provisions of Financial Accounting Interpretation No. 46 (Revised), “Consolidation of Variable Interest Entities” (“FIN 46(R)”), which clarifies the application of ARB 51 to entities that are variable interest entities (“VIEs”). VIEs typically are entities that are controlled through means other than ownership of common stock. FIN 46(R) requires the Company to assess its investments in franchisees and determine if the franchisees are VIEs. For franchisees that are VIEs, the Company must determine whether variable interests owned by the Company absorb a majority of the VIE’s expected losses and expected residual returns, and then consolidate the financial statements of those VIEs with respect to which the Company’s variable interests absorb a majority of those expected losses or returns.

Adoption of FIN 46(R) caused the Company to begin consolidating the financial statements of New England Dough, LLC (“New England Dough”) and KremeKo, Inc. (“KremeKo”). Prior to May 2, 2004, the Company accounted for its investments in these entities using the equity method. New England Dough and KremeKo, together with Glazed Investments and Freedom Rings, are hereinafter sometimes referred to as “Consolidated Franchisees.” The Company ceased consolidating the financial statements of KremeKo and Freedom Rings in May and October, 2005, respectively, after these entities filed for bankruptcy, as described in Note 9.

One of the differences between ARB 51 and FIN 46(R) is that the latter requires elimination in consolidation of 100% of the profit and revenues on intercompany transactions with less than wholly-owned subsidiaries, while the former requires elimination of such profit and revenues only to the extent of the parent’s ownership interest in the subsidiary. FIN 46(R) provides that upon the initial consolidation of variable interest entities created before December 31, 2003, the assets and liabilities of the variable interest entity should be reported as if FIN 46(R) had been in effect on the date on which the consolidating entity became the primary beneficiary of the variable interest entity and was therefore required to consolidate the entity’s financial statements.

Prior to adoption of FIN 46(R), the Company eliminated profits on the sale of equipment and the initial franchise fees charged to New England Dough and KremeKo to the extent of its ownership interests in these entities. Had FIN 46(R) been in effect in such pre-adoption periods, the Company would have been required to eliminate 100% of such intercompany profits and revenues. Accordingly, upon adoption of FIN 46(R) in the first quarter of fiscal 2005, the Company eliminated the previously recognized intercompany profits and revenues described above related to New England Dough and KremeKo. Such elimination totaled $1,231,000 (after reduction for income taxes of $803,000), and appears under the caption “Cumulative effect of change in accounting principle, net of income taxes” in the consolidated statement of operations.

Pursuant to an application made by the Company, on April 15, 2005, the Ontario Superior Court for Justice entered an order affording KremeKo protection from its creditors under the Companies’ Creditors Arrangement Act (the “CCAA”); this protection is similar to that offered by Chapter 11 of the United States Bankruptcy Code. The Company discontinued consolidation of KremeKo’s financial statements with those of the Company as a consequence of the CCAA filing; such deconsolidation was not reflected in the Company’s financial statements until the quarter ended July 31, 2005, because, except for Freedom Rings, the results of operations of Consolidated Franchisees (as well as the Company’s share of income or loss from Equity Method Franchisees) are reflected in the Company’s results of operations on a one-month lag. Because the Company reacquired control of the KremeKo business in December 2005, the Company is accounting for its investment in KremeKo during the period from April 15, 2005 through its reacquisition of the business on December 19, 2005 using the equity method, in accordance with APB 18.

On October 15, 2005, Freedom Rings, LLC, (“Freedom Rings”), a wholly-owned subsidiary, filed for bankruptcy protection, and the Company discontinued consolidation of Freedom Rings’ financial statements with those of the Company as of that date. Following such deconsolidation, Freedom Rings has been accounted for using the cost method.

Investments in entities over which the Company has the ability to exercise significant influence, and whose financial statements are not required to be consolidated under ARB 51 or FIN 46(R), are accounted for using the equity method. These entities typically are 20% to 50% owned and are hereinafter sometimes referred to as “Equity Method Franchisees.”

EARNINGS PER SHARE.The computation of basic earnings per share is based on the weighted average number of common shares outstanding during the period. The computation of diluted earnings per share reflects the potential dilution that would occur if stock options were exercised and the dilution from the issuance of restricted shares, computed using the treasury stock method.

The following table sets forth amounts used in the computation of basic and diluted earnings per share from continuing operations:


	Three Months Ended						Nine Months Ended
	October 30,			October 31,			October 30,			October 31,
	2005			2004			2005			2004
	(In thousands)
				(restated)						(restated)
Numerator: loss from continuing operations	$	(29,735	)	$	(137,443	)	$	(98,033	)	$	(121,190	)

Denominator:
Basic earnings per share-weighted average shares outstanding		61,825			61,753			61,796			61,582
Effect of dilutive securities:
Stock options		—			—			—			—
Restricted stock		—			—			—			—

Diluted earnings per share-weighted average shares outstanding		61,825			61,753			61,796			61,582

All potentially dilutive securities have been excluded from the number of shares used in the computation of diluted earnings per share for all periods presented because the Company incurred a loss from continuing operations and their inclusion would be antidilutive to the loss per share from continuing operations.

STOCK-BASED COMPENSATION.The Financial Accounting Standards Board (“FASB”) has adopted Statement of Financial Accounting Standards No. 123, “Stock-Based Compensation” (“FAS 123”), which permits, but does not require, the Company to utilize a fair-value based method of accounting for stock-based compensation. The Company has elected to continue use of the APB 25 intrinsic value method of accounting for its stock option plans and accordingly has recorded no compensation cost for grants of stock options. Had compensation cost for the Company’s stock option plans been determined based on the estimated fair value at the grant dates in accordance with the provisions of FAS 123, the Company’s losses would have been affected as set forth in the table below:


	Three Months Ended						Nine Months Ended
	October 30,			October 31,			October 30,			October 31,
	2005			2004			2005			2004
	(In thousands, except per share amounts)
				(restated)						(restated)
Net income (loss), as reported	$	(29,735	)	$	(142,519	)	$	(98,033	)	$	(162,254	)
Add: stock-based expense charged (credited) to earnings		(315	)		10			5,816			41
Deduct: stock-based compensation expense determined under fair value method for all awards		(2,729	)		(8,015	)		(14,286	)		(13,877	)

Pro forma net income (loss)	$	(32,779	)	$	(150,524	)	$	(106,503	)	$	(176,090	)


Earnings (loss) per share:
Reported earnings (loss) per share — Basic	$	(0.48	)	$	(2.31	)	$	(1.59	)	$	(2.63	)
Pro forma earnings (loss) per share — Basic	$	(0.53	)	$	(2.44	)	$	(1.72	)	$	(2.86	)
Reported earnings (loss) per share — Diluted	$	(0.48	)	$	(2.31	)	$	(1.59	)	$	(2.63	)
Pro forma earnings (loss) per share — Diluted	$	(0.53	)	$	(2.44	)	$	(1.72	)	$	(2.86	)

Stock-based compensation for the three and nine months ended October 30, 2005 includes ($315,000) and $1,792,000, respectively, representing a portion of the estimated fair value of a warrant to purchase 1.2 million shares of the Company’s common stock issued during the first quarter of fiscal 2006 to Kroll Zolfo Cooper (“KZC”), a corporate recovery and advisory firm engaged by the Company as more fully described in Note 2. The cost of the warrant is being charged to earnings from January 18, 2005, the date on which the advisory firm was engaged, to April 6, 2006, the date on which the warrant became exercisable and non-forfeitable. The credit to earnings related to the warrant for the three months ended October 30, 2005 reflects a decrease in the estimated aggregate fair value of the warrant at that date compared to July 31, 2005.

CORRECTION OF ACCOUNTING ERRORS RELATED TO STOCK-BASED COMPENSATION.In connection with the preparation of its fiscal 2006 consolidated financial statements, the Company performed certain procedures with respect to grants of stock options in prior fiscal years.

In performing such procedures, the Company identified certain grants of stock options with respect to which the Company was unable to substantiate that the grant date specified in the options was the appropriate date on which compensation cost should have been measured under APB 25. Each of the stock options was dated August 2, 2000 and had an exercise price equal to the closing

price of the Company’s common stock on that date. The closing price on August 2, 2000 was the lowest closing price of the Company’s common stock during the fiscal quarter. Because the Company was unable to substantiate August 2, 2000 as the measurement date, the Company considered all available relevant information and concluded that it should use September 12, 2000, the approximate date on which the optionees were informed of the principal terms of the grants, as the measurement date.

The market price of the Company’s common stock on this revised measurement date was greater than the exercise price specified in the options and, accordingly, the Company should have recognized compensation expense related to the options in an aggregate amount equal to such excess multiplied by the number of options awarded, in accordance with APB 25. Such aggregate charges total approximately $4.0 million, and should have been recorded in the Company’s fiscal 2001 through fiscal 2004 consolidated financial statements.

These grants were made principally to three new non-employee members of the board of directors. The Company is aware of no evidence which suggests the optionees influenced the selection of the grant date, were aware of how August 2, 2000 was selected by the Company as the grant date, or believed the Company’s accounting for such options to be improper.

The Company has concluded that the stock-based compensation amounts are not material either quantitatively or qualitatively to the Company’s consolidated financial statements in the affected periods and are not material to the fiscal 2006 consolidated financial statements. Accordingly, the Company has corrected the error by recording the approximately $4.0 million aggregate charge to earnings in the first quarter of fiscal 2006 rather than restating prior periods’ consolidated financial statements.

The Company’s income tax returns for certain years currently are under examination by the Internal Revenue Service. In connection with that examination, the Company determined that certain income tax deductions related to exercises of stock options reflected in its fiscal 2004 tax return were overstated. The Company accounted for the tax benefit of such deductions as a deferred income tax asset, with a corresponding credit to common stock, in fiscal 2004. These accounting entries constituted errors because the Company was not entitled to the related income tax deductions. In fiscal 2005, the Company established a valuation allowance against its deferred income tax assets via a charge to earnings, and such charge was overstated as a consequence of the fiscal 2004 error related to the tax benefit of stock option exercises. Because the Company has concluded that these amounts were not material to the Company’s consolidated financial statements in the affected periods, and are not material to the fiscal 2006 consolidated financial statements, the Company has corrected the errors by recording an approximately $1.5 million charge to common stock and a corresponding credit to the provision for income taxes in the first quarter of fiscal 2006 rather than restating prior periods’ consolidated financial statements.

Recent Accounting Pronouncements

In September 2006, the FASB issued Statement No. 157, “Fair Value Measurements” (“FAS 157”), which addresses how companies should measure fair value when they are required to use a fair value measure for recognition or disclosure purposes under generally accepted accounting principles (“GAAP”). As a result of FAS 157, there is now a common definition of fair value to be used throughout GAAP, which is expected to make the measurement of fair value more consistent and comparable. The Company must adopt FAS 157 in fiscal 2009, but has not yet begun to evaluate the effects, if any, of adoption on its consolidated financial statements.

In July 2006, the FASB released FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109” (“FIN 48”). FIN 48 prescribes a comprehensive model for the financial statement recognition, measurement, presentation and disclosure of income tax uncertainties with respect to positions taken or expected to be taken in income tax returns. The Company must adopt FIN 48 in fiscal 2008, and management currently is evaluating the effect of adoption on the Company’s consolidated financial statements.

In December 2004, the FASB issued Statement No. 123 (revised 2004), Share-Based Payment (“FAS 123(R)”), which requires the measurement and recognition of compensation expense for all share-based payment (“SBP”) awards. The new standard supersedes the Company’s current accounting under APB 25 and will require the Company to recognize compensation expense for all SBP awards based on fair value. In March 2005, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 107 relating to the adoption of FAS 123(R). Beginning in the first quarter of fiscal 2007, the Company will adopt the provisions of FAS 123(R), and expects to use a modified prospective transition method and the Black-Scholes option pricing model. Under the new standard, the Company’s estimate of the fair value of SBP awards, and therefore compensation expense, will require a number of complex and subjective assumptions, including the Company’s stock price volatility, employee exercise patterns influencing the expected life of the options, future forfeitures and related tax effects. The Company currently expects to recognize SBP compensation

expense for awards on a straight-line basis over the vesting period of the award. Pro forma net income and earnings per share amounts for the three months and nine months ended October 30 2005 and October 31, 2004, computed as if the Company had used a fair-value based method similar to the methods required under FAS 123(R) to measure compensation expense for employee stock-based compensation awards, are set forth under “Stock-Based Compensation” above.

In November 2004, the FASB issued Statement No. 151, “Inventory Costs” (“FAS 151”), which amends the guidance in Accounting Research Bulletin No. 43, “Inventory Pricing,” to clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs and wasted material (spoilage). FAS 151 requires that those items be recognized as current period charges and that the allocation of fixed production overheads to the cost of converting work in process to finished goods be based on the normal capacity of the production facilities. The Company will adopt this statement in fiscal 2007, but adoption of this statement will not have a material effect on the Company’s consolidated financial statements.

In February 2005, the Emerging Issues Task Force reached a consensus in Issue No. 03-13, “Applying the Conditions in Paragraph 42 of FASB Statement No. 144 in Determining Whether to Report Discontinued Operations” (“EITF 03-13”). The Company considered the guidance in EITF 03-13 in evaluating whether the operations and cash flows of components disposed of in fiscal 2006 had been or will be eliminated from ongoing operations, and the types of continuing involvement that constitute significant continuing involvement in the operations of the disposed components. These evaluations affect the determination of whether the results of operations of a disposed component are reported as discontinued operations. The Company concluded that none of the components disposed of in fiscal 2006 should be reported as discontinued operations.

In May 2005, the FASB issued Statement No. 154, “Accounting Changes and Error Corrections” (“FAS 154”) to replace Accounting Principles Board Opinion No. 20, “Accounting Changes” and FAS 3, “Reporting Accounting Changes in Interim Periods.” FAS 154 provides guidance on the accounting for and reporting of accounting changes and error corrections, and establishes retrospective application as the required method for reporting a change in accounting principle. FAS 154 provides guidance for determining whether retrospective application of a change in accounting principle is impracticable, and for reporting a change when retrospective application is determined to be impracticable. FAS 154 also addresses the reporting of a correction of an error by restating previously issued financial statements. FAS 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. The Company will adopt this pronouncement beginning in fiscal 2007.

Note 2 — Business Conditions, Uncertainties and Liquidity

The Company incurred a net loss of $198.3 million in fiscal 2005 and $98.0 million for the first nine months of fiscal 2006. The loss for the first nine months of fiscal 2006 includes a charge of $35.8 million related to the anticipated settlement of certain litigation described in Note 6. Cash provided by operating activities declined from $65.3 million in the first nine months of fiscal 2005 to $9.3 million in the first nine months of fiscal 2006.

During fiscal 2005, the Company experienced first a slowing in the rate of growth in sales in its Company Stores segment and, later in the year, declines in sales compared to the comparable periods of fiscal 2004. The Company’s Franchise and KKM&D segments experienced revenue trends similar to those experienced in the Company Stores segment. These sales declines continued in the first nine months of fiscal 2006, during which the Company’s revenues declined to $421.1 million from $546.1 million in the first nine months of fiscal 2005, reflecting, among other things, lower revenues at KKM&D, store closures (including closures by Consolidated Franchisees) and lower revenues at remaining stores. These trends adversely affected operating margins because of the fixed or semi-fixed nature of many of the Company’s direct operating expenses. In addition, litigation has been commenced against the Company and certain current and former officers and directors, and investigations of the Company have been initiated by the Securities and Exchange Commission (the “Commission”) and the United States Attorney for the Southern District of New York, as described in Note 6. In October 2004, the Company’s Board of Directors appointed a Special Committee to conduct an independent investigation of certain matters, including accounting matters. In August 2005, the Company’s Board of Directors received the report of the Special Committee, a summary of which was filed as an exhibit to a Current Report on Form 8-K dated August 9, 2005.

The loss incurred in fiscal 2005 reflects impairment charges of approximately $159.0 million related to goodwill, other intangible assets and property and equipment associated with the Company Stores business segment, and approximately $35.1 million related to the Company’s discontinued Montana Mills segment (see Note 10). The loss for the first nine months of fiscal 2006 reflects a net provision of $35.8 million for the anticipated settlement of certain litigation, and impairment charges and lease termination costs of $29.7 million associated with closed stores. In addition, the Company has incurred substantial expenses to defend the Company and its officers and directors in connection with pending litigation, to cooperate with the investigations of the Special Committee, the Commission and the United States Attorney, to undertake the Company’s internal investigation of accounting matters, and to

indemnify certain current and former officers and directors for certain legal and other expenses incurred by them. These expenses were significantly greater in fiscal 2006 than in fiscal 2005, are continuing in fiscal 2007, and could be substantial in future years.

In January 2005, the Company’s Chairman, President and Chief Executive Officer retired, and the Board of Directors engaged KZC, a corporate recovery and advisory firm, to provide interim executive management services to the Company. Since that time, the Company has undertaken a number of initiatives designed to improve the Company’s operating results and financial position. Such initiatives include closing a substantial number of underperforming stores, reducing corporate overhead and other costs to bring them more in line with the Company’s current level of operations, recruiting new management personnel for certain positions, obtaining the Secured Credit Facilities described in Note 5, restructuring certain financial arrangements associated with franchisees in which the Company has an ownership interest and with respect to which the Company has financial guarantee obligations and selling certain non-strategic assets.

In addition to the foregoing, a committee of the Company’s board of directors conducted a search for a new chief executive officer to lead the Company on a permanent basis. On March 7, 2006, the Company announced the appointment, effective immediately, of a new chief executive officer having over 20 years experience in the food industry and with particular experience in consumer packaged goods.

While the Company believes that these actions have enhanced the likelihood that the Company will be able to improve its business, the Company remains subject to a number of risks, many of which are not within the control of the Company. Among the more significant of those risks are pending litigation and governmental investigations, the outcome of which cannot be predicted, the costs of defending such litigation and cooperating with such investigations, and the magnitude of indemnification expenses which the Company will incur under indemnification provisions of North Carolina law, the Company’s bylaws and certain indemnification agreements. Any of these risks could cause the Company’s operations to fail to improve or to continue to erode.

