FORM 10-Q

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

(Mark one)


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

For the quarterly period ended October 29, 2006


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

For the transition period from to

Commission file number 001-16485

KRISPY KREME DOUGHNUTS, INC.

(Exact name of registrant as specified in its charter)


North Carolina		56-2169715
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

370 Knollwood Street,
Winston-Salem, North Carolina		27103
(Address of principal executive offices)		(Zip Code)

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

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes o No þ

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

Large accelerated filer o Accelerated filer þ Non-accelerated filer o

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

Number of shares of Common Stock, no par value, outstanding as of December 31, 2006: 62,672,994.

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 2007 and fiscal 2006 mean the fiscal years ended January 28, 2007 and January 29, 2006, respectively.

FORWARD-LOOKING STATEMENTS

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

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

	•		the resolution of shareholder derivative and class action litigation;

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

	•		material weaknesses in our internal control over financial reporting;

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

	•		continuing negative publicity;

	•		significant changes in our management;

	•		the quality of franchise store operations;

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

	•		disputes with our franchisees;

	•		our ability to implement our international growth strategy;

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

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

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

	•		our relationships with wholesale customers;

	•		our ability to protect our trademarks;

	•		risks associated with our high levels of indebtedness;

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

	•		our ability to meet our ongoing liquidity needs;

	•		changes in customer preferences and perceptions;

	•		risks associated with competition; and

	•		other factors in Krispy Kreme’s periodic reports and other information filed with the Securities and Exchange Commission, including under Item 1A, “Risk Factors,” in the Company’s Annual Report on Form 10-K for the fiscal year ended January 29, 2006 (the “2006 Form 10-K”).

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

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

KRISPY KREME DOUGHNUTS, INC.

CONSOLIDATED BALANCE SHEET
(Unaudited)


	October 29,			January 29,
	2006			2006
	(In thousands)
ASSETS
CURRENT ASSETS:
Cash and cash equivalents	$	35,800		$	16,980
Receivables		32,424			26,677
Accounts and notes receivable — equity method franchisees		2,023			12,151
Inventories		21,401			23,761
Insurance recoveries receivable		39,717			34,967
Deferred income taxes		848			848
Other current assets		16,743			31,641

Total current assets		148,956			147,025
Property and equipment		179,577			205,579
Non-current portion of notes receivable — equity method franchisees		—			42
Investments in and advances to equity method franchisees		4,273			8,601
Goodwill and other intangible assets		30,021			30,291
Other assets		15,203			19,317

Total assets	$	378,030		$	410,855


LIABILITIES AND SHAREHOLDERS’ EQUITY
CURRENT LIABILITIES:
Short-term borrowings	$	649		$	54
Current maturities of long-term debt		2,368			4,432
Book overdraft		—			60
Accounts payable		11,787			8,897
Accrued litigation settlements		75,550			70,800
Other accrued liabilities		42,600			69,676

Total current liabilities		132,954			153,919
Long-term debt, less current maturities		115,757			118,241
Deferred income taxes		848			848
Other long-term obligations		26,462			29,176

Commitments and contingencies

SHAREHOLDERS’ EQUITY:
Preferred stock, no par value		—			—
Common stock, no par value		309,268			298,255
Accumulated other comprehensive income		1,571			1,426
Accumulated deficit		(208,830	)		(191,010	)

Total shareholders’ equity		102,009			108,671

Total liabilities and shareholders’ equity	$	378,030		$	410,855

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

KRISPY KREME DOUGHNUTS, INC.

