Krispy Kreme Doughnuts (KKD) 10-Q 2016 Q2 Quarterly report

UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
________________

Form 10-Q

(Mark one)
☑	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
	For the quarterly period ended August 2, 2015
OR
☐	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	56-2169715
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)
370 Knollwood Street	27103
Winston-Salem, North Carolina	(Zip Code)
(Address of principal executive offices)

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. Yes☑  No☐

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes☑  No☐

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

Large accelerated filer  ☑	Accelerated filer   ☐
Non-accelerated filer  ☐	Smaller reporting company   ☐

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ☐ No☑

Number of shares of Common Stock, no par value, outstanding as of August 28, 2015: 62,912,961.

1

TABLE OF CONTENTS

		Page
FORWARD-LOOKING STATEMENTS		3
PART I - FINANCIAL INFORMATION		4
Item 1.	FINANCIAL STATEMENTS (UNAUDITED)	4
Item 2.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
	RESULTS OF OPERATIONS	25
Item 3.	QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK	57
Item 4.	CONTROLS AND PROCEDURES	57
PART II - OTHER INFORMATION		57
Item 1.	LEGAL PROCEEDINGS	57
Item 1A.	RISK FACTORS	57
Item 2.	UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS	57
Item 3.	DEFAULTS UPON SENIOR SECURITIES	58
Item 4.	MINE SAFETY DISCLOSURES	58
Item 5.	OTHER INFORMATION	58
Item 6.	EXHIBITS	58
	SIGNATURES	59
	EXHIBIT INDEX	60

2

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. References to fiscal 2016 and fiscal 2015 mean the fiscal years ending January 31, 2016 and February 1, 2015, respectively.

FORWARD-LOOKING STATEMENTS

This quarterly report contains forward looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”) that relate to our plans, objectives, estimates and goals. Statements expressing expectations regarding our future and projections relating to products, sales, revenues, expenditures, costs and earnings are typical of such statements, and are made under 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,” “forecast,” “could,” “will,” “should,” “would,” “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 quality of Company and franchise store operations and changes in sales volume;
 

● risks associated with the use and implementation of information technology;
 

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

● our relationships with our franchisees;
 

● actions by franchisees that could harm our business;
 

● our ability to implement our domestic and international growth strategies;
 

● our ability to implement and operate our domestic shop model;
 

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

● the price and availability of raw materials needed to produce doughnut mixes and other ingredients, and the price of motor fuel;
 

● our relationships with consumer packaged goods - wholesale customers;
 

● reliance on third parties in many aspects of our business;
 

● our ability to protect our trademarks and trade secrets;
 

● changes in customer preferences and perceptions;
 

● risks associated with competition;
 

● risks related to the food service industry, including food safety and protection of personal information;
 

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

● increased costs or other effects of new government regulations; and
 

● other factors discussed in Krispy Kreme’s periodic reports and other information filed with the United States Securities and Exchange Commission (the “SEC”), including under Part I, Item 1A, “Risk Factors,” in the Company’s Annual Report on Form 10-K for the fiscal year ended February 1, 2015 (the “2015 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 except as required by the federal securities laws.

3

PART I - FINANCIAL INFORMATION

Item 1. FINANCIAL STATEMENTS (UNAUDITED).

	Page
Index to Financial Statements
Consolidated statement of income for the three and six months ended August 2, 2015 and August 3, 2014		5
Consolidated statement of comprehensive income for the three and six months ended August 2, 2015 and August 3, 2014		6
Consolidated balance sheet as of August 2, 2015 and February 1, 2015		7
Consolidated statement of cash flows for the six months ended August 2, 2015 and August 3, 2014		8
Consolidated statement of changes in shareholders’ equity for the six months ended August 2, 2015 and August 3, 2014		9
Notes to financial statements		10

4

KRISPY KREME DOUGHNUTS, INC.

CONSOLIDATED STATEMENT OF INCOME
(Unaudited)

	Three Months Ended						Six Months Ended
	August 2, 2015			August 3, 2014			August 2, 2015			August 3, 2014
	(In thousands, except per share amounts)
Revenues	$	127,336		$	120,516		$	259,810		$	242,096
Operating expenses:
Direct operating expenses (exclusive of depreciation and               amortization expense shown below)		104,145			99,067			207,917			195,457
General and administrative expenses		6,718			6,737			14,272			13,784
Depreciation and amortization expense		4,074			3,033			8,067			6,206
Impairment charges and lease termination costs		304			38			308			46
Pre-opening costs related to Company Stores		515			245			838			471
(Gains) and losses on commodity derivatives, net		841			1,341			394			(103	)
(Gain) on refranchisings, net of business acquisition charges		-			431			-			431
Operating income		10,739			9,624			28,014			25,804
Interest income		72			64			219			235
Interest expense		(387	)		(162	)		(764	)		(305	)
Equity in losses of equity method franchisees		-			(61	)		-			(118	)
Other non-operating income and (expense), net		89			152			273			320
Income before income taxes		10,513			9,617			27,742			25,936
Provision for income taxes		4,595			3,865			11,158			10,528
Net income	$	5,918		$	5,752		$	16,584		$	15,408
Earnings per common share:
Basic	$	0.09		$	0.09		$	0.25		$	0.23
Diluted	$	0.09		$	0.08		$	0.24		$	0.22

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

5

KRISPY KREME DOUGHNUTS, INC.

CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME
(Unaudited)

	Three Months Ended				Six Months Ended
	August 2, 2015		August 3, 2014		August 2, 2015		August 3, 2014
	(In thousands)
Net income	$	5,918	$	5,752	$	16,584	$	15,408
Other comprehensive income		-		-		-		-
Comprehensive income	$	5,918	$	5,752	$	16,584	$	15,408

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

6

KRISPY KREME DOUGHNUTS, INC.

CONSOLIDATED BALANCE SHEET
(Unaudited)

	August 2, 2015			February 1, 2015
	(In thousands)
ASSETS
CURRENT ASSETS:
Cash and cash equivalents	$	44,105		$	50,971
Receivables		28,704			27,799
Receivables from equity method franchisees		945			782
Inventories		18,319			18,194
Deferred income taxes		23,155			23,245
Other current assets		8,418			6,856
Total current assets		123,646			127,847
Property and equipment		120,021			115,758
Investments in equity method franchisees		-			-
Goodwill and other intangible assets		29,838			30,070
Deferred income taxes		58,490			68,278
Other assets		10,054			10,760
Total assets	$	342,049		$	352,713
LIABILITIES AND SHAREHOLDERS’ EQUITY
CURRENT LIABILITIES:
Current portion of lease obligations	$	328		$	333
Accounts payable		18,929			17,095
Accrued liabilities		32,214			32,530
Total current liabilities		51,471			49,958
Lease obligations, less current portion		11,252			9,354
Other long-term obligations and deferred credits		25,506			25,615
Commitments and contingencies
SHAREHOLDERS’ EQUITY:
Preferred stock, no par value; 10,000 shares authorized; none issued and outstanding		-			-
Common stock, no par value; 300,000 shares authorized; 63,545 shares and 64,926 shares        outstanding, respectively		280,218			310,768
Accumulated deficit		(26,398	)		(42,982	)
Total shareholders’ equity		253,820			267,786
Total liabilities and shareholders’ equity	$	342,049		$	352,713

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

7

KRISPY KREME DOUGHNUTS, INC.

CONSOLIDATED STATEMENT OF CASH FLOWS
(Unaudited)

	Six Months Ended
	August 2, 2015			August 3, 2014
	(In thousands)
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income	$	16,584		$	15,408
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization expense		8,067			6,206
Deferred income taxes		9,878			9,388
Impairment charges		343			-
Accrued rent expense		268			324
Loss on disposal of property and equipment		87			99
Share-based compensation		3,662			2,207
Provision for doubtful accounts		(3	)		174
Amortization of deferred financing costs		54			54
Equity in losses of equity method franchisees		-			118
Unrealized (gains) losses on commodity derivative positions		(532	)		121
Other		23			6
Change in assets and liabilities:
Receivables		(1,730	)		(4,197	)
Inventories		(98	)		(80	)
Other current and non-current assets		(1,442	)		(2,259	)
Accounts payable and accrued liabilities		264			229
Other long-term obligations and deferred credits		13			(111	)
Net cash provided by operating activities		35,438			27,687
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of property and equipment		(10,158	)		(13,063	)
Proceeds from disposals of property and equipment		216			196
Acquisition of stores from franchisees		(312	)		(7,152	)
Other investing activities		917			427
Net cash used for investing activities		(9,337	)		(19,592	)
CASH FLOWS FROM FINANCING ACTIVITIES:
Repayment of lease obligations		(166	)		(200	)
Proceeds from exercise of stock options		519			6,655
Repurchase of common shares		(33,320	)		(34,618	)
Net cash used for financing activities		(32,967	)		(28,163	)
Net decrease in cash and cash equivalents		(6,866	)		(20,068	)
Cash and cash equivalents at beginning of period		50,971			55,748
Cash and cash equivalents at end of period	$	44,105		$	35,680
Supplemental schedule of non-cash investing and financing activities:
Assets acquired under leasing arrangements	$	2,035		$	3,781

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

8

KRISPY KREME DOUGHNUTS, INC.

CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS' EQUITY
(Unaudited)

	Common Shares Outstanding		Common Stock			Accumulated Deficit			Total
	(In thousands)
Balance at February 1, 2015	64,926		$	310,768		$	(42,982	)	$	267,786
Comprehensive income for the six months        ended August 2, 2015	-			-			16,584			16,584
Exercise of stock options	81			519			-			519
Share-based compensation	447			3,662			-			3,662
Repurchase of common shares	(1,909	)		(34,731	)		-			(34,731	)
Balance at August 2, 2015	63,545		$	280,218		$	(26,398	)	$	253,820
Balance at February 2, 2014	64,940		$	338,135		$	(73,042	)	$	265,093
Comprehensive income for the six months        ended August 3, 2014	-			-			15,408			15,408
Exercise of stock options	1,245			6,655			-			6,655
Share-based compensation	60			2,207			-			2,207
Repurchase of common shares	(1,861	)		(32,773	)		-			(32,773	)
Balance at August 3, 2014	64,384		$	314,224		$	(57,634	)	$	256,590

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

9

KRISPY KREME DOUGHNUTS, INC.

NOTES TO FINANCIAL STATEMENTS
(Unaudited)

Note 1 — Accounting Policies

Krispy Kreme Doughnuts, Inc. (“KKDI”) and its subsidiaries (collectively, the “Company”) are engaged in the sale of doughnuts and complementary products through Company-owned stores. The Company also licenses the Krispy Kreme business model and certain of its intellectual property to franchisees in the United States and over 20 other countries around the world, and derives revenue from franchise and development fees and royalties from those franchisees. Additionally, the Company sells doughnut mixes, other ingredients and supplies and doughnut-making equipment to franchisees.

Significant Accounting Policies

BASIS OF PRESENTATION.The consolidated financial statements contained herein should be read in conjunction with the Company’s 2015 Form 10-K. 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 in the United States of America (“GAAP”) with respect to annual financial statements. The interim consolidated financial statements have been prepared in accordance with the Company’s accounting practices described in the 2015 Form 10-K, but have not been audited. In management’s opinion, the financial statements include all adjustments, which 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 February 1, 2015 were derived from the Company’s audited financial statements.

BASIS OF CONSOLIDATION.The financial statements include the accounts of KKDI and its subsidiaries.

Investments in entities over which the Company has the ability to exercise significant influence but which the Company does not control, and whose financial statements are not otherwise required to be consolidated, are accounted for using the equity method.

CHANGE IN PRESENTATION.In the first quarter of fiscal 2016, the Company changed the presentation of the Consolidated Statement of Income and segment financial information. Pre-opening costs related to Company Stores; gains and losses on commodity derivatives, net and gain on refranchisings, net of business acquisition charges are now separate line items on the Consolidated Statement of Income and are no longer in the respective business segments’ operating income in Note 2. Such changes were made to provide more clarity and visibility to the Company’s operations and to conform to new management reporting. The Company furnished a Current Report on Form 8-K on June 10, 2015 providing the Consolidated Statement of Income and segment financial information for the quarterly and annual periods in fiscal 2014 and fiscal 2015 conformed to the fiscal 2016 presentation. The Company has made no changes to its reportable segments. These presentation changes had no impact on the Company’s consolidated operating income or consolidated net income.

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 additional common shares that would have been outstanding if dilutive potential common shares had been issued, computed using the treasury stock method. Such potential common shares consist of shares issuable upon the exercise of stock options and the vesting of currently unvested restricted stock units.

10

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

	Three Months Ended				Six Months Ended
	August 2,		August 3,		August 2,		August 3,
	2015		2014		2015		2014
	(In thousands)
Numerator: net income	$	5,918	$	5,752	$	16,584	$	15,408
Denominator:
Basic earnings per share - weighted average shares outstanding		65,502		66,008		66,053		66,265
Effect of dilutive securities:
Stock options		1,546		2,097		1,594		2,352
Restricted stock units		321		620		324		619
Diluted earnings per share - weighted average shares
outstanding plus dilutive potential common shares		67,369		68,725		67,971		69,236

Stock options with respect to 285,000 and 295,000 shares for the three months ended August 2, 2015 and August 3, 2014, respectively, and 214,000 and 110,000 unvested restricted stock units for the three months ended August 2, 2015 and August 3, 2014, respectively, have been excluded from the computation of the number of shares used to compute diluted earnings per share because their inclusion would be antidilutive.

Stock options with respect to 294,000 and 234,000 shares for the six months ended August 2, 2015 and August 3, 2014, respectively, and 192,000 and 55,000 unvested restricted stock units for the six months ended August 2, 2015 and August 3, 2014, respectively, have been excluded from the computation of the number of shares used to compute diluted earnings per share because their inclusion would be antidilutive.

Recent Accounting Pronouncements

The Financial Accounting Standards Board (the “FASB”) Accounting Standards Codification is the sole source of authoritative GAAP other than SEC issued rules and regulations that apply only to SEC registrants. The FASB issues an Accounting Standard Update ("ASU") to communicate changes to the codification. The Company considers the applicability and impact of all ASU's. The followings are those ASU's that are relevant to the Company.

In July 2015, the FASB issued ASU 2015-11, “Simplifying the Measurement of Inventory”, which changes guidance for subsequent measurement of inventory within the scope of the update from the lower of cost or market to the lower of cost and net realizable value. This update is effective for annual and interim periods beginning after December 15, 2016 and early adoption is permitted. The Company will evaluate the effects of adoption of this guidance on the Company's consolidated financial statements.

In April 2015, the FASB issued ASU 2015-03, “Simplifying the Presentation of Debt Issuance Costs.” This guidance requires that debt issuance costs related to a recognized debt liability be presented in the balance sheet as a direct deduction from the carrying amount of that debt liability, consistent with debt discounts. In August 2015, the FASB issued ASU 2015-15, “Presentation and Subsequent Measurement of Debt Issuance Costs Associated with Line-of-Credit Arrangements.” This guidance states that given the absence of authoritative guidance within ASU 2015-03 for debt issuance costs related to the line-of-credit arrangements, the SEC staff would not object to an entity deferring and presenting debt issuance costs as an asset and subsequently amortizing the costs ratably over the term of the arrangement, regardless of whether there are any outstanding borrowings on the line-of-credit. As all of the Company’s debt issuance costs are related to line-of-credit arrangements and are currently classified as assets, this update will not have any impact on the Company’s financial statements.

In May 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers, to clarify the principles used to recognize revenue for all entities. This guidance was deferred by ASU 2015-14, issued by the FASB in August 2015, and is now effective for fiscal years beginning on or after December 15, 2017 with early adoption permitted as of the original effective date. The Company will evaluate the effects, if any, of adoption of this guidance on the Company’s consolidated financial statements.

Note 2 — Segment Information

The Company’s operating and reportable segments are Company Stores, Domestic Franchise, International Franchise and KK Supply Chain.

11

The Company Stores segment is comprised of the stores owned and operated by the Company. These stores sell doughnuts and complementary products through both on-premises and consumer packaged goods - wholesale (“CPG”) sales channels, although some stores serve only one of these distribution channels.

The Domestic Franchise and International Franchise segments consist of the Company’s franchise operations. Under the terms of franchise agreements, domestic and international franchisees pay royalties and fees to the Company in return for the use of the Krispy Kreme name and ongoing brand and operational support. Revenues and costs related to licensing certain Krispy Kreme trademarks to domestic third parties other than franchisees also are included in the Domestic Franchise segment. Expenses for these segments include costs to recruit new franchisees, to assist in store openings, and to support franchisee operations and marketing efforts, as well as allocated corporate costs.

The majority of the ingredients and materials used by Company stores are purchased from the KK Supply Chain segment, which supplies doughnut mix, other ingredients and supplies and doughnut-making equipment to both Company and franchisee-owned stores. All intercompany sales by the KK Supply Chain segment to the Company Stores segment are at prices intended to reflect an arms-length transfer price and are eliminated in consolidation. Operating income for the Company Stores segment does not include any profit earned by the KK Supply Chain segment on sales of doughnut mix and other items to the Company Stores segment; such profit is included in KK Supply Chain operating income.

The following table presents the results of operations of the Company’s operating segments for the three and six months ended August 2, 2015 and August 3, 2014. Segment operating income is consolidated operating income before general and administrative expenses, corporate depreciation and amortization expense, impairment charges and lease termination costs, pre-opening costs related to Company Stores, gains and losses on commodity derivatives, net and gain on refranchisings, net of business acquisition charges.