For the year ended January 29, 2006, the Company’s revenues declined to $543.4 million from $707.8 million in fiscal 2005, reflecting, among other things, lower revenues at KKM&D, store closures (including closures by Consolidated Franchisees) and lower revenues at remaining stores. The Company incurred a loss of $135.8 million in fiscal 2006, and cash provided by operating activities declined to $1.9 million from $84.9 million in fiscal 2005.

In order to fund its business and potential indemnification obligations, including the payment of legal expenses, the Company is dependent upon its ability to generate cash from operations and continued access to external financing.

The Company’s principal source of external financing is its Secured Credit Facilities. These facilities contain significant financial and other covenants as described in Note 5. Failure to generate sufficient earnings to comply with these financial covenants, or the occurrence or failure to occur of certain events, would cause the Company to default under the Secured Credit Facilities. In the absence of a waiver of, or forbearance with respect to, any such default from the Company’s lenders, the Company could be obligated to repay outstanding indebtedness under the facilities, and the Company’s ability to access additional borrowings under the facilities would be restricted. The facilities contain covenants which limit the total indebtedness of the Company and limit the Company’s ability to obtain borrowings under the facilities, as described in Note 5.

The Company believes that it will have sufficient access to credit under the Secured Credit Facilities to continue the restructuring of the Company’s business, and that it will be able to comply with the covenants contained in such facilities. The financial covenants contained in such facilities are based upon the Company’s fiscal 2007 operating plan and preliminary plans for fiscal 2008, which include, among other things, anticipated sales of certain assets and reductions in the amount of indebtedness and other obligations of franchisees guaranteed by the Company. There can be no assurance that the Company will be able to comply with the financial and other covenants in these facilities. In the event the Company were to fail to comply with one or more such covenants, the Company would attempt to negotiate waivers of any such noncompliance. There can be no assurance that the Company will be able to negotiate any such waivers, and the costs or conditions associated with any such waivers could be significant.

In the event that credit under the Secured Credit Facilities were not available to the Company, there can be no assurance that alternative sources of credit will be available to the Company or, if they are available, under what terms or at what cost. Until such time as the Company is current in filing with the Commission all periodic reports required to be filed by the Company under the Securities Exchange Act of 1934 (the “Exchange Act”), the Company will not be able to obtain capital by issuing any security whose registration would be required under the Securities Act of 1933. The Company has not filed its Quarterly Reports on Form 10-Q for the third quarter of fiscal 2005 or for the first and second quarters of fiscal 2007. While the Company is working diligently to

complete the filings referred to in the preceding sentence (focusing first on the fiscal 2007 reports and then on the third quarter fiscal 2005 report), there can be no assurance as to when the Company will be current in its reporting obligations.

Note 3 — Receivables

The components of receivables are as follows:


	Oct. 30,			Jan. 30,
	2005			2005
	(In thousands)
Trade receivables:
Wholesale doughnut customers	$	18,270		$	21,743
Unaffiliated franchisees		20,794			18,897
Current portion of notes receivable		1,114			937
Less — allowance for doubtful accounts		(13,631	)		(11,379	)

	$	26,547		$	30,198


Receivables from related parties:
Equity Method Franchisees:
Trade	$	16,423		$	12,804
Current portion of notes receivable		5,309			2,000
Less — allowance for doubtful accounts		(2,852	)		(1,105	)

		18,880			13,699


Franchisees owned by Directors emeriti:
Trade		—			1,669
Current portion of notes receivable		—			142

		—			1,811

	$	18,880		$	15,510


Non-current portion of notes receivable from related parties:
Equity Method Franchisees	$	100		$	1,958
Franchisees owned by Directors emeriti		—			162

	$	100		$	2,120

During the quarter ended October 30, 2005, the Company eliminated the position of non-voting emeritus director and the persons then holding such position retired as non-voting emeritus directors.

Note 4 — Inventories

The components of inventories are as follows:


	Oct. 30,		Jan. 30,
	2005		2005
	(In thousands)
Raw materials	$	6,808	$	8,210
Work in progress		31		56
Finished goods		5,165		7,225
Purchased merchandise		13,200		12,948
Manufacturing supplies		162		152

	$	25,366	$	28,591

Note 5 — Long Term Debt

Long-term debt and capital lease obligations consist of the following:


	Oct. 30,			Jan. 30,
	2005			2005
	(In thousands)
Krispy Kreme Doughnut Corporation:
$225 million Secured Credit Facility	$	119,700		$	—
$119.3 million revolving line of credit		—			59,000
$30.7 million term loan		—			28,600
Capital lease obligations		4,116			7,360

		123,816			94,960


Glazed Investments:
$12 million credit facility		6,141			7,003
Real estate and equipment loans		5,772			6,347
Capital lease obligations		1,355			1,370
Subordinated notes		136			136

		13,404			14,856


New England Dough:
$14.4 million term loans		9,595			13,487
$12 million revolving line of credit		—			1,606

		9,595			15,093


KremeKo:
Credit facility		—			11,581
Building and equipment loans		—			2,199
Capital lease obligations		—			358

		—			14,138

		146,815			139,047
Less: current maturities		(27,516	)		(48,097	)

	$	119,299		$	90,950

Secured Credit Facilities

On April 1, 2005, the Company closed new secured credit facilities totaling $225 million (collectively, the “Secured Credit Facilities”). KKDC is the borrower under each of the Secured Credit Facilities, and KKDI and certain of its domestic subsidiaries are guarantors. The facilities consist of a $75 million revolving credit facility maturing April 1, 2008, secured by a first lien on substantially all of the assets of KKDC and the guarantors (the “First Lien Revolver”), and a $150 million credit facility maturing April 1, 2010, secured by a second lien on those assets (the “Second Lien Facility”). The Second Lien Facility consists of a $120 million term loan (the “Term Loan”) and a $30 million revolving credit facility (the “Second Lien Revolver”). At closing, the Company borrowed the full $120 million available under the Term Loan, and used the proceeds to retire approximately $88 million of indebtedness outstanding under a bank credit facility (which was then terminated) and to pay fees and expenses associated with the Secured Credit Facilities. The balance of the term loan proceeds were retained for general corporate purposes.

During the first quarter of fiscal 2006, the Company wrote off approximately $840,000 of unamortized financing costs associated with the retired bank financing and approximately $640,000 related to the termination of an interest rate hedge related to such financing. Such charges are included in interest expense in the accompanying consolidated statement of operations.

Both the First Lien Revolver and the Second Lien Revolver contain provisions which permit the Company to obtain letters of credit. Issuance of letters of credit under these provisions constitutes usage of the lending commitments, and the amount of such letters of credit reduces the amount available for cash borrowings under the related revolver. On the closing date, the Company obtained approximately $9.2 million of letters of credit (the “Backstop LCs”) under the Second Lien Revolver, which were issued to secure the Company’s reimbursement obligations relating to letters of credit issued under the retired credit facility, and a new letter of credit of $6.0 million to secure obligations to one of the Company’s banks. The letters of credit issued under the retired credit facility (the majority of which secured the Company’s obligations under self-insured worker’s compensation insurance policies) subsequently were replaced with new letters of credit issued under the Second Lien Revolver, and corresponding amounts of the Backstop LCs were terminated.

The description of the Secured Credit Facilities contained herein reflects post-closing amendments, the most recent of which was effective October 30, 2006.

Interest on borrowings under the First Lien Revolver is payable either at LIBOR or at the Alternate Base Rate (which is the greater of Fed funds rate plus 0.50% or the prime rate), in each case plus the Applicable Margin. The Applicable Margin for LIBOR-based loans is 2.75% and for Alternate Base Rate- based loans is 1.75% (3.25% and 2.25%, respectively, from December 12, 2005 through January 28, 2007). In addition, the Company is required to pay a fee equal to the Applicable Margin for LIBOR-based loans on the outstanding amount of letters of credit issued under the First Lien Revolver, as well as a 0.25% fronting fee. There also is a fee of 0.50% (0.75% from December 12, 2005 through January 28, 2007) on the unused portion of the First Lien Revolver lending commitment.

The Company pays fees aggregating 5.975% (7.35% from December 12, 2005 through January 28, 2007) on the entire $30 million Second Lien Revolver commitment. In addition, interest accrues on outstanding borrowings at either the Fed funds rate or LIBOR, and the outstanding amount of letters of credit issued under the Second Lien Revolver incurs a fronting fee of 0.25%.

Interest on the outstanding balance of the Term Loan accrues either at LIBOR or at the Fed funds rate plus, in each case, the Applicable Margin. The Applicable Margin for LIBOR-based loans is 5.875% and for Fed funds-based loans is 4.875% (7.25% and 6.25%, respectively, from December 12, 2005 through January 28, 2007).

As required by the Secured Credit Facilities, the Company has entered into an interest rate derivative contract having a notional principal amount of $75 million. The derivative contract eliminates the Company’s exposure, with respect to such notional amount, to increases in three month LIBOR beyond 4.0% through April 2006, 4.50% from May 2006 through April 2007 and 5.0% from May 2007 through March 2008. This derivative has been accounted for as a cash flow hedge from its inception in fiscal 2006.

Borrowings under the First Lien Revolver are limited to 150% of the Consolidated EBITDA of the Financial Test Group, minus the amount of outstanding letters of credit issued under the First Lien Revolver. The operation of this restriction, and the restrictive financial covenants described below, may limit the amount the Company may borrow under the First Lien Revolver to less than $75 million. As defined in the agreement, “Consolidated EBITDA,” a non-GAAP measure, means, generally, net income or loss, exclusive of unrealized gains and losses on hedging instruments and gains or losses on the early extinguishment of debt, plus the sum of net interest expense, income taxes, depreciation and amortization, non-cash charges, store closure costs, costs associated with certain litigation and investigations described in the Note 6 (including, but not limited to, the purported securities class action litigation, the shareholder derivative actions and the purported ERISA class action litigation) the costs and expenses paid to KZC and other extraordinary professional fees; and minus the sum of non-cash credits and the unremitted earnings of Equity Method Franchisees. The “Financial Test Group” consists of the Company and its subsidiaries, exclusive of the Consolidated Franchisees.

Borrowings under the First Lien Revolver and the Second Lien Revolver (and issuances of letters of credit) are subject to the satisfaction of usual and customary conditions, including accuracy of representations and warranties and the absence of defaults and, in the case of the First Lien Revolver, the existence of minimum Net Liquidity (as defined in the First Lien Revolver) of at least $10 million.

The Term Loan is payable in equal quarterly installments of $300,000 and a final installment equal to the remaining principal balance on April 1, 2010.

The Secured Credit Facilities are required to be repaid with the net proceeds of certain equity issuances, debt incurrences, asset sales and casualty events. In addition, the First Lien Revolver is required to be repaid on a daily basis to the extent the Company’s Net Liquidity (as defined in the First Lien Revolver) is below $20.0 million. Mandatory repayments under the First Lien Revolver do not reduce commitments under the First Lien Revolver. Net proceeds are generally required to be first applied to repay amounts outstanding under the First Lien Revolver and then (without giving effect to the amount repaid under the First Lien Revolver) to be offered to the holders of the Term Loan. To the extent application of these mandatory prepayment provisions results in prepayment of amounts outstanding under the Term Loan, such prepaid amounts cannot be reborrowed, and any such prepayments are not subject to the prepayment fees described in the following paragraph.

The Company may permanently reduce the commitments under both the First Lien Revolver and the Second Lien Revolver. The Company must pay a fee of 1% of the amount of any such reduction of the commitments under the First Lien Revolver which occurs before August 1, 2006. The Company may not reduce the commitments under the Second Lien Revolver until August 1, 2006. The Company must pay a fee of 3% of the amount of any such reduction which occurs on or before August 1, 2007; such fee declines to 2% on August 2, 2007, to 1% on August 2, 2008 and to zero on August 2, 2009. The Company has not reduced the commitments under either the First Lien Revolver or the Second Lien Revolver. The Company may prepay the Term Loan on or after August 1,

2006; prepayment fees equal to the commitment termination fees for the Second Lien Revolver apply to any such Term Loan prepayments.

The Secured Credit Facilities require the Company to meet certain financial tests, including a maximum leverage ratio (expressed as a multiple of earnings before interest, taxes and depreciation (“EBITDA”)) and a minimum interest coverage ratio (expressed as a ratio of EBITDA to net interest expense), computed based upon EBITDA and net interest expense for the most recent four fiscal quarters. As of October 30, 2005, these tests were set at 4.5 to 1.0, in the case of the maximum leverage ratio, and 3.15 to 1.0, in the case of the minimum interest coverage ratio. As of October 30, 2005, the Company’s leverage ratio was approximately 3.6 to 1.0 and the Company’s interest coverage ratio was approximately 4.8 to 1.0. After giving effect to the October 30, 2006 amendments to the Secured Credit Facilities, the maximum leverage ratio for years after fiscal 2006 ranges from 5.4 to 1.0 to 3.7 to 1.0, and the minimum interest coverage ratio ranges from 2.05 to 1.0 to 3.4 to 1.0. In addition, the Secured Credit Facilities contain other covenants which, among other things, limit the incurrence of additional indebtedness (including guarantees), liens, investments (including investments in and advances to franchisees which own and operate Krispy Kreme stores), dividends, transactions with affiliates, asset sales, acquisitions, capital expenditures, mergers and consolidations, prepayments of other indebtedness and other matters customarily restricted in such agreements. The Secured Credit Facilities also prohibit the transfer of cash or other assets to KKDI from its subsidiaries, whether by dividend, loan or otherwise, but provide for exceptions to enable KKDI to pay taxes and operating expenses and certain judgment and settlement costs.

As of October 30, 2005, the maximum additional borrowings available to the Company under the Secured Credit Facilities were approximately $48 million. Such amount reflects the effects of application of the restrictive financial covenants described in the preceding paragraph.

The Secured Credit Facilities also contain customary events of default, including without limitation, payment defaults, breaches of representations and warranties, covenant defaults, cross-defaults to other indebtedness in excess of $1 million, certain events of bankruptcy and insolvency, judgment defaults in excess of $1 million and the occurrence of a change of control.

Consolidated Franchisees

Both Glazed Investments and New England Dough had various credit facilities to fund their operations and capital expenditures. Those credit facilities bore interest at floating rates and contained various financial and other covenants. At October 30, 2005, both Glazed Investments and New England Dough were in violation of one or more covenants under their credit facilities, and accordingly all borrowings outstanding under those facilities were classified as current liabilities at that date.

Accounts receivable, inventories and property and equipment having carrying values of approximately $333,000, $181,000 and $15.1 million at October 30, 2005 are pledged as collateral for indebtedness of New England Dough, a VIE whose financial statements have been consolidated with those of the Company pursuant to FIN46(R). Creditors of New England Dough have no recourse to the general credit of the Company except to the extent of the Company’s guarantee of certain of New England Dough’s indebtedness; such guarantee totaled approximately $5.4 million at October 30, 2005.

During the quarter ended October 30, 2005, the Company settled KremeKo’s secured indebtedness, which was guaranteed, in part, by the Company, and subsequent to October 30, 2005, the remaining indebtedness of Consolidated Franchisees was paid, as described in Note 9.

Note 6 — Commitments and Contingencies

Except as disclosed below, the Company is currently not aware of any legal proceedings or claims that the Company believes could have, individually or in the aggregate, a material adverse effect on the Company’s business, financial condition or results of operations.

Litigation Settled or Pending Settlement

Federal Securities Class Actions and Settlement Thereof and Federal Court Shareholder Derivative Actions and Partial Settlement Thereof

On May 12, 2004, a purported securities class action was filed on behalf of persons who purchased the Company’s publicly traded securities between August 21, 2003 and May 7, 2004 against the Company and certain of its current and former officers in the United

States District Court for the Middle District of North Carolina. Plaintiff alleged that defendants violated Sections 10(b) and 20(a) of the Exchange Act and Rule 10b-5 promulgated thereunder in connection with various public statements made by the Company. Plaintiff sought damages in an unspecified amount. Thereafter, 14 substantially identical purported class actions were filed in the same court. On November 8, 2004, all of these cases were consolidated into one action. The court appointed lead plaintiffs in the consolidated action, who filed a second amended complaint on May 23, 2005, alleging claims under Sections 10(b) and 20(a) of the Exchange Act on behalf of persons who purchased the Company’s publicly-traded securities between March 8, 2001 and April 18, 2005. The Company filed a motion to dismiss the second amended complaint on October 14, 2005 that is currently pending.

Three shareholder derivative actions have been filed in the United States District Court for the Middle District of North Carolina:Wright v. Krispy Kreme Doughnuts, Inc., et al., filed September 14, 2004;Blackwell v. Krispy Kreme Doughnuts, Inc., et al., filed May 23, 2005; andAndrews v. Krispy Kreme Doughnuts, Inc., et al., filed May 24, 2005.

The defendants in one or more of these actions include all current and certain former directors of the Company (other than members of the Special Committee and Messrs. Brewster and Schindler), certain current and former officers of the Company, including Scott Livengood (the Company’s former Chairman and Chief Executive Officer), John Tate (the Company’s former Chief Operating Officer) and Randy Casstevens (the Company’s former Chief Financial Officer), and certain persons or entities that sold franchises to the Company. The complaints in these actions allege that the defendants breached their fiduciary duties in connection with their management of the Company and the Company’s acquisitions of certain franchises. The complaints sought damages, rescission of the franchise acquisitions, disgorgement of the proceeds from these acquisitions and other unspecified relief.

In orders dated November 5, 2004, November 24, 2004, April 4, 2005 and June 1, 2005, the court stayed theWrightaction pending completion of the investigation of the Special Committee.