CONSOLIDATED STATEMENT OF OPERATIONS
(Unaudited)


	Three Months Ended						Nine Months Ended
	October 29,			October 30,			October 29,			October 30,
	2006			2005			2006			2005
	(In thousands, except per share amounts)
Revenues	$	117,107		$	128,818		$	349,007		$	421,115
Operating expenses:
Direct operating expenses (exclusive of depreciation and amortization shown below)		96,192			115,995			290,325			365,742
General and administrative expenses		12,457			15,206			41,218			50,667
Depreciation and amortization expense		5,177			6,915			16,114			22,400
Impairment charges and lease termination costs		5,423			15,695			6,560			29,718
Settlement of litigation		—			—			—			35,833

Operating (loss)		(2,142	)		(24,993	)		(5,210	)		(83,245	)
Interest income		460			211			1,168			811
Interest expense		(5,196	)		(4,681	)		(15,365	)		(15,225	)
Equity in (losses) of equity method franchisees		(65	)		(488	)		(924	)		(3,759	)
Minority interests in results of consolidated franchisees		—			563			—			1,485
Other income (expense), net		173			(39	)		3,292			754

(Loss) before income taxes		(6,770	)		(29,427	)		(17,039	)		(99,179	)
Provision for income taxes (benefit)		431			308			781			(1,146	)

Net (loss)	$	(7,201	)	$	(29,735	)	$	(17,820	)	$	(98,033	)


(Loss) per common share:
Basic	$	(.12	)	$	(.48	)	$	(.29	)	$	(1.59	)


Diluted	$	(.12	)	$	(.48	)	$	(.29	)	$	(1.59	)

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

KRISPY KREME DOUGHNUTS, INC.

CONSOLIDATED STATEMENT OF CASH FLOWS
(Unaudited)


	Nine Months Ended
	October 29,			October 30,
	2006			2005
	(In thousands)
CASH FLOW FROM OPERATING ACTIVITIES:
Net (loss)	$	(17,820	)	$	(98,033	)
Adjustments to reconcile net loss to net cash provided by operating activities:
Depreciation and amortization		16,114			22,400
Deferred income taxes		(95	)		(2,003	)
Impairment charges		5,243			28,453
Settlement of litigation		—			35,833
Deferred rent expense		775			952
(Gain) on disposal of property and equipment		(44	)		(1,036	)
(Gain) on sale of interests in equity method franchisees		(3,580	)		—
Share-based compensation		8,175			5,816
Provision for doubtful accounts		1,335			5,625
Amortization of deferred financing costs		2,074			1,989
Minority interests in results of consolidated franchisees		—			(1,485	)
Equity in losses of equity method franchisees		924			3,759
Cash distributions from equity method franchisees		—			453
Other		317			270
Change in assets and liabilities:
Receivables		(4,330	)		(4,668	)
Inventories		2,174			2,806
Other current and non-current assets		3,916			(1,869	)
Accounts payable and accrued liabilities		(369	)		7,268
Other long-term obligations		1,592			2,750

Net cash provided by operating activities		16,401			9,280

CASH FLOW FROM INVESTING ACTIVITIES:
Purchase of property and equipment		(2,839	)		(8,989	)
Proceeds from disposals of property and equipment		6,219			4,570
Investments in and advances to franchise investee		(1,100	)		(10,388	)
Recovery of investments in and advances to franchise investee		2,500			—
Sale of interests in equity method franchisees		5,982			—
Acquisition of stores from franchisee		(2,900	)		—
Increase in other assets		(3	)		(1,077	)

Net cash provided by (used for) investing activities		7,859			(15,884	)

CASH FLOW FROM FINANCING ACTIVITIES:
Issuance of short-term debt		2,984			2,274
Repayment of short-term debt		(2,389	)		(1,130	)
Issuance of long-term debt		—			120,000
Repayment of long-term debt		(4,589	)		(97,237	)
Net borrowings (repayments) under revolving credit lines		—			(1,606	)
Deferred financing costs		—			(8,761	)
Proceeds from exercise of stock options		—			154
Net change in book overdraft		(60	)		(8,480	)
Cash received from minority interests		—			2,620

Net cash provided by (used for) financing activities		(4,054	)		7,834

Effect of exchange rate changes on cash		27			(11	)

Cash balances of subsidiaries at date of deconsolidation		(1,413	)		(1,011	)

Net increase in cash and cash equivalents		18,820			208
Cash and cash equivalents at beginning of period		16,980			27,686

Cash and cash equivalents at end of period	$	35,800		$	27,894

Supplemental schedule of non-cash investing and financing activities:
Assets acquired under capital leases	$	41		$	—

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

KRISPY KREME DOUGHNUTS, INC.

CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS’ EQUITY
(Unaudited)


													Accumulated
													other
	Common			Common			Unearned			Notes			comprehensive			Accumulated
	shares			stock			compensation			receivable			income			deficit			Total
	(In thousands)
BALANCE AT JANUARY 29, 2006		61,841		$	298,255		$	—		$	—		$	1,426		$	(191,010	)	$	108,671
Comprehensive income (loss):
Net (loss) for the nine months ended October 29, 2006																	(17,820	)		(17,820	)
Foreign currency translation adjustment, net of income taxes of $79														120						120
Unrealized gain from cash flow hedge, net of income taxes of $16														25						25

Total comprehensive (loss)																				(17,675	)
Issuance of common stock warrant					6,700															6,700
Other share-based compensation (Note 1)					4,313															4,313
Cancellation of restricted shares		(2	)

BALANCE AT OCTOBER 29, 2006		61,839		$	309,268		$	—		$	—		$	1,571		$	(208,830	)	$	102,009


BALANCE AT JANUARY 30, 2005		61,756		$	295,611		$	(17	)	$	(197	)	$	796		$	(55,250	)	$	240,943
Comprehensive income (loss):
Net (loss) for the nine months ended October 30, 2005																	(98,033	)		(98,033	)
Foreign currency translation adjustment, net of income tax benefit of $105														(88	)					(88	)
Unrealized gain from cash flow hedge, net of income taxes of $582														931						931

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

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

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

KRISPY KREME DOUGHNUTS, INC.

NOTES TO FINANCIAL STATEMENTS
(Unaudited)

Note 1 — Overview

Significant Accounting Policies

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

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

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

The Company consolidates the financial statements of all entities in which the Company has a controlling financial interest, as required by Accounting Research Bulletin No. 51, “Consolidated Financial Statements,” and Statement of Financial Accounting Standards No. 94, “Consolidation of All Majority-Owned Subsidiaries.” In addition, the Company consolidates the financial statements of variable interest entities (“VIEs”) with respect to which the Company’s variable interests absorb a majority of the VIE’s expected losses and expected residual returns, in accordance with FASB Interpretation No. 46 (Revised), “Consolidation of Variable Interest Entities” (“FIN 46(R)”).

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

The Company began consolidating the financial statements of KremeKo, Inc. (“KremeKo”) and New England Dough, LLC (“New England Dough”) upon the Company’s adoption of FIN 46(R) on May 2, 2004. Prior to that date, the Company accounted for its investments in these entities using the equity method. New England Dough and KremeKo, together with Glazed Investments, LLC (“Glazed Investments”) and Freedom Rings, LLC (“Freedom Rings”), are hereinafter sometimes referred to as “Consolidated Franchisees.” The Company ceased consolidating the financial statements of KremeKo, Freedom Rings and Glazed Investments in May 2005, October 2005 and February 2006, respectively, after these entities filed for bankruptcy, as described below and in Note 9.

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

the business on December 19, 2005 using the equity method, in accordance with Accounting Principles Board Opinion No. 18, “The Equity Method of Accounting for Investments in Common Stock.”

Subsequent to their bankruptcy filings, the Company accounted for its investments in Freedom Rings and Glazed Investments using the cost method.

