Executive Report

Strategic risks are the risks related to changes in the business environment that could potentially have significant effects on operations and business objectives.We have broken down the major strategic risks into three major categories: Market Risks, Organizational/Cultural Risks, and Political Risks.

Market risks are the risks associated with market characteristics, market trends, major competitors, customer behavior, and brand positioning. There are a number of factors related to market risk that has a significant impact on Dunkin’ Donuts and Krispy Kreme’s sales results. Both Dunkin’ and Krispy Kreme, as well as others in the industry, experience similar effects on financials from consumer trends and preferences. These risks tend to beunmanageable because it’shard for a company to predict the ever-changing tastes and newest diets of their customers. It is difficult but not unmanageable. There are ways to stay in touch with the customer base: focus groups, being engaged with social media, staying involved with the local communities where stores operate and, of course, keeping up with sales analysis and reacting appropriately. Dunkin’ Donuts and Krispy Kreme try to mitigate these risks by offering a wide variety of products, such as low calorie drinks and gluten free items. Also, they both offer different products to reflect the regional preferences of customers.

Another major risk factor that impacts the success of both companies is brand positioning and competition from others in the industry. A significant risk for Dunkin’ Donuts and Krispy Kreme is publicity concerning food quality, which can result in customers avoiding their products. It is extremely important for both companies to maintain consumer confidencein their products and store operations. One negative experience from a customer related to the health and safety of their store or food will make business results fall dramatically. These risks can be mitigated by having strict rules for employees and franchisees to follow regarding customer service, food safety issues, and quality management.

The most significant risk for Dunkin’ Donuts is the loss of one of their major wholesale customers. Their top two wholesale customer accounted for 16% of total Company Stores segment revenues during fiscal 2015 (Dunkin’ Brands Group Inc.). The loss of one of these customers to a competitor could adversely affect their financial condition and results of operations. This risk could be mitigated by merging with Dunkin’ Donuts (you mean to merge with Krispy Kreme) to eliminate competition, by acquiring new wholesale customers, and by making wholesale customers sign long-term contracts. This is a huge risk. In fact, all publicly traded companies are required to include in their 10-k a list of customers who contribute 10% or more toward total revenues. Signing long-term contracts must include a penalty for early termination, and even then it's not guaranteed if the company is insolvent. It's surprising to me that 16% of DD revenue is from two wholesale customers.

Organizational and cultural risks are the risks associated with how employees and management will react to the acquisition of Krispy Kreme by Dunkin’ Donuts. The acquisition can have a negative impact on future revenues, as well as the culture and morale within the organization.These risks can be mitigated by identifying employee expectations and key personnel to reduce disappointed staff members, and to make sure vital knowledge is not lost during the acquisition. True. Communication is key but it's hard to effectively communicate when secrecy is sometimes paramount. Employees tend to panic and jump ship at the mere talk of major change. One of my previous employers was acquired and we lost many good people. The rest of us worked a ridiculous number of hours to do all that work. At that point our company had no choice but to offer retention bonuses to incent people to stay until the end. The acquiring company also sent offer letters to those of us being offered positions. Other organizational risks that will significantly impact the acquisition comes from the differences in mission statements and business strategy between the two businesses. Identifying the strengths and weaknesses of both companies will help to mitigate this risk. Also, developing a strategy to incorporate both companies’ objectives and by incorporating both mission statements into one will help for a smooth transition. All in all, the key to reducing organizational and cultural risk in this potential acquisition is to identify and acknowledge the greatest resources and major differences between the two companies, and by coming to an agreement on important business issues.

Some of the risk factors that fall under the category of political risks are issues related to governmental stability, corruption, socioeconomic conditions, and internal and external conflicts.The political atmosphere changes over time due to changes in governmental powers. Companies need to be aware of the different cultural and religious beliefs that they will be serving. Both Krispy Kreme and Dunkin’ Donuts can mitigate this risk by carefully performing and reviewing a SWOT analysis, which will allow them to be very well versed in their market. Not knowing your market will be very detrimental to your company. Knowing your market and showing that you know it give the consumers a sense that you as the company care about their needs and wants. If the company wants to do business in foreign countries then there is a lot more political risk than those mentioned above.

Another political risk facing the market and both companies directly is the new statute law that ban commodities with high fat content throughout the entire province of CA (Canada is not a province; it's a country with several provinces) and United States. Krispy Kreme and Dunkin Donuts must eliminate high fats from all of its doughnuts within the next few years. This will be a very cost intensive process, and for it to be effective, it is necessary to ensure that the testing with the new recipes do not include high fats contents,and to retain the familiar texture, taste, and quality of Krispy Kreme and Dunkin’ Donuts signature products. (You did not include an in-paper citation so I did some checking of my own. The FDA is banned artificial trans fats but not natural trans fats. This is different than the statement "ban commodities with high fat content." The risk associated with this is the difference in cost associated with acquiring natural trans fat and any storage and manufacturing changes needed. Also, if natural trans fats spoil then transportation of the final products will be more expensive due to being more sensitive to delivery times.)