12

	Three Months Ended						Six Months Ended
	August 2,			August 3,			August 2,			August 3,
	2015			2014			2015			2014
	(In thousands)
Revenues:
Company Stores	$	84,117		$	78,535		$	174,834		$	158,983
Domestic Franchise		3,936			3,296			7,645			6,795
International Franchise		7,314			7,534			14,042			14,115
KK Supply Chain:
Total revenues		63,469			59,503			126,986			119,815
Less – intersegment sales elimination		(31,500	)		(28,352	)		(63,697	)		(57,612	)
External KK Supply Chain revenues		31,969			31,151			63,289			62,203
Total revenues	$	127,336		$	120,516		$	259,810		$	242,096
Operating income:
Company Stores	$	1,592		$	1,937		$	8,949		$	6,579
Domestic Franchise		2,440			1,900			4,534			4,056
International Franchise		5,487			5,111			10,391			9,391
KK Supply Chain		10,144			9,830			21,093			21,140
Total segment operating income		19,663			18,778			44,967			41,166
General and administrative expenses		(6,718	)		(6,737	)		(14,272	)		(13,784	)
Corporate depreciation and amortization expense		(546	)		(362	)		(1,141	)		(733	)
Impairment charges and lease termination costs		(304	)		(38	)		(308	)		(46	)
Pre-opening costs related to Company Stores		(515	)		(245	)		(838	)		(471	)
Gains and (losses) on commodity derivatives, net		(841	)		(1,341	)		(394	)		103
Gain on refranchisings, net of business acquisition charges		-			(431	)		-			(431	)
Consolidated operating income	$	10,739		$	9,624		$	28,014		$	25,804
Depreciation and amortization expense:
Company Stores	$	3,261			2,457			6,430		$	5,041
Domestic Franchise		16			49			33			95
International Franchise		-			2			-			3
KK Supply Chain		251			163			463			334
Corporate		546			362			1,141			733
Total depreciation and amortization expense	$	4,074			3,033			8,067		$	6,206

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 3 — Receivables

The components of receivables are as follows:

	August 2,			February 1,
	2015			2015
	(In thousands)
Receivables:
Consumer packaged goods - wholesale customers	$	9,697		$	9,557
Unaffiliated franchisees		14,157			12,743
Third-party distributors		2,980			4,075
Other receivables		1,228			867
Current portion of notes receivable from franchisees		1,036			1,052
		29,098			28,294
Less — allowance for doubtful accounts:
Consumer packaged goods - wholesale customers		(146	)		(204	)
Unaffiliated franchisees		(248	)		(291	)
		(394	)		(495	)
	$	28,704		$	27,799
Receivables from equity method franchisees (Note 5):
Trade	$	945		$	782

13

The changes in the allowance for doubtful accounts are summarized as follows:

	Six Months Ended
	August 2,			August 3,
	2015			2014
	(In thousands)
Allowance for doubtful accounts related to receivables:
Balance at beginning of period	$	495		$	241
Provision for doubtful accounts		(41	)		260
Net recoveries (chargeoffs)		(60	)		24
Balance at end of period	$	394		$	525

The Company also has notes receivable from franchisees included in “Other assets” in the accompanying consolidated balance sheet, which are summarized in the following table.

	August 2,			February 1,
	2015			2015
	(In thousands)
Notes receivable:
Notes receivable from franchisees	$	4,289		$	4,534
Less — portion due within one year included in receivables		(1,036	)		(1,052	)
	$	3,253		$	3,482

Notes receivable at August 2, 2015 and February 1, 2015 consist principally of amounts payable to the Company related to a refranchising transaction, to the sale of certain leasehold interests to a franchisee and to sales of equipment.

In addition to the foregoing notes receivable, the Company had promissory notes totaling approximately $1.2 million at August 2, 2015 and $1.9 million at February 1, 2015 representing principally royalties and fees due to the Company which, as a result of doubt about their collection, the Company has not yet recorded as revenues. The Company collected approximately $700,000 and $900,000 during the three and six months ended August 2, 2015 and August 3, 2014, respectively, related to these promissory notes and recorded such collections in revenues as received.

Finally, the Company has a promissory note receivable from Krispy Kreme of South Florida, LLC (“KKSF”) totaling approximately $720,000 at August 2, 2015 and $1.0 million at February 1, 2015 arising from the Company’s advance to KKSF of approximately $1.6 million in November 2013 to enable KKSF to retire certain indebtedness with respect to which KKSF had been in default since October 2009 and payment of which was demanded by the lender in October 2013. The lender also made demand on the Company to perform under its guarantee of such indebtedness. Because of the uncertainty of recovery of amounts advanced to KKSF the note receivable is not reflected as an asset in the accompanying consolidated balance sheet at August 2, 2015 or February 1, 2015. The Company is recording payments on the note as they are received from KKSF, and reflecting such amounts as a component of other non-operating income. Such collections were approximately $90,000 and $150,000 in the three months ended August 2, 2015 and August 3, 2014, respectively, and $260,000 and $320,000 in the six months ended August 2, 2015 and August 3, 2014, respectively.

14

Note 4 — Inventories

The components of inventories are as follows:

	August 2,		February 1,
	2015		2015
	(In thousands)
Raw materials	$	7,202	$	6,779
Work in progress		81		115
Finished goods and purchased merchandise		11,036		11,300
	$	18,319	$	18,194

Note 5 — Investments in Franchisees

As of August 2, 2015, the Company had an ownership interest in three franchisees, the aggregate carrying value of which was zero. The Company’s financial exposures related to franchisees in which the Company has an investment are summarized in the tables below.

	August 2, 2015
	Company	Investment
	Ownership	and
	Percentage	Advances			Receivables
	(Dollars in thousands)
Kremeworks, LLC	25.0%	$	900		$	487
Kremeworks Canada, LP	24.5%		667			43
Krispy Kreme of South Florida, LLC	35.3%		-			415
			1,567			945
Less: reserves and allowances			(1,567	)		-
		$	-		$	945
	February 1, 2015
	Company	Investment
	Ownership	and
	Percentage	Advances			Receivables
	(Dollars in thousands)
Kremeworks, LLC	25.0%	$	900		$	353
Kremeworks Canada, LP	24.5%		667			30
Krispy Kreme of South Florida, LLC	35.3%		-			399
			1,567			782
Less: reserves and allowances			(1,567	)		-
		$	-		$	782

The carrying values of the Company’s investments and advances in Kremeworks, LLC (“Kremeworks”) and Kremeworks Canada, LP (“Kremeworks Canada”) were zero at August 2, 2015 and February 1, 2015. In addition, the Company had reserved all of the balance of its advances to Kremeworks and Kremeworks Canada at such dates; accrued but uncollected interest on such advances of approximately $375,000 at August 2, 2015 had not been reflected in income at such date.

15

Note 6 — Credit Facility and Lease Obligations

Lease obligations consist of the following:

	August 2,			February 1,
	2015			2015
	(In thousands)
Capital lease obligations	$	2,784		$	2,940
Financing obligations		8,796			6,747
		11,580			9,687
Less: current portion		(328	)		(333	)
	$	11,252		$	9,354

Lease Obligations

The Company acquires equipment and facilities under capital and operating leases and build-to-suit arrangements.

In certain build-to-suit leasing arrangements, the Company is involved in the construction of leased stores and is deemed the owner of the leased stores for accounting purposes during the construction period. The Company records the related assets and liabilities for construction costs incurred under these build-to-suit leasing arrangements during the construction period. Upon completion of the leased store, the Company considers whether the assets and liabilities qualify for derecognition under the sale-leaseback accounting guidance. These leasing arrangements entered into to date do not qualify for sale-leaseback treatment and, accordingly, the Company records the transactions as financing obligations. A portion of the lease payments is allocated to land and is classified as an operating lease. The remainder of the lease payments is allocated between interest expense and amortization of the financing obligations. The assets are depreciated over their estimated useful lives. At the end of the lease term, the carrying value of the leased asset and of the remaining financing obligation are expected to be equal, at which time the Company may either surrender the leased assets as settlement of the remaining financing obligation or enter into a new arrangement for the continued use of the asset.

At August 2, 2015, the Company had property and lease obligations related to build-to-suit leasing arrangements of approximately $8.8 million.

2013 Revolving Credit Facility

On July 12, 2013, the Company entered into a $40 million revolving secured credit facility (the “2013 Revolving Credit Facility”) which matures in July 2018. The 2013 Revolving Credit Facility is secured by a first lien on substantially all of the personal property assets of the Company and certain of its domestic subsidiaries. No borrowings were made on the 2013 Revolving Credit Facility on the closing date.

Interest on borrowings under the 2013 Revolving Credit Facility is payable either at LIBOR or the Base Rate (which is the greatest of the prime rate, the Fed funds rate plus 0.50%, or the one-month LIBOR rate plus 1.00%), in each case plus the Applicable Percentage. The Applicable Percentage for LIBOR loans ranges from 1.25% to 2.15%, and for Base Rate loans ranges from 0.25% to 1.15%, in each case depending on the Company’s leverage ratio. As of August 2, 2015, the Applicable Percentage was 1.25%.

The 2013 Revolving Credit Facility contains provisions which permit the Company to obtain letters of credit, issuance of which constitutes usage of the lending commitments and reduces the amount available for cash borrowings. At closing, $9.2 million of letters of credit were issued under the 2013 Revolving Credit Facility to replace letters of credit issued under the terminated credit facilities, substantially all of which secure the Company’s reimbursement obligations to insurers under the Company’s self-insurance programs. At August 2, 2015, the Company had approximately $8.7 million of letters of credits outstanding

The Company is required to pay a fee equal to the Applicable Percentage for LIBOR-based loans on the outstanding amount of letters of credit. There also is a fee on the unused portion of the 2013 Revolving Credit Facility lending commitment, ranging from 0.15% to 0.35%, depending on the Company’s leverage ratio. As of August 2, 2015, the fee on the unused portion of the 2013 Revolving Credit Facility was 0.15%.

The 2013 Revolving Credit Facility requires the Company to meet certain financial tests, including a maximum leverage ratio and a minimum fixed charge coverage ratio. The leverage ratio is required to be not greater than 2.25 to 1.0 and the fixed charge coverage ratio is required to be not less than 1.3 to 1.0.

As of August 2, 2015, the Company’s leverage ratio was 0.3 to 1.0 and the fixed charge coverage ratio was 3.8 to 1.0.

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The operation of the restrictive financial covenants described above may limit the amount the Company may borrow under the 2013 Revolving Credit Facility. The restrictive covenants did not limit the Company’s ability to borrow the full $31.3 million of unused credit under the 2013 Revolving Credit Agreement as of August 2, 2015.

The 2013 Revolving Credit Facility also contains covenants which, among other things, generally limit (with certain exceptions): liquidations, mergers, and consolidations; the incurrence of additional indebtedness (including guarantees); the incurrence of additional liens; the sale, assignment, lease, conveyance or transfer of assets; certain investments; dividends and stock redemptions or repurchases in excess of certain amounts; transactions with affiliates; engaging in materially different lines of business; certain sale-leaseback transactions; and other activities customarily restricted in such agreements. The 2013 Revolving Credit Facility also prohibits the transfer of cash or other assets to the Parent Company, whether by dividend, loan or otherwise, but provides for exceptions to enable the Parent Company to pay taxes, directors’ fees and operating expenses, as well as exceptions to permit dividends in respect of the Company’s common stock and stock redemptions and repurchases, to the extent permitted by the 2013 Revolving Credit Facility.

The 2013 Revolving Credit Facility also contains customary events of default including, without limitation, payment defaults, breaches of representations and warranties, covenant defaults, cross-defaults to other indebtedness in excess of $5 million, certain events of bankruptcy and insolvency, judgment defaults in excess of $5 million and the occurrence of a change of control.

Borrowings and issuances of letters of credit under the 2013 Revolving Credit Facility are subject to the satisfaction of usual and customary conditions, including the accuracy of representations and warranties and the absence of defaults.

Note 7 — Commitments and Contingencies

Except as disclosed below, the Company currently is not a party to any material legal proceedings.

Pending Litigation

K² Asia Litigation

On April 7, 2009, a Cayman Islands corporation, K² Asia Ventures, and its owners filed a lawsuit in Forsyth County, North Carolina Superior Court against the Company, its franchisee in the Philippines, and other persons associated with the franchisee. The suit alleges that the Company and the other defendants conspired to deprive the plaintiffs of claimed “exclusive rights” to negotiate franchise and development agreements with prospective franchisees in the Philippines, and seeks unspecified damages. The Company therefore does not know the amount or range of possible loss related to this matter. The Company believes that these allegations are false and intends to vigorously defend against the lawsuit. On July 26, 2013, the Superior Court dismissed the Philippines-based defendants for lack of personal jurisdiction, and the plaintiffs noticed an appeal of that decision. On January 22, 2015, the North Carolina Supreme Court denied the plaintiffs’ request to review the case. The Company moved for summary judgment on May 7, 2015 and is awaiting a decision by the Superior Court.

The Company does not believe it is probable that a loss has been incurred with respect to this matter, and accordingly no liability related to it has been reflected in the accompanying financial statements.

Other Legal Matters

The Company also is engaged in various legal proceedings arising in the normal course of business. The Company maintains insurance policies against certain kinds of such claims and suits, including insurance policies for workers’ compensation and personal injury, all of which are subject to deductibles. While the ultimate outcome of these matters could differ from management’s expectations, management currently does not believe their resolution will have a material adverse effect on the Company’s consolidated financial statements.

Other Commitments and Contingencies

The Company’s primary bank had issued letters of credit on behalf of the Company totaling $8.7 million at August 2, 2015, substantially all of which secure the Company’s reimbursement obligations to insurers under the Company’s self-insurance arrangements.

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Note 8 — Shareholders’ Equity

Share-Based Compensation for Employees and Directors

The Company measures and recognizes compensation expense for share-based payment (“SBP”) awards based on their fair values. The fair value of SBP awards for which employees and directors render the requisite service necessary for the award to vest is recognized over the related vesting period.

The aggregate cost of SBP awards charged to earnings for the three and six months ended August 2, 2015 and August 3, 2014 is set forth in the following table. The Company did not realize any excess tax benefits from the exercise of stock options or the vesting of restricted stock units during any of the periods.

	Three Months Ended				Six Months Ended
	August 2,		August 3,		August 2,		August 3,
	2015		2014		2015		2014
	(In thousands)
Costs charged to earnings related to:
Stock options	$	295	$	226	$	618	$	561
Restricted stock units		1,370		814		3,044		1,646
Total costs	$	1,665	$	1,040	$	3,662	$	2,207
Costs included in:
Direct operating expenses	$	767	$	460	$	1,795	$	1,163
General and administrative expenses		898		580		1,867		1,044
Total costs	$	1,665	$	1,040	$	3,662	$	2,207

Repurchases of Common Stock

In fiscal 2014, the Company’s Board of Directors authorized the repurchase of up to $50 million of the Company's common stock and subsequently increased such authorization three times, the most recent being in June 2015, such that the authorization now totals $155 million. The authorization has no expiration date.

The Company generally permits holders of restricted stock unit awards to satisfy their obligations to reimburse the Company for the minimum required statutory withholding taxes arising from the vesting of such awards by surrendering vested common shares in lieu of reimbursing the Company in cash.

The following table summarizes repurchases of common stock for the three and six months ended August 2, 2015 and August 3, 2014.

	Three Months Ended
	August 2,			August 3,
	2015			2014
		Common			Common
	Shares	Stock		Shares	Stock
	(In thousands)
Shares repurchased under share repurchase authorization	1,494	$	26,883	403	$	7,304
Shares surrendered in reimbursement for withholding taxes	13		223	21		334
	1,507	$	27,106	424	$	7,638

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	Six Months Ended
	August 2,			August 3,
	2015			2014
		Common			Common
	Shares	Stock		Shares	Stock
	(In thousands)
Shares repurchased under share repurchase authorization	1,885	$	34,311	1,840	$	32,439
Shares surrendered in reimbursement for withholding taxes	24		420	21		334
	1,909	$	34,731	1,861	$	32,773

Through August 2, 2015, the Company repurchased 5,307,149 shares under the authorization at an average price of $18.07 per share, for a total cost of $95.9 million. Repurchases of approximately $32.9 million and $34.6 million of the shares repurchased were settled during the six months ended August 2, 2015 and August 3, 2014, respectively. As of August 2, 2015, approximately $59.1 million remained outstanding under the $155 million share repurchase authorization.

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Note 9 — Impairment Charges and Lease Termination Costs

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

	Three Months Ended						Six Months Ended
	August 2,			August 3,			August 2,			August 3,
	2015			2014			2015			2014
	(In thousands)
Impairment of long-lived assets	$	343		$	-		$	343		$	-
Lease termination costs:
Provision for lease termination costs		71			40			75			48
Less - reversal of previously recorded accrued rent expense		(110	)		(2	)		(110	)		(2	)
Net provision		(39	)		38			(35	)		46
Total impairment charges and lease termination costs	$	304		$	38		$	308		$	46

The Company tests long-lived assets for impairment when events or changes in circumstances indicate that their carrying value may not be recoverable. These events and changes in circumstances include store closing and refranchising decisions, the effects of changing costs on current results of operations, unfavorable observed trends in operating results, and evidence of changed circumstances observed as a part of periodic reforecasts of future operating results and as part of the Company’s annual budgeting process. When the Company concludes that the carrying value of long-lived assets is not recoverable (based on future projected undiscounted cash flows), the Company records impairment charges to reduce the carrying value of those assets to their estimated fair values. During the three and six months ended August 2, 2015, the Company recorded impairment charges related to long-lived assets for one Company store that closed during the second quarter of fiscal 2016 to reduce the carrying value of those assets to their estimated fair values. Substantially all of such long-lived assets were real properties, the fair values of which were estimated based on an independent appraisal and are included in other current assets as assets held for sale.