On June 3, 2005, the plaintiffs in theWright,BlackwellandAndrewsactions filed a motion to consolidate the three actions and to name lead plaintiffs in the consolidated action. On June 27, 2005, Trudy Nomm, who, like the plaintiffs in theWright,BlackwellandAndrewsactions, identified herself as a Krispy Kreme shareholder, filed a motion to intervene in these derivative actions and to be named lead plaintiff. On July 12, 2005, the court consolidated theWright,BlackwellandAndrewsshareholder derivative actions under the headingWright v. Krispy Kreme Doughnuts, Inc., et al.and ordered the plaintiffs to file a consolidated complaint on or before the later of 45 days after the plaintiffs receive the report of the Special Committee or 30 days after the court appoints lead counsel. A consolidated complaint has not yet been filed.

On August 10, 2005, the Company announced that the Special Committee had completed its investigation. The Special Committee concluded that it was in the best interest of the Company to reject the demands by shareholders that the Company commence litigation against the current and former directors and officers of the Company named in the derivative actions and to seek dismissal of the shareholder litigation against the outside directors, the sellers of certain franchises and current and former officers, except for Messrs. Livengood, Tate and Casstevens, as to whom the Special Committee concluded that it would not seek dismissal of the shareholder derivative litigation.

On October 21, 2005, the court granted Ms. Nomm’s motion to intervene. On October 28, 2005, the court appointed the plaintiffs in theWrightaction, Judy Woodall and William Douglas Wright, as co-lead plaintiffs in the consolidated action.

On October 31, 2006, the Company and the Special Committee entered into a Stipulation and Settlement Agreement (the “Stipulation”) with the lead plaintiffs in the securities class action, the derivative plaintiffs and all defendants named in the class action and derivative litigation, except for Mr. Livengood, providing for the settlement of the securities class action and a partial settlement of the derivative action, on the terms described below.

With respect to the securities class action, the Stipulation provides for the certification of a class consisting of all persons who purchased the Company’s publicly-traded securities between March 8, 2001 and April 18, 2005, inclusive. The settlement class will receive total consideration of approximately $75 million, consisting of a cash payment of $34,967,000 to be made by the Company’s directors’ and officers’ insurers, a cash payment of $100,000 to be made by Mr. Tate, a cash payment of $100,000 to be made by Mr. Casstevens, a cash payment of $4,000,000 to be made by the Company’s independent registered public accounting firm and common stock and warrants to purchase common stock to be issued by the Company having an aggregate value of $35,833,000 (based on the current market price of the Company’s common stock). Claims against all defendants will be dismissed with prejudice; however, claims that the Company may have against Mr. Livengood that may be asserted by the Company in the derivative action for contribution to the securities class action settlement or otherwise under applicable law are expressly preserved. The Stipulation

contains no admission of fault or wrongdoing by the Company or the other defendants. The settlement is subject to preliminary and final approval of the court.

With respect to the derivative litigation, the Stipulation provides for the settlement and dismissal with prejudice of claims against all defendants except for claims against Mr. Livengood. The Company, acting through its Special Committee, settled claims against Mr. Tate and Mr. Casstevens for the following consideration: Messrs. Tate and Casstevens each agreed to contribute $100,000 in cash to the settlement of the securities class action; Mr. Tate agreed to cancel his interest in 6,000 shares of the Company’s common stock; and Messrs. Tate and Casstevens agreed to limit their claims for indemnity from the Company in connection with future proceedings before the SEC or the United States Attorney for the Southern District of New York to specified amounts. The Company, acting through its Special Committee, has been in negotiations with Mr. Livengood but has not reached agreement to resolve the derivative claims against him and counsel for the derivative plaintiffs are deferring their application for fees until conclusion of the derivative actions against Mr. Livengood. All other claims against defendants named in the derivative actions will be dismissed with prejudice without paying any consideration, consistent with the findings and conclusions of the Special Committee in its report of August 2005.

The Company estimated that, based on the current market price of its common stock, it will issue approximately 1,875,000 shares of its common stock and warrants to purchase approximately 4,400,000 shares of its common stock in connection with the Stipulation. The exercise price of the warrants will be equal to 125% of the average of the closing prices of the Company’s common stock for the 10-day period surrounding the filing of its 2006 Form 10-K.

The Company has recorded a non-cash charge to earnings in the first quarter of fiscal 2006 of $35,833,000, representing the estimated fair value of the common stock and warrants to be issued by the Company. The Company has recorded a related receivable from its insurers in the amount of $34,967,000, as well as a liability in the amount of $70,800,000 representing the aggregate value of the securities to be issued by the Company and the cash to be paid by the insurers. The settlement is conditioned on the Company’s insurers and the other contributors paying their share of the settlement. The provision for settlement costs will be adjusted to reflect changes in the fair value of the securities until they are issued following final court approval of the Stipulation, which the Company anticipates will occur in late calendar 2006 or early calendar 2007.

State Court Shareholder Derivative Actions

Two shareholder derivative actions have been filed in the Superior Court of North Carolina, Forsyth County:Andrews v. Krispy Kreme Doughnuts, Inc., et al., filed November 12, 2004, andLockwood v. Krispy Kreme Doughnuts, Inc., et al., filed January 21, 2005. On April 26, 2005, those actions were assigned to the North Carolina Business Court. On May 26, 2005, the plaintiffs in these actions voluntarily dismissed these actions in favor of a federal court action they filed on May 25, 2005 (theAndrewsaction discussed above).

ERISA Class Action

On March 16, 2005, KKDC was served with a purported class action lawsuit filed in the United States District Court for the Middle District of North Carolina that asserted claims for breach of fiduciary duty under ERISA against KKDC and certain of its current and former officers and employees. Plaintiffs purported to represent a class of persons who were participants in or beneficiaries of KKDC’s retirement savings plan or profit sharing stock ownership plan between January 1, 2003 and the date of filing and whose accounts included investments in the Company’s common stock. Plaintiffs contended that defendants failed to manage prudently and loyally the assets of the plans by continuing to offer the Company’s common stock as an investment option and to hold large percentages of the plans’ assets in the Company’s common stock; failed to provide complete and accurate information about the risks of the Company’s common stock; failed to monitor the performance of fiduciary appointees; and breached duties and responsibilities as co-fiduciaries. On May 15, 2006, the Company announced that a proposed settlement had been reached with respect to this matter. The settlement would include a one-time cash payment to be made to the settlement class by the Company’s insurer in the amount of $4,750,000. The Company and the individual defendants deny any and all wrongdoing and would pay no money in the settlement. Several contingent events must be satisfied before the settlement becomes final, including final approval by the United States District Court where the matter is pending. It is anticipated that if the United States District Court gives final approval to the proposed settlement, this matter will be resolved finally by the end of calendar 2007. Other long-term obligations in the accompanying consolidated balance sheet as of May 1, 2005 includes an accrual equal to the $4.75 million proposed settlement amount, and a related receivable from the insurer of an equal amount is included in other assets at that date.

Franchisee Litigation

Lone Star.On May 19, 2005, KKDC was sued by one of its area developers, Lone Star Doughnuts, Ltd., in the District Court for Harris County, Texas. The trial court entered a temporary injunction requiring KKDC to continue shipments of supplies to Lone Star on normalized rather than cash-before- delivery terms, and referred the matter to the American Arbitration Association for arbitration in Winston-Salem, North Carolina. The issues between the parties included KKDC’s claims against Lone Star for past due amounts for royalties, the Brand Fund, and equipment and supplies furnished to Lone Star. Lone Star’s claims against KKDC included breach of contract, fraud, negligent misrepresentation, breach of warranties, and violation of North Carolina’s Unfair and Deceptive Trade Practices Act. On February 9, 2006, the Company reached an agreement with Lone Star to settle all outstanding disputes and claims, including the dismissal of this lawsuit. The settlement agreement includes a complete separation of the relationship between Lone Star Doughnuts, Ltd. and KKDC, the return of certain proprietary equipment and a de-identification of all former Krispy Kreme locations.

Sweet Traditions.On July 19, 2005, KKDC was sued by one of its area developers, Sweet Traditions, LLC, and its Illinois corporate entity Sweet Traditions of Illinois, LLC, in the Circuit Court for St. Clair County, Illinois seeking specific performance, declaratory judgment and injunctive relief, as well as moving for a temporary restraining order and preliminary injunction. Sweet Traditions sought to compel KKDC to continue to supply product to its franchisee stores without payment. On July 22, 2005, the case was removed to the United States District Court for the Southern District of Illinois. On July 27, 2005, the District Court entered an order denying Plaintiffs’ Motion for Preliminary Injunction on the basis that their claims had no reasonable likelihood of success on the merits. A settlement was reached between the parties and on August 25, 2006 a joint stipulation for dismissal of the litigation with prejudice was filed with the court. The court dismissed the case on August 28, 2006.

Great Circle.On September 29, 2005, KKDI, KKDC, certain former officers and directors of KKDI and KKDC and various other defendants were sued in California Superior Court for Los Angeles County, by Richard Reinis and Roger E. Glickman. Messrs. Reinis and Glickman are the principals and managing members of the Company’s Southern California developer and franchisee, Great Circle Family Foods, LLC, and the guarantors of Great Circle’s monetary obligations to KKDC. The complaint, which sought unspecified damages and injunctive relief, purported to assert various claims on behalf of Great Circle, as well as certain individual claims by the plaintiffs that arose out of and related to Great Circle’s franchise relationship with the Company. On July 28, 2006, KKDI and KKDC announced that they reached agreements with Great Circle on an integrated transaction involving the settlement of all pending litigation between the parties and the court dismissed the case on August 31, 2006. As part of the transaction, which closed on August 31, 2006, Southern Doughnuts, LLC, a wholly owned subsidiary of KKDC, acquired three of Great Circle’s stores located in Burbank, Ontario and Orange, California, together with the related franchise rights. Southern Doughnuts paid Great Circle $2.9 million for the acquired stores and related assets. Pursuant to the agreements, Great Circle has the right to repurchase the three stores and related assets from the Company for $2.9 million plus interest at 8% per annum to the date of repurchase. Such repurchase right terminates under certain conditions, but in no event later than May 29, 2007. Under the agreements, Krispy Kreme, Great Circle and related parties exchanged mutual releases and dismissals regarding the pending litigation.

In addition, on or about April 14, 2006, Great Circle initiated an arbitration before the American Arbitration Association (“AAA”) against KKDI, KKDC and various other respondents, seeking in excess of $20 million in alleged damages, contract rescission, indemnification, injunctive and declaratory relief, and other relief. The claims asserted in the arbitration demand arise out of and relate to Great Circle’s franchise relationship with the Company and largely mirror the claims asserted by Messrs. Reinis and Glickman in the litigation described above. On June 7, 2006, Krispy Kreme and certain co-defendants filed their response to the demand. Also on that date, Krispy Kreme filed a counterclaim/cross-claim against Great Circle and Messrs. Reinis and Glickman, asserting thirteen causes of action relating to breaches of Great Circle’s development agreement and franchise agreements with Krispy Kreme. A settlement agreement was reached between the parties and on August 31, 2006 the parties jointly requested that the AAA dismiss the arbitration with prejudice.

KremeKo.On January 11, 2006, KKDI, KKDC, two of their former officers and PricewaterhouseCoopers LLP were sued in California Superior Court for Los Angeles County by Robert C. Fisher. Mr. Fisher is a shareholder of KKDC’s former developer and franchisee for Central and Eastern Canada, KremeKo, Inc., and a guarantor of KremeKo’s monetary obligations to KKDC. The complaint purports to assert claims for fraud, constructive fraud, breach of fiduciary duty, rescission, negligent misrepresentation and declaratory relief and seeks unspecified damages based on defendants’ alleged misstatements regarding KKDI’s operations and financial performance and KKDC’s acquisition of KremeKo. In June 2006, the parties entered into a settlement agreement which settled all claims in this matter. The settlement amounts involved were not material.

The Company has made provision in its consolidated financial statements related to the resolution of the foregoing matters as described above.

Pending Litigation and Investigations

The Company is subject to other litigation and investigations, the outcome of which cannot presently be determined. The Company cannot predict the likelihood of an unfavorable outcome with respect to these other matters, or the amount or range of potential loss with respect to, or the amount that might be paid in connection with any settlement of, any of these other matters, and, accordingly, no provision for loss with respect to any of the following matters has been reflected in the consolidated financial statements.

SEC Investigation

On October 7, 2004, the staff of the Commission advised the Company that the Commission had entered a formal order of investigation concerning the Company. The Company is cooperating with the investigation.

United States Attorney Investigation

On February 24, 2005, the United States Attorney’s Office for the Southern District of New York advised the Company that it would seek to conduct interviews of certain current and former officers and employees of the Company. The Company is cooperating with the investigation.

Department of Labor Review

On March 9, 2005, and March 21, 2005, the DOL informed the Company that it was commencing a “review” of the Krispy Kreme Doughnut Corporation Retirement Savings Plan and the Krispy Kreme Profit Sharing Stock Ownership Plan to determine whether any violations of Title I of ERISA have occurred. The DOL investigation is ongoing and the DOL has not yet indicated whether it believes any violations of ERISA have occurred. The Company is cooperating with the DOL.

State Franchise/FTC Inquiry

On June 15, 2005, the Commonwealth of Virginia, on behalf of itself, the FTC and eight other states, inquired into certain activities related to prior sales of franchises and the status of the Company’s financial statements and requested that the Company provide them with certain documents. The inquiry related to potential violations for failures to file certain amendments to franchise registrations and the failure to deliver accurate financial statements to prospective franchisees. Fourteen states (the “Registration States”) and the FTC regulate the sale of franchises. The Registration States specify forms of disclosure documents that must be provided to franchisees and filed with the state. In the non-registration states, according to FTC rules, documents must be provided to franchisees but are not filed. Earlier in 2005, the Company had chosen not to renew its disclosure document in the Registration States because the Company realized that its financial statements would need to be restated and because the Company had stopped selling domestic franchises. The Company is fully cooperating with the inquiry and has delivered the requested documents. Since June 15, 2005, Virginia has indicated that it and a majority of the remaining states would withdraw from the inquiry. The Company has not received any additional information from the FTC or any other state that one or more of them intend to pursue or abandon the inquiry.

State Court Books and Records Action

On February 21, 2005, a lawsuit was filed against the Company in the Superior Court of North Carolina, Wake County, Nomm v. Krispy Kreme, Inc., seeking an order requiring the Company to permit the plaintiff to inspect and copy the books and records of the Company. On March 29, 2005, the action was transferred to the Superior Court of North Carolina for Forsyth County. On May 20, 2005, the case was assigned to the North Carolina Business Court. On June 27, 2005, plaintiff filed a motion to intervene and be named lead plaintiff in the federal court derivative actions described above. On August 2, 2005, the North Carolina Business Court stayed this action pending a decision on Ms. Nomm’s motion to intervene and to serve as lead plaintiff in the federal court actions described above. On October 21, 2005, the court in the federal court actions granted Ms. Nomm’s motion to intervene and, on October 28, 2005, denied Ms. Nomm’s motion to be named lead plaintiff.

The Company also is engaged in various legal proceedings incidental to its normal business activities. The Company maintains customary insurance policies against claims and suits which arise in the course of its business, including insurance policies for workers’ compensation and personal injury, some of which provide for relatively large deductible amounts.

Other Contingencies and Commitments

The Company has guaranteed certain leases and loans from third-party financial institutions on behalf of franchisees, primarily to assist the franchisees in obtaining third-party financing. The loans are also collateralized by certain assets of the franchisee, generally

the Krispy Kreme store and related equipment. The Company’s contingent liability related to these guarantees was approximately $25.1 million at October 30 and January 30, 2005, exclusive of guarantees related to Consolidated Franchisees. For leases, the guaranteed amount was determined based upon the gross amount of remaining lease payments due and for debt the guaranteed amount was determined based upon the principal amount outstanding under the respective agreement. Of the total guaranteed amount at October 30 and January 30, 2005, approximately $25.1 million and $24.6 million, respectively, relates to Equity Method Franchisees, as summarized in Note 9. Each of the guarantee amounts at October 30, 2005 includes approximately $9.7 million related to KremeKo which was not included in the balance of guarantees as of January 30, 2005 because the financial statements of KremeKo at that date were consolidated with those of the Company and KremeKo’s indebtedness was reflected as a liability in the Company’s consolidated balance sheet. The percentage guaranteed generally approximates the Company’s ownership percentage in the franchisee. The remaining guarantees relate to franchisees in which the Company has no ownership interest. These guarantees require payment from the Company in the event of default on payment by the respective debtor and, if the debtor defaults, the Company may be required to pay amounts outstanding under the respective agreements in addition to the principal amount guaranteed, including accrued interest and related fees. At the time the guarantees were issued, the Company determined the fair value of the guarantees was immaterial and, accordingly, no amount was reflected for the liabilities in the consolidated balance sheet.

The Company is subject to indemnification obligations to its directors and officers as described in Note 2.

Note 7 — Impairment Charges and Lease Termination Costs

The components of impairment charges and lease termination costs are as follows:


	Three Months Ended					Nine Months Ended
	Oct. 30,			Oct. 31,		Oct. 30,			Oct. 31,
	2005			2004		2005			2004
	(In thousands)
				(restated)					(restated)
Impairment charges:
Impairment of goodwill	$	—		$	131,609	$	—		$	131,609
Impairment of long-lived assets		15,293			9,331		28,293			15,030
Impairment of reacquired franchise rights		120			600		160			600
Other		—			7		—			556

Total impairment charges		15,413			141,547		28,453			147,795

Lease termination costs:
Provision for termination costs		369			1,025		1,804			2,735
Less — reversal of previously recorded deferred rent expense		(87	)		85		(539	)		(274	)

Net provision		282			1,110		1,265			2,461

	$	15,695		$	142,657	$	29,718		$	150,256

The goodwill impairment charge in fiscal 2005 reduced the carrying value of goodwill associated with the Company Stores segment to its estimated fair value.