Operational risks are the risks that are directly attributable to business operations which has a potential impact on a company’s financial position and performance. We have broken down the major operational risks into two major categories:Legal/Environmental Risks, and Quality Management/Technology Risks.

There are several factors that impact both Krispy Kreme’s and Dunkin’ Donuts’ environmental and legal matters. Environmental rules have to be met by both companies in order to adhere to a variety of federal, local, and state laws and regulations. These regulations deal with health and sanitation laws, safety, fire, and building rules; as well as regulations from other agencies in multiple locations across the United States and internationally. These risks can be mitigated by having an agent that specializes in these areas in different locations across the globe. The responsibility of these agents would be to inform each store of the local, federal, state, and international laws and regulations they would need to be in compliance with. Also, having the agent check the stores for potential regulations they may be in violation of on a routinely basis will ensure that the stores are in compliance.

Not only do both companies need to adhere to federal, local, and state regulations, but also must be concerned with the laws that govern employment regulations. This is a big factor because it can really affect the company’s budget. The Senate in California has recently passed a new bill that will raise the minimum wage in 2 waves. The first raise will be at the beginning of 2016 from $9per hour to $11 per hour; then again in 2017 from $11 to $13 per hour. This could significantly impact the company’s stores in California. Currently Krispy Kreme has 28 stores in California that includes 15 factories, 11 hot shops, and 2 fresh shops. Recently the company has made agreements and is contractually obligated to open 28 more franchisees by the year 2021. The Dunkin Brands is not a stranger to some of the California laws, because they have a few Baskin Robins restaurants already operating there. Just recently Dunkin’ Donuts opened four traditional restaurants in California in 2014. In order to mitigate the risk of the upcoming wage increase, both companies should implement a plan that will be in line with the increases. Krispy Kreme and Dunkin’ Donuts may be forced to find new ways of cutting costs; as well as implementing a price increase for their products to make up for the wage hike. All true. And this becomes a big issue with all fast food stores because the wage increase isn't the only cost increase. When wages go up so do associated payroll taxes and workers comp premiums. Companies doing business in California will have no choice but to get creative in keeping labor costs low. Companies may purchase technology to replace order takers. They may use only part-time workers to avoid the cost of benefits. There is only so much room to increase the price of the product before customers cut the products from their own budgets. Another alternative is to reduce the serving size of the product, which affects perception of quality. This is where some companies brainstorm "premium" products, which are products that carry a certain status people are willing to pay for. That is a tall order in the fast food business.

Another environmental risk for both companies that have a significant impact on revenues is seasonality. During the summer months, Krispy Kreme’s coffee sales significantly decrease and iced beverages increase; although, there is a significant increase in sales during certain holidays. Dunkin’ Donuts hot coffee sales fall in the summer as well; although, they acquired Baskin Robbins years ago to create a steady line of income all year long. One way Krispy Kreme can mitigate this risk is to utilize Dunkin’s strategy of implementing a summer product in hopes to make up for lost coffee sales. Also, the timing of advertisement for potential new beverages should be an analyzed thoroughly. Then, marketing the products during the right time to ensure potential customers are exposed is the key to maximizing profits.

There are several significant factors associated with quality management and technology risks for both Krispy Kreme and Dunkin’ Donuts. These factors will directly impact the company’s products and operations, for example: the supplier quality because it has a direct influence over the firm’s finished product; the reliability of production techniques; and the dependence on each supplier related to the availability and price fluctuations of raw materials. Other significant risks that affects both companies is loss of technological knowledge through personnel leaving, patent rights, and the loss of secret recipes. Also, more risk factors are associated with the companies’ IT and support systems due to personal data being compromised, as well as knowledge being leaked to competitors.

One of the most significant risks for Krispy Kreme which directly affects the quality management, is thatthe company makes their own equipment. The custom made equipment is used for making the doughnuts they produce. The problem with producing their own equipment is that it can jeopardize potential new stores. In what specific way? This could also jeopardize the ability of producing maintenance parts to existing stores. In turn, Krispy Kreme will not be able to produce the demand of products needed. One way this risk can be mitigated is to obtain more back up resources that will produce the custom made equipment. Krispy Kreme can also sell patent rights of the equipment, if not already done,in order to hire more manufacturers to produce the products and equipment.