Lease termination costs represent the estimated fair value of liabilities related to unexpired leases, after reduction by the amount of accrued rent expense, if any, related to the leases, and are recorded when the lease contracts are terminated or, if earlier, the date on which the Company ceases use of the leased property. The fair value of these liabilities is estimated as the excess, if any, of the contractual payments required under the unexpired leases over the current market lease rates for the properties, discounted at a credit-adjusted risk-free rate over the remaining term of the leases. The provision for lease termination costs also includes adjustments to liabilities recorded in prior periods arising from changes in estimated sublease rentals and from settlements with landlords. During the three and six months ended August 2, 2015, the Company recorded lease termination costs related to a store closed during the second quarter of fiscal 2016.

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

	Three Months Ended						Six Months Ended
	August 2,			August 3,			August 2,			August 3,
	2015			2014			2015			2014
	(In thousands)
Balance at beginning of period	$	85		$	167		$	116		$	178
Provision for lease termination costs:
Provisions associated with leased properties, net of estimated
sublease rentals		57			44			57			44
Adjustments to previously recorded provisions resulting from
settlements with lessors and adjustments of previous
estimates		12			(10	)		13			(5	)
Accretion of discount		2			6			5			9
Total provision		71			40			75			48
Payments on unexpired leases, including settlements with
lessors		(35	)		(31	)		(70	)		(50	)
Balance at end of period	$	121		$	176		$	121		$	176

The lease termination accrual at August 2, 2015 of $121,000 is expected to be paid within one year.

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Note 10 — Income Taxes

The Company accounts for its provision for income taxes in accordance with GAAP, which requires management to estimate the annual effective income tax rate for the full year to be applied to the respective interim period taking into account year-to-date amounts and projected results for the full year. For the three and six months ended August 2, 2015, the Company's effective income tax rate was 43.7% and 40.2%, respectively, compared with to an effective income tax rate of 40.2% and 40.6%, respectively, for the three and six months ended August 3, 2014.

The increase in the effective income tax rate in the quarter was due primarily to the revaluation of the Company’s deferred tax assets, principally attributable to state net operating loss (“NOL”) carryforwards, resulting from the decrease in the North Carolina (“NC”) corporate income tax rate. Specifically, in the second quarter of fiscal 2016, the North Carolina state legislature announced it surpassed its revenue estimates and these increased tax revenues triggered an automatic reduction to the state corporate income tax rate, which caused the Company to revalue its deferred income tax assets to reflect the lower corporate income tax rate. The net effect of the NC tax rate reduction and associated revaluation of the Company’s deferred tax assets resulted in the reduction in net deferred tax assets of $467,000; such amount was included in income tax expense for the second quarter of fiscal 2016.

The Company recognizes deferred income tax assets and liabilities based upon management’s expectation of the future tax consequences of temporary differences between the income tax and financial reporting bases of assets and liabilities. Deferred tax liabilities generally represent tax expense recognized for which payment has been deferred, or expenses which have been deducted in the Company’s tax returns but which have not yet been recognized as an expense in the financial statements. Deferred tax assets generally represent tax deductions or credits that will be reflected in future tax returns for which the Company has already recorded a tax benefit in its consolidated financial statements.

The Company establishes valuation allowances for deferred income tax assets in accordance with GAAP, which provides that such valuation allowances shall be established unless realization of the income tax benefits is more likely than not.

The valuation allowance of $2.5 million at August 2, 2015 and $2.6 million at February 1, 2015 represents the portion of the Company’s deferred tax assets management estimates will not be realized in the future. Such assets are associated principally with state net operating loss carryforwards related to states in which the scope of the Company’s operations has decreased. In such states, the Company’s ability to realize the net operating loss carryforwards is adversely affected because the Company is expected to have little income earned in or apportioned to those states in the future.

Realization of net deferred tax assets generally is dependent on generation of taxable income in future periods. While management believes its forecast of future taxable income is reasonable, actual results inevitably will vary from management’s forecasts. Such variances could result in adjustments to the valuation allowance on deferred tax assets in future periods, and such adjustments could be material to the financial statements.

Note 11 — Fair Value Measurements

The accounting standards for fair value measurements define fair value as the price that would be received for an asset or paid to transfer a liability in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants at the measurement date.

The accounting standards for fair value measurements establish a three-level fair value hierarchy that prioritizes the inputs used to measure fair value. This hierarchy requires entities to maximize the use of observable inputs and minimize the use of unobservable inputs. The three levels of inputs used to measure fair value are as follows:

● Level 1 - Quoted prices in active markets that are accessible at the measurement date for identical assets or liabilities.
 

● Level 2 - Observable inputs other than quoted prices included within Level 1, such as quoted prices for similar assets and liabilities in active markets; quoted prices for identical or similar assets and liabilities in markets that are not active; or other inputs that are observable or can be corroborated by observable market data.
 

● Level 3 - Unobservable inputs that are supported by little or no market activity and that are significant to the fair value measurement of the assets or liabilities. These include certain pricing models, discounted cash flow methodologies and similar techniques that use significant unobservable inputs.

21

Assets and Liabilities Measured at Fair Value on a Recurring Basis

The following table presents the Company’s assets and liabilities that are measured at fair value on a recurring basis at August 2, 2015 and February 1, 2015.

	August 2, 2015(1)
	Level 1		Level 2		Level 3
	(In thousands)
Assets:
401(k) mirror plan assets	$	2,335	$	-	$	-
Liabilities:
Agricultural commodity futures contracts	$	502	$	-	$	-
Gasoline commodity futures contracts		777		-		-
Total liabilities	$	1,279	$	-	$	-
	February 1, 2015(1)
	Level 1		Level 2		Level 3
	(In thousands)
Assets:
401(k) mirror plan assets	$	2,496	$	-	$	-
Liabilities:
Agricultural commodity futures contracts	$	874	$	-	$	-
Gasoline commodity futures contracts		937		-		-
Total liabilities	$	1,811	$	-	$	-

(1)        There were no transfers of financial assets or liabilities among the levels within the fair value hierarchy during the three and six months ended August 2, 2015 or during the year ended February 1, 2015.

Assets and Liabilities Measured at Fair Value on a Non-Recurring Basis

The following table presents the nonrecurring fair value measurements recorded during the three and six months ended August 2, 2015. There were no material nonrecurring fair value measurements recorded during the three and six months ended August 3, 2014.

	Three Months Ended August 2, 2015
	Level 1		Level 2		Level 3		Total gain (loss)
	(In thousands)
Long-lived assets	$	-	$	94	$	-	$	(343)
	Six Months Ended August 2, 2015
	Level 1		Level 2		Level 3		Total gain (loss)
	(In thousands)
Long-lived assets	$	-	$	94	$	-	$	(343)

Long-Lived Assets

During the three and six months ended August 2, 2015, long-lived assets having an aggregate carrying value of $437,000 were written down to their estimated fair values of $94,000, resulting in recorded impairment charges of $343,000. Substantially all of such long-lived assets were real properties, the fair values of which were estimated based on an independent appraisal and are included in other current assets as assets held for sale. These inputs are classified as Level 2 within the valuation hierarchy. There were no other material nonrecurring fair value measurements recorded during the three and six months ended August 2, 2015.

22

Fair Values of Financial Instruments at the Balance Sheet Dates

The carrying values and approximate fair values of certain financial instruments as of August 2, 2015 and February 1, 2015 were as follows:

	August 2, 2015				February 1, 2015
	Carrying		Fair		Carrying		Fair
	Value		Value		Value		Value
	(In thousands)
Assets:
Cash and cash equivalents	$	44,105	$	44,105	$	50,971	$	50,971
Receivables		28,704		28,704		27,799		27,799
Receivables from equity method franchisees		945		945		782		782
Liabilities:
Accounts payable		18,929		18,929		17,095		17,095
Agricultural commodity futures contracts		502		502		874		874
Gasoline commodity futures contracts		777		777		937		937
Lease obligations (including current portion)		11,580		11,580		9,687		9,687

The carrying values of all financial instruments approximate their fair values at August 2, 2015 and February 1, 2015.

Note 12 — Derivative Instruments

The Company is exposed to certain risks relating to its ongoing business operations. The primary risks managed by using derivative instruments are commodity price risk. The Company does not hold or issue derivative instruments for trading purposes.

The Company is exposed to credit-related losses in the event of non-performance by the counterparties to its derivative instruments. The Company mitigates this risk of nonperformance by dealing with highly rated counterparties.

Additional disclosure about the fair value of derivative instruments is included in Note 11.

Commodity Price Risk

The Company is exposed to the effects of commodity price fluctuations in the cost of ingredients of its products, of which flour, sugar and shortening are the most significant. In order to bring greater stability to the cost of ingredients, 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 and soybean oil. The Company is also exposed to the effects of commodity price fluctuations in the cost of gasoline used by its delivery vehicles. To mitigate the risk of fluctuations in the price of its gasoline purchases, the Company may purchase exchange-traded commodity futures contracts and options on such contracts. The difference between the cost, if any, and the fair value of commodity derivatives is reflected in earnings because the Company has not designated any of these instruments as hedges. Gains and losses on these contracts are intended to offset losses and gains on the hedged transactions in an effort to reduce the earnings volatility resulting from fluctuating commodity prices. The settlement of commodity derivative contracts is reported in the consolidated statement of cash flows as a cash flow from operating activities. At August 2, 2015, the Company had commodity derivatives with an aggregate contract volume of 880,000 bushels of wheat, 1.5 million pounds of soybean oil and 2.6 million gallons of gasoline. Other than the requirement to meet minimum margin requirements with respect to the commodity derivatives, there are no collateral requirements related to such contracts.

Interest Rate Risk

The Company is exposed to market risk from increases in interest rates on any borrowings outstanding under its 2013 Revolving Credit Facility. As of August 2, 2015, there were no borrowings outstanding under such facility.

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Quantitative Summary of Derivative Positions and Their Effect on Results of Operations

The following table presents the fair values of derivative instruments included in the consolidated balance sheet as of August 2, 2015 and February 1, 2015:

		Liability Derivatives
		Fair Value
		August 2,		February 1,
Derivatives Not Designated as Hedging Instruments	Balance Sheet Location	2015		2015
		(In thousands)
Agricultural commodity futures contracts	Accrued liabilities	$	502	$	874
Gasoline commodity futures contracts	Accrued liabilities		777		937
Total		$	1,279	$	1,811

The effects of derivative instruments on the consolidated statement of income for the three and six months ended August 2, 2015 and August 3, 2014 were as follows:

		Amount of Derivative Gain or (Loss)
		Recognized in Income
		Three Months Ended
		August 2,			August 3,
Derivatives Not Designated as Hedging Instruments	Location of Derivative Gain or (Loss) Recognized in Income	2015			2014
		(In thousands)
Agricultural commodity futures contracts	Gains and losses on commodity derivatives, net	$	(71	)	$	(1,341	)
Gasoline commodity futures contracts	Gains and losses on commodity derivatives, net		(770	)		-
Total		$	(841	)	$	(1,341	)
		Amount of Derivative Gain or (Loss)
		Recognized in Income
		Six Months Ended
		August 2,			August 3,
Derivatives Not Designated as Hedging Instruments	Location of Derivative Gain or (Loss) Recognized in Income	2015			2014
		(In thousands)
Agricultural commodity futures contracts	Gains and losses on commodity derivatives, net	$	(406	)	$	103
Gasoline commodity futures contracts	Gains and losses on commodity derivatives, net		12			-
Total		$	(394	)	$	103

Note 13 — Acquisitions and Divestitures

Acquisition of Krispy Kreme Shops

On April 23, 2015, the Company entered into several legal arrangements with a franchisee, which included an asset purchase agreement and management agreement, whereby the Company agreed to operate the franchisee’s Krispy Kreme shop in Little Rock, Arkansas as a Company store. The Company paid $312,000 in cash for specific assets of the Krispy Kreme shop and has accounted for the transaction as the acquisition of a business. The Krispy Kreme shop had fiscal 2015 sales of approximately $2.7 million. The allocation of the purchase price was as follows: $252,000 to property and equipment, $27,000 to inventory, $137,000 to reacquired franchise rights and $104,000 to a liability, related to a lease which included an unfavorable term compared to the market, which will be amortized over the remaining life of the lease agreement. The Company’s results of operations, computed on a pro forma basis assuming the acquisition had been consummated at the beginning of the current and prior year periods, are not materially different from the Company’s historical results of operations and, accordingly, have been omitted. The acquired business’s revenues and earnings for periods subsequent to the acquisition are not material to the Company’s consolidated financial statements.

24

On June 17, 2014, the Company acquired the business and operating assets of its franchisee in Birmingham, Alabama, consisting of four Krispy Kreme shops that had fiscal 2014 sales of approximately $9 million. The acquired assets also include the seller’s franchise rights for 13 counties in Alabama. The total consideration was approximately $7.5 million cash. In connection with the acquisition, the Company entered into leases with the seller for three of the shops and assumed a lease with an unrelated party on the fourth shop.

The Company recorded charges to earnings related to the acquisition of $431,000 in the quarter ended August 3, 2014. The charges include $343,000 for the settlement of the pre-existing franchise contract between the Company and the franchisee, certain terms of which were unfavorable, from the Company’s point of view, to current market terms. The charge was determined by discounting to present value as of the acquisition date the excess of royalties on the acquired business’s sales at the Company’s current prevailing royalty rates over the lower royalties otherwise payable by the former franchisee pursuant to the terminated franchise agreement. The discount rate used reflected both the time value of money and the level of risk associated with achievement of the related cash flows. The Company also expensed transaction costs related to the acquisition of $88,000.

The cost of the acquired business was allocated as follows:

	(In thousands)
Purchase price allocated to:
Working capital, exclusive of cash	$	(5	)
Property and equipment		710
Reacquired franchise rights associated with the Company Stores segment		3,853
Goodwill associated with the Company Stores segment		2,594
	$	7,152

Amounts allocated to reacquired franchise rights are being amortized by charges to earnings on a straight-line basis through March 2020, which was the expiration date of the terminated franchise agreement. All of the goodwill recognized in the acquisition for financial reporting purposes is expected to be deductible for income tax purposes.

The results of operations of the acquired business subsequent to the acquisition had no material effect on the Company’s consolidated results of operations. The Company’s results of operations for the year ended February 2, 2014, computed on a pro forma basis assuming the acquisition had been consummated at the beginning of those periods, would not be materially different from the Company’s historical results of operations and, accordingly, have been omitted.

In December 2013, the Company acquired the land, building and doughnut-making equipment at a facility in Illinois that had fiscal 2014 sales of approximately $3 million. The aggregate purchase price for the facility was approximately $1.6 million cash, all of which was allocated to property and equipment. The facility was being operated as a Krispy Kreme shop pursuant to a management agreement approved by the Company between the facility’s former owner and one of the Company’s franchisees. The management agreement was terminated in connection with the Company’s acquisition of the facility, and was replaced by an operating agreement between the Company and the franchisee. Pursuant to the operating agreement, the Company agreed to permit the franchisee to continue to operate the facility for its account through June 2014 in exchange for monthly rental payments, and the payment of amounts based on the facility’s sales equivalent to the amounts that would be payable to the Company if the facility were subject to a franchise agreement. The Company assumed operation of the facility for its own account in July 2014.

Asset Divestitures

On September 9, 2014, the Company refranchised its retail Krispy Kreme shop in Rockville, Maryland to a new franchisee for approximately $1.8 million cash. The Company realized a gain of $1.2 million on the refranchising transaction. The refranchising included the execution of a development agreement pursuant to which the new franchisee has agreed to develop an additional 20 retail Krispy Kreme shops in Virginia, Washington, DC and Maryland over the next seven years.

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

The following discussion of the Company’s financial condition and results of operations should be read in conjunction with the consolidated financial statements and notes thereto appearing elsewhere herein.

25

Results of Operations

The following table sets forth operating metrics for the three and six months ended August 2, 2015 and August 3, 2014.

	Three Months Ended								Six Months Ended
	August 2,				August 3,				August 2,				August 3,
	2015				2014				2015				2014
Change in Same Store Sales(retail sales only):
Company stores		2.3		%		1.5		%		3.3		%		(0.5	)	%
Domestic Franchise stores		7.3		%		3.5		%		6.6		%		3.8		%
International Franchise stores		(12.6	)	%		(1.0	)	%		(10.9	)	%		(3.0	)	%
International Franchise stores, in constant dollars(1)		(2.7	)	%		(2.5	)	%		(2.2	)	%		(2.5	)	%
Company Stores - Consumer Packaged Goods - wholesale
sales:
Change in average weekly number of doors		(0.2	)	%		2.3		%		0.3		%		0.9		%
Change in average weekly sales per door		(0.8	)	%		(2.2	)	%		(0.1	)	%		(0.3	)	%
Systemwide Sales(in thousands):(2)
Company stores	$	83,332			$	77,806			$	173,300			$	157,624
Domestic Franchise stores		91,042				84,096				182,814				171,807
International Franchise stores		118,642				114,706				239,392				229,217
International Franchise stores, in constant dollars(3)		118,642				102,192				239,392				206,983
Average Weekly Sales Per Store(in thousands):(4) (5) (6)
Company stores:
Factory stores:
Commissaries - Consumer Packaged Goods - wholesale	$	208.3			$	214.9			$	203.6			$	213.6
Dual-channel stores:
On-premises		38.0				36.4				40.8				38.2
Consumer Packaged Goods - wholesale		42.5				48.5				45.4				49.2
Total		80.5				84.9				86.2				87.4
On-premises only stores		31.8				34.4				34.1				36.3
All factory stores		63.3				70.6				66.4				72.8
Satellite stores		23.8				21.2				25.0				22.2
All stores		57.6				60.9				60.3				63.0
Domestic Franchise stores:
Factory stores	$	51.2			$	50.5			$	52.2			$	51.7
Satellite stores		18.9				17.6				19.0				18.3
International Franchise stores:
Factory stores	$	37.4			$	40.5			$	37.6			$	40.6
Satellite stores		8.1				9.2				8.4				9.4

26

(1)	Represents the change in International Franchise same store sales computed by reconverting franchise store sales in each foreign currency to U.S. dollars at a constant rate of exchange for each period.
(2)	Excludes sales among Company and franchise stores. Systemwide sales is a non-GAAP financial measure.
(3)	Represents International Franchise store sales computed by reconverting International Franchise store sales for the three and six months ended August 3, 2014 to U.S. dollars based upon the weighted average of the exchange rates prevailing in the three and six months ended August 2, 2015.
(4)	Includes sales between Company and franchise stores.
(5)	Metrics are computed based on only stores open at the respective period end.
(6)	Metrics are computed based on each store’s classification at the end of the respective period end.