Impairment charges associated with long-lived assets consist principally of charges to reduce the carrying value of leasehold improvements related to closed stores to reflect that the leasehold improvements are abandoned when the leased properties revert to the lessor, and charges to reduce the carrying value of equipment related to closed stores to its estimated fair value, if any. The fair value of equipment is based upon its estimated selling price to franchisees opening new stores, after considering refurbishment and transportation costs.

Lease termination costs represent the net present value of remaining contractual lease payments related to closed stores, after reduction by estimated sublease rentals.

The transactions reflected in the accrual for lease termination costs are as follows:


	Three Months Ended						Nine Months Ended
	Oct. 30,			Oct. 31,			Oct. 30,			Oct. 31,
	2005			2004			2005			2004
	(In thousands)
				(restated)						(restated)
Balance at beginning of period	$	1,804		$	1,596		$	2,281		$	—

Provision for lease termination costs:
Provisions associated with store closings, net of estimated sublease rentals		164			812			1,319			2,522
Adjustments to previously recorded provisions resulting from settlements with lessors and adjustments of previous estimates		184			197			416			197
Accretion of discount		21			16			69			16

Total provision		369			1,025			1,804			2,735

Accrual related to KremeKo (Note 1)		—			—			(862	)		—
Accrual related to Freedom Rings (Note 1)		(150	)		—			(150	)		—
Payments		(250	)		(414	)		(1,300	)		(528	)

Balance at end of period	$	1,773		$	2,207		$	1,773		$	2,207

Note 8 — Segment Information

The Company’s reportable segments are Company Stores, Franchise and Krispy Kreme Manufacturing and Distribution (“KKM&D”). The Company Store segment is comprised of the operating activities of the stores owned by the Company and by consolidated franchisees. These stores sell doughnuts and complementary products through both on-premises and off-premises sales channels. The majority of the ingredients and materials used by Company Stores is purchased from the KKM&D segment. The Franchise segment represents the results of the Company’s franchise program. Under the terms of the franchise agreements, the franchisees pay royalties and fees to the Company in return for the use of the Krispy Kreme name and ongoing brand and operational support. Expenses for this segment include costs incurred to recruit new franchisees and to open, monitor and aid in the performance of these stores and direct general and administrative expenses. The KKM&D segment supplies mix, equipment, coffee and other items to both Company and franchisee-owned stores.

All intercompany transactions between the KKM&D segment and the Company Stores segment are at prices intended to reflect an arms-length transfer price and are eliminated in consolidation. Operating earnings for the Company Stores segment does not include any profit earned by the KKM&D segment on sales of doughnut mix, ingredients and supplies to the Company Stores segment; such profit is included in KKM&D operating income. Royalties charged by the Company to Consolidated Franchisees and eliminated in consolidation are not included in Franchise segment revenues or operating income, and have not been charged to Company Stores operating income, in the table set forth below. The gross profit earned by the KKM&D segment on sales of equipment to the Company Stores segment and eliminated in consolidation similarly is not included in the KKM&D segment operating income shown below, and depreciation expense charged to Company Stores operating income reflects the elimination of that intercompany profit.

The following table presents the results of operations of the Company’s reportable segments. Segment operating income is consolidated operating income before unallocated general and administrative expenses, impairment and lease termination costs and settlement of litigation.


	Three Months Ended						Nine Months Ended
	Oct. 30,			Oct. 31,			Oct. 30,			Oct. 31,
	2005			2004			2005			2004
	(In thousands)
				(restated)						(restated)
Revenues:
Company Stores	$	93,668		$	128,411		$	309,248		$	388,247
Franchise		4,121			5,681			14,100			19,147
KKM&D		60,982			84,702			196,321			277,052
Intersegment sales eliminations		(29,953	)		(44,401	)		(98,554	)		(138,386	)

Total revenues	$	128,818		$	174,393		$	421,115		$	546,060

Operating income (loss):
Company Stores	$	(3,529	)	$	983		$	(1,375	)	$	13,855
Franchise		3,231			3,709			10,213			13,558
KKM&D		6,654			12,469			25,541			49,883
Unallocated general and administrative expenses		(15,654	)		(13,034	)		(52,073	)		(37,049	)
Impairment charges and lease termination costs		(15,695	)		(142,657	)		(29,718	)		(150,256	)
Settlement of litigation		—			—			(35,833	)		—

Total operating (loss)	$	(24,993	)	$	(138,530	)	$	(83,245	)	$	(110,009	)

Depreciation and amortization expense:
Company Stores	$	5,555		$	7,162		$	18,257		$	19,257
Franchise		32			43			113			129
KKM&D		880			833			2,624			2,456
Corporate administration		448			516			1,406			1,483

Total depreciation and amortization expense	$	6,915		$	8,554		$	22,400		$	23,325

Segment information for total assets and capital expenditures is not presented as such information is not used in measuring segment performance or allocating resources among segments.

Note 9 — Investments in Franchisees

Consolidated Franchisees

Pursuant to an application made by the Company, on April 15, 2005, the Ontario Superior Court for Justice (the “Ontario Court”) entered an order affording KremeKo protection from its creditors under the CCAA; this protection is similar to that offered by Chapter 11 of the United States Bankruptcy Code. The Company discontinued consolidation of KremeKo’s financial statements with those of the Company coincident with the CCAA action; such deconsolidation was not reflected in the Company’s financial statements until the quarter ended July 31, 2005 because, except for Freedom Rings, the results of operations of Consolidated Franchisees and the Company’s share of income or loss from Equity Method Franchisees are reflected in the Company’s results of operations on a one-month lag.

An officer of the Company was appointed chief restructuring officer of KremeKo, with the authority to operate the business and implement a financial and operating restructuring plan under the supervision of the Court. In connection with its implementation of the restructuring plan, the Company reached an agreement with KremeKo’s two secured creditors to settle the Company’s obligations with respect to its guarantees of certain indebtedness to such lenders and related equipment repurchase agreements. Pursuant to the agreement, the Company paid approximately $9.3 million to the lenders in settlement of all of the Company’s obligations to them, and the lenders assigned to the Company KremeKo’s notes payable to the lenders (the “KremeKo Notes”). On December 19, 2005, a newly formed subsidiary of the Company acquired from KremeKo all of its operating assets in exchange for the KremeKo Notes pursuant to a sale authorized by the Ontario Court, and thereafter the business has operated as a wholly-owned subsidiary of the Company. Because the Company reacquired control of the KremeKo business in December 2005, the Company is accounting for its investment in KremeKo during the period from April 15, 2005 through its reacquisition of the business on December 19, 2005 using the equity method, in accordance with APB 18.

On October 15, 2005, the Company acquired the 30% interest in Freedom Rings owned by the minority investor in exchange for nominal consideration. On October 16, 2005, Freedom Rings filed for bankruptcy protection, and the Company thereafter discontinued consolidation of Freedom Rings’ financial statements. All of Freedom Rings’ stores have been closed and its operations have been substantially wound up.

In December 2005, the Company and the minority investors in New England Dough reached an agreement to reorganize the operations of the business. In connection with that agreement, the Company acquired three New England Dough stores, a fourth store was acquired by the minority investors, and the remaining New England Dough stores were closed. The Company and the minority owners of New England Dough retired its outstanding debt, which was subject to guarantees of the owners in proportion to their ownership interests (approximately 60% of New England Dough is owned by the Company and approximately 40% is owned by a minority investor). New England Dough’s affairs have been substantially wound up.

On February 3, 2006, Glazed Investments filed for bankruptcy protection, and the Company thereafter discontinued consolidation of Glazed Investments’ financial statements. Under the supervision of the court, on March 31, 2006, the majority of Glazed Investments’ stores were sold to another of the Company’s franchisees for $10 million cash. Glazed Investments closed the balance of its stores. As part of this transaction, the Company assigned its interest in KK Wyotana, LLC to the purchaser of the Glazed Investments stores. While the proceeds of the sale and the proceeds from liquidation of Glazed Investments’ other assets were sufficient to retire a substantial majority of Glazed Investments’ outstanding debt, the Company paid approximately $1.1 million of Glazed Investments’ debt pursuant to the Company’s guarantee of certain of such indebtedness.

Equity Method Franchisees

As of October 30, 2005, the Company has invested in 14 Equity Method Franchisees. Investments in these franchisees have been made in the form of capital contributions and, in certain instances, loans evidenced by promissory notes.

The Company’s financial exposures related to Equity Method Franchisees and Freedom Rings are summarized in the table below; amounts shown for loan and lease guarantees are not reflected in the consolidated balance sheet.


	October 30, 2005
	Investment									Loan and
	and			Trade		Notes Receivable				Lease
	Advances			Receivables		Current		Long-term		Guarantees
	(In thousands)
A-OK, LLC	$	(100	)	$	1,466	$	60	$	10	$	2,861
Amazing Glazed, LLC		(439	)		567		76		19		2,218
Amazing Hot Glazers, LLC		184			170		24		4		894
Caribbean Glaze Corporation		90			—		—		—		—
Freedom Rings (accounted for using the cost method)		2,000			116		88		—		833
KK-TX I, L.P.		(137	)		106		—		—		1,543
KK Wyotana, LLC		—			38		—		—		—
KKNY, LLC		(7	)		605		—		—		—
KremeKo, Inc.		5,210			—		1,013		—		—
Kremeworks, LLC		2,349			1,562		—		—		2,667
Krispy Kreme Australia Pty Limited		(358	)		3,191		4,024		67		4,622
Krispy Kreme of South Florida, LLC		—			1,644		—		—		7,899
Krispy Kreme U.K. Limited		2,745			4,418		—		—		1,102
Krispy Kreme Mexico, S. de R.L. de C.V.		1,190			1,526		—		—		—
Priz Doughnuts, LP		—			1,014		24		—		436

	$	12,727		$	16,423	$	5,309	$	100	$	25,075


	January 30, 2005
	Investment									Loan and
	and			Trade		Notes Receivable				Lease
	Advances			Receivables		Current		Long-term		Guarantees
	(In thousands)
A-OK, LLC	$	(33	)	$	1,222	$	58	$	55	$	3,001
Amazing Glazed, LLC		22			443		73		76		2,590
Amazing Hot Glazers, LLC		175			122		23		22		951
Caribbean Glaze Corporation		90			—		—		—		—
KK-TX I, L.P.		(44	)		110		—		—		1,578
KK Wyotana, LLC		—			51		—		—		—
KKNY, LLC		(7	)		1,199		—		—		—
Kremeworks, LLC		638			3,072		900		—		2,667
Krispy Kreme Australia Pty Limited		385			1,551		922		1,767		4,419
Krispy Kreme of South Florida, LLC		413			1,310		—		20		8,068
Krispy Kreme U.K. Limited		3,327			1,456		—		—		851
Krispy Kreme Mexico, S. de R.L. de C.V.		1,007			1,363		—		—		—
Priz Doughnuts, LP		—			905		24		18		468

	$	5,973		$	12,804	$	2,000	$	1,958	$	24,593

On November 30, 2005, the Company sold its 35% equity investment in Krispy Kreme Australia Pty Limited (“KK Australia”) to the majority investor in the franchise for AUS$3,500,000 cash (approximately US$2.5 million at the time of the transaction), and on May 29, 2006, the majority investor purchased from the Company, for cash and at par, the Company’s notes receivable from KK Australia totaling AUS$5,075,000 (approximately $3.7 million at the time of the transaction) and, in connection therewith, all of the Company’s guarantees of certain of KK Australia’s indebtedness were released. The Company realized a gain of approximately $3.3 million on the sales of these interests, which will be reflected in earnings in the second quarter of fiscal 2007.

In December 2005, the Company returned its interest in Amazing Glazed, LLC (“Amazing Glazed”) to the franchisee and was released from all its obligations under Guarantees related to the franchisee. In connection with these transactions, the Company loaned $300,000 to Amazing Glazed, which is evidenced by a promissory note bearing interest at 10%, with interest payable beginning in April 2007 and principal payable in full in December 2010.

In March 2006, in connection with Glazed Investments’ sale of certain of its stores as described above, the Company assigned its membership interest in KK Wyotana, LLC (“KK Wyotana”) to the purchaser of Glazed Investments’ stores, which was also the majority owner of KK Wyotana.

In May 2006, the Company entered into an agreement to sell the Company’s 35% equity investment in and notes receivable from Krispy Kreme U.K. Limited (“KK UK”) to KK UK’s majority shareholder for $5.6 million. On October 20, 2006, the Company received $2.0 million from the purchasers, representing the purchase price of the notes. The Company expects to receive the $3.6 million balance of the sales price in November 2006. In connection with the sale, all of the Company’s obligations with respect to guarantees related to KK UK were terminated.

In May 2006, KKNY, LLC (“KKNY”) ceased operations. The Company acquired two of KKNY’s stores in exchange for $500,000 cash, and the balance of KKNY’s stores were closed.

In June 2006, the Company returned its interest in Amazing Hot Glazers, LLC to the franchisee and was released from all its obligations under guarantees related to the franchisee.

In September 2006, the Company sold its investment in Caribbean Glaze Corporation to its majority owner in exchange for $150,000 cash.

Note 10 — Discontinued Operations

In the first quarter of fiscal 2005, the Company’s Board of Directors adopted a plan to divest the Montana Mills operations. The Company acquired Montana Mills, an owner and operator of upscale “village bread stores” in the Northeastern United States, in April 2003 and reported the results of operations of Montana Mills as a separate segment of the business. Montana Mills has been accounted for as a discontinued operation, and its results of operations are separately presented in the accompanying consolidated

statement of operations. Cash flows associated with Montana Mills have not been segregated from cash flows associated with continuing operations in the accompanying consolidated statement of cash flows.

Subsequent to its decision to divest the Montana Mills business, the Company closed twelve Montana Mills locations, and in November 2004 completed the sale of its remaining assets.

Summarized results from discontinued operations for the three months and nine months ended October 31, 2004 are as follows:


	Three			Nine
	Months			Months
	Ended			Ended
	Oct. 31,			Oct. 31,
	2004			2004
	(In thousands)
	(restated)
Revenues	$	853		$	3,564


Loss before income taxes, including impairment charges of $1,001 and $35,119, respectively, for the three months and nine months ended October 31, 2004	$	(1,424	)	$	(37,626	)
Provision for income taxes		3,652			2,207

Net loss from discontinued operations	$	(5,076	)	$	(39,833	)

Item 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

Krispy Kreme is a leading branded retailer and wholesaler of high-quality doughnuts. The Company’s principal business, which began in 1937, is owning and franchising Krispy Kreme doughnut stores where over 20 varieties of doughnuts, including the Company’s Hot Original Glazed™, are made, sold and distributed and where a broad array of coffees and other beverages are offered.

As of October 30, 2005, there were 416 Krispy Kreme stores operated systemwide in the United States, Australia, Canada, Mexico, South Korea and the United Kingdom, of which 153 were owned by the Company (including 36 owned by consolidated franchisees) and 263 were owned by franchisees (other than consolidated franchisees). Of the 416 total stores, there were 351 factory stores and 65 satellites; 360 stores were located in the United States and 56 were located in other countries.

Factory stores (stores which contain a doughnut-making production line) typically support multiple sales channels to more fully utilize production capacity and reach additional consumer segments. These sales channels are comprised of on-premises sales (sales to customers visiting stores) and off-premises sales (sales to supermarkets, convenience stores, mass merchants and other food service and institutional accounts). Satellite stores consist primarily of the fresh shop, kiosk and tunnel oven formats. Tunnel oven stores contain heating technology that allows customers to have a hot doughnut experience throughout the day. Fresh shops and free-standing kiosk locations do not contain doughnut heating technology.

The Company generates revenues from three distinct sources: stores operated by the Company, referred to as Company Stores; franchise fees and royalties from franchise stores, referred to as Franchise; and a vertically integrated supply chain, referred to as Krispy Kreme Manufacturing and Distribution, or KKM&D.

The following discussion of the Company’s financial condition and results of operations should be read together with the Company’s consolidated financial statements and notes thereto appearing elsewhere herein. Financial information for the three months and nine months ended October 31, 2004 reflects the restatement adjustments described in Notes 2 and 25 to the Company’s consolidated financial statements included in the Company’s Annual Report on Form 10-K for the year ended January 30, 2005.

During fiscal 2005, the Company experienced first a slowing in the rate of growth in sales in the Company Stores segment and, later in the year, declines in sales compared to the comparable periods of fiscal 2004. These sales declines continued in fiscal 2006. For the nine months ended October 30, 2005, systemwide and Company average weekly sales per factory store decreased approximately 17.6% and 19.6%, respectively, compared to the prior year. The 19.6% decline in Company average weekly sales per factory store resulted in a larger percentage decline in Company Store profitability due to the significant fixed or semi-fixed nature of many store operating costs. In response to declining sales, the Company closed 24 poorly performing factory stores during the first nine months of fiscal 2006, and recorded impairment charges and lease termination costs of approximately $29.7 million related to store closing decisions. Also in the first nine months of fiscal 2006, lower sales to franchisees adversely affected the KKM&D segment and lower sales by franchise stores adversely affected the Franchise Operations segment. The Company was also adversely affected by the substantial costs associated with the legal and regulatory matters discussed in Notes 2 and 6 to the consolidated financial statements appearing elsewhere herein.

RESULTS OF OPERATIONS

The following table presents the Company’s operating results for the three and nine months ended October 30, 2005 and October 31, 2004, expressed as a percentage of revenues (amounts may not add to totals due to rounding).


	Three months ended						Nine months ended
	Oct. 30,			Oct. 31,			Oct. 30,			Oct. 31,
	2005			2004			2005			2004
				(restated)						(restated)
Revenues		100.0	%		100.0	%		100.0	%		100.0	%
Operating expenses:
Direct operating expenses		90.0			85.6			86.9			81.8
General and administrative expenses		11.8			7.2			12.0			6.5
Depreciation and amortization expense		5.4			4.9			5.3			4.3
Impairment charges and lease termination costs		12.2			81.8			7.1			27.5
Settlement of litigation		—			—			8.5			—

Operating income		(19.4	)%		(79.4	)%		(19.8	)%		(20.1	)%

To facilitate an understanding of the Company’s operating results, data on the number of factory stores appear in the table below. The number of factory stores includes commissaries but excludes satellite stores. Transferred stores for the nine months ended October 30, 2005 represent stores operated by KremeKo, a Consolidated Franchisee which filed for bankruptcy protection in April 2005; the Company ceased consolidation of the financial statements of KremeKo following the bankruptcy filing. Transferred stores for the nine months ended October 31, 2004 represent stores operated by KremeKo and New England Dough, franchisees whose financial statements were first consolidated with those of the Company as of May 2, 2004, the end of the first quarter of fiscal 2005.


