Doughnut World

The plummet of Doughnut's stock price is a function of the skepticism investors have in the company. The following plan is intended to reduce the uncertainty surrounding the companies stock and increase the net present value of future cash flows.

Recommendation 1 states that Doughnut should continue closing stores with negative net present values. In addition smaller outlets will be franchised. This is a move less risky than corporate owned expansion and will likely produce positive cash flow. Franchised stores will eventually replace whole selling to grocery and convenience stores, a strategy with a negative net present value due to erosion in sales at franchised or company owned stores.

Recommendation 1 resolves the problem surrounding high operating leverage in areas with low sales potential. While these markets are profitable, high investments in buildings and equipment provide excess capacity at a high cost.

In an attempt to reduce the uncertainty of Doughnut's stock recommendation 2 suggests that Doughnut make a firm commitment to issue financial statements on a feasible date. Many of the firm's problems stem from inaccurate accounting data. A confident and prompt restatement of earning would go a long way in resolving the agency problem that plagued the firm under former CEO Livengood. The sooner accurate statements can be made available, the better.

Long run success is dependent on honest financial reporting and resolving other components of the agency problem. Under the leadership of Stephen F. Cooper, many of these problems have been resolved. However a myriad of legal clams against the company still have to be sorted through and financial statements must be filed.

Ratios

Doughnut's uncorrected financial statements show a gradual decay in activity ratios; however, most of these ratios are still considered strong (Appendix B). Short-term solvency ratios change significantly in 2003. They appear to get stronger. Before 2003 they are relatively constant (Appendix B). This large change was possibly due to an exaggeration in Doughnut's cash position. When net income was overstated, the exaggeration could have flowed over to the cash position.

However, Norris quoted turnaround specialist Cooper saying, "It looks like the company has a reasonable level of free cash flow, so I see no reason why this (Doughnut) should be a bankruptcy candidate."

The firm's interest coverage ratio is shaped like a house top (Appendix D). The interest coverage ratio rose rapidly from 2000 to 2002 when it peaked. If these statements are correct Doughnut was primarily equity financed during this period. However, in 2003 there is a large decline in the interest coverage ratio of Doughnut. This was not necessarily a bad thing; however, it signaled a change in the company's capital structure. In 2002 Doughnut was a growing company whose product was viewed as a novelty. In 2003 as the company pushed rapidly to expand, the firm took on more debt.

The problem with Doughnut's financial statements is that they are based on bad accounting data. In an attempt to compensate for misstated earnings an estimated corrected income statement for Doughnut was generated. Net income for 2004 was cut by 6.2 million while expenses were left constant. Nowell reported that Doughnut officials believe that restated earnings will decrease net income by 5.2 to 6.2 million. While the revenue estimate for 2004 is unlikely to be correct, it is closer to reality than the value reported in Doughnut's 2004 10k statement. With corrected financial statements the housetop shape of the firm's interest coverage ratio may be even more exaggerated. However, without legitimate financial statements, ratio analysis yields significantly less insight.

Activity ratios remain relatively stable for the last few years with the corrected financial statements. These numbers may in fact decline when restated financial statements are issued. This is a change from the increases in activity ratios reported on the 2004 10k statement. The real mystery is Doughnut's cash position. Doughnut recently secured new debt financing improving its cash position, but 2005's beginning cash position is still unknown. A weaker cash balance than reported would cause short-term solvency ratios to decline.

Capital Structure

For now Doughnut likely has enough cash to avoid bankruptcy. Many potential improvements to the firm involve changing the structure of Doughnut's operations. The goal of the following recommendations is to reduce risk, increase long-term cash flow and increase stock price.

Operating Leverage

Doughnut has done something that no other donut chain has; the company made a large capital investment in machinery to produce large quantities of donuts. This works great in markets that can sustain a high level of demand. However, for markets that only have a short burst of high demand, this structure is unprofitable in the long run. Norris credits this partially to low carbohydrate diets. A large capital investment creates a high degree of operating leverage. If revenues are not high enough to pay fixed costs, the company loses money.

In large metropolitan areas, a large Doughnut donut outlet is profitable because there is enough demand to generate the revenue needed to pay fixed costs and provide profit. However, Doughnut has expanded into smaller markets where revenue is below the breakeven point. This does not mean that these markets are unprofitable; it means that Doughnut must alter the way it does business to make smaller markets profitable.

An alternative is to make donuts the traditional way, by hand. This has the potential of eroding the Doughnut image, however, a large percentage of sales go through other retail sites such as convenience stores or grocery stores. In smaller markets opening smaller more traditional donut shops would certainly be profitable. The demand for the product exists; however, it is not as large as originally planned.

A second alternative would be to centralize operations regionally. Donuts would not be as fresh, but Doughnut would be able to utilize machinery and possibly reduce costs. Fresh donuts could be trucked to retail sites from larger metropolitan areas. Although this strategy would certainly lower production costs, it is very similar to what Doughnut has already attempted to do.

The optimal strategy would be to close outlets in areas that expect to have projected negative net present values. Stores with expected positive net present values will remain open and smaller

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