In the first quarter of fiscal 2016, the Company revised its presentation of the change in same store sales metric. The change in same store sales now includes retail sales only and excludes fundraising. The Company believes this change provides a more meaningful measurement of the change in same store sales and that this is a more relevant metric as the continued success of the Company’s retail model is largely dependent on the approximate 90% of on-premises sales coming from the retail business. All same store sales change metrics in this current report reflect the new presentation for all periods. The Company furnished a Current Report on Form 8-K on June 10, 2015 providing quarterly tables showing the change in same store sales for Company, domestic franchise and international franchise shops for fiscal 2013 through fiscal 2015 using the revised presentation compared to the former presentation.

The change in “same store sales” is computed by dividing the aggregate retail sales (excluding fundraising sales) during the current year period for all stores which had been open for 18 or more months during the current year by the aggregate retail sales of such stores for the comparable weeks in the preceding year. Once a store has been open for 18 or more months, its sales are included in the computation of same store sales for all subsequent periods. In the event a store is closed temporarily (for example, for remodeling) and has no sales during one or more weeks, such store’s sales for the comparable weeks during the earlier or subsequent period are excluded from the same store sales computation.

For consumer packaged goods - wholesale (“CPG”) sales, “average weekly number of doors” represents the average number of customer locations to which product deliveries to grocers/mass merchants and convenience stores were made during a week, and “average weekly sales per door” represents the average weekly sales to each such location.

Systemwide sales, a non-GAAP financial measure, include sales by both Company and franchise Krispy Kreme stores. The Company believes systemwide sales data are useful in assessing consumer demand for the Company’s products, the overall success of the Krispy Kreme brand and, ultimately, the performance of the Company. All of the Company’s royalty revenues are computed as percentages of sales made by the Company’s domestic and international franchisees, and substantially all of KK Supply Chain’s external sales of doughnut mixes and other ingredients ultimately are determined by demand for the Company’s products at franchise stores. Accordingly, sales by the Company’s franchisees have a direct effect on the Company’s royalty and KK Supply Chain revenues, and therefore on the Company’s profitability. The Company’s consolidated financial statements appearing elsewhere herein include sales by Company stores, sales to franchisees by the KK Supply Chain business segment, and royalties and fees received from franchise stores based on their sales, but exclude sales by franchise stores to their customers.

27

The following table sets forth data about the number of systemwide stores as of August 2, 2015 and August 3, 2014.

	August 2,	August 3,
	2015	2014
Number of Stores Open At Period End:
Company stores:
Factory:
Commissaries	8	7
Dual-channel stores	33	33
On-premises only stores	57	42
Satellite stores	16	21
Total Company stores	114	103
Domestic Franchise stores:
Factory stores	121	109
Satellite stores	52	51
Total Domestic Franchise stores	173	160
International Franchise stores:
Factory stores	136	128
Satellite stores	622	493
Total International Franchise stores	758	621
Total systemwide stores	1,045	884

28

The following table sets forth data about the number of store operating weeks for the three and six months ended August 2, 2015 and August 3, 2014.

	Three Months Ended		Six Months Ended
	August 2,	August 3,	August 2,	August 3,
	2015	2014	2015	2014
Store Operating Weeks:
Company stores:
Factory stores:
Commissaries	104	91	208	182
Dual-channel stores	429	414	847	817
On-premises only stores	716	529	1,415	1,036
Satellite stores	222	255	468	488
Domestic Franchise stores:(1)
Factory stores	1,549	1,416	3,022	2,810
Satellite stores	665	684	1,328	1,359
International Franchise stores:(1)
Factory stores	1,486	1,408	2,932	2,788
Satellite stores	7,753	6,216	15,190	12,120

(1)        Metrics for the three and six months ended August 2, 2015 and August 3, 2014 include only stores open at the respective period end.

29

Changes in the number of Company stores during the three and six months ended August 2, 2015 and August 3, 2014 are summarized in the table below.

	Number of Company Stores
	Factory
	Stores		Hot Shops		Fresh Shops	Total
Three months ended August 2, 2015
May 3, 2015		95	18		1		114
Opened		3	-		-		3
Closed		-	(3	)	-		(3	)
August 2, 2015		98	15		1		114
Six months ended August 2, 2015
February 1, 2015		92	18		1		111
Opened		5	-		-		5
Closed		-	(3	)	-		(3	)
Acquired (divested)		1	-		-		1
August 2, 2015		98	15		1		114
Three months ended August 3, 2014
May 4, 2014		78	18		1		97
Opened		1	-		-		1
Closed		-	-		-		-
Change in store type		1	(1	)	-		-
Acquired (divested)		2	3		-		5
August 3, 2014		82	20		1		103
Six months ended August 3, 2014
February 2, 2014		76	18		1		95
Opened		3	-		-		3
Closed		-	-		-		-
Change in store type		1	(1	)	-		-
Acquired (divested)		2	3		-		5
August 3, 2014		82	20		1		103

30

Changes in the number of domestic franchise stores during the three and six months ended August 2, 2015 and August 3, 2014 are summarized in the table below.

	Number of Domestic Franchise Stores
	Factory
	Stores		Hot Shops		Fresh Shops		Total
Three months ended August 2, 2015
May 3, 2015	115		39		12		166
Opened	6		1		-		7
Closed	-		-		-		-
August 2, 2015	121		40		12		173
Six months ended August 2, 2015
February 1, 2015	116		39		12		167
Opened	8		1		-		9
Closed	(2	)	-		-		(2	)
Acquired (divested)	(1	)	-		-		(1	)
August 2, 2015	121		40		12		173
Three months ended August 3, 2014
May 4, 2014	109		40		14		163
Opened	2		1		-		3
Closed	-		-		(1	)	(1	)
Acquired (divested)	(2	)	(3	)	-		(5	)
August 3, 2014	109		38		13		160
Six months ended August 3, 2014
February 2, 2014	107		37		15		159
Opened	4		4		-		8
Closed	-		-		(2	)	(2	)
Acquired (divested)	(2	)	(3	)	-		(5	)
August 3, 2014	109		38		13		160

31

Changes in the number of international franchise stores during the three and six months ended August 2, 2015 and August 3, 2014 are summarized in the table below.

	Number of International Franchise Stores
	Factory
	Stores		Hot Shops	Fresh Shops		Kiosks		Total
Three months ended August 2, 2015
May 3, 2015	133		9	391		190		723
Opened	4		-	29		8		41
Closed	(1	)	-	(5	)	-		(6	)
August 2, 2015	136		9	415		198		758
Six months ended August 2, 2015
February 1, 2015	133		9	381		186		709
Opened	6		-	47		12		65
Closed	(3	)	-	(12	)	(1	)	(16	)
Change in store type	-		-	(1	)	1		-
August 2, 2015	136		9	415		198		758
Three months ended August 3, 2014
May 4, 2014	126		9	310		150		595
Opened	3		-	20		7		30
Closed	(1	)	-	(3	)	-		(4	)
August 3, 2014	128		9	327		157		621
Six months ended August 3, 2014
February 2, 2014	125		9	296		144		574
Opened	5		-	34		14		53
Closed	(2	)	-	(3	)	(1	)	(6	)
August 3, 2014	128		9	327		157		621

Three months ended August 2, 2015 compared to three months ended August 3, 2014

The following discussion of the Company’s results of operations should be read in conjunction with the consolidated financial statements and notes thereto appearing elsewhere herein.

Non-GAAP Measures

Adjusted net income and adjusted earnings per share are non-GAAP measures.

The Company has substantial net operating loss carryforwards and, accordingly, the Company’s cash payments for income taxes are not significant and are expected to remain insignificant for the next three to five years. See “Provision for Income Taxes” below.

Management evaluates the Company’s results of operations using, among other measures, adjusted net income and adjusted earnings per share, which reflect the provision for income taxes only to the extent such taxes are currently payable in cash. In addition, management excludes from adjusted net income charges and credits that are unusual and infrequently occurring. Management believes adjusted net income and adjusted earnings per share are useful performance measures because they more closely measure the cash flows generated by the Company’s operations and the trends in those cash flows than do GAAP net income and earnings per share, and because they exclude the effects of transactions that are not indicative of the Company’s ongoing results of operations.

The following presentation of adjusted net income, the related reconciliation of adjusted net income to GAAP net income, and the presentation of adjusted earnings per share are intended to illustrate the material difference between the Company’s income tax expense and income taxes currently payable. These non-GAAP performance measures are consistent with other measurements made by management in the operation of the business which do not consider income taxes except to the extent to which those taxes currently are payable, for example, capital allocation decisions and incentive compensation measurements that are made on a pretax basis.

32

	Three Months Ended
	August 2,		August 3,
	2015		2014
	(In thousands, except per share amounts)
Net income, as reported	$	5,918	$	5,752
Provision for deferred income taxes		3,928		3,226
Adjusted net income	$	9,846	$	8,978
Adjusted earnings per common share:
Basic	$	0.15	$	0.14
Diluted	$	0.15	$	0.13
Weighted average shares outstanding:
Basic		65,502		66,008
Diluted		67,369		68,725

Overview

Total revenues rose 5.7% to $127.3 million for the three months ended August 2, 2015 compared to $120.5 million for the three months ended August 3, 2014. Consolidated operating income increased to $10.7 million from $9.6 million, and consolidated net income was $5.9 million compared to $5.8 million for the three months ended August 2, 2015 and August 3, 2014, respectively.

33

Revenues by business segment (expressed in dollars and as a percentage of total revenues) are set forth in the table below (percentage amounts may not add to totals due to rounding).

	Three Months Ended
	August 2,				August 3,
	2015				2014
	(Dollars in thousands)
Revenues by business segment:
Company Stores	$	84,117			$	78,535
Domestic Franchise		3,936				3,296
International Franchise		7,314				7,534
KK Supply Chain:
Total revenues		63,469				59,503
Less - intersegment sales elimination		(31,500	)			(28,352	)
External KK Supply Chain revenues		31,969				31,151
Total revenues	$	127,336			$	120,516
Segment revenues as a percentage of total revenues:
Company Stores		66.1		%		65.2		%
Domestic Franchise		3.1				2.7
International Franchise		5.7				6.3
KK Supply Chain (external sales)		25.1				25.8
		100.0		%		100.0		%
Segment operating results:
��  Company Stores	$	1,592			$	1,937
Domestic Franchise		2,440				1,900
International Franchise		5,487				5,111
KK Supply Chain		10,144				9,830
Total segment operating income		19,663				18,778
General and administrative expenses		(6,718	)			(6,737	)
Corporate depreciation and amortization expense		(546	)			(362	)
Impairment charges and lease termination costs		(304	)			(38	)
Pre-opening costs related to Company Stores		(515	)			(245	)
Gains and (losses) on commodity derivatives, net		(841	)			(1,341	)
Gain on refranchisings, net of business acquisition charges		-				(431	)
Consolidated operating income		10,739				9,624
Interest income		72				64
Interest expense		(387	)			(162	)
Equity in losses of equity method franchisees		-				(61	)
Other non-operating income and (expense), net		89				152
Income before income taxes		10,513				9,617
Provision for income taxes		4,595				3,865
Consolidated net income	$	5,918			$	5,752

A discussion of the revenues and operating results of each of the Company’s four business segments follows, together with a discussion of income statement line items not associated with specific segments. In the first quarter of fiscal 2016, the Company changed the presentation of the Consolidated Statement of Income and segment financial information. Pre-opening costs related to Company Stores, gains and losses on commodity derivatives, net and gain on refranchisings, net of business acquisition charges are now separate line items on the Consolidated Statement of Income and are no longer in the respective business segments’ operating income. The Company furnished a Current Report on Form 8-K on June 10, 2015 providing the Consolidated Statement of Income and segment financial information for the quarterly and annual periods in fiscal 2014 and fiscal 2015 conformed to the fiscal 2016 presentation. These presentation changes had no impact on the Company’s consolidated operating income or consolidated net income.

34

Company Stores

The components of Company Stores revenues and expenses (expressed in dollars and as a percentage of total revenues) are set forth in the table below (percentage amounts may not add to totals due to rounding).

					Percentage of Total Revenues
	Three Months Ended				Three Months Ended
	August 2,		August 3,		August 2,		August 3,
	2015		2014		2015		2014
	(In thousands)
Revenues:
On-premises sales:
Retail sales	$	41,664	$	36,124	49.5	%	46.0	%
Fundraising sales		2,693		2,696	3.2		3.4
Total on-premises sales		44,357		38,820	52.7		49.4
Consumer packaged goods sales - wholesale sales:
Grocery/mass merchant		23,817		23,977	28.3		30.5
Convenience store		14,194		14,565	16.9		18.5
Other consumer packaged goods		1,749		1,173	2.1		1.5
Total consumer packaged goods sales		39,760		39,715	47.3		50.6
Total revenues		84,117		78,535	100.0		100.0
Operating expenses:
Cost of sales:
Food, beverage and packaging		30,732		29,619	36.5		37.7
Labor and benefits costs		27,891		25,497	33.2		32.5
Total cost of sales		58,623		55,116	69.7		70.2
Vehicle costs(1)		3,623		4,274	4.3		5.4
Occupancy(2)		3,022		2,639	3.6		3.4
Utilities expense		1,904		1,682	2.3		2.1
Other store operating expenses		5,661		4,292	6.7		5.5
Total store level costs		72,833		68,003	86.6		86.6
Company Stores contribution(3)		11,284		10,532	13.4		13.4
Marketing expense		1,581		1,520	1.9		1.9
Depreciation and amortization expense		3,261		2,457	3.9		3.1
Direct and indirect operating costs(4)		4,850		4,618	5.8		5.9
Segment operating income	$	1,592	$	1,937	1.9	%	2.5	%

(1)	Includes fuel, maintenance and repairs, rent, taxes, insurance and other costs of operating the delivery fleet, exclusive of depreciation.
(2)	Includes rent, property taxes, common area maintenance charges, insurance, building maintenance and other occupancy costs, exclusive of utilities and depreciation.
(3)	Company Stores contribution is a non-GAAP financial measure. The Company believes that this is a useful metric to assess and evaluate the performance of Company shops.
(4)	Includes marketing costs not charged to stores, segment management costs, CPG selling expenses and support functions and allocated corporate overhead.

Sales at Company Stores increased 7.1% to $84.1 million in the second quarter of fiscal 2016 from $78.5 million in the second quarter of fiscal 2015. Company Stores contribution increased 7.1% to $11.3 million in the second quarter of fiscal 2016 from $10.5 million in the second quarter of fiscal 2015 and Company Stores contribution margin remained flat at 13.4%.

35

A reconciliation of Company Stores segment sales from the second quarter of fiscal 2015 to the second quarter of fiscal 2016 follows:

				Consumer
				Packaged Goods -
	On-Premises			Wholesale			Total
	(In thousands)
Sales for the three months ended August 3, 2014	$	38,820		$	39,715		$	78,535
Sales at closed stores		(567	)		-			(567	)
Fiscal 2015 sales at refranchised stores		(562	)		-			(562	)
Increase (decrease) in sales at established stores (open stores only)		186			(1,024	)		(838	)
Increase in sales related to stores opened in fiscal 2015 and 2016		4,918			-			4,918
Increase in sales related to stores acquired in fiscal 2015 and 2016		1,562			1,069			2,631
Sales for the three months ended August 2, 2015	$	44,357		$	39,760		$	84,117

On-premises sales increased 14.3% to $44.4 million in the second quarter of fiscal 2016. The increase in on-premises sales includes an increase in retail sales of 15.3% to $41.7 million in the second quarter of fiscal 2016 compared to $36.1 million in the second quarter of fiscal 2015. The growth in retail sales in the second quarter of fiscal 2016 was principally due to a 14.1% increase in store operating weeks and a 2.3% increase in same store sales. The change in same store sales rose in the second quarter of fiscal 2016 due to a 2.2% increase in the average guest check, which was driven primarily by management’s use of more strategic promotional incentives.

The Company continuously evaluates and adjusts its marketing, promotional and operational activities and techniques with the goal of increasing both average guest check and customer traffic in its shops, which management believes will continue to be an important factor in increasing the profitability of the Company Stores business segment.

CPG sales

Sales to CPG accounts were $39.8 million in the second quarter of fiscal 2016 compared to $39.7 million in the second quarter of fiscal 2015. Sales to grocers and mass merchants and convenience stores declined in the second quarter of fiscal 2016 compared to the second quarter of fiscal 2015. These decreases were offset by an increase in other CPG sales.

Sales to grocers and mass merchants decreased 0.7% to $23.8 million, reflecting a 1.6% decrease in average weekly sales per door principally offset by a 1.5% increase in the average number of doors served. The decline in the average weekly sales per door in the grocery/mass merchant channel was due to a decline in higher volume doors on a year-over-year basis. The increase in the average number of doors served in the grocery/mass merchant channel principally reflects an increase in doors resulting from the acquisition of a store in Little Rock, Arkansas in late first quarter fiscal 2016. Sales of packaged products comprise substantially all of the Company’s sales to grocers and mass merchants.