	NUMBER OF FACTORY STORES (1)
	COMPANY			FRANCHISE			TOTAL
Three months ended October 30, 2005:
JULY 31, 2005		151			216			367
Opened		—			6			6
Closed		(5	)		(17	)		(22	)
Transferred		—			—			—

OCTOBER 30, 2005		146			205			351


Nine months ended October 30, 2005:
JANUARY 30, 2005		175			221			396
Opened		3			11			14
Closed		(24	)		(35	)		(59	)
Transferred		(8	)		8			—

OCTOBER 30, 2005		146			205			351


Three months ended October 31, 2004:
AUGUST 1, 2004		171			216			387
Opened		8			5			13
Closed		(4	)		(4	)		(8	)
Transferred		—			—			—

OCTOBER 31, 2004		175			217			392


Nine months ended October 31, 2004:
FEBRUARY 1, 2004		141			216			357
Opened		20			31			51
Closed		(10	)		(6	)		(16	)
Transferred		24			(24	)		—

OCTOBER 31, 2004		175			217			392


(1)		Excludes satellites.

The table below presents average weekly sales per factory store (which represents, on a company or systemwide basis, total sales of all stores divided by the number of operating weeks for factory stores) and average weekly sales per store (which represents, on a company or systemwide basis, total sales of all stores divided by the number of operating weeks for both factory stores and satellites). Operating weeks represents the aggregate number of weeks in a period that factory stores or all stores were in operation.

Systemwide sales, a non-GAAP financial measure, include the sales by both our Company and franchise stores. The Company believes systemwide sales data is useful in assessing the overall performance of the Krispy Kreme brand and, ultimately, the performance of the Company. The Company’s consolidated financial statements appearing elsewhere herein include sales by Company Stores, including the sales by consolidated franchisees’ stores, sales to non-consolidated franchisees by the KKM&D business segment, and royalties and fees received from franchisees, but exclude the sales by franchise stores to their customers.


	Three months ended				Nine months ended
	Oct. 30,		Oct. 31,		Oct. 30,		Oct. 31,
	2005		2004		2005		2004
	( In thousands, except operating weeks)
			(restated)				(restated)
Average weekly sales per factory store (1):
Company	$	47.3	$	56.1	$	48.9	$	60.8
Systemwide	$	45.4	$	52.6	$	46.4	$	56.3
Factory Store operating weeks:
Company		1,967		2,282		6,249		6,315
Systemwide		4,669		4,981		14,672		14,506
Average weekly sales per store (1):
Company	$	46.7	$	53.2	$	48.0	$	57.3
Systemwide	$	40.3	$	48.4	$	42.4	$	52.5
Store operating weeks:
Company		1,993		2,407		6,370		6,697
Systemwide		5,257		5,413		16,063		15,549


(1)		Excludes sales between company and franchise stores.

THREE MONTHS ENDED OCTOBER 30, 2005 COMPARED TO THREE MONTHS ENDED OCTOBER 31, 2004

Overview

Systemwide sales for the third quarter of fiscal 2006 decreased 18.7% compared to the third quarter of fiscal 2005. The decrease reflects a 16.7% decrease in average weekly sales per store and a 2.9% decrease in store operating weeks. The systemwide sales decrease reflects a 27.1% decrease in Company Stores sales and a 11.3% decrease in franchise store sales.

Revenues

Total revenues decreased 26.1% to $128.8 million for the three months ended October 30, 2005 from $174.4 million for the three months ended October 31, 2004. This decrease was comprised of a 27.1% decrease in Company Stores revenues to $93.7 million, a 27.5% decrease in Franchise revenues to $4.1 million, and a 23.0% decrease in KKM&D revenues to $31.0 million.

Revenues by business segment (expressed in dollars and as a percentage of total revenues) are set forth in the table below. KKM&D revenues exclude intersegment sales eliminated in consolidation.


	Three months ended
	Oct. 30,		Oct. 31,
	2005		2004
	(In thousands)
			(restated)
REVENUES BY BUSINESS SEGMENT:
Company Stores	$	93,668	$	128,411
Franchise		4,121		5,681
KKM&D		31,029		40,301

Total revenues	$	128,818	$	174,393


	Three months ended
	Oct. 30,			Oct. 31,
	2005			2004
	(In thousands)
				(restated)
PERCENTAGE OF TOTAL REVENUES:
Company Stores		72.7	%		73.6	%
Franchise		3.2			3.3
KKM&D		24.1			23.1

Total revenues		100.0	%		100.0	%

Company Stores Revenues.Company Stores revenues decreased 27.1% to $93.7 million from $128.4 million in the third quarter of fiscal 2005. The decrease reflects a 12.2% decline in average weekly sales per store and a 17.2% decrease in store operating weeks. The decline in average weekly sales per store reflects lower average per store off-premises sales and, to a lesser extent, lower average on premises sales per store, each of which reflects lower volumes. Off-premises sales also were affected by price reductions on certain products. The decrease in store operating weeks reflects store closures as well as the deconsolidation of the financial statements of KremeKo. Company Stores revenues for the three months ended October 31, 2004 includes $7.3 million of revenues related to KremeKo.

Franchise Revenues.Franchise revenues, consisting principally of franchise fees and royalties, decreased 27.5% to $4.1 million in the third quarter of fiscal 2006 from $5.7 million in the third quarter of fiscal 2005. The decline in franchise revenues reflects a decrease in royalty revenues resulting from lower sales by franchisees in the third quarter of fiscal 2006 compared to the third quarter of fiscal 2005. In addition, during the third quarter of fiscal 2006 the Company did not recognize as revenue approximately $1.4 million of uncollected royalties which accrued during the period because the Company did not believe collection of these royalties was reasonably assured. Sales by franchise stores, as reported by the franchisees, were approximately $118.9 million in the third quarter of fiscal 2006 compared to approximately $134.1 million in the third quarter of fiscal 2005.

KKM&D Revenues.KKM&D sales to franchise stores decreased 23.0% to $31.0 million in the third quarter of fiscal 2006 from $40.3 million in the third quarter of fiscal 2005. The most significant reason for the decrease in revenues was lower average sales per franchise store, which resulted in decreased sales of mixes, icings and fillings, sugar, shortening, coffee and supplies by KKM&D.

Direct Operating Expenses

Direct operating expenses, which exclude depreciation and amortization expense, were 90.0% of revenues in the third quarter of fiscal 2006 compared to 85.6% of revenues in the third quarter of fiscal 2005. Direct operating expenses by business segment (expressed in dollars and as a percentage of applicable segment revenues) are set forth in the table below. The estimated profit earned by the KKM&D segment on sales to the Company Stores segment has been deducted from Company Stores direct operating expenses in the table below to illustrate the effects of the Company’s vertical integration on the overall profit earned on Company Stores revenues. However, the profit earned by KKM&D on sales to Company Stores is included in KKM&D operating income in the segment information which appears in Note 8 to the Company’s consolidated financial statements appearing elsewhere herein.


	Three months ended
	Oct. 30,			Oct. 31,
	2005			2004
	(In thousands)
				(restated)
DIRECT OPERATING EXPENSES BY BUSINESS SEGMENT:
Company Stores	$	88,208		$	114,295
Franchise		858			1,929
KKM&D		26,929			32,970

Total direct operating expenses	$	115,995		$	149,194


DIRECT OPERATING EXPENSES AS A PERCENTAGE OF SEGMENT REVENUES:
Company Stores		94.2	%		89.0	%
Franchise		20.8	%		34.0	%
KKM&D		86.8	%		81.8	%
Total direct operating expenses		90.0	%		85.6	%

approximately $2.1 million and $2.3 million of bad debt provisions related to receivables from franchisees in the third quarter of fiscal 2006 and fiscal 2005, respectively, representing approximately 6.8% and 5.7%, respectively, of KKM&D revenues. Franchise segment operating expenses fell, both in absolute terms and as a percentage of franchise revenues, due to reduced provisions for uncollectible receivables and a reduction in corporate cost allocations arising from cost reductions in certain categories which are allocated, in part, to the franchise segment.

General and Administrative Expenses

General and administrative expenses increased to $15.2 million, or 11.8% of total revenues, in the third quarter of fiscal 2006 from $12.5 million, or 7.2% of total revenues, in the third quarter of fiscal 2005. General and administrative expenses include fees paid to the interim management firm engaged by the Company in January 2005, and professional fees related to the internal and external investigations and litigation described in Notes 2 and 6 to the consolidated financial statements included elsewhere herein, totaling approximately $7.2 million (net of estimated insurance recoveries of approximately $3.6 million) for the third quarter of fiscal 2006 and approximately $200,000 (net of estimated insurance recoveries of approximately $1.4 million) in the third quarter of fiscal 2005. Exclusive of these costs, general and administrative expenses were 6.2% and 7.1% of total revenues in the third quarter of fiscal 2006 and 2005, respectively. Among the more significant reductions in general and administrative expenses in the third quarter of fiscal 2006 compared to the comparable quarter of the preceding year were reductions of approximately $900,000 in executive compensation, benefits and travel, and approximately $900,000 in the cost of corporate aircraft.

Depreciation and Amortization Expense

Depreciation and amortization expense decreased to $6.9 million, or 5.4% of total revenues, in the third quarter of fiscal 2006 from $8.6 million, or 4.9% of total revenues, in the third quarter of fiscal 2005. The decrease in depreciation and amortization expense relates almost entirely to the Company Stores segment, in which depreciation and amortization expense declined principally due to store closures. Depreciation and amortization expense as a percentage of total revenues rose primarily because revenues declined disproportionately to the decline in the number of stores in the third quarter of fiscal 2006 compared to the comparable quarter of fiscal 2005.

Impairment Charges and Lease Termination Costs

The Company recorded impairment charges and lease termination costs of $15.7 million in the third quarter of fiscal 2006 compared to $142.7 million in the third quarter of fiscal 2005. The fiscal 2005 charges include approximately $132.2 million to reduce the carrying value of goodwill and reacquired franchise rights associated with the Company Stores segment to their estimated fair values. Substantially all of the remaining fiscal 2005 charges and all of the fiscal 2006 charges arose from store closing decisions, and included approximately $15.4 million of impairment charges related principally to long-lived assets and approximately $0.3 million of lease termination costs in the third quarter of fiscal 2006, and approximately $9.3 million of impairment charges related principally to long-lived assets and approximately $1.1 million of lease termination costs in the third quarter of fiscal 2005. The Company closed five factory stores in the third quarter of fiscal 2006 and four factory stores in the third quarter of fiscal 2005. The Company generally records impairment charges associated with a decision to close a store in the accounting period in which the closing decision is made; lease termination costs are recorded when the lease contract is terminated or, if earlier, the date on which the Company ceases use of the leased property.

Interest Expense

Interest expense increased to $4.7 million in the third quarter of fiscal 2006 from $1.7 million in the third quarter of fiscal 2005. The aggregate costs associated with the Company’s primary credit facilities (the Secured Credit Facilities and, prior to April 1, 2005, a bank credit facility which was retired using proceeds of the Secured Credit Facilities), including interest, fees and amortization of deferred debt issue costs, increased approximately $3.3 million for the three months ended October 30, 2005 over the comparable quarter of the preceding year, reflecting higher outstanding debt balances, interest rates, lender margin and transaction costs in the third quarter of fiscal 2006 compared to the prior year quarter. Interest expense associated with Consolidated Franchisees declined approximately $365,000 in the third quarter of fiscal 2006 compared to the third quarter of fiscal 2005, principally because the Company ceased consolidation of the financial statements of KremeKo during the second quarter of fiscal 2006.

Equity in Income (Losses) of Equity Method Franchisees

The Company’s share of losses incurred by equity method franchisees totaled $488,000 in the third quarter of fiscal 2006 compared to $190,000 in the third quarter of fiscal 2005. This caption represents the Company’s share of operating results of unconsolidated franchisees which develop and operate Krispy Kreme stores.

Minority Interests in Results of Consolidated Franchisees

The minority interest in the results of operations of consolidated franchisees represents the portion of the income or loss of consolidated franchisees allocable to other investors’ interests in those franchisees. In the third quarter of fiscal 2006, minority investors absorbed losses incurred by consolidated franchisees totaling $563,000, substantially all of which relates to New England Dough; the interests of minority investors in KremeKo and Freedom Rings previously had been reduced to zero and, accordingly, no portion of these entities’ losses was absorbed by minority interests in the quarter. In the third quarter of fiscal 2005, minority investors’ shared in $4.2 million of the aggregate net losses by consolidated franchisees, the substantial majority of which related to KremeKo.

Other Income and (Expense), Net

Other income and (expense), net, for the three months ended October 31, 2004 includes a charge of approximately $1,545,000 to reduce the carrying value of an investment in a franchisee to its then estimated fair value, which reduction resulted from an adverse change in the financial condition of the franchisee.

Provision for Income Taxes

The provision for income taxes on continuing operations was $308,000 in the third quarter of fiscal 2006, which consists of adjustments to the valuation allowance for deferred income tax assets to maintain such allowance at an amount sufficient to reduce the Company’s aggregate net deferred income tax assets to zero, as well as a provision for taxes estimated to be payable currently. Since the third quarter of fiscal 2005, the valuation allowance has been maintained in an amount sufficient to reduce the Company’s net deferred income tax asset to zero because management is unable to conclude, in light of the cumulative loss realized by the Company for the three year period ended in fiscal 2005 and the fact that the Company incurred a loss in its fiscal year ended January 29, 2006, that realization of the net deferred income tax asset is more likely than not.

The provision for income taxes on continuing operations in the third quarter of fiscal 2005 was a benefit of $133,000. The significant losses incurred by the Company caused the Company to be unable to conclude, as of the end of the third quarter of fiscal 2005, that realization of the Company’s net deferred income tax assets was more likely than not, and the Company established an allowance against deferred income tax assets equal to the amount of the deferred income tax assets, net of deferred income tax liabilities. Accordingly, the Company recorded no tax benefit of its losses in the third quarter, except to reverse taxes provided in the first and second quarters of fiscal 2005 (less amounts estimated to be payable currently), and the Company also established a valuation allowance of $7.9 million equal to the Company’s net deferred income tax assets related to continuing operations as of the beginning of fiscal 2005.

Income (Loss) From Continuing Operations

The Company incurred a loss from continuing operations of $29.7 million for the third quarter of fiscal 2006, compared to a loss from continuing operations of $137.4 million the third quarter of fiscal 2005.

NINE MONTHS ENDED OCTOBER 30, 2005 COMPARED TO NINE MONTHS ENDED OCTOBER 31, 2004

Overview

Systemwide sales for the first nine months fiscal 2006 decreased 16.5% compared to the first nine months of fiscal 2005. This decrease was attributable to a 19.2% decrease in average weekly sales per store, partially offset by a 3.3% increase in store operating weeks. The systemwide sales decrease reflects a 20.3% decrease in Company Stores sales and a 13.5% decrease in franchise store sales.

Revenues

Total revenues decreased 22.9% to $421.1 million for the nine months ended October 30, 2005 from $546.1 million for the nine months ended October 31, 2004. This decrease was comprised of a 20.3% decrease in Company Stores revenues to $309.2 million, a 26.4% decrease in Franchise revenues to $14.1 million, and a 29.5% decrease in KKM&D revenues to $97.8 million.

Revenues by business segment (expressed in dollars and as a percentage of total revenues) are set forth in the table below. KKM&D revenues exclude intersegment sales eliminated in consolidation.


	Nine months ended
	Oct. 30,			Oct. 31,
	2005			2004
	(In thousands)
				(restated)
REVENUES BY BUSINESS SEGMENT:
Company Stores	$	309,248		$	388,247
Franchise		14,100			19,147
KKM&D		97,767			138,666

Total revenues	$	421,115		$	546,060


PERCENTAGE OF TOTAL REVENUES:
Company Stores		73.4	%		71.1	%
Franchise		3.4			3.5
KKM&D		23.2			25.4

Total revenues		100.0	%		100.0	%

Company Stores Revenues.Company Stores revenues decreased 20.3% to $309.2 million in the first nine months of fiscal 2006 from $388.2 million in the first nine months of fiscal 2005. The decrease reflects a 16.2% decline in average weekly sales per store and a 4.9% decrease in store operating weeks. The decline in average weekly sales per store reflects lower average per store off-premises sales and, to a lesser extent, lower average on premises sales per store, each of which reflects lower volumes. Off-premises sales also were affected by price reductions on certain products. The decrease in store operating weeks reflects store closures as well as the deconsolidation of the financial statements of KremeKo. Company Stores revenues for the nine months ended October 30, 2005 and October 31, 2004 includes $6.8 million and $16.1 million, respectively, of revenues related to KremeKo.

Franchise Revenues.Franchise revenues, consisting principally of franchise fees and royalties, decreased 26.4% to $14.1 million in the first nine months of fiscal 2006 from $19.1 million in the first nine months of fiscal 2005. The decline in franchise revenues reflects a decline in royalty revenues resulting from lower sales by franchisees in the fiscal 2006 period compared to the comparable period of fiscal 2005 and, to a lesser extent, reduced initial franchise fees due to fewer store openings in the first nine months of fiscal 2006 compared to the prior year. In addition, during the first nine months of fiscal 2006 the Company did not recognize as revenue approximately $2.7 million of uncollected royalties which accrued during the period because the Company did not believe collection of these royalties was reasonably assured. Sales by franchise stores, as reported by the franchisees, were approximately $374.1 million for the nine months ended October 30, 2005, compared to approximately $432.5 million for the nine months ended October 31, 2004.