Another potential risk related to quality management is the fact the Krispy Kreme only has one supplier for their famous glaze flavor. You're right; this is a risk of epic proportions. One supplier for a major differentiating ingredient? Not smart. Not being able to produce the doughnuts due to interruption in supplies would impair the company tremendously, potentially losing them millions of dollars. It is extremely important for Krispy Kreme to have more than one supplier for the source of their product. Therefore, obtaining a backup supplier would ensure the company does not run into a bad situation and also mitigate this risk. Although, obtaining another supplier could create a problem within itself. The loss of the company’s trade secrets could damage the company forever. Coca Cola uses independent beverage manufacturers to make its products. Coke sends its own ingredients to those companies but those companies have the recipes of how to make the beverages. All those companies sign confidentiality agreements with severe penalties. Coke has kept its recipe secret for 130 years. Krispy Kreme using one maker of the glaze is also cutting itself short on price. If that one supplier knows they are the only supplier then they raise the price. The company was founded on their secret doughnut recipes; which is a competitive advantage that needs to be kept. Ensuring the integrity of the employees could protect the trade secret. Also, dividing the production of the recipe into sections could mitigate this risk by not allowing the whole recipe to be revealed.

Financial risks are the risks that could have a potential impact on the companies’ financial position and performance. We have broken down the major financial risks into three major categories: Liquidity Risks, Solvency Risks, and Profitability Risks.

Liquidity is a company’s ability to meet both expected and unexpected short-term obligations without drastically affecting daily operations or the financial condition of the company. Liquidity risk is associated with the company’s real or perceived inability to meet those short-term contractual obligations. When looking at Dunkin Donut’s current (liquidity) ratio over the last three fiscal years, their current assets compared to their current liabilities made a pretty drastic jump from 1.24 in 2012, to 1.34 in 2013; but then leveled off in 2014 ending the year at 1.24. This is a good indication that Dunkin’ Donut’s has the ability to meet contractual obligations in the coming year. By maintaining a ratio of 1.2, they have the flexibility to cover any contractual obligations without drastically affecting daily operations. Dunkin’ Donut’s could improve their liquidity by reducing the amount of current obligations on the books while increasing the amount of cash or other current assets.

Krispy Kreme has seen there liquidity drop slightly over the past three fiscal years. Their current ratio has dropped from 2.89 in 2012, to 2.75 in 2013; and then dropped again to 2.56 in 2014. Even though they are still maintaining 2.5 current asset to every current liability, if the decrease continues, it will indicate that they are moving in the wrong direction by taking on an increasing amount of debt, or by not effectively utilizing there revolving credit, or using it too much.The acquisition of Krispy Kreme would be beneficial from a liquidity perspective because it will add a more liquid subsidiary to the mix. Dunkin’ Donut’s would be able to improve their liquidity and have some additional flexibility.

*Number taken from SEC.gov directly from the 10K of Krispy Kreme and Dunkin’ Donut’s

Solvency is a company’s ability to meet is long-term obligations and sustain operations. Dunkin’ Donuts is a pretty solvent company because it has a less than one ratio for total liabilities to total assets, as well as total debt to total liabilities. This indicates they will be able to meet future long-term obligations. Dunkin’ Donuts looks to finance with debt over equity, as they have a more that six to one ratio of debt to equity. What do you think about this debt level? What is the industry average and how does DD stack up? When you take a look at how DD would finance an acquisition of KK, make sure you address what would happen to the debt to equity ratio. Another good indicator for Dunkin’ Donut’s is that they are more than able to cover the interest that is calculated on their long-term obligations. When looking at the interest coverage ratio, they have been increasingly growing their earnings before interest and taxes when compared to the amount of interest expense they pay on an annual basis.

Krispy Kreme looks to be a little more solvent than Dunkin’ Donut’s. They have a lower debt to equity ratio, which indicates they are using more equity to finance than debt. Also, Krispy Kreme’s interest coverage ratio is much higher; which means that Krispy Kreme’s EBIT is more than sufficient to cover the amount of interest they pay on the debt obligations. The acquisition of Krispy Kreme would improve both the liquidity and solvency of Dunkin’ Donut’s.

*Number taken from SEC.gov directly from the 10K of Krispy Kreme and Dunkin’ Donut’s

Profitability is very important when looking at a company from an investor’s perspective. Companies want to be profitable to stay in business, but to also provide incentive for investors to invest in their company. In regards to Dunkin’ Donut’s profitability, they are doing well with respect to their operating profit margin, as well as the net profit margin. The operating profit margin shows how well Dunkin’ Donut’s net income to operations is compared to sales. This gives the investor insight as to how well Dunkin’ Donut’s is operating their core business. The net profit margin give a good indication as to how well Dunkin’ Donut’s is doing mitigating expenses that are not associated with their core business.

Krispy Kreme looks to be moving in the right direction in terms of profitability, even though they have had some significant jumps in their profitability ratios. Their operating profit margin has had significant jump from 8.66% in 2012, to 10.12% in 2013; but then leveled off at 9.84% in 2015. This is a good indication that they are improving their income from operations. Likewise, the net profit margin followed a similar trend moving from 4.77% in 2012, to 7.44% in 2013; then leveling off in 2014 at 6.13%. This fluctuation is due to some drastic drops in interest expense that the company had to pay over the last three fiscal years. This is another good indication they are reducing the amount of debt obligations, which will only help improve the profitability of Krispy Kreme.

*Number taken from SEC.gov directly from the 10K of Krispy Kreme and Dunkin’ Donut’s