Sales to convenience stores decreased 2.5% to $14.2 million, reflecting a 2.0% decrease in the average number of doors served and a 0.4% decrease in the average weekly sales per door. The decrease in the average number of doors served in the convenience stores channel in the second quarter of fiscal 2016 reflects a reduction in the number of lower volume doors. This decrease was partially offset by an increase in doors resulting from the acquisition of a store in Little Rock, Arkansas in late first quarter fiscal 2016. Sales of loose unpackaged products comprise approximately 80% of sales to convenience store customers, with the balance comprised of sales of packaged products.

Company Stores contribution and costs and expenses

The increase in Company Stores contribution (a non-GAAP financial measure) in the second quarter of fiscal 2016 of $752,000, or 7.1%, was driven by the 7.1% increase in revenues.

Cost of food, beverage and packaging as a percentage of revenues decreased 1.2 percentage points from the second quarter of fiscal 2015 to 36.5% in the second quarter of fiscal 2016. This improvement was principally due to a decrease in input costs and an increase in on-premises sales, which typically have lower food costs, compared to CPG sales, as a percentage of total revenues. The cost of food, beverage and packaging as a percentage of sales is often greater in the CPG distribution channel compared to the on-premises channel because average product selling prices generally are lower in the CPG distribution channel and because of the effect of returns in the CPG distribution channel.

Labor and benefits costs as a percentage of revenues increased 0.7 percentage points from the second quarter of fiscal 2015 to 33.2% in the second quarter of fiscal 2016. An increase in shop labor as a percentage of revenue was partially offset by a decrease in delivery labor as a percentage of revenue. Additionally, benefits expense increased as a result of higher health care and workers’ compensation costs on a year-over-year basis. The Company is self-insured for such costs (subject to stop-loss coverage for large individual claims); and accordingly, variations from period to period in the number and severity of claims directly affect the Company’s results of operations. As a result of the Company’s periodic update of its actuarial valuation of workers’ compensation claims, the Company recorded a favorable adjustment relating to its workers’ compensation liability claims for prior policy years of approximately $630,000 in the second quarter of fiscal 2015. There was no adjustment related to workers’ compensation claims as a result of the Company’s periodic update of its actuarial valuation during the second quarter of fiscal 2016. 

36

The Patient Protection and Affordable Care Act (the “Act”) requires large employers to offer health care benefits to all full-time employees, or face financial penalties, generally beginning in January 2015. To avoid these penalties, the health benefits must provide a specified “minimum value” and be “affordable,” each as defined in the Act. Largely as a result of modifications made to the Company’s plans, management anticipates that its health care costs in fiscal 2016 will be approximately $1.0 million higher compared to fiscal 2015.

Vehicle costs as a percentage of revenues decreased from 5.4% in the second quarter of fiscal 2015 to 4.3% in the second quarter of fiscal 2016, reflecting lower fuel costs, a reduction in mileage and a reduction in vehicle insurance costs. The Company is self-insured for vehicle claims, but maintains stop-loss coverage for individual claims exceeding certain amounts. As a result of the Company’s periodic update of its actuarial valuation of vehicle claims, the Company recorded favorable adjustments relating to its vehicle liability claims for prior policy years of approximately $372,000 in the second quarter of fiscal 2016 compared to $90,000 in the second quarter of fiscal 2015.

Other store operating expenses increased to 6.7% of revenues in the second quarter of fiscal 2016 from 5.5% of revenues in the second quarter of fiscal 2015 due to an increase in equipment repairs and maintenance and an increase in other supplies and services costs.

Many store level operating costs are fixed or semi-fixed in nature and, accordingly, store profit margins are sensitive to changes in sales volumes.

Depreciation and amortization expense increased in the second quarter of fiscal 2016 to 3.9% of revenues from 3.1% due to construction of new stores and store refurbishments at existing stores since the second quarter of fiscal 2015.

Domestic Franchise

	Three Months Ended
	August 2,			August 3,
	2015			2014
	(In thousands)
Revenues:
Royalties	$	3,291		$	2,971
Development and franchise fees		325			125
Other		320			200
Total revenues		3,936			3,296
Operating expenses:
Segment operating expenses		1,305			1,247
Depreciation expense		16			49
Allocated corporate overhead		175			100
Total operating expenses		1,496			1,396
Segment operating income	$	2,440		$	1,900
Segment operating margin		62.0	%		57.6	%

Domestic Franchise revenues increased 19.4% to $3.9 million in the second quarter of fiscal 2016. The increase reflects higher royalty revenues resulting from an increase in sales by domestic franchise stores from $84 million in the second quarter of fiscal 2015 to $91 million in the second quarter of fiscal 2016. Domestic Franchise same store sales rose 7.3% in the second quarter of fiscal 2016. Additionally, development and franchise fees increased in the second quarter of fiscal 2016 compared to the second quarter of fiscal 2015 resulting from an increase in store openings during the second quarter of fiscal 2016 compared to last year.

Other Domestic Franchise revenues include revenue from the licensing of certain Krispy Kreme trademarks to third parties for use in marketing Krispy Kreme branded beverages and rental income charged to franchisees for stores leased or subleased to franchisees. The Company first entered into such licensing agreements in fiscal 2014 and intends to expand licensing of its brand to additional products. Licensing revenue increased in the second quarter of fiscal 2016 compared to the prior year, partially offset by a decrease in rental income.

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Domestic Franchise segment operating expenses include costs to recruit new domestic franchisees, to assist in domestic store openings, and to monitor and aid in the performance of domestic franchise stores, as well as allocated corporate costs.

Domestic franchisees opened seven stores in the second quarter of fiscal 2016. As of August 2, 2015, development agreements for territories in the United States provide for the development of approximately 120 additional stores through fiscal 2022. Royalty revenues are directly related to sales by franchise stores and, accordingly, the success of franchisees’ operations has a direct effect on the Company’s revenues, results of operations and cash flows.

International Franchise

	Three Months Ended
	August 2,			August 3,
	2015			2014
	(In thousands)
Revenues:
Royalties	$	6,821		$	7,044
Development and franchise fees		493			490
Total revenues		7,314			7,534
Operating expenses:
Segment operating expenses		1,627			2,121
Depreciation expense		-			2
Allocated corporate overhead		200			300
Total operating expenses		1,827			2,423
Segment operating income	$	5,487		$	5,111
Segment operating margin		75.0	%		67.8	%

International Franchise revenues decreased 2.9% to $7.3 million in the second quarter of fiscal 2016 compared to $7.5 million in the second quarter of fiscal 2015.

International Franchise royalties decreased 3.2% to $6.8 million in the second quarter of fiscal 2016 from $7.0 million in the second quarter of fiscal 2015, principally due to unfavorable foreign exchange rates. Sales by international franchise stores increased from $115 million in the second quarter of fiscal 2015 to $119 million in the second quarter of fiscal 2016. Changes in the rates of exchange between the U.S. dollar and the foreign currencies in which the Company’s international franchisees do business decreased sales by international franchisees measured in U.S. dollars by approximately $14.5 million in the second quarter of fiscal 2016 compared to the second quarter of fiscal 2015, which adversely affected royalties by approximately $750,000. Excluding the effects of changes in foreign exchange rates, sales by international franchisees rose 16.1%. Additionally, the Company recognized royalty revenue of approximately $700,000 and $900,000 collected during the second quarter of fiscal 2016 and 2015, respectively, related to franchisee sales in prior periods which had not previously been recorded as revenue due to the uncertainty surrounding the collection of these royalties. Substantially all of the amounts relate to a single franchisee. There is no prescribed repayment schedule for the remaining $1.2 million owed to the Company by the franchisee and the Company therefore cannot predict the amount or timing of future payments, if any, on this obligation. Accordingly, the Company has not recognized such amount in the financial statements.

International Franchise same store sales, measured on a constant currency basis to eliminate the effects of changing exchange rates between foreign currencies and the U.S. dollar (“constant dollar same store sales”), fell 2.7%. The decline in International Franchise same store sales reflects, among other things, the normal cannibalization effects on existing stores in growing markets of additional store openings in those markets driven by the international market’s reliance on the hub and spoke model.

Constant dollar same store sales in established markets rose 1.5% in the second quarter of fiscal 2016 and fell 7.0% in new markets. “Established markets” means countries in which the first Krispy Kreme store opened before fiscal 2007. Sales at stores in established markets comprised 53% of aggregate constant dollar same store sales for the second quarter of fiscal 2016. While the Company considers countries in which Krispy Kreme first opened before fiscal 2007 to be established markets, franchisees in those markets continue to develop their business. Of the 721 international shops currently in operation that opened since the beginning of fiscal 2007, 305 shops are in these established markets.

International Franchise development and franchise fees were flat in the second quarter of fiscal 2016 compared to the second quarter of fiscal 2015. Certain franchisees’ license agreements provide that the franchisees may develop, with the Company’s consent, additional Krispy Kreme shops within the franchise territory without payment of initial franchise or development fees. Accordingly, some shop openings by international franchisees do not result in the recognition of such fees.

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International Franchise operating expenses include costs to recruit new international franchisees, to assist in international store openings, and to monitor and aid in the performance of international franchise stores, as well as allocated corporate costs. International Franchise operating expenses decreased to $1.6 million in the second quarter of fiscal 2016 from $2.1 million in the second quarter of fiscal 2015, as a result of higher costs related to the transition of personnel in the second quarter of fiscal 2015. Additionally, the second quarter of fiscal 2016 reflects a net credit in bad debt expense of approximately $90,000, principally due to recoveries of amounts previously written off, compared to a charge of approximately $180,000 related to a single franchisee in the second quarter of fiscal 2015. A net credit in bad debt expense should not be expected to recur frequently.

International franchisees opened 41 stores and closed six stores in the second quarter of fiscal 2016. As of August 2, 2015, development agreements for territories outside the United States provide for the development of approximately 330 additional stores through fiscal 2021. Royalty revenues are directly related to sales by franchise stores and, accordingly, the success of franchisees’ operations has a direct effect on the Company’s revenues, results of operations and cash flows.

KK Supply Chain

The components of KK Supply Chain revenues and expenses (expressed in dollars and as a percentage of total revenues before intersegment sales elimination) are set forth in the table below (percentage amounts may not add to totals due to rounding).

					Percentage of Total Revenues
					Before Intersegment
					Sales Elimination
	Three Months Ended				Three Months Ended
	August 2,		August 3,		August 2,		August 3,
	2015		2014		2015		2014
	(In thousands)
Revenues:
Doughnut mixes	$	22,103	$	21,061	34.8	%	35.4	%
Other ingredients, packaging and supplies		36,759		34,925	57.9		58.7
Equipment		4,014		2,814	6.3		4.7
Freight revenue		593		703	0.9		1.2
Total revenues before intersegment sales elimination		63,469		59,503	100.0		100.0
Operating expenses:
Cost of goods produced and purchased		45,565		42,254	71.8		71.0
Distribution costs		4,482		3,678	7.1		6.2
Other segment operating costs		2,727		3,278	4.3		5.5
Depreciation expense		251		163	0.4		0.3
Allocated corporate overhead		300		300	0.5		0.5
Total operating costs		53,325		49,673	84.0		83.5
Segment operating income	$	10,144	$	9,830	16.0	%	16.5	%

KK Supply Chain revenues before intersegment sales eliminations increased 6.7% to $63.5 million in the second quarter of fiscal 2016 compared to $59.5 million in the second quarter of fiscal 2015.

Sales of doughnut mixes increased 4.9% year-over-year in the second quarter of fiscal 2016, due to higher selling prices and slightly higher unit volumes reflecting higher sales at Company and franchise shops.

Sales of other ingredients, packaging and supplies, which are made principally to Company and Domestic Franchise stores, rose 5.3% year-over-year in the second quarter of fiscal 2016, principally due to higher unit volumes partially offset by lower selling prices.

While systemwide sales at Company and Domestic Franchise stores rose at a faster rate than KK Supply Chain revenues did during the second quarter of fiscal 2016 compared to the second quarter of the preceding fiscal year, a greater percentage of such sales was to on-premises customers compared to CPG customers. On-premises sales at Company and Domestic Franchise stores generate proportionately lower KK Supply Chain sales than do sales to CPG customers. This negatively impacted the growth rate within the KK Supply Chain business as compared to the overall system.

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Equipment sales increased to $4.0 million in the second quarter of fiscal 2016 from $2.8 million in the second quarter of the prior year principally due to an increase in store openings.

KK Supply Chain adjusts the selling prices on the majority of ingredients, packaging and supplies sold to Company-owned and franchise stores on a quarterly basis at the beginning of each quarter. As a result, KK Supply Chain operating margin can vary between quarters but the Company’s objective is to keep gross profit on a per unit basis at KK Supply Chain relatively constant by passing increases and decreases in input costs to Company-owned and franchise stores by adjusting such sales prices.

The increase in cost of goods produced and purchased as a percentage of sales in the second quarter of fiscal 2016 compared to the second quarter of fiscal 2015 reflects, among other things, a decrease in the percentage of doughnut mix sales composed of mix concentrates, which carry higher profit margins than sales of finished doughnut mixes. Mix concentrates have higher profit margins than finished doughnut mixes because the Company attempts to maintain the gross profit on sales of mix concentrates and finished mixes relatively constant when measured on a finished mix equivalent basis.

Distribution costs rose in the second quarter of fiscal 2016 compared to the second quarter of fiscal 2015 due to an increase in unit volumes. Distribution costs increased as a percentage of sales because selling prices on certain ingredients and supplies decreased compared to last year.

Other segment operating costs include segment management, purchasing, customer service and support, laboratory and quality control costs, and research and development expenses.

Franchisees opened 48 stores and closed six stores in the second quarter of fiscal 2016. A substantial portion of KK Supply Chain’s revenues are directly related to sales by franchise stores and, accordingly, the success of franchisees’ operations has a direct effect on the Company’s revenues, results of operations and cash flows.

A significant portion of franchise store sales is attributable to sales by franchisees outside the United States. The Company sells doughnut mixes, either manufactured by the Company in the United States or blended by contract mix manufacturers using concentrates supplied by the Company, to all its international franchisees. Most of these franchisees purchase substantially all other ingredients, packaging and supplies through sourcing arrangements approved by the Company. Accordingly, KK Supply Chain revenues are less correlated with sales by international franchisees than with sales by domestic franchisees, which purchase substantially all of their ingredients from KK Supply Chain. Like all international businesses, the Company and its international franchisees must address the risks of international trade, including taxes, tariffs, duties and transportation costs, which can affect the franchisees’ product costs and therefore indirectly affect the pace of development. The Company, in cooperation with its international franchisees, continually seeks to mitigate the impact of these factors. For example, the Company has developed premix and concentrate doughnut mix production models, and has been continuously pursuing alternative sourcing arrangements in various markets.

General and Administrative Expenses

General and administrative expenses consist of costs incurred in various functional areas whose activities are not associated exclusively with an individual business segment. Such costs include expenses associated with finance and accounting; internal and external financial reporting, including financial planning and analysis; internal audit; human resources; risk management; information technology; training; corporate office occupancy; public company costs; and executive management. Certain personnel and other costs in some of these functional areas (for example, some of the costs of information technology and human resources) are associated primarily with the operation of individual business segments, and are allocated to those segments as allocated corporate costs. General and administrative expenses in the consolidated statement of income are presented net of such allocated costs, which are reflected in the results of operations of the four operating segments. Such allocated costs totaled $1.9 million in second quarter of fiscal 2016 compared to $1.8 million in second quarter of fiscal 2015.

General and administrative expenses were flat at $6.7 million in both the second quarter of fiscal 2016 and fiscal 2015, but as a percentage of revenues decreased to 5.3% from 5.6%. General and administrative expenses include an increase in costs related to the implementation and on-going system support of a new enterprise resource planning (“ERP”) system and an increase in share-based compensation costs offset by lower professional and legal fees.

During the first quarter of fiscal 2016, the Company implemented an ERP software solution that included a new general ledger and accounting system. Total costs of on-going system support were approximately $1.0 million in second quarter of fiscal 2016 compared to implementation costs of $900,000 in the second quarter of fiscal 2015. The Company expects general and administrative expenses related to the ERP implementation and support to approximate $2.0 million in the second half of fiscal 2016 for a total cost of $4.0 million in fiscal 2016.

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General and administrative expenses also include an increase in share-based compensation costs of approximately $300,000 in the second quarter of fiscal 2016 compared to the second quarter of fiscal 2015, resulting, in part, from an increase in the equity awards granted in the first half of fiscal 2016 compared to the first half of fiscal 2015.

Impairment Charges and Lease Termination Costs

Impairment charges and lease termination costs were $304,000 in the second quarter of fiscal 2016 compared to $38,000 in the second quarter of fiscal 2015.

	Three Months Ended
	August 2,			August 3,
	2015			2014
	(In thousands)
Impairment of long-lived assets	$	343		$	-
Lease termination costs		(39	)		38
	$	304		$	38

The Company tests long-lived assets for impairment when events or changes in circumstances indicate that their carrying value may not be recoverable. These events and changes in circumstances include store closing and refranchising decisions, the effects of changing costs on current results of operations, observed trends in operating results, and evidence of changed circumstances observed as a part of periodic reforecasts of future operating results and as part of the Company’s annual budgeting process. Impairment charges generally relate to Company stores expected to be closed or refranchised, as well as to stores management believes will not generate sufficient future cash flows to enable the Company to recover the carrying value of the stores’ assets, but which management has not yet decided to close. When the Company concludes that the carrying value of long-lived assets is not recoverable (based on future projected undiscounted cash flows), the Company records impairment charges to reduce the carrying value of those assets to their estimated fair values. The fair values of these assets are estimated based on the present value of estimated future cash flows, on independent appraisals and, in the case of assets the Company currently is negotiating to sell, based on the Company’s negotiations with unrelated third-party buyers. During the three months ended August 2, 2015, the Company recorded impairment charges related to long-lived assets for one Company store that was closed during the quarter to reduce the carrying value of those assets to their estimated fair values. Substantially all of such long-lived assets were real properties, the fair values of which were estimated based on an independent appraisal.