KKM&D Revenues.KKM&D sales to franchise stores decreased 29.5% to $97.8 million in the first nine months of fiscal 2006 from $138.7 million in the comparable period of fiscal 2005. The most significant reason for the decrease in revenues was lower average sales per franchise store, which resulted in decreased sales of mixes, icings and fillings, sugar, shortening, coffee and supplies by KKM&D. In addition, reduced store expansion by franchisees in the first nine months of fiscal 2006 compared to the prior year resulted in lower equipment sales. In the first nine months of fiscal 2006, franchisees opened 11 new factory stores compared to 31 in the first nine months of fiscal 2005.

Direct Operating Expenses

Direct operating expenses, which exclude depreciation and amortization expense, were 86.9% of revenues in the first nine months of fiscal 2006 compared to 81.8% of revenues in the first nine months of fiscal 2005. Direct operating expenses by business segment (expressed in dollars and as a percentage of applicable segment revenues) are set forth in the table below. The estimated profit earned by the KKM&D segment on sales to the Company Stores segment has been deducted from Company Stores direct operating expenses in the table below to illustrate the effects of the Company’s vertical integration on the overall profit earned on Company Stores

revenues. However, the profit earned by KKM&D on sales to Company Stores is included in KKM&D operating income in the segment information which appears in Note 8 to the Company’s consolidated financial statements appearing elsewhere herein.


	Nine months ended
	Oct. 30,			Oct. 31,
	2005			2004
	(In thousands)
				(restated)
DIRECT OPERATING EXPENSES BUSINESS SEGMENT:
Company Stores	$	278,720		$	334,476
Franchise		3,774			5,460
KKM&D		83,248			106,986

Total direct operating expenses	$	365,742		$	446,922


DIRECT OPERATING EXPENSES AS A PERCENTAGE OF SEGMENT REVENUES:
Company Stores		90.1	%		86.2	%
Franchise		26.8	%		28.5	%
KKM&D		85.1	%		77.2	%
Total direct operating expenses		86.9	%		81.8	%

Direct operating expenses as a percentage of revenues increased in the Company Stores and KKM&D segments. The increase in direct operating expenses as a percentage of revenues in each segment reflects the effects of the fixed or semi-fixed nature of many operating costs on a reduced revenue base compared to the first nine months of fiscal 2005. In addition, the Company Stores segment, for which direct operating expenses as a percentage of revenues are higher than either the Franchise or KKM&D segment, represented 73.4% of consolidated revenues in the first nine months of fiscal 2006 compared to 71.1% of consolidated revenues in the first nine months of fiscal 2005. KKM&D direct operating expenses include approximately $4.7 million and $2.3 million of bad debt provisions related to receivables from franchisees in first nine months of fiscal 2006 and the first nine months of fiscal 2005, respectively, representing approximately 4.8% and 1.7%, respectively, of KKM&D revenues.

General and Administrative Expenses

General and administrative expenses increased to $50.7 million, or 12.0% of total revenues, in the first nine months of fiscal 2006 from $35.6 million, or 6.5% of total revenues, in the first nine months of fiscal 2005. General and administrative expenses include fees paid to the interim management firm engaged by the Company in January 2005 and professional fees related to the internal and external investigations and litigation described in Notes 2 and 6 to the consolidated financial statements included elsewhere herein totaling approximately $23.5 million (net of estimated insurance recoveries of approximately $12.0 million) for the nine months ended October 31, 2005 and approximately $200,000 (net of estimated insurance recoveries of approximately $1.4 million) in the first nine months of fiscal 2005. In addition, general and administrative expenses in the first nine months of fiscal 2006 include approximately $4.0 million of out-of-period costs related to stock-based compensation. The Company erroneously failed to record these costs in prior years, but concluded that such error was not material to the consolidated financial statements of the affected periods or to the fiscal 2006 consolidated financial statements. Accordingly, the Company recorded the costs in the first quarter of fiscal 2006 rather than restating prior periods’ financial statements, as more fully described in Note 1 to the consolidated financial statements. Exclusive of these costs, general and administrative expenses for the fiscal 2006 period were approximately 5.5% of total revenues. Among the more significant reductions in general and administrative expenses in the first nine months of fiscal 2006 compared to the comparable period of the preceding year were reductions of approximately $3.3 million in executive compensation, benefits and travel; approximately $2.6 million in the cost of corporate aircraft; approximately $1.1 million in charitable contributions; and approximately $700,000 in investor relations costs.

Depreciation and Amortization Expense

Depreciation and amortization expense decreased to $22.4 million, or 5.3% of total revenues, for the first nine months of fiscal 2006 from $23.3 million, or 4.3% of total revenues, in the first nine months of fiscal 2005. The decline in depreciation and amortization expense principally reflects store closures. Depreciation and amortization expense as a percentage of total revenues rose primarily due to the decline in revenues from the prior year.

Impairment Charges and Lease Termination Costs

The Company recorded impairment charges and lease termination costs of $29.7 million in the first nine months of fiscal 2006 compared to $150.3 million in the first nine months of fiscal 2005. The fiscal 2005 charges include approximately $132.2 million to reduce the carrying value of goodwill and reacquired franchise rights associated with the Company Stores segment to their estimated fair values. Substantially all of the remaining fiscal 2005 charges and all of the fiscal 2006 charges arose from store closing decisions, and included approximately $28.5 million of impairment charges related principally to long-lived assets and approximately $1.3 million of lease termination costs in the first nine months of fiscal 2006, and approximately $15.6 million of impairment charges related principally to long-lived assets and approximately $2.5 million of lease termination costs in the first nine months of fiscal 2005. Substantially all of the remaining fiscal 2005 charges and all of the fiscal 2006 charges arose from store closing decisions. The Company closed 24 factory stores in the first nine months of fiscal 2006 and 10 factory stores in the first nine months of fiscal 2005. The Company generally records impairment charges associated with a decision to close a store in the accounting period in which the closing decision is made; lease termination costs are recorded when the lease contract is terminated or, if earlier, the date on which the Company ceases use of the leased property.

Settlement of Litigation

On October 31, 2006, the Company agreed to settle a federal securities class action and to settle, in part, certain shareholder derivative actions, as more fully described in Note 6 to the consolidated financial statements appearing elsewhere herein. As part of the settlement, the Company agreed to issue to the plaintiffs a combination of common stock and warrants to acquire common stock. In the first quarter of fiscal 2006, the Company recorded a charge for the anticipated settlement of $35.8 million, representing the estimated fair value of the 1,875,000 shares of common stock and warrants acquire 4,400,000 shares of common stock estimated to be issued by the Company, based upon the price of the Company’s common stock as of late October 2006. The provision for settlement costs will be adjusted to reflect changes in the fair value of the securities until they are issued following final court approval of the settlement, which the Company anticipates will occur in late calendar 2006 or early calendar 2007.

Interest Expense

Interest expense increased to $15.2 million for the nine months ended October 30, 2005, from $4.8 million for the nine months ended October 31, 2004. The aggregate costs, including interest, fees and amortization of deferred debt issue costs, associated with the Company’s primary credit facilities (the Secured Credit Facilities and, prior to April 1, 2005, a bank credit facility which was retired using proceeds of the Secured Credit Facilities) increased approximately $8.7 million for the nine months ended October 30, 2005, over the nine months ended October 31, 2004. Of the $8.7 million increase, approximately $7.5 million reflects higher outstanding debt balances, interest rates, lender margin and transaction costs in the first nine months of fiscal 2006 compared to the first nine months of fiscal 2005; the remainder of the increase results principally from one-time fees and expenses associated with the bank credit facility prior to its retirement using proceeds of the Secured Credit Facility. In addition, interest expense in the first nine months fiscal 2006 includes the write-off of approximately $840,000 of unamortized financing costs associated with the retired bank financing and approximately $640,000 charged to earnings upon termination of an interest rate hedge related to the retired bank financing.

Equity in Losses of Equity Method Franchisees

Equity in losses of equity method franchisees totaled $3.8 million in the first nine months of fiscal 2006 compared to $675,000 for the first nine months of fiscal 2005. Approximately $1.7 million of the increase reflects higher losses incurred by KremeKo in the fiscal 2006 period compared to the comparable period of the prior year. Subsequent to the deconsolidation of the financial statements of KremeKo at the end of May 2005, KremeKo has been accounted for using the equity method; KremeKo was accounted for using the equity method prior to the initial consolidation of KremeKo’s financial statements with those of the Company as of the end of the first quarter of fiscal 2004.

Minority Interests in Results of Consolidated Franchisees

The minority interest in the results of operations of consolidated franchisees represents the portion of the income or loss of consolidated franchisees allocable to other investors’ interest in those franchisees. In the first nine months of fiscal 2006, minority investors absorbed an aggregate of $1.5 million of losses incurred by Glazed Investments and New England Dough; the interests of minority investors in KremeKo and Freedom Rings previously had been reduced to zero and, accordingly, no portion of these entities’ losses was absorbed by minority interests in fiscal 2006. In the first nine months of fiscal 2005, minority investors shared in $4.8 million of aggregate net losses incurred by consolidated franchisees, the substantial majority of which related to KremeKo.

Other Income and (Expense), net

Other income and (expense), net, for the nine months ended October 31, 2004 includes a charge of approximately $1,545,000 to reduce the carrying value of an investment in a franchisee to its then estimated fair value, which reduction resulted from an adverse change in the financial condition of the franchisee.

Provision for Income Taxes

The provision for income taxes on continuing operations was a benefit of $1.1 million for the first nine months of fiscal 2006, which includes adjustments to the valuation allowance for deferred income tax assets to maintain such allowance at an amount sufficient to reduce the Company’s aggregate net deferred income tax assets to zero, as well as a provision for taxes estimated to be payable currently. Since the third quarter of fiscal 2005, the valuation allowance has been maintained in an amount sufficient to reduce the Company’s net deferred income tax asset to zero because management is unable to conclude, in light of the cumulative loss realized by the Company for the three year period ended in fiscal 2005 and the fact that the Company incurred a loss in its fiscal year ended January 29, 2006, that realization of the net deferred income tax asset is more likely than not. The provision for income taxes for the first nine months of fiscal 2006 also includes an out-of-period credit of approximately $1.5 million. This credit corrects an overstatement of the valuation allowance for deferred income tax assets recorded by a charge to earnings in fiscal 2005. The Company concluded that this error was not material to the consolidated financial statements of the affected periods or to the fiscal 2006 consolidated financial statements. Accordingly, the Company recorded the credit in the first quarter of fiscal 2006 rather than restating prior periods’ financial statements, as more fully described in Note 1 to the consolidated financial statements appearing elsewhere herein.

The provision for income taxes on continuing operations was approximately $9.7 million for the first nine months of fiscal 2005. The provision includes a valuation allowance of $7.9 million, equal to the Company’s net deferred income tax assets related to continuing operations as of the beginning of fiscal 2005, as well as taxes estimated to be payable currently. The significant losses incurred by the Company caused the Company to be unable to conclude, as of the end of the third quarter of fiscal 2005, that realization of the Company’s net deferred income tax assets was more likely than not, and the Company established an allowance against deferred income tax assets equal to the amount of the deferred income tax assets, net of deferred income tax liabilities.

Income (Loss) From Continuing Operations

The Company incurred a loss from continuing operations of $98.0 million for the first nine months of fiscal 2006, compared to a loss from continuing operations of $121.2 million the first nine months of fiscal 2005.

LIQUIDITY AND CAPITAL RESOURCES

The following table presents a summary of the Company’s cash flows from operating, investing and financing activities for the first nine months of fiscal 2006 and 2005.


	Nine months ended
	Oct. 30,			Oct. 31,
	2005			2004
	(In thousands)
				(restated)
Net cash provided by operating activities	$	9,280		$	65,270
Net cash (used for) investing activities		(15,884	)		(45,146	)
Net cash provided by (used for) financing activities		7,834			(27,170	)
Effect of exchange rate changes on cash		(11	)		135
Cash balances of subsidiaries at date of consolidation		—			3,217
Cash balances of subsidiaries at date of deconsolidation		(1,011	)		—

Net increase (decrease) in cash and cash equivalents	$	208		$	(3,694	)

Cash Flows from Operating Activities

Net cash provided by operating activities was $9.3 million and $65.3 million in the first nine months of fiscal 2006 and 2005, respectively.

In the first nine months of fiscal 2006, cash flow from operating activities was adversely affected by a decline in sales and lower operating margins compared to the first nine months of fiscal 2005. These trends continued for the balance of fiscal 2006.

Cash Flows from Investing Activities

Net cash used for investing activities was $15.9 million and $45.1 million in the first nine months of fiscal 2006 and 2005, respectively.

The decline in cash used for investing activities principally reflects significantly reduced capital expenditures in fiscal 2006. Capital expenditures will continue to be substantially lower in fiscal 2006 than in fiscal 2005 because the Company substantially eliminated store expansion in fiscal 2006. The Company realized approximately $4.6 million and $1.7 million from property disposals in the first nine months of fiscal 2006 and 2005, respectively. During the third quarter of fiscal 2006, the Company paid approximately $9.3 million to settle the Company’s obligations under certain guarantees of indebtedness of KremeKo, as more fully described in Note 9 to the consolidated financial statements included elsewhere herein; such payment is included in “Investments in and advance to equity method franchisees” in the consolidated statement of cash flows. Cash inflows from investing activities for the first nine months of fiscal 2005 included approximately $16.7 million from the sale and leaseback of stores at Glazed Investments and approximately $4.1 million from the collection of notes receivable associated with a group of stores sold to a franchisee in fiscal 2004.

Cash Flows from Financing Activities

Net cash provided by financing activities was $7.8 million in the first nine months of fiscal 2006, compared to net cash used for financing activities of $27.2 million in the first nine months of fiscal 2005.

During the first nine months of fiscal 2006, the Company closed the Secured Credit Facilities described below and in Note 5 to the consolidated financial statements appearing elsewhere herein. The Company borrowed $120 million under these facilities at closing, and used approximately $88 million to repay borrowing outstanding under a prior credit facility (which was terminated). In the first nine months of fiscal 2006, the Company paid approximately $8.8 million of fees, costs and expenses associated with the new facility. Cash inflows from financing activities in the first nine months of fiscal 2006 also included a $2.6 million capital contribution to a Consolidated Franchisee by the minority investors in that franchisee. In the first nine months of fiscal 2005, the Company repaid approximately $43 million of long-term debt using cash provided by operations and the proceeds of the sale and leaseback transaction.

Business Conditions, Uncertainties and Liquidity

The Company incurred a net loss of $198.3 million in fiscal 2005 and $98.0 million for the first nine months of fiscal 2006. The loss for the first nine months of fiscal 2006 includes a charge of $35.8 million related to the anticipated settlement of certain litigation described in Note 6 to the consolidated financial statements appearing elsewhere herein. Cash provided by operating activities declined from $65.3 million in the first nine months of fiscal 2005 to $9.3 million in the first nine months of fiscal 2006.

During fiscal 2005, the Company experienced first a slowing in the rate of growth in sales in its Company Stores segment and, later in the year, declines in sales compared to the comparable periods of fiscal 2004. The Company’s Franchise and KKM&D segments experienced revenue trends similar to those experienced in the Company Stores segment. These sales declines continued in the first nine months of fiscal 2006, during which the Company’s revenues declined to $421.1 million from $546.1 million in the first nine months of fiscal 2005, reflecting, among other things, lower revenues at KKM&D, store closures (including closures by Consolidated Franchisees) and lower revenues at remaining stores. These trends adversely affected operating margins because of the fixed or semi-fixed nature of many of the Company’s direct operating expenses. In addition, litigation has been commenced against the Company and certain current and former officers and directors, and investigations of the Company have been initiated by the Securities and Exchange Commission (the “Commission”) and the United States Attorney for the Southern District of New York, as described in Note 6 to the consolidated financial statements appearing elsewhere herein. In October 2004, the Company’s Board of Directors appointed a Special Committee to conduct an independent investigation of certain matters, including accounting matters. In August 2005, the Company’s Board of Directors received the report of the Special Committee, a summary of which was filed as an exhibit to a Current Report on Form 8-K dated August 9, 2005.

certain litigation, and impairment charges and lease termination costs of $29.7 million associated with closed stores. In addition, the Company has incurred substantial expenses to defend the Company and its officers and directors in connection with pending litigation, to cooperate with the investigations of the Special Committee, the Commission and the United States Attorney, to undertake the Company’s internal investigation of accounting matters, and to indemnify certain current and former officers and directors for certain legal and other expenses incurred by them. These expenses were significantly greater in fiscal 2006 than in fiscal 2005, are continuing in fiscal 2007, and could be substantial in future years.

In January 2005, the Company’s Chairman, President and Chief Executive Officer retired, and the Board of Directors engaged KZC, a corporate recovery and advisory firm, to provide interim executive management services to the Company. Since that time, the Company has undertaken a number of initiatives designed to improve the Company’s operating results and financial position. Such initiatives include closing a substantial number of underperforming stores, reducing corporate overhead and other costs to bring them more in line with the Company’s current level of operations, recruiting new management personnel for certain positions, obtaining the Secured Credit Facilities described in Note 5 to the consolidated financial statements appearing elsewhere herein, restructuring certain financial arrangements associated with franchisees in which the Company has an ownership interest and with respect to which the Company has financial guarantee obligations and selling certain non-strategic assets.