Lease termination costs represent the estimated fair value of liabilities related to unexpired leases, after reduction by the amount of accrued rent expense, if any, related to the leases, and are recorded when the lease contracts are terminated or, if earlier, the date on which the Company ceases use of the leased property. The fair value of these liabilities were estimated as the excess, if any, of the contractual payments required under the unexpired leases over the current market lease rates for the properties, discounted at a credit-adjusted risk-free rate over the remaining term of the leases. The provision for lease termination costs also includes adjustments to liabilities recorded in prior periods arising from changes in estimated sublease rentals and from settlements with landlords. During the three months ended August 2, 2015, the Company recorded lease termination charges related to a store closure in the second quarter of fiscal 2016 and adjustments to liabilities recorded in prior periods arising from changes in estimated sublease rentals totaling $71,000 offset by the reversal of previously recorded accrued rent of $110,000 related to the closed store.

Pre-opening Costs Related to Company Stores

Pre-opening costs related to Company Stores include costs related to new stores, a portion of which relates to stores which had not yet opened by the end of the quarter. Pre-opening costs related to Company Stores increased to $515,000 in the second quarter of fiscal 2016 compared to $245,000 in second quarter of fiscal 2015 as a result of the timing of store openings. The average pre-opening costs per store are approximately $150,000 to $200,000.

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Gains and Losses on Commodity Derivatives, Net

Gains and losses on commodity derivatives, net represents the difference between the cost, if any, and the fair value of the commodity derivatives and is reflected in earnings because the Company has not designated any of these instruments as hedges. Net losses on commodity derivatives were $841,000 in the second quarter of fiscal 2016 compared to net losses of $1.3 million in the second quarter of fiscal 2015. Gains and losses on commodity derivatives are comprised of the following:

	Three Months Ended
	August 2, 2015
(Gains) and Losses on Commodity Derivatives	Agricultural			Gasoline		Total
	(In thousands)
Realized	$	285		$	28	$	313
Unrealized		(214	)		742		528
(Gains) and losses on commodity derivatives, net	$	71		$	770	$	841

	Three Months Ended
	August 3, 2014
(Gains) and Losses on Commodity Derivatives	Agricultural			Gasoline		Total
	(In thousands)
Realized	$	(182	)	$	-	$	(182	)
Unrealized		1,523			-		1,523
(Gains) and losses on commodity derivatives, net	$	1,341		$	-	$	1,341

Gain on refranchising, net of business acquisition charges

During the second quarter of fiscal 2015, the Company recorded charges of $431,000 related to the acquisition of the business and operating assets of its franchisee in Birmingham, Alabama as more fully described in Note 13 to the consolidated financial statements appearing elsewhere herein. The charges principally reflect a $343,000 settlement as part of the acquisition of the pre-existing franchise contract between the Company and the franchisee and transaction costs related to the acquisition of $88,000.

Interest Expense

Interest expense increased $225,000 in the second quarter of fiscal 2016 to $387,000 from $162,000 in the second quarter of fiscal 2015. This increase was due principally to interest expense related to leasing obligations that the Company entered into in fiscal 2015 and fiscal 2016 associated with approximately $8.8 million of build-to-suit leasing arrangements as described in Note 6 in the consolidated financial statements appearing elsewhere herein.

Equity in Losses of Equity Method Franchisees

The Company recorded equity in the losses of equity method franchisees of $61,000 in the second quarter of fiscal 2015. This caption represents the Company’s share of operating results of equity method franchisees which develop and operate Krispy Kreme stores.

Other Non-Operating Income and Expense, Net

Other non-operating income and expense, net includes payments of approximately $90,000 and $150,000 in the second quarter of fiscal 2016 and fiscal 2015, respectively, received from an equity method franchisee in reimbursement for amounts paid by the Company in fiscal 2014 pursuant to the Company’s guarantee of the investee’s indebtedness. Such repayments are being reflected in income as received due to the uncertainty of their continued collection as more fully described in Note 3 to the consolidated financial statements appearing elsewhere herein.

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Provision for Income Taxes

The Company’s effective tax rate for the second quarter of fiscal 2016 was 43.7% compared to 40.2% for the second quarter of fiscal 2015. Included in income tax expense for the second quarter of fiscal 2016 is a charge of approximately $467,000 to revalue the Company’s deferred income tax assets to reflect a reduction in the North Carolina corporate income tax rate announced by the state legislature during the quarter, as described in Note 10 to the consolidated financial statements appearing elsewhere herein.

The portion of the income tax provision representing taxes estimated to be payable currently was $667,000 and $639,000 in the second quarter of fiscal 2016 and fiscal 2015, respectively, consisting principally of foreign withholding taxes related to royalties and franchise fees paid by international franchisees to the Company. The current provision for income taxes also reflects adjustments to accruals for uncertain tax positions, including potential interest and penalties which could result from the resolution of such uncertainties.

The Company estimates that the annual effective income tax rate on GAAP ordinary income for fiscal 2016 will be 39% to 40%. Management’s estimate of the fiscal 2016 effective income tax rate is subject to revision in subsequent quarters as additional information becomes available.

See “Results of Operations – Three months ended August 2, 2015 compared to three months ended August 3, 2014 – Non-GAAP Measures” above for non-GAAP financial information and related reconciliation to GAAP measures intended to illustrate the material difference between the Company’s income tax expense and income taxes currently payable.

The Company has forecasted future earnings using estimates management believes to be reasonable and which are based on objective verifiable evidence, most significantly the Company’s results of operations for the two most recent fiscal years. If the Company’s earnings continue to increase, it is reasonably likely that management would conclude that its estimate of annual income in future years should increase. A significant upward adjustment in the amount of pretax income estimated to be earned in future periods could have the effect of enabling the Company to utilize certain foreign tax credit carryforwards as credits against taxes otherwise payable rather than as deductions against future taxable income as currently forecasted. The amount of such additional tax benefits which might be realized is unlikely to exceed $2.3 million.

The Company recognizes deferred income tax assets and liabilities based upon management’s expectation of the future tax consequences of temporary differences between the income tax and financial reporting bases of assets and liabilities. Deferred tax liabilities generally represent tax expense recognized for which payment has been deferred, or expenses which have been deducted in the Company’s tax returns but which have not yet been recognized as an expense in the financial statements. Deferred tax assets generally represent tax deductions or credits that will be reflected in future tax returns for which the Company has already recorded a tax benefit in its consolidated financial statements.

The Company had valuation allowances against deferred income tax assets of $2.5 million at August 2, 2015 and $2.6 million at February 1, 2015, respectively, representing the portion of such deferred tax assets which, as of such dates, management estimated would not be realized. Under GAAP, future realization of deferred tax assets is evaluated under a “more likely than not” standard.

Realization of net deferred tax assets generally is dependent on generation of taxable income in future periods. The evaluation of the amount of net deferred tax assets expected to be realized, and therefore the necessary amount of any valuation allowance to be attributed to those net assets requires management to forecast the amount of taxable income that will be generated in future years. In addition, because a substantial portion of the Company’s deferred tax assets consists of net operating loss and tax credit carryforwards that are subject to expiration, the specific future periods in which taxable income is generated may have a material effect on the amount of deferred tax assets that ultimately is realized.

In determining the amount of the necessary valuation allowance as of the end of both fiscal 2014 and fiscal 2015, management estimated that the Company’s annual pretax income in subsequent years would be $45 million, which approximated the Company’s pretax income for fiscal 2014. The Company’s pretax income rose to $48.2 million in fiscal 2015. Management believes that because estimates of future earnings are inherently subjective, and because such estimates necessarily involve forecasting many years into the future, frequent revisions to such estimates should not be expected. While the Company’s results of operations continued to improve in fiscal 2015 and exceeded management’s estimated annual pretax income for future years of $45 million, the Company believes that additional evidence is necessary before concluding that a level of pretax income substantially in excess of $45 million is sustainable on a long-term basis. Management believes that such evidence should include, among other things, at least one additional year of pretax profits substantially in excess of $45 million before it would be appropriate for management to revise upward its estimate of future annual pretax income, although management will continue to revisit this assessment during this fiscal year. 

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Furthermore, assuming the Company generates pretax income in each future year approximating $45 million, management estimates that $91.5 million of its deferred tax assets will be realized in future periods, and that a valuation allowance of $2.6 million was appropriate as of February 1, 2015, representing deferred tax assets management expects will not be realized. A 20% increase or reduction in the amount of assumed future annual pretax income would have had no material effect on management’s estimate of the amount of deferred tax valuation allowance. In addition, management currently expects that the resulting future downward adjustments to the valuation allowance, if any, are unlikely to exceed approximately $500,000 in any case. Any future downward adjustment to the valuation allowance or increase in tax benefits associated with foreign tax credits would result in an increase in the Company’s aggregate net deferred tax assets, with an offsetting credit to the provision for income taxes. The realization of deferred income tax assets is dependent on future events.

While management believes its forecast of future pretax income is reasonable, actual results inevitably will vary from management’s forecasts. Such variances could result in adjustments to its accounting for certain foreign tax credit carryforwards and the valuation allowance on deferred tax assets in future periods, and such adjustments could be material to the financial statements.

Net Income

The Company reported net income of $5.9 million for the three months ended August 2, 2015 compared to $5.8 million for the three months ended August 3, 2014.

Six months ended August 2, 2015 compared to six months ended August 3, 2014

The following discussion of the Company’s results of operations should be read in conjunction with the consolidated financial statements and notes thereto appearing elsewhere herein.

Non-GAAP Measures

Adjusted net income and adjusted earnings per share are non-GAAP measures.

The Company has substantial net operating loss carryforwards and, accordingly, the Company’s cash payments for income taxes are not significant and are expected to remain insignificant for the next three to five years. See “Provision for Income Taxes” below.

Management evaluates the Company’s results of operations using, among other measures, adjusted net income and adjusted earnings per share, which reflect the provision for income taxes only to the extent such taxes are currently payable in cash. In addition, management excludes from adjusted net income charges and credits that are unusual and infrequently occurring. Management believes adjusted net income and adjusted earnings per share are useful performance measures because they more closely measure the cash flows generated by the Company’s operations and the trends in those cash flows than do GAAP net income and earnings per share, and because they exclude the effects of transactions that are not indicative of the Company’s ongoing results of operations.

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The following presentation of adjusted net income, the related reconciliation of adjusted net income to GAAP net income, and the presentation of adjusted earnings per share are intended to illustrate the material difference between the Company’s income tax expense and income taxes currently payable. These non-GAAP performance measures are consistent with other measurements made by management in the operation of the business which do not consider income taxes except to the extent to which those taxes currently are payable, for example, capital allocation decisions and incentive compensation measurements that are made on a pretax basis.

	Six Months Ended
	August 2,		August 3,
	2015		2014
	(In thousands, except per share amounts)
Net income, as reported	$	16,584	$	15,408
Provision for deferred income taxes		9,878		9,388
Adjusted net income	$	26,462	$	24,796
Adjusted earnings per common share:
Basic	$	0.40	$	0.37
Diluted	$	0.39	$	0.36
Weighted average shares outstanding:
Basic		66,053		66,265
Diluted		67,971		69,236

Overview

Total revenues rose 7.3% to $259.8 million for the six months ended August 2, 2015 compared to $242.1 million for the six months ended August 3, 2014. Consolidated operating income increased to $28.0 million from $25.8 million, and consolidated net income was $16.6 million compared to $15.4 million for the six months ended August 2, 2015 and August 3, 2014, respectively.

Revenues by business segment (expressed in dollars and as a percentage of total revenues) are set forth in the table below (percentage amounts may not add to totals due to rounding).

45

	Six Months Ended
	August 2,				August 3,
	2015				2014
	(Dollars in thousands)
Revenues by business segment:
Company Stores	$	174,834			$	158,983
Domestic Franchise		7,645				6,795
International Franchise		14,042				14,115
KK Supply Chain:
Total revenues		126,986				119,815
Less - intersegment sales elimination		(63,697	)			(57,612	)
External KK Supply Chain revenues		63,289				62,203
Total revenues	$	259,810			$	242,096
Segment revenues as a percentage of total revenues:
Company Stores		67.3		%		65.7		%
Domestic Franchise		2.9				2.8
International Franchise		5.4				5.8
KK Supply Chain (external sales)		24.4				25.7
		100.0		%		100.0		%
Segment operating results:
Company Stores	$	8,949			$	6,579
Domestic Franchise		4,534				4,056
International Franchise		10,391				9,391
KK Supply Chain		21,093				21,140
Total segment operating income		44,967				41,166
General and administrative expenses		(14,272	)			(13,784	)
Corporate depreciation and amortization expense		(1,141	)			(733	)
Impairment charges and lease termination costs		(308	)			(46	)
Pre-opening costs related to Company Stores		(838	)			(471	)
Gains and (losses) on commodity derivatives, net		(394	)			103
Gain on refranchisings, net of business acquisition charges		-				(431	)
Consolidated operating income		28,014				25,804
Interest income		219				235
Interest expense		(764	)			(305	)
Equity in losses of equity method franchisees		-				(118	)
Other non-operating income and (expense), net		273				320
Income before income taxes		27,742				25,936
Provision for income taxes		11,158				10,528
Consolidated net income	$	16,584			$	15,408

A discussion of the revenues and operating results of each of the Company’s four business segments follows, together with a discussion of income statement line items not associated with specific segments. In the first quarter of fiscal 2016, the Company changed the presentation of the Consolidated Statement of Income and segment financial information. Pre-opening costs related to Company Stores, gains and losses on commodity derivatives, net and gain on refranchisings, net of business acquisition charges are now separate line items on the Consolidated Statement of Income and are no longer in the respective business segments’ operating income. The Company furnished a Current Report on Form 8-K on June 10, 2015 providing the Consolidated Statement of Income and segment financial information for the quarterly and annual periods in fiscal 2014 and fiscal 2015 conformed to the fiscal 2016 presentation. These presentation changes had no impact on the Company’s consolidated operating income or consolidated net income.

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Company Stores

The components of Company Stores revenues and expenses (expressed in dollars and as a percentage of total revenues) are set forth in the table below (percentage amounts may not add to totals due to rounding).

					Percentage of Total Revenues
	Six Months Ended				Six Months Ended
	August 2,		August 3,		August 2,		August 3,
	2015		2014		2015		2014
	(In thousands)
Revenues:
On-premises sales:
Retail sales	$	86,759	$	72,231	49.6	%	45.4	%
Fundraising sales		7,694		7,675	4.4		4.8
Total on-premises sales		94,453		79,906	54.0		50.3
Consumer packaged goods sales - wholesale sales:
Grocery/mass merchant		48,601		48,103	27.8		30.3
Convenience store		28,298		28,993	16.2		18.2
Other consumer packaged goods		3,482		1,981	2.0		1.2
Total consumer packaged goods sales		80,381		79,077	46.0		49.7
Total revenues		174,834		158,983	100.0		100.0
Operating expenses:
Cost of sales:
Food, beverage and packaging		63,401		59,149	36.3		37.2
Labor and benefits costs		55,909		51,085	32.0		32.1
Total cost of sales		119,310		110,234	68.2		69.3
Vehicle costs(1)		7,453		8,537	4.3		5.4
Occupancy(2)		5,981		5,223	3.4		3.3
Utilities expense		3,572		3,145	2.0		2.0
Other store operating expenses		10,417		8,603	6.0		5.4
Total store level costs		146,733		135,742	83.9		85.4
Company Stores contribution(3)		28,101		23,241	16.1		14.6
Marketing expense		3,172		2,767	1.8		1.7
Depreciation and amortization expense		6,430		5,041	3.7		3.2
Direct and indirect operating costs(4)		9,550		8,854	5.5		5.6
Segment operating income	$	8,949	$	6,579	5.1	%	4.1	%

(1)	Includes fuel, maintenance and repairs, rent, taxes, insurance and other costs of operating the delivery fleet, exclusive of depreciation.
(2)	Includes rent, property taxes, common area maintenance charges, insurance, building maintenance and other occupancy costs, exclusive of utilities and depreciation.
(3)	Company Stores contribution is a non-GAAP financial measure. The Company believes that this is a useful metric to assess and evaluate the performance of Company shops.
(4)	Includes marketing costs not charged to stores, segment management costs, CPG selling expenses and support functions and allocated corporate overhead.

Sales at Company Stores increased 10.0% to $174.8 million in the first six months of fiscal 2016 from $159.0 million in the first six months of fiscal 2015. Company Stores contribution increased 20.9% to $28.1 million in the first six months of fiscal 2016 from $23.2 million in the first six months of fiscal 2015 and Company Stores contribution increased 1.5 percentage points.

47

A reconciliation of Company Stores segment sales from the six months ended August 3, 2014 to the six months ended August 2, 2015 follows:

				Consumer
				Packaged Goods -
	On-Premises			Wholesale			Total
	(In thousands)
Sales for the six months ended August 3, 2014	$	79,906		$	79,077		$	158,983
Sales at closed stores		(793	)		-			(793	)
Fiscal 2015 sales at refranchised stores		(1,203	)		-			(1,203	)
Increase (decrease) in sales at established stores (open stores only)		1,008			(1,110	)		(102	)
Increase in sales related to stores opened in fiscal 2015 and 2016		11,443			-			11,443
Increase in sales related to stores acquired in fiscal 2015 and 2016		4,092			2,414			6,506
Sales for the six months ended August 2, 2015	$	94,453		$	80,381		$	174,834

On-premises sales rose 18.2% to $94.5 million in the first six months of fiscal 2016. The increase in on-premises sales includes an increase in retail sales of 20.1% to $86.8 million in the first six months of fiscal 2016 compared to $72.2 million in the first six months of fiscal 2015. The growth in retail sales in the first six months of fiscal 2016 was principally due to a 16.4% increase in store operating weeks and a 3.3% increase in same store sales. The change in same store sales rose in the first six months of fiscal 2016 due to a 3.3% increase in the average guest check, which was driven primarily by management’s use of more strategic promotional incentives.

The Company continuously evaluates and adjusts its marketing, promotional and operational activities and techniques with the goal of increasing both average guest check and customer traffic in its shops, which management believes will continue to be an important factor in increasing the profitability of the Company Stores business segment.

CPG sales

Sales to CPG accounts increased 1.6% to $80.4 million in the first six months of fiscal 2016.

Sales to grocers and mass merchants increased 1.0% to $48.6 million, reflecting a 2.2% increase in the average number of doors served partially offset by a 0.4% decrease in the average weekly sales per door. The increase in the average number of doors served in the grocery/mass merchant channel principally reflects an increase in doors resulting from the acquisition of stores in the Birmingham, Alabama market in the second quarter of fiscal 2015 and the acquisition of a store in Little Rock, Arkansas in late first quarter fiscal 2016. The decline in the average weekly sales per door in the grocery/mass merchant channel was due to a decline in higher volume doors on a year-over-year basis. Sales of packaged products comprise substantially all of the Company’s sales to grocers and mass merchants.

Sales to convenience stores decreased 2.4% to $28.3 million, reflecting a 1.8% decrease in the average number of doors served and a 0.5% decrease in the average weekly sales per door. The decrease in the average number of doors served in the convenience stores channel in the first six months of fiscal 2016 reflects a reduction in the number of lower volume doors. This decrease was partially offset by an increase in doors resulting from the acquisition of stores in the Birmingham, Alabama market in the second quarter of fiscal 2015 and the acquisition of a store in Little Rock, Arkansas in late first quarter fiscal 2016. Sales of loose unpackaged products comprise approximately 80% of sales to convenience store customers, with the balance comprised of sales of packaged products.

Company Stores contribution and costs and expenses

The increase in Company Stores contribution (a non-GAAP financial measure) in the first six months of fiscal 2016 of $4.9 million, or 20.9%, was driven by the 10.0% increase in revenues, partially offset by the 8.1% increase in store level costs.

Cost of food, beverage and packaging as a percentage of revenues decreased by 0.9 percentage points from the first six months of fiscal 2015 to 36.3% in the first six months of fiscal 2016. This improvement was principally due to a decrease in input costs and an increase in on-premises sales, which typically have lower food costs, compared to CPG sales, as a percentage of total revenues. The cost of food, beverage and packaging as a percentage of sales is often greater in the CPG distribution channel compared to the on-premises channel because average product selling prices generally are lower in the CPG distribution channel and because of the effect of returns in the CPG distribution channel.

Labor and benefits costs as a percentage of revenues decreased 0.1 percentage points from the first six months of fiscal 2015 to 32.0% in the first six months of fiscal 2016. An increase in shop labor as a percentage of revenue was fully offset by a decrease in delivery labor as a percentage of revenue. Additionally, benefits expense decreased as a result of lower health care costs in the first six months of fiscal 2016 compared to the first six months of fiscal 2015 partially offset by an increase in workers’ compensation costs. The Company is self-insured for such costs (subject to stop-loss coverage for large individual claims); accordingly, variations from period to period in the number and severity of claims directly affect the Company’s results of operations. As a result of the Company’s periodic update of its actuarial valuation of workers’ compensation claims, the Company recorded a favorable adjustment relating to its workers’ compensation liability claims for prior policy years of approximately $630,000 in the second quarter of fiscal 2015. There was no adjustment related to workers’ compensation claims as a result of the Company’s periodic update of its actuarial valuation during the second quarter of fiscal 2016.  

48

The Patient Protection and Affordable Care Act (the “Act”) requires large employers to offer health care benefits to all full-time employees, or face financial penalties, generally beginning in January 2015. To avoid these penalties, the health benefits must provide a specified “minimum value” and be “affordable,” each as defined in the Act. Largely as a result of modifications made to the Company’s plans, management anticipates that its health care costs in fiscal 2016 will be approximately $1.0 million higher compared to fiscal 2015.

Vehicle costs as a percentage of revenues decreased from 5.4% of revenues in the first six months of fiscal 2015 to 4.3% of revenues in the first six months of fiscal 2016, reflecting lower fuel costs, a reduction in mileage and a reduction in vehicle insurance costs. The Company is self-insured for vehicle claims, but maintains stop-loss coverage for individual claims exceeding certain amounts. As a result of the Company’s periodic update of its actuarial valuation of vehicle claims, the Company recorded favorable adjustments relating to its vehicle liability claims for prior policy years of approximately $372,000 in the second quarter of fiscal 2016 compared to $90,000 in the second quarter of fiscal 2015.

Other store operating expenses increased to 6.0% of revenues in the first six months of fiscal 2016 from 5.4% of revenues in the first six months of fiscal 2015 principally due to an increase in equipment repairs and maintenance and an increase in other supplies and services costs.

Many store level operating costs are fixed or semi-fixed in nature and, accordingly, store profit margins are sensitive to changes in sales volumes.

Depreciation and amortization expense increased in the first six months of fiscal 2016 to 3.7% of revenues from 3.2% in the first six months of fiscal 2015 due to construction of new stores and store refurbishments at existing stores since the first six months of fiscal 2015.

Domestic Franchise

	Six Months Ended
	August 2,			August 3,
	2015			2014
	(In thousands)
Revenues:
Royalties	$	6,577		$	6,053
Development and franchise fees		425			295
Other		643			447
Total revenues		7,645			6,795
Operating expenses:
Segment operating expenses		2,728			2,444
Depreciation expense		33			95
Allocated corporate overhead		350			200
Total operating expenses		3,111			2,739
Segment operating income	$	4,534		$	4,056
Segment operating margin		59.3	%		59.7	%

Domestic Franchise revenues increased 12.5% to $7.6 million in the first six months of fiscal 2016. The increase reflects higher royalty revenues resulting from an increase in sales by domestic franchise stores from $172 million in the first six months of fiscal 2015 to $183 million in the first six months of fiscal 2016. Domestic Franchise same store sales rose 6.6% in the first six months of fiscal 2016. The increase in development and franchise fees in the first six months of fiscal 2016 compared to the first six months of fiscal 2015 resulted from an increase in Domestic Franchise store openings. Additionally, more factory stores opened in the first six months of fiscal 2016 compared to the first six months of fiscal 2015, which resulted in the recognition of higher franchise fees.

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Other Domestic Franchise revenues include revenue from the licensing of certain Krispy Kreme trademarks to third parties for use in marketing Krispy Kreme branded beverages and rental income charged to franchisees for stores leased or subleased to franchisees. The Company first entered into such licensing agreements in fiscal 2014 and intends to expand licensing of its brand to additional products. Licensing revenue increased in the first six months of fiscal 2016 compared to the prior year, partially offset by a decrease in rental income.

Domestic Franchise segment operating expenses include costs to recruit new domestic franchisees, to assist in domestic store openings, and to monitor and aid in the performance of domestic franchise stores, as well as allocated corporate costs. Domestic Franchise operating expenses increased in the first six months of fiscal 2016 to $2.7 million compared to $2.4 million in the first six months of fiscal 2015, principally reflecting higher costs associated with the continued execution of the Company’s domestic franchise expansion program.

Domestic franchisees opened nine stores and closed two stores in the first six months of fiscal 2016. As of August 2, 2015, development agreements for territories in the United States provide for the development of approximately 120 additional stores through fiscal 2022. Royalty revenues are directly related to sales by franchise stores and, accordingly, the success of franchisees’ operations has a direct effect on the Company’s revenues, results of operations and cash flows.

International Franchise

	Six Months Ended
	August 2,			August 3,
	2015			2014
	(In thousands)
Revenues:
Royalties	$	13,246		$	13,292
Development and franchise fees		796			823
Total revenues		14,042			14,115
Operating expenses:
Segment operating expenses		3,251			4,121
Depreciation expense		-			3
Allocated corporate overhead		400			600
Total operating expenses		3,651			4,724
Segment operating income	$	10,391		$	9,391
Segment operating margin		74.0	%		66.5	%

International Franchise revenues decreased slightly to $14.0 million in the first six months of fiscal 2016 from $14.1 million in the first six months of fiscal 2015.

International Franchise royalties decreased slightly to $13.2 million in the first six months of fiscal 2016 from $13.3 million the first six months of fiscal 2015 principally due to unfavorable foreign exchange rates. Sales by international franchise stores increased from $229 million in the first six months of fiscal 2015 to $239 million in the first six months of fiscal 2016. Changes in the rates of exchange between the U.S. dollar and the foreign currencies in which the Company’s international franchisees do business decreased sales by international franchisees measured in U.S. dollars by approximately $25.7 million in the first six months of fiscal 2016 compared to the first six months of fiscal 2015, which adversely affected royalties by approximately $1.4 million. Excluding the effects of changes in foreign exchange rates, sales by international franchisees rose 15.7%. Additionally, the Company recognized royalty revenue of approximately $700,000 and $900,000 collected during the first six months of fiscal 2016 and 2015, respectively, related to franchisee sales in prior periods which had not previously been recorded as revenue due to the uncertainty surrounding the collection of these royalties. Substantially all of the amounts relate to a single franchisee. There is no prescribed repayment schedule for the remaining $1.2 million owed to the Company by the franchisee and the Company therefore cannot predict the amount or timing of future payments, if any, on this obligation. Accordingly, the Company has not recognized such amount in the financial statements.

International Franchise same store sales, measured on a constant currency basis to eliminate the effects of changing exchange rates between foreign currencies and the U.S. dollar (“constant dollar same store sales”), fell 2.2%. The decline in International Franchise same store sales reflects, among other things, the normal cannibalization effects on existing stores in growing markets of additional store openings in those markets driven by the international market’s reliance on the hub and spoke model.

50

Constant dollar same store sales in established markets rose 1.5% in the first six months of fiscal 2016 and fell 5.9% in new markets. “Established markets” means countries in which the first Krispy Kreme store opened before fiscal 2007. Sales at stores in established markets comprised 52% of aggregate constant dollar same store sales for the first six months of fiscal 2016. While the Company considers countries in which Krispy Kreme first opened before fiscal 2007 to be established markets, franchisees in those markets continue to develop their business. Of the 721 international shops currently in operation that opened since the beginning of fiscal 2007, 305 shops are in these established markets.

International Franchise development and franchise fees were flat in the first six months of fiscal 2016 and fiscal 2015. Certain franchisees’ license agreements provide that the franchisees may develop, with the Company’s consent, additional Krispy Kreme shops within the franchise territory without payment of initial franchise or development fees. Accordingly, some shop openings by international franchisees do not result in the recognition of such fees.

International Franchise operating expenses include costs to recruit new international franchisees, to assist in international store openings, and to monitor and aid in the performance of international franchise stores, as well as allocated corporate costs.International Franchise operating expenses decreased from $4.1 million in the first six months of fiscal 2015 to $3.3 million in the first six months of fiscal 2016 as a result of higher costs related to the transition of personnel in the first six months of fiscal 2015.Additionally, the first six months of fiscal 2016 reflects a net credit in bad debt expense of approximately $145,000, principally due to recoveries of amounts previously written off, compared to a charge of approximately $210,000 in the first six months of fiscal 2015. A net credit in bad debt expense should not be expected to recur frequently.

International franchisees opened 65 stores and closed 16 stores in the first six months of fiscal 2016. As of August 2, 2015, development agreements for territories outside the United States provide for the development of approximately 330 additional stores through fiscal 2021. Royalty revenues are directly related to sales by franchise stores and, accordingly, the success of franchisees’ operations has a direct effect on the Company’s revenues, results of operations and cash flows.

KK Supply Chain

The components of KK Supply Chain revenues and expenses (expressed in dollars and as a percentage of total revenues before intersegment sales elimination) are set forth in the table below (percentage amounts may not add to totals due to rounding).

					Percentage of Total Revenues
					Before Intersegment
					Sales Elimination
	Six Months Ended				Six Months Ended
	August 2,		August 3,		August 2,		August 3,
	2015		2014		2015		2014
	(In thousands)
Revenues:
Doughnut mixes	$	45,046	$	42,293	35.5	%	35.3	%
Other ingredients, packaging and supplies		74,073		70,519	58.3		58.9
Equipment		6,961		5,532	5.5		4.6
Freight revenue		906		1,471	0.7		1.2
Total revenues before intersegment sales elimination		126,986		119,815	100.0		100.0
Operating expenses:
Cost of goods produced and purchased		90,338		84,093	71.1		70.2
Distribution costs		8,935		7,452	7.0		6.2
Other segment operating costs		5,557		6,196	4.4		5.2
Depreciation expense		463		334	0.4		0.3
Allocated corporate overhead		600		600	0.5		0.5
Total operating costs		105,893		98,675	83.4		82.4
Segment operating income	$	21,093	$	21,140	16.6	%	17.6	%

KK Supply Chain revenues before intersegment sales eliminations increased 6.0% to $127.0 million in the first six months of fiscal 2016 compared to $119.8 million in the first six months of fiscal 2015.

Sales of doughnut mixes increased 6.5% year-over-year in the first six months of fiscal 2016, due to higher unit volumes and slightly higher selling prices.

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Sales of other ingredients, packaging and supplies, made principally to Company and Domestic Franchise stores, rose 5.0% year-over-year in the first six months of fiscal 2016 due to higher unit volumes partially offset by lower selling prices.

While systemwide sales at Company and Domestic Franchise stores rose at a faster rate than KK Supply Chain revenues did during the first six months of fiscal 2016 compared to the first six months of the preceding fiscal year, a greater percentage of such sales was to on-premises customers compared to CPG customers. On-premises sales at Company and Domestic Franchise stores generate proportionately lower KK Supply Chain sales than do sales to CPG customers. This negatively impacted the growth rate within the KK Supply Chain business as compared to the overall system.

Equipment sales increased to $7.0 million in the first six months of fiscal 2016 from $5.5 million in the first six months of fiscal 2016 principally due to an increase in store openings.

KK Supply Chain adjusts the selling prices on the majority of ingredients, packaging and supplies sold to Company-owned and franchise stores on a quarterly basis at the beginning of each quarter. As a result, KK Supply Chain operating margin can vary between quarters but the Company’s objective is to keep gross profit on a per unit basis at KK Supply Chain relatively constant by passing increases and decreases in input costs to Company-owned and franchise stores by adjusting such sales prices.

The increase in cost of goods produced and purchased as a percentage of sales in the first six months of fiscal 2016 compared to the first six months of fiscal 2015 reflects, among other things, a decrease in the percentage of doughnut mix sales composed of mix concentrates, which carry higher profit margins than sales of finished doughnut mixes. Mix concentrates have higher profit margins than finished doughnut mixes because the Company attempts to maintain the gross profit on sales of mix concentrates and finished mixes relatively constant when measured on a finished mix equivalent basis.

Distribution costs rose in the first six months of fiscal 2016 compared to the first six months of fiscal 2015 due to an increase in unit volumes. Distribution costs increased as a percentage of sales because selling prices on certain ingredients and supplies decreased compared to last year.

Other segment operating costs include segment management, purchasing, customer service and support, laboratory and quality control costs, and research and development expenses.

Franchisees opened 74 stores and closed 18 stores in the first six months of fiscal 2016. A substantial portion of KK Supply Chain’s revenues are directly related to sales by franchise stores and, accordingly, the success of franchisees’ operations has a direct effect on the Company’s revenues, results of operations and cash flows.

A significant portion of franchise store sales is attributable to sales by franchisees outside the United States. The Company sells doughnut mixes, either manufactured by the Company in the United States or blended by contract mix manufacturers using concentrates supplied by the Company, to all its international franchisees. Most of these franchisees purchase substantially all other ingredients, packaging and supplies through sourcing arrangements approved by the Company. Accordingly, KK Supply Chain revenues are less correlated with sales by international franchisees than with sales by domestic franchisees, which purchase substantially all of their ingredients from KK Supply Chain. Like all international businesses, the Company and its international franchisees must address the risks of international trade, including taxes, tariffs, duties and transportation costs, which can affect the franchisees’ product costs and therefore indirectly affect the pace of development. The Company, in cooperation with its international franchisees, continually seeks to mitigate the impact of these factors. For example, the Company has developed premix and concentrate doughnut mix production models, and has been continuously pursuing alternative sourcing arrangements in various markets.

General and Administrative Expenses

General and administrative expenses consist of costs incurred in various functional areas whose activities are not associated exclusively with an individual business segment. Such costs include expenses associated with finance and accounting; internal and external financial reporting, including financial planning and analysis; internal audit; human resources; risk management; information technology; training; corporate office occupancy; public company costs; and executive management. Certain personnel and other costs in some of these functional areas (for example, some of the costs of information technology and human resources) are associated primarily with the operation of individual business segments, and are allocated to those segments as allocated corporate costs.General and administrative expenses in the consolidated statement of income are presented net of such allocated costs, which are reflected in the results of operations of the four operating segments. Such allocated costs totaled $3.7 million in the first six months of fiscal 2016 compared to $3.6 million in the first six months of fiscal 2015.

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General and administrative expenses increased to $14.3 million in the first six months of fiscal 2016 from $13.8 million in the first six months of fiscal 2015 due to increased costs related to the implementation and on-going system support of a new ERP system and increased share-based compensation costs partially offset by lower professional and legal fees and lower healthcare costs. However, general and administrative expenses as a percentage of revenues decreased to 5.5% from 5.7%.