The Company’s principal source of external financing is its Secured Credit Facilities. These facilities contain significant financial and other covenants as described in Note 5 to the consolidated financial statements appearing elsewhere herein. Failure to generate sufficient earnings to comply with these financial covenants, or the occurrence or failure to occur of certain events, would cause the Company to default under the Secured Credit Facilities. In the absence of a waiver of, or forbearance with respect to, any such default from the Company’s lenders, the Company could be obligated to repay outstanding indebtedness under the facilities, and the Company’s ability to access additional borrowings under the facilities would be restricted. The facilities contain covenants which limit the total indebtedness of the Company and limit the Company’s ability to obtain borrowings under the facilities, as described in Note 5 to the consolidated financial statements appearing elsewhere herein.

time as the Company is current in filing with the Commission all periodic reports required to be filed by the Company under the Securities Exchange Act of 1934 (the “Exchange Act”), the Company will not be able to obtain capital by issuing any security whose registration would be required under the Securities Act of 1933. The Company has not filed its Quarterly Reports on Form 10-Q for the third quarter of fiscal 2005 or for the first and second quarters of fiscal 2007. While the Company is working diligently to complete the filings referred to in the preceding sentence (focusing first on the fiscal 2007 reports and then on the third quarter fiscal 2005 report), there can be no assurance as to when the Company will be current in its reporting obligations.

Recent Accounting Pronouncements

In November 2004, the FASB issued Statement No. 151, “Inventory Costs” (“FAS 151”), which amends the guidance in Accounting Research Bulletin No. 43, “Inventory Pricing,” to clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs and wasted material (spoilage). FAS 151 requires that those items be recognized as current period charges and that the allocation of fixed production overheads to the cost of converting work in process to finished goods be based on the normal capacity of the production facilities. The Company will adopt this statement in fiscal 2007, but adoption of this statement is not expected to have a material effect on the consolidated financial statements.

In February 2005, the Emerging Issues Task Force reached a consensus in Issue No. 03-13, “Applying the Conditions in Paragraph 42 of FASB Statement No. 144 in Determining Whether to Report Discontinued Operations” (“EITF 03-13”). The Company considered the guidance in EITF 03-13 in evaluating whether the operations and cash flows of components disposed of in fiscal 2006 had been or will be eliminated from ongoing operations, and the types of continuing involvement that constitute significant continuing involvement in the operations of the disposed component. These evaluations affect the determination of whether the results of operations of a disposed component are reported as discontinued operations. The Company concluded that none of the components disposed of in fiscal 2006 should be reported as discontinued operations.

error by restating previously issued financial statements. FAS 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. The Company will adopt this pronouncement beginning in fiscal 2007.

Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.

The Company is exposed to market risk from increases in interest rates on its outstanding debt. All of the borrowings under the Company’s secured credit facilities bear interest at variable rates based upon either the prime rate, the Fed funds rate or LIBOR. The Company has entered into an interest rate derivative contract having a notional principal amount of $75 million which eliminates the Company’s exposure, with respect to such notional amount, to increases in three month LIBOR beyond 4.0% through April 2006, 4.50% from May 2006 through April 2007 and 5.0% from May 2007 through March 2008. The Company’s consolidated franchisees are parties to various debt agreements used to finance store development and working capital needs, substantially all of which bear interest at floating rates. The interest cost of the Company’s debt is affected by changes in short term interest rates and increases in those rates adversely affect the Company’s results of operations.

As of October 30, 2005, the Company had approximately $119.7 million in cash borrowings (excluding leases and indebtedness of Consolidated Franchisees). A hypothetical increase of 100 basis points in short-term interest rates would result in an increase in the Company’s annual interest expense of approximately $450,000, after giving effect to additional payments due to the Company from the interest rate hedge described above.

Because the substantial majority of the Company’s revenue, expense and capital purchasing activities are transacted in United States dollars, the exposure to foreign currency exchange risk historically has been minor. In addition to operating revenues and expenses, the Company’s investments in franchisees operating in the United Kingdom, Australia, Mexico and Canada expose the Company to exchange rate risk. The Company historically has not attempted to hedge these exchange rate risks, although the Company may implement such strategies in the future.

The Company is exposed to the effects of commodity price fluctuations on the cost of ingredients of its products, of which flour, sugar, shortening and coffee beans are the most significant. In order to secure adequate supplies of materials and bring greater stability to the cost of ingredients, the Company routinely enters into forward purchase contracts and other purchase arrangements with suppliers. Under the forward purchase contracts, the Company commits to purchasing agreed-upon quantities of ingredients at agreed-upon prices at specified future dates. The outstanding purchase commitment for these commodities at any point in time typically ranges from three months’ to two years’ anticipated requirements, depending on the ingredient. Other purchase arrangements typically are contractual arrangements with vendors (for example, with respect to certain beverages and ingredients) under which the Company is not required to purchase any minimum quantity of goods, but must purchase minimum percentages of its requirements for such goods from these vendors with whom it has executed these contracts.

In addition to entering into forward purchase contracts, from time to time the Company purchases exchange-traded commodity futures contracts, and options on such contracts, for raw materials which are ingredients of its products or which are components of such ingredients, including wheat, soybean oil and coffee. The Company typically assigns the futures contract to a supplier in connection with entering into a forward purchase contract for the related ingredient. Quantitative information about the Company’s option contracts and unassigned commodity futures contracts as of October 30, 2005, all of which mature in fiscal 2006 and 2007, is set forth in the table below.

Aggregate

Weighted

Contract

Aggregate

Average Contract

Amount

Fair

Contract Volume

or Strike Price

Value

(Dollars in thousands, except average prices)

Futures contracts:

Wheat

35,000 bushels

$ 3.38/bushel

$ 118

$ 12

Coffee

412,500 lbs.

$ 1.104/lb.

455

(47

)

Options contracts:

Call options on coffee futures

487,500 lbs.

$ 1.10/lb.

536

)

$ (41

)

Although the Company utilizes forward purchase contracts and futures contracts to mitigate the risks related to commodity price fluctuations, such contracts do not fully mitigate commodity price risk. Adverse changes in commodity prices could adversely affect the Company’s profitability and liquidity.

Item 4. CONTROLS AND PROCEDURES.

Evaluation of Disclosure Controls and Procedures

As of October 30, 2005, the end of the period covered by this Quarterly Report on Form 10-Q, management performed, under the supervision and with the participation of the Company’s chief executive officer and chief financial officer, an evaluation of the effectiveness of the Company’s disclosure controls and procedures as defined in Rules 13a-15(e) and 15d-15(e) of the Exchange Act. The Company’s disclosure controls and procedures are designed to ensure that information required to be disclosed in the reports the Company files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Commission’s rules and forms, and that such information is accumulated and communicated to management, including the Company’s chief executive officer and chief financial officer, to allow timely decisions regarding required disclosures. Based on this evaluation and the identification of material weaknesses in the Company’s internal control over financial reporting as described in the 2005 Form 10-K and 2006 Form 10-K, the Company’s chief executive officer and chief financial officer have concluded that, as of October 30, 2005, the Company’s disclosure controls and procedures were not effective. Based on a number of factors, including performance of additional procedures as discussed under “Remediation of Material Weaknesses” and “Subsequent Material Changes in Internal Control over Financial Reporting” below, management has concluded that the consolidated financial statements included in this Quarterly Report on Form 10-Q fairly present, in all material respects, the Company’s financial position, results of operations and cash flows for the periods presented in conformity with generally accepted accounting principles (“GAAP”).

Changes in Internal Control Over Financial Reporting

There were changes in the Company’s internal control over financial reporting during the quarter ended October 30, 2005 and throughout fiscal 2006, as more fully set forth in Item 9A, “Controls and Procedures,” of the 2006 Form 10-K. The report of management on internal control over financial reporting as of January 29, 2006 included in the 2006 Form 10-K is reproduced below.

Management’s Report on Internal Control over Financial Reporting (as of January 29, 2006)

Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act. Internal control over financial reporting is a process, effected by an entity’s board of directors, management and other personnel, designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of consolidated financial statements for external purposes in accordance with GAAP. Internal control over financial reporting includes those policies and procedures which pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of assets; provide reasonable assurance that transactions are recorded as necessary to permit preparation of consolidated financial statements in accordance with GAAP; provide reasonable assurance that receipts and expenditures are being made only in accordance with our and/or our Board of Directors’ authorization; and provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of our assets that could have a material effect on our consolidated financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of the effectiveness of our internal control over financial reporting to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

Management assessed the effectiveness of our internal control over financial reporting as of January 29, 2006, using the criteria inInternal Control — Integrated Frameworkissued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”).

A material weakness is a control deficiency, or combination of control deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim consolidated financial statements will not be prevented or detected.

As of January 29, 2006, management concluded that our internal control over financial reporting was not effective because of the material weaknesses described below.

We did not maintain an effective control environment based on the criteria established in the COSO framework. The following material weaknesses were identified related to our control environment:

	•		We did not establish a formal enterprise risk assessment process.

	•		We did not formalize lines of communication among legal, finance and operations personnel. Specifically, there was inadequate sharing of financial information within and across our corporate and divisional offices and other operating facilities to adequately raise issues to the appropriate level of accounting and financial reporting personnel.

	•		We did not establish an effective program to ensure that our code of conduct and ethics guidelines are fully communicated and distributed appropriately to our employees.

	•		We did not maintain written accounting policies and procedures nor did we maintain adequate controls with respect to the review, supervision and monitoring of our accounting operations.

	•		We did not have an adequate process for monitoring the appropriateness of user access and segregation of duties related to financial applications.

These control environment material weaknesses contributed to the material weaknesses described below.

We did not maintain effective control over our financial closing and reporting processes. Specifically, the following material weaknesses were identified:

	•		We did not maintain effective controls to ensure that journal entries were reviewed and approved. Specifically, effective controls were not designed and in place to ensure that journal entries, including journal entries related to intercompany eliminations, were prepared with sufficient supporting documentation and that those entries were reviewed and approved to ensure the completeness, accuracy and validity of the entries recorded. This material weakness resulted in an audit adjustment to accounts receivable and revenue in the fiscal 2006 consolidated financial statements.

	•		We did not maintain effective controls to ensure that account reconciliations were performed accurately, or that reconciliations were reviewed for accuracy and completeness and approved.

	•		We did not maintain effective controls over the accounting for acquisitions and divestitures. Specifically, effective controls were not designed and in place to ensure that such transactions were completely and accurately accounted for in accordance with GAAP.

	•		We did not maintain effective controls over our accounting for consolidated franchisees and equity method franchisees. Specifically, we did not maintain effective controls to ensure the completeness and accuracy of our accounting for our franchisees either consolidated or accounted for under the equity method in accordance with GAAP.

	•		We did not design and maintain effective controls to ensure that accrued expenses, including accruals for vacation benefits and legal and professional fees, were complete and accurate in accordance with GAAP.

	•		We did not design and maintain effective controls to ensure the completeness and accuracy of our translation of financial statement accounts denominated in foreign currencies and translation of foreign currency transaction gains or losses recorded in accordance with GAAP.

•

We did not design and maintain effective controls to ensure that our financial statement accounts related to derivative instruments embedded in exchange-traded futures contracts for certain raw materials were completely and accurately recorded in accordance with GAAP.

We did not maintain effective controls over the completeness and accuracy of certain franchisee revenue and receivables. Specifically, effective controls were not designed and in place to ensure that revenue was recognized in the proper period for sales of equipment to franchisees in connection with new store openings. In addition, effective controls were not designed and in place to ensure that an appropriate analysis of receivables from franchisees was conducted, reviewed and approved in order to identify and estimate required allowances for uncollectible accounts in accordance with GAAP.

We did not maintain effective controls over the completeness and accuracy of our accounting for lease related assets, liabilities and expenses. Specifically, our controls over the application and monitoring of accounting policies related to lease renewal options, rent escalations, amortization periods for leasehold improvements and lease classification principally affecting property and equipment, deferred rent, capital lease obligations, rent expense and depreciation were ineffective to ensure that such transactions were completely and accurately accounted for in conformity with GAAP.

We did not maintain effective controls over the accuracy and completeness of our property and equipment accounts, including the related depreciation. Specifically, effective controls were not designed and in place to ensure that retired assets were written off in the appropriate period, that appropriate depreciable lives were assigned to capital additions and assets were capitalized in accordance with GAAP.

These control deficiencies contributed to the previously reported restatement of our consolidated financial statements for fiscal 2003 and fiscal 2004 and all quarterly periods in fiscal 2004 and the first three quarters of fiscal 2005. Management has concluded that each of the control deficiencies above could result in a misstatement to the financial statements accounts and disclosures that would result in a material misstatement to our annual or interim consolidated financial statements that would not be prevented or detected. Accordingly, management has concluded that each of the control deficiencies listed above constitutes material weaknesses as of January 29, 2006.

Because of these material weaknesses, management has concluded that we did not maintain effective internal control over financial reporting as of January 29, 2006, based on the COSO criteria.

Remediation of Material Weaknesses

We have begun remediation efforts with respect to the material weaknesses we have identified. We plan to continue to review and make necessary changes to the design of our internal control environment, including the roles and responsibilities of each functional group within the organization and reporting structure, and to enhance and document policies and procedures to improve the effectiveness of our internal control over financial reporting. During fiscal 2006, our attention was focused primarily on the restatement of our annual consolidated financial statements for fiscal 2003 and 2004 and certain earlier years, as well as our consolidated financial statements for the first three quarters of fiscal 2005, and we did not file our fiscal 2005 annual report until April 28, 2006. This focus, and the effects of substantial personnel turnover in our accounting and finance function, prevented us from making significant improvements to our control environment during fiscal 2006. We have hired a Chief Accounting Officer and Controller during the second and third quarters of fiscal 2006 respectively, and filled other vacant positions in our accounting organization throughout fiscal 2006. As discussed below, we devoted significantly more time to remediation efforts subsequent to January 29, 2006 and prior to the issuance of this report.

We previously reported in our fiscal 2005 Annual Report on Form 10-K the existence of a material weakness pertaining to the effectiveness of our controls over accounting for goodwill and intangible assets. As of January 29, 2006 we had designed effective controls to ensure the accuracy, completeness and valuation of our goodwill and intangible asset accounts and those controls were operating effectively.

We expect our remediation efforts, as more specifically described below, for our material weaknesses to continue for the remainder of fiscal 2007 and beyond. While these efforts are underway, we are relying on extensive manual procedures to help ensure the proper collection, evaluation, and disclosure of the information included in the

consolidated financial statements. However, there remains a risk that the transitional procedures on which we currently rely will fail to prevent or detect a material misstatement of the annual or interim consolidated financial statements

Subsequent Changes in Internal Control over Financial Reporting

Subsequent to January 29, 2006, but prior to issuance of this Annual Report on Form 10-K, we implemented several measures described below to remediate the material weaknesses we have identified, and we intend to implement additional measures during the remainder of fiscal 2007 and thereafter.

We completed our assessment of the effectiveness of our internal control over financial reporting as of January 29, 2006 in October 2006. Because we must not only design new controls to remediate these material weaknesses, but also implement and test them in order to ensure that the weaknesses have been remediated, we expect that a number of these material weaknesses will not be remediated by January 28, 2007, the next date as of which we must assess our internal control over financial reporting. While unremediated, these material weaknesses have the potential to result in our failure to prevent or detect misstatements in our consolidated financial statements.

We intend to design, implement and maintain an effective control environment over financial reporting. We have taken, or will take, the following actions:

	•		With the strong encouragement of the Special Committee, the Company’s independent directors determined that new leadership of the Company was required. On January 18, 2005, the Company’s former chief executive officer retired, and a turnaround management firm was engaged to manage the business on an interim basis. Effective March 6, 2006, the board of directors appointed Daryl G. Brewster, a seasoned executive with over 20 years’ experience in the food industry, as President and Chief Executive Officer and a member of the board.

	•		We have hired a Vice President of Internal Audit during the second quarter of fiscal 2007 and intend to continue to devote resources to our internal audit function and our assessment and evaluation of our internal control over financial reporting and disclosure controls and procedures;

	•		We have formed a Risk Management Committee comprised of senior management from our legal, finance and operations organizations during the third quarter of fiscal 2007. This committee will oversee implementation of our remediation activities and will be responsible for enterprise risk management.

	•		We are enhancing the education process and redistributing to all of our employees our Code of Business Conduct and Ethics which, among other things, reiterates to our employees the availability of our previously implemented ethics hotline, through which employees at all levels can submit anonymously information regarding any unethical behavior or other irregularities of which they become aware;

	•		We are implementing enhanced controls to ensure effective communication among our legal, finance and operations organizations to ensure that important information about our business, including the effects, if any, of all material agreements, is addressed appropriately and on a timely basis in our financial reporting; and,

	•		We have begun creating policies and procedures manuals, including documentation of our accounting policies and methods of applying those policies, and intend to continue to increase the resources devoted to our accounting and finance function.

In addition to the foregoing actions relating to our control environment material weaknesses, we have implemented or will implement internal controls to remediate the material weaknesses associated with the specific accounting processes described above.

Additional Control Deficiencies Not Constituting Material Weaknesses

In addition to the material weaknesses described above, we have identified other deficiencies, including significant deficiencies, in internal control over our financial reporting that did not constitute material weaknesses as

of January 29, 2006. We have implemented or intend to implement measures designed to remediate the significant control deficiencies and have undertaken other interim measures to mitigate the potential effects of these significant control deficiencies. However, if we are not successful in implementing our plans, these other deficiencies in our internal control over financial reporting may rise to the level of material weaknesses in future periods.

Management’s Conclusions on the Remediation Plan

We believe the remediation measures described above will strengthen our internal control over financial reporting and remediate the material weaknesses we have identified. However, we have not yet implemented all of these measures and/or tested them. We are committed to continuing to improve our internal control processes and will continue to diligently review our financial reporting controls and procedures in order to ensure compliance with the requirements of the Sarbanes-Oxley Act and the related rules promulgated by the SEC. However, any control system, regardless of how well designed, operated and evaluated, can provide only reasonable, not absolute, assurance that the control objectives will be met. As we continue to evaluate and work to improve our internal control over financial reporting, we may take additional measures to address control deficiencies and/or determine not to complete certain of the remediation measures described above.

As a result of the material weaknesses identified in our evaluation of internal control over financial reporting, we extended the fiscal 2006 reporting process, thereby allowing us to conduct additional analyses and take such additional steps as we considered necessary to ensure the accuracy and completeness of our financial reporting.