During the first quarter of fiscal 2016, the Company implemented an ERP software solution that included a new general ledger and accounting system. Total costs of the implementation and on-going system support were approximately $700,000 higher in the first six months of fiscal 2016 compared to the first six months of fiscal 2015. The Company expects general and administrative expenses related to the ERP implementation and support to approximate $2.0 million in the second half of fiscal 2016 for a total cost of $4.0 million in fiscal 2016.

General and administrative expenses also include an increase in share-based compensation costs of approximately $800,000 in the first six months of fiscal 2016 compared to the first six months of fiscal 2015, resulting, in part, from a change in the timing of granting equity awards from the fourth quarter of fiscal 2015 to the first quarter of fiscal 2016 and from an increase in the equity awards granted in the first half of fiscal 2016 compared to the first half of fiscal 2015.

Impairment Charges and Lease Termination Costs

Impairment charges and lease termination costs were $308,000 in the first six months of fiscal 2016 compared to $46,000 in the first six months of fiscal 2015.

	Six Months Ended
	August 2,			August 3,
	2015			2014
	(In thousands)
Impairment of long-lived assets	$	343		$	-
Lease termination costs		(35	)		46
	$	308		$	46

The Company tests long-lived assets for impairment when events or changes in circumstances indicate that their carrying value may not be recoverable. These events and changes in circumstances include store closing and refranchising decisions, the effects of changing costs on current results of operations, observed trends in operating results, and evidence of changed circumstances observed as a part of periodic reforecasts of future operating results and as part of the Company’s annual budgeting process. Impairment charges generally relate to Company stores expected to be closed or refranchised, as well as to stores management believes will not generate sufficient future cash flows to enable the Company to recover the carrying value of the stores’ assets, but which management has not yet decided to close. When the Company concludes that the carrying value of long-lived assets is not recoverable (based on future projected undiscounted cash flows), the Company records impairment charges to reduce the carrying value of those assets to their estimated fair values. The fair values of these assets are estimated based on the present value of estimated future cash flows, on independent appraisals and, in the case of assets the Company currently is negotiating to sell, based on the Company’s negotiations with unrelated third-party buyers. During the six months ended August 2, 2015, the Company recorded impairment charges related to long-lived assets for one Company Store that closed during the second quarter of fiscal 2016 to reduce the carrying value of those assets to their estimated fair values. Substantially all of such long-lived assets were real properties, the fair values of which were estimated based on an independent appraisal.

Lease termination costs represent the estimated fair value of liabilities related to unexpired leases, after reduction by the amount of accrued rent expense, if any, related to the leases, and are recorded when the lease contracts are terminated or, if earlier, the date on which the Company ceases use of the leased property. The fair value of these liabilities were estimated as the excess, if any, of the contractual payments required under the unexpired leases over the current market lease rates for the properties, discounted at a credit-adjusted risk-free rate over the remaining term of the leases. The provision for lease termination costs also includes adjustments to liabilities recorded in prior periods arising from changes in estimated sublease rentals and from settlements with landlords. During the six months ended August 2, 2015, the Company recorded lease termination charges related to a store closure in the second quarter of fiscal 2016 and adjustments to liabilities recorded in prior periods arising from changes in estimated sublease rentals totaling $71,000 offset by the reversal of previously recorded accrued rent of $110,000 related to the closed store.

Pre-opening Costs Related to Company Stores

Pre-opening costs related to Company Stores include costs related to new stores, a portion of which relates to stores which had not yet opened by the end of the quarter. Pre-opening costs related to Company Stores increased to $838,000 in the first six months of fiscal 2016 compared to $471,000 in first six months of fiscal 2015 as a result of the timing of store openings. The average pre-opening costs per store are approximately $150,000 to $200,000.

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Gains and Losses on Commodity Derivatives, Net

Gains and losses on commodity derivatives, net represents the difference between the cost, if any, and the fair value of the commodity derivatives and is reflected in earnings because the Company has not designated any of these instruments as hedges. The Company recorded net losses on commodity derivatives of $394,000 in the first six months of fiscal 2016 compared to net gains of $103,000 in the first six months of fiscal 2015. Gains and losses on commodity derivatives are comprised of the following:

	Six Months Ended August 2, 2015
(Gains) and Losses on Commodity Derivatives	Agricultural			Gasoline			Total
	(In thousands)
Realized	$	778		$	148		$	926
Unrealized		(372	)		(160	)		(532	)
(Gains) and losses on commodity derivatives, net	$	406		$	(12	)	$	394
	Six Months Ended August 3, 2014
(Gains) and Losses on Commodity Derivatives	Agricultural			Gasoline			Total
	(In thousands)
Realized	$	(224	)	$	-		$	(224	)
Unrealized		121			-			121
(Gains) and losses on commodity derivatives, net	$	(103	)	$	-		$	(103	)

Gain on refranchising, net of business acquisition charges

During the first six months of fiscal 2015, the Company recorded charges of $431,000 related to the acquisition of the business and operating assets of its franchisee in Birmingham, Alabama as more fully described in Note 13 to the consolidated financial statements appearing elsewhere herein. The charges principally reflect a $343,000 settlement as part of the acquisition of the pre-existing franchise contract between the Company and the franchisee and transaction costs related to the acquisition of $88,000.

Interest Expense

Interest expense increased $459,000 in the first six months of fiscal 2016 to $764,000 from $305,000 in the first six months of fiscal 2015. This increase was due principally to interest expense related to leasing obligations that the Company entered into in fiscal 2015 and fiscal 2016 associated with approximately $8.8 million of build-to-suit leasing arrangements as described in Note 6 in the consolidated financial statements appearing elsewhere herein.

Equity in Losses of Equity Method Franchisees

The Company recorded equity in the losses of equity method franchisees of $118,000 in the first six months of fiscal 2015. This caption represents the Company’s share of operating results of equity method franchisees which develop and operate Krispy Kreme stores.

Other Non-Operating Income and Expense, Net

Other non-operating income and expense, net includes payments of approximately $265,000 and $320,000 in the first six months of fiscal 2016 and fiscal 2015, respectively, received from an equity method franchisee in reimbursement for amounts paid by the Company in fiscal 2014 pursuant to the Company’s guarantee of the investee’s indebtedness. Such repayments are being reflected in income as received due to the uncertainty of their continued collection as more fully described in Note 3 to the consolidated financial statements appearing elsewhere herein.

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Provision for Income Taxes

The Company’s effective tax rate for the first six months of fiscal 2016 was 40.2% compared to 40.6% for the first six months of fiscal 2015. Included in income tax expense for the first six months of fiscal 2016 is a net charge of approximately $467,000 to revalue the Company’s deferred income tax assets to reflect a reduction in the North Carolina corporate income tax rate announced by the state legislature during the quarter, as described in Note 10 to the consolidated financial statements appearing elsewhere herein. Additionally, the effective tax rate was reduced as a result of the benefit of specific incentive stock options being reclassified as non- qualified stock options and in adjustments to accruals for uncertain tax positions.

The portion of the income tax provision representing taxes estimated to be payable currently was $1.3 million and $1.1 million in the first six months of fiscal 2016 and fiscal 2015, respectively, consisting principally of foreign withholding taxes related to royalties and franchise fees paid by international franchisees to the Company. The current provision for income taxes also reflects adjustments to accruals for uncertain tax positions, including potential interest and penalties which could result from the resolution of such uncertainties.

See “Results of Operations – Three months ended August 2, 2015 compared to three months ended August 3, 2014 –Provision for Income Taxes” above for further insight associated with management’s estimate of fiscal 2016 annual effective income tax rate; potential future period tax benefits; deferred tax assets and valuation allowances.

See “Results of Operations – Six months ended August 2, 2015 compared to six months ended August 3, 2014 –Non-GAAP Measures” above for non-GAAP financial information and related reconciliation to GAAP measures intended to illustrate the material difference between the Company’s income tax expense and income taxes currently payable.

While management believes its forecast of future pretax income is reasonable, actual results inevitably will vary from management’s forecasts. Such variances could result in adjustments to its accounting for certain foreign tax credit carryforwards and the valuation allowance on deferred tax assets in future periods, and such adjustments could be material to the financial statements.

Net Income

The Company reported net income of $16.6 million for the six months ended August 2, 2015 compared to $15.4 million for the six months ended August 3, 2014.

LIQUIDITY AND CAPITAL RESOURCES

The following table summarizes the Company’s cash flows from operating, investing and financing activities for the first six months of fiscal 2016 and fiscal 2015.

	Six Months Ended
	August 2, 2015			August 3, 2014
	(In thousands)
Net cash provided by operating activities	$	35,438		$	27,687
Net cash used for investing activities		(9,337	)		(19,592	)
Net cash used for financing activities		(32,967	)		(28,163	)
Net increase (decrease) in cash and cash equivalents	$	(6,866	)	$	(20,068	)

Cash Flows from Operating Activities

Cash provided by operating activities increased $7.8 million in the first six months of fiscal 2016 from the comparable fiscal 2015 period. The increase was driven by the continued growth of Company and franchise shops, which led to an increase in pretax income of approximately $1.8 million. Additionally, the increase in cash provided by operating activities was due to an increase in depreciation and amortization expense of approximately $1.9 million and share-based compensation of approximately $1.5 million, along with changes in working capital, partially offset by other non-cash adjustments.

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Cash Flows from Investing Activities

Net cash used for investing activities was $9.3 million in the first six months of fiscal 2016 compared to $19.6 million in the first six months of fiscal 2015.

Cash used for capital expenditures decreased to $10.2 million in the first six months of fiscal 2016 from $13.1 million in the first six months of fiscal 2015. The components of capital expenditures were as follows:

	Six Months Ended
	August 2, 2015			August 3, 2014
	(In thousands)
New store construction	$	6,872		$	7,409
Store remodels and betterments		1,603			2,633
Capital leases on stores acquired		-			1,052
Other store equipment, including vehicles and technology		1,615			1,562
Mix manufacturing equipment and refurbishments		1,275			561
Corporate information technology		663			3,030
Other		420			388
Total capital expenditures		12,448			16,635
Assets acquired under leasing arrangements		(2,035	)		(3,781	)
Net change in unpaid capital expenditures included in accounts payable        and accrued liabilities		(255	)		209
Cash used for capital expenditures	$	10,158		$	13,063

The Company currently expects capital expenditures to range from $30 million to $40 million in fiscal 2016. The Company intends to fund these capital expenditures from cash provided by operating activities, from existing cash balances and, to a lesser extent, through leases.

In the first six months of fiscal 2016, the Company acquired a Krispy Kreme shop from its franchisee in Little Rock, Arkansas, in exchange for $312,000 cash as more fully described in Note 13 to the consolidated financial statements appearing elsewhere herein.

In the first six months of fiscal 2015, the Company acquired the business and operating assets of its franchisee in Birmingham, Alabama, consisting of four Krispy Kreme shops in exchange for $7.2 million cash, as more fully described in Note 13.

Cash Flows from Financing Activities

Net cash used for financing activities for the six months ended August 2, 2015 was $33.0 million. During the first six months ended August 2, 2015, the Company repurchased 1,885,106 shares of its common stock, pursuant to the Company’s Board of Directors authorized common stock repurchase plan more fully described in Note 8 to the consolidated financial statements appearing elsewhere herein, for a total cost of $34.3 million. Repurchases of approximately $32.9 million were settled during the six months ended August 2, 2015. In addition to share repurchases made pursuant to the aforementioned repurchase plan, the Company repurchased $420,000 of common shares in the first six months of fiscal 2016, representing the value of shares surrendered by employees to satisfy their obligations to reimburse the Company for the minimum required statutory withholding taxes arising from the vesting of restricted stock awards by surrendering vested common shares in lieu of reimbursing the Company in cash. These amounts were partially offset by $519,000 of proceeds from the exercise of stock options.

Net cash used for financing activities for the six months ended August 3, 2014 was $28.2 million. During the first six months ended August 3, 2014, the Company repurchased 1,840,300 shares under the Board authorization, for a total cost of $32.4 million. Repurchases of approximately $34.6 million were settled during the first six months ended August 3, 2014. This amount was partially offset by $6.7 million of proceeds from the exercise of stock options.

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Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.

There have been no material changes from the disclosures in Part II, Item 7A, “Quantitative and Qualitative Disclosures About Market Risk,” in the 2015 Form 10-K.

Item 4. CONTROLS AND PROCEDURES.

Evaluation of Disclosure Controls and Procedures

As of August 2, 2015, 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 SEC’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, the Company’s chief executive officer and chief financial officer have concluded that, as of August 2, 2015, the Company’s disclosure controls and procedures were effective.

Changes in Internal Control Over Financial Reporting

During the quarter ended August 2, 2015, there were no changes in the Company’s internal control over financial reporting that materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

PART II – OTHER INFORMATION

Item 1. LEGAL PROCEEDINGS.

Pending Matters

Except as disclosed below, the Company currently is not a party to any material legal proceedings.

K² Asia Litigation

On April 7, 2009, a Cayman Islands corporation, K² Asia Ventures, and its owners filed a lawsuit in Forsyth County, North Carolina Superior Court against the Company, its franchisee in the Philippines, and other persons associated with the franchisee. The suit alleges that the Company and the other defendants conspired to deprive the plaintiffs of claimed “exclusive rights” to negotiate franchise and development agreements with prospective franchisees in the Philippines, and seeks unspecified damages. The Company therefore does not know the amount or range of possible loss related to this matter. The Company believes that these allegations are false and intends to vigorously defend against the lawsuit. On July 26, 2013, the Superior Court dismissed the Philippines-based defendants for lack of personal jurisdiction, and the plaintiffs noticed an appeal of that decision. On January 22, 2015, the North Carolina Supreme Court denied the plaintiffs’ request to review the case. The Company moved for summary judgment on May 7, 2015 and is awaiting a decision by the Superior Court.

Item 1A. RISK FACTORS.

There have been no material changes from the risk factors disclosed in Part I, Item 1A, “Risk Factors,” in the 2015 Form 10-K.

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

There were no unregistered sales of equity securities in the quarter ended August 2, 2015.

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Issuer Purchases Of Equity Securities

Period	Total Number of Shares (or units) Purchased (a)(1)	Average Price Paid per Share (or unit) (b)		Total Number of Shares (or units) Purchased as Part of Publicly Announced Plans or Programs (c)	Maximum Number (or Approximate Dollar Value) of Shares (or Units) that May Yet Be Purchased Under the Plans or Programs (d)
May 4, 2015 through May 31, 2015	655,000	$	17.46	655,000	$	74,570,097
June 1, 2015 through June 28, 2015	353,018		17.79	344,627		68,432,524
June 29, 2015 through August 2, 2015	498,496		18.84	494,169		59,121,787
Total	1,506,514	$	17.99	1,493,796

(1) On July 15, 2013, the Company announced that the Board of Directors had authorized the repurchase of up to $50 million of the Company's common stock. Subsequently, the Board of Directors increased such authorization on March 12, 2014, September 17, 2014 and on June 16, 2015, such that it now totals $155 million. The authorization has no expiration date. Through August 2, 2015, the Company repurchased 5,307,149 shares under the authorization at an average price of $18.07 per share, for a total cost of $95.9 million. During the three months ended August 2, 2015, the Company repurchased 1,493,796 shares under the authorization at an average price of $18.00 per share, for a total cost of $26.9 million. During the six months ended August 2, 2015, the Company repurchased 1,885,106 shares under the authorization at an average price of $18.20 per share, for a total cost of $34.3 million. Repurchases of approximately $32.9 million were settled during the six months ended August 2, 2015. Due to the Company’s incorporation in North Carolina, which does not recognize treasury shares, the shares repurchased are canceled at the time of repurchase. Additionally, the Company generally permits holders of restricted stock unit awards to satisfy their obligations to reimburse the Company for the minimum required statutory withholding taxes arising from the vesting of such awards by surrendering vested common shares in lieu of reimbursing the Company in cash. During the three months ended August 2, 2015, the Company repurchased 12,718 shares to satisfy obligations to reimburse the Company at an average price of $17.63 per share, for a total cost of $223,000. During the six months ended August 2, 2015, the Company repurchased 23,607 to satisfy obligations to reimburse the Company at an average price of $17.84 per share, for a total cost of $420,000.

Item 3. DEFAULTS UPON SENIOR SECURITIES.

None.

Item 4. MINE SAFETY DISCLOSURES.

Not applicable.

Item 5. OTHER INFORMATION.

None.

Item 6. EXHIBITS.

The exhibits filed with this Quarterly Report on Form 10-Q are set forth in the Exhibit Index on page 60 and are incorporated herein by reference.

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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: September 11, 2015	By:	/s/ G. Price Cooper, IV
	Name:	G. Price Cooper, IV
	Title:	Chief Financial Officer
		(Duly Authorized Officer and Principal Financial Officer)

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Exhibit Index

3.1	*	—	Restated Articles of Incorporation of the Registrant, as amended through June 18, 2015
3.2		—	Amended and Restated Bylaws of the Registrant (incorporated by reference to Exhibit 3.1 to the Registrant’s Current Report on Form 8-K filed on December 15, 2008)
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
101			The following materials from our Quarterly Report on Form 10-Q for the quarter ended August 2, 2015, formatted in XBRL (eXtensible Business Reporting Language): (i) the Consolidated Statement of Income for the three and six months ended August 2, 2015, and August 3, 2014; (ii) the Consolidated Statement of Comprehensive Income for the three and six months ended August 2, 2015 and August 3, 2014; (iii) the Consolidated Balance Sheet as of August 2, 2015 and February 1, 2015; (iv) the Consolidated Statement of Cash Flows for the six months ended August 2, 2015 and August 3, 2014; (v) the Consolidated Statement of Changes in Shareholders’ Equity for the six months ended August 2, 2015 and August 3, 2014; and (vi) the Notes to the Condensed Consolidated Financial Statements

* Filed herewith

Our SEC file number for documents filed with the SEC pursuant to the Securities Exchange Act of 1934, as amended, is 001-16485.

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