Our management has concluded that the consolidated financial statements included in this Annual Report on Form 10-K fairly present, in all material respects, our financial position, results of operations and cash flows for the periods presented in conformity with GAAP.

PART II — OTHER INFORMATION

Item 1. LEGAL PROCEEDINGS.

From time to time the Company is subject to claims and suits arising in the course of business. The Company maintains customary insurance policies against claims and suits which arise in the course of business, including insurance policies for workers’ compensation and personal injury, some of which provide for relatively large deductible amounts.

Governmental Investigations

SEC Investigation.On October 7, 2004, the staff of the Commission advised us that the Commission had entered a formal order of investigation concerning the Company. The Company is cooperating with the investigation.

United States Attorney Investigation.On February 24, 2005, the United States Attorney’s Office for the Southern District of New York advised the Company that it would seek to conduct interviews of certain current and former officers and employees of the Company. The Company is cooperating with the investigation.

Department of Labor Review.On March 9, 2005, and March 21, 2005, the DOL informed the Company that it was commencing a “review” of the Krispy Kreme Doughnut Corporation Retirement Savings Plan and the Krispy Kreme Profit Sharing Stock Ownership Plan to determine whether any violations of Title I of ERISA have occurred. The DOL investigation is ongoing and the DOL has not yet indicated whether it believes any violations of ERISA have occurred. The Company is cooperating with the DOL.

State Franchise/FTC InquiryOn June 15, 2005, the Commonwealth of Virginia, on behalf of itself, the FTC and eight other states, inquired into certain activities related to prior sales of franchises and the status of our financial statements and requested that the Company provide them with certain documents. The inquiry related to potential violations for failures to file certain amendments to franchise registrations and the failure to deliver accurate financial statements to prospective franchisees. Fourteen states (the “Registration States”) and the FTC regulate the sale of franchises. The Registration States specify forms of disclosure documents that must be provided to franchisees and filed with the state. In the non-registration states, according to FTC rules, documents must be provided to franchisees but are not filed. Earlier in 2005, the Company chose not to renew its disclosure document in the Registration States because the Company realized that its financial statements would need to be restated and because the Company had stopped selling domestic franchises. The Company is fully cooperating with the inquiry and has delivered the requested documents. Since June 15, 2005, Virginia has indicated that it and a majority of the remaining states would withdraw from the inquiry. The Company has not received any additional information from the FTC or any other state that one or more of them intend to pursue or abandon the inquiry.

Litigation

Federal Securities Class Actions and Settlement Thereof and Federal Court Shareholder Derivative Actions and Partial Settlement Thereof.On May 12, 2004, a purported securities class action was filed on behalf of persons who purchased the Company’s publicly traded securities between August 21, 2003 and May 7, 2004 against the Company and certain of its current and former officers in the United States District Court for the Middle District of North Carolina. Plaintiff alleged that defendants violated Sections 10(b) and 20(a) of the Exchange Act and Rule 10b-5 promulgated thereunder in connection with various public statements made by the Company. Plaintiff sought damages in an unspecified amount. Thereafter, 14 substantially identical purported class actions were filed in the same court. On November 8, 2004, all of these cases were consolidated into one action. The court appointed lead plaintiffs in the consolidated action, who filed a second amended complaint on May 23, 2005, alleging claims under Sections 10(b) and 20(a) of the Exchange Act on behalf of persons who purchased the Company’s publicly-traded securities between March 8, 2001 and April 18, 2005. The Company filed a motion to dismiss the second amended complaint on October 14, 2005 that is currently pending.

In orders dated November 5, 2004, November 24, 2004, April 4, 2005 and June 1, 2005, the court stayed theWrightaction pending completion of the investigation of the Special Committee.

With respect to the securities class action, the Stipulation provides for the certification of a class consisting of all persons who purchased the Company’s publicly-traded securities between March 8, 2001 and April 18, 2005, inclusive. The settlement class will receive total consideration of approximately $75 million, consisting of a cash payment of $34,967,000 to be made by the Company’s directors’ and officers’ insurers, a cash payment of $100,000 to be made by Mr. Tate, a cash payment of $100,000 to be made by Mr. Casstevens, a cash payment of $4,000,000 to be made by the Company’s independent registered public accounting firm and common stock and warrants to purchase common stock to be issued by the Company having an aggregate value of $35,833,000 (based on the current market price of the Company’s common stock as of late October 2006). All claims against defendants will be dismissed with prejudice; however, claims that the Company may have against Mr. Livengood that may be asserted by the Company in the derivative action for contribution to the securities class action settlement or otherwise under applicable law are expressly preserved. The Stipulation contains no admission of fault or wrongdoing by the Company or the other defendants. The settlement is subject to preliminary and final approval of the court.

With respect to the derivative litigation, the Stipulation provides for the settlement and dismissal with prejudice of all claims against defendants except for claims against Mr. Livengood. The Company, acting through its Special Committee, settled claims against Mr. Tate and Mr. Casstevens for the following consideration: Messrs. Tate and Casstevens each agreed to contribute $100,000 in cash to the settlement of the securities class action; Mr. Tate agreed to cancel his interest in 6,000 shares of the Company’s common stock; and Messrs. Tate and Casstevens agreed to limit their claims for indemnity from the Company in connection with future proceedings before the Commission or the United States Attorney for the Southern District of New York to specified amounts. The Company, acting through its Special Committee, has been in negotiations with Mr. Livengood but has not reached agreement to resolve the derivative claims against him and counsel for the derivative plaintiffs are deferring their application for fees until conclusion of the derivative actions against Mr. Livengood. All other claims against defendants named in the derivative actions will

be dismissed with prejudice without paying any consideration, consistent with the findings and conclusions of the Special Committee in its report of August 2005.

The Company estimated that, based on the market price of its common stock as of late October 2006, it will issue approximately 1,875,000 shares of its common stock and warrants to purchase approximately 4,400,000 shares of its common stock in connection with the Stipulation. The exercise price of the warrants will be equal to 125% of the average of the closing prices of the Company’s common stock for the 10-day period surrounding the filing of the 2006 Form 10-K.

The Company has recorded a non-cash charge to earnings in the first quarter of fiscal 2006 of $35,833,000, representing the estimated fair value of the common stock and warrants to be issued by the Company. The Company has recorded a related receivable from its insurers in the amount of $34,967,000, as well as a liability in the amount of $70,800,000 representing the aggregate value of the securities to be issued by the Company and the cash to be paid by the insurers. The settlement is conditioned upon the Company’s insurers and the other contributors paying their share of the settlement. The provision for settlement costs will be adjusted to reflect changes in the fair value of the securities until they are issued following final court approval of the Stipulation, which the Company anticipates will occur in late calendar 2006 or early calendar 2007.

State Court Shareholder Derivative Actions.Two shareholder derivative actions have been filed in the Superior Court of North Carolina, Forsyth County:Andrews v. Krispy Kreme Doughnuts, Inc., et al., filed November 12, 2004, andLockwood v. Krispy Kreme Doughnuts, Inc., et al., filed January 21, 2005. On April 26, 2005, those actions were assigned to the North Carolina Business Court. On May 26, 2005, the plaintiffs in these actions voluntarily dismissed these actions in favor of a federal court action they filed on May 25, 2005 (theAndrewsaction discussed above).

State Court Books and Records Action.On February 21, 2005, a lawsuit was filed against the Company in the Superior Court of North Carolina, Wake County, Nomm v. Krispy Kreme, Inc., seeking an order requiring the Company to permit the plaintiff to inspect and copy the books and records of the Company. On March 29, 2005, the action was transferred to the Superior Court of North Carolina for Forsyth County. On May 20, 2005, the case was assigned to the North Carolina Business Court. On June 27, 2005, plaintiff filed a motion to intervene and be named lead plaintiff in the federal court derivative actions described above. On August 2, 2005, the North Carolina Business Court stayed this action pending a decision on Ms. Nomm’s motion to intervene and to serve as lead plaintiff in the federal court actions. On October 21, 2005, the court in the federal court actions granted Ms. Nomm’s motion to intervene and, on October 28, 2005, denied Ms. Nomm’s motion to be named lead plaintiff.

ERISA Class Action.On March 16, 2005, the Company’s wholly-owned subsidiary, KKDC, was served with a purported class action lawsuit filed in the United States District Court for the Middle District of North Carolina that asserted claims for breach of fiduciary duty under ERISA against KKDC and certain of its current and former officers and employees. Plaintiffs purported to represent a class of persons who were participants in or beneficiaries of KKDC’s retirement savings plan or profit sharing stock ownership plan between January 1, 2003 and the date of filing and whose accounts included investments in our common stock. Plaintiffs contended that defendants failed to manage prudently and loyally the assets of the plans by continuing to offer the Company’s common stock as an investment option and to hold large percentages of the plans’ assets in the Company’s common stock; failed to provide complete and accurate information about the risks of our common stock; failed to monitor the performance of fiduciary appointees; and breached duties and responsibilities as co-fiduciaries. On May 15, 2006 we announced that a proposed settlement had been reached with respect to this matter. The settlement would include a one-time cash payment to be made to the settlement class by our insurer in the amount of $4,750,000. The Company and the individual defendants deny any and all wrongdoing and would pay no money in the settlement. Several contingent events must be satisfied before the settlement becomes final, including final approval by the United States District Court where the matter is pending. It is anticipated that if the United States District Court gives final approval to the proposed settlement, this matter will be resolved finally by the end of calendar 2007.

Franchisee Litigation

Lone Star. On May 19, 2005, KKDC was sued by one of our area developers, Lone Star Doughnuts, Ltd., in the District Court for Harris County, Texas. The trial court entered a temporary injunction requiring KKDC to continue shipments of supplies to Lone Star on normalized rather than cash-before-delivery terms, and referred the matter to the American Arbitration Association for arbitration in Winston-Salem, North Carolina. The issues between the parties included KKDC’s claims against Lone Star for past due amounts for royalties, the Brand Fund, and equipment and supplies furnished to Lone Star. Lone Star’s claims against KKDC included breach of contract, fraud, negligent misrepresentation, breach of warranties, and violation of North Carolina’s Unfair and Deceptive Trade Practices Act. On February 9, 2006, we reached an agreement with Lone Star to settle all outstanding disputes and claims, including

the dismissal of this lawsuit. The settlement agreement includes a complete separation of the relationship between Lone Star Doughnuts, Ltd. and KKDC, the return of certain proprietary equipment and a de-identification of all former Krispy Kreme locations.

Sweet Traditions. On July 19, 2005, KKDC was sued by one of our area developers, Sweet Traditions, LLC, and its Illinois corporate entity Sweet Traditions of Illinois, LLC, in the Circuit Court for St. Clair County, Illinois seeking specific performance, declaratory judgment and injunctive relief, as well as moving for a temporary restraining order and preliminary injunction. Sweet Traditions sought to compel KKDC to continue to supply product to its franchisee stores without payment. On July 22, 2005, the case was removed to the United States District Court for the Southern District of Illinois. On July 27, 2005, the District Court entered an order denying Plaintiffs’ Motion for Preliminary Injunction on the basis that their claims had no reasonable likelihood of success on the merits. A settlement was reached between the parties and on August 25, 2006 a joint stipulation for dismissal of the litigation with prejudice was filed with the court. The court dismissed the case on August 28, 2006.

Great Circle. On September 29, 2005, KKDI, KKDC, certain former officers and directors of KKDI and KKDC and various other defendants were sued in California Superior Court for Los Angeles County, by Richard Reinis and Roger E. Glickman. Messrs. Reinis and Glickman are the principals and managing members of the Company’s Southern California developer and franchisee, Great Circle Family Foods, LLC, and the guarantors of Great Circle’s monetary obligations to KKDC. The complaint, which sought unspecified damages and injunctive relief, purported to assert various claims on behalf of Great Circle, as well as certain individual claims by the plaintiffs that arose out of and related to Great Circle’s franchise relationship with the Company. On July 28, 2006, KKDI and KKDC announced that they reached agreements with Great Circle on an integrated transaction involving the settlement of all pending litigation between the parties and the court dismissed the case on August 31, 2006. As part of the transaction, which closed on August 31, 2006, Southern Doughnuts, LLC, a wholly owned subsidiary of KKDC, acquired three of Great Circle’s stores located in Burbank, Ontario and Orange, California, together with the related franchise rights. Southern Doughnuts paid Great Circle $2.9 million for the acquired stores and related assets. Pursuant to the agreements, Great Circle has the right to repurchase the three stores and related assets from the Company for $2.9 million plus interest at 8% per annum to the date of repurchase. Such repurchase right terminates under certain conditions, but in no event later than May 29, 2007. Under the agreements, Krispy Kreme, Great Circle and related parties exchanged mutual releases and dismissals regarding the pending litigation.

KremeKo. On January 11, 2006, KKDI, KKDC, two of their former officers and PricewaterhouseCoopers LLP were sued in California Superior Court for Los Angeles County by Robert C. Fisher. Mr. Fisher is a shareholder of KKDC’s former Canadian developer and franchisee, KremeKo, Inc., and a guarantor of KremeKo’s monetary obligations to KKDC. The complaint purports to assert claims for fraud, constructive fraud, breach of fiduciary duty, rescission, negligent misrepresentation and declaratory relief and seeks unspecified damages based on defendants’ alleged misstatements regarding KKDI’s operations and financial performance and KKDC’s acquisition of KremeKo. On June 30, 2006, the parties entered into a settlement agreement which settled all claims in this matter. The settlement amounts involved were not material.

Item 1A. RISK FACTORS.

Any material changes from the risk factors disclosed in Part I, Item 1A, “Risk Factors,” in the 2005 Form 10-K have been incorporated into the risk factors disclosed in Part I, Item 1A, “Risk Factors,” in the 2006 Form 10-K.

Item 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS.

None.

Item 3. DEFAULTS UPON SENIOR SECURITIES.

None.

Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.

None.

Item 5. OTHER INFORMATION.

None.

Item 6. EXHIBITS.


Exhibit
Number		Description of Exhibits
3.1	—	Amended Articles of Incorporation of the Registrant (incorporated by reference to Exhibit 3.1 of the Registrant’s Registration Statement on Form S-8 (Commission File No. 333-97787), filed with the Commission on August 7, 2002)

3.2	—	Amended and Restated Bylaws of the Registrant, as amended (incorporated by reference to Exhibit 3.1 to the Registrant’s Current Report on Form 8-K filed December 22, 2005)

10.1	—	Amendment No. 5, dated as of April 30, 2006, to the First Lien Credit Agreement (the “First Lien Credit Agreement”) dated as of April 1, 2005, as amended, among KKDC, KKDI, the Subsidiary Guarantors party thereto, the Lenders party thereto, Credit Suisse (formerly known as Credit Suisse First Boston), as Administrative Agent and Issuing Lender, and Wells Fargo Foothill, Inc., as Collateral Agent, Issuing Lender and Swingline Lender (incorporated by reference to Exhibit 10.1 to the Registrant’s Current Report on Form 8-K filed May 3, 2006)

10.2	—	Amendment No. 5, dated as of April 30, 2006, to the Second Lien Credit Agreement (the “Second Lien Credit Agreement”) dated as of April 1, 2005, as amended, among KKDC, KKDI, the Subsidiary Guarantors party thereto, the Lenders party thereto, Credit Suisse (formerly known as Credit Suisse First Boston), as Administrative Agent, Paying Agent, Fronting Bank and Collateral Agent (incorporated by reference to Exhibit 10.2 to the Registrant’s Current Report on Form 8-K filed May 3, 2006)

10.3	—	Amendment No. 6, dated as of July 31, 2006, to the First Lien Credit Agreement (incorporated by reference to Exhibit 10.1 to the Registrant’s Current Report on Form 8-K filed August 3, 2006)

10.4	—	Amendment No. 6, dated as of July 31, 2006, to the Second Lien Credit Agreement (incorporated by reference to Exhibit 10.2 to the Registrant’s Current Report on Form 8-K filed August 3, 2006)

10.5	—	Contractor Services Agreement effective September 11, 2006, between KKDI, KKDC and Charles A. Blixt (incorporated by reference to Exhibit 10.1 to the Registrant’s Current Report on Form 8-K filed September 14, 2006)

10.6	—	Amendment No. 7, dated as of October 30, 2006, to the First Lien Credit Agreement (incorporated by reference to Exhibit 10.1 to the Registrant’s Current Report on Form 8-K filed October 31, 2006)

10.7	—	Amendment No. 7, dated as of October 30, 2006, to the Second Lien Credit Agreement (incorporated by reference to Exhibit 10.2 to the Registrant’s Current Report on Form 8-K filed October 31, 2006)


Exhibit
Number		Description of Exhibits
10.8	—	Advisory Agreement, dated June 14, 2006, by and between Krispy Kreme Doughnuts, Inc. and Kroll Zolfo Cooper LLC (incorporated by reference to Exhibit 10.47 to the Registrant’s Annual Report on Form 10-K for the fiscal year ended January 29, 2006 filed October 31, 2006)

10.9	—	Stipulation and Agreement of Class and Derivative Settlement, dated as of October 30, 2006 (incorporated by reference to Exhibit 10.1 to the Registrant’s Current Report on Form 8-K filed November 6, 2006)

31.1	—	Certification of Chief Executive Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a) of the Securities Exchange Act of 1934, as amended.

31.2	—	Certification of Chief Financial Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a) of the Securities Exchange Act of 1934, as amended.

32.1	—	Certification by Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

32.2	—	Certification by Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.


		Krispy Kreme Doughnuts, Inc.

Date: November 9, 2006	By:	/s/ Daryl G. Brewster

		Name:	Daryl G. Brewster
		Title:	Chief Executive Officer

Date: November 9, 2006	By:	/s/ Michael C. Phalen

		Name:	Michael C. Phalen
		Title:	Chief Financial Officer

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Constraining
Legalese
Litigious
Readability	H.S. junior Avg

Krispy Kreme Doughnuts (KKD) Inactive 10-Q2006 Q3 Quarterly report

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