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

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


	Three Months Ended						Nine Months Ended
	October 29,			October 30,			October 29,			October 30,
	2006			2005			2006			2005
	(In thousands)
Numerator: net (loss)	$	(7,201	)	$	(29,735	)	$	(17,820	)	$	(98,033	)

Denominator:
Basic earnings per share — weighted average shares outstanding		61,839			61,825			61,839			61,796
Diluted earnings per share — weighted average shares outstanding		61,839			61,825			61,839			61,796

All potentially dilutive securities have been excluded from the number of shares used in the computation of diluted earnings per share for the three months and nine months ended October 29, 2006 and October 30, 2005 because the Company incurred a net loss for these periods and their inclusion would be antidilutive.

SHARE-BASED COMPENSATION. Effective January 30, 2006 (the first day of fiscal 2007), the Company adopted Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment” (“FAS 123(R)”), which requires the measurement and recognition of compensation expense for share-based payment (“SBP”) awards, including stock options. Such adoption included consideration of the provisions of Staff Accounting Bulletin No. 107, which contains the views of the staff of the Securities and Exchange Commission (the “Commission”) relating to adoption of FAS 123(R). Prior to fiscal 2007, the Company accounted for SBP awards using the intrinsic value method prescribed by Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”).

The Company adopted FAS 123(R) using the modified prospective method of adoption and, accordingly, financial statements for prior periods have not been restated to reflect the fair value method of recognizing compensation cost relating to stock options. Under the modified prospective method of adoption, the portion of the aggregate fair value of stock options which were unvested at the end of fiscal 2006 that is attributable to employee service after fiscal 2006 will be charged to earnings over the remaining service period associated with the options. In addition, the Company will recognize compensation expense for stock option awards granted in fiscal 2007 and thereafter. The Company previously recognized compensation expense for grants of restricted stock based upon the fair value of the shares awarded, and this practice will continue after adoption of FAS 123(R). The fair value of each of the Company’s SBP awards is charged to expense on a straight-line basis over the vesting period of the awards, which generally ranges from three to four years.

Information about outstanding stock options as of January 29, 2006 is set forth in the table below. These options generally have contractual terms of 10 years, the maximum term permitted under the plans pursuant to which the options were awarded.


					Weighted
	Shares		Weighted		Average
	Subject		Average		Remaining		Aggregate
	to		Exercise		Contractual		Intrinsic
	Option		Price		Term		Value
							(In thousands)
Total outstanding		6,078,400	$	16.58		4.6	$	9,925
Vested and exercisable		5,299,300		15.15		4.2		9,925
Non-vested		779,100		26.29		7.6		—

As of January 29, 2006, the total unrecognized compensation cost related to SBP awards (all of which relates to unvested stock options) was approximately $7.9 million. The remaining service periods over which compensation cost will be recognized for these awards range from approximately three months to three years, with a weighted average service period of approximately one year.

During the first nine months of fiscal 2007, the Company recognized compensation expense for all SBP awards granted after January 29, 2006 (which consist of common stock and options to acquire common stock) based on the fair value of the awards at the grant date. Adoption of FAS 123(R) had the effect of increasing compensation expense for the three months and nine months ended October 29, 2006 by approximately $1.1 million and $3.9 million, respectively. Because the Company recorded no income tax benefit with respect to its operating losses for these periods, the after tax effect of the accounting change also was approximately $1.1 million, or $.02 per share, and $3.9 million, or $.06 per share, for the three months and nine months ended October 29, 2006, respectively. This additional expense includes not only a portion of the fair value of stock options granted during the first nine months of fiscal 2007, but also a portion of the fair value of stock options granted in prior years. In addition to the compensation cost recognized as a result of adoption of FAS 123(R), compensation expense for the first nine months of fiscal 2007 includes approximately $400,000 of compensation cost related to restricted stock awards which also would have been recognized under APB 25. The Company did not realize any excess tax benefits from the exercise of options during the first nine months of fiscal 2007.

The fair value of options for 500,000 common shares granted during the first nine months of fiscal 2007 was estimated at $3.88 per option, computed using the Black-Scholes option-pricing model (which the Company intends to use to value stock options having only service conditions) with the following assumptions: volatility of 55%; expected term of 7 years; a risk free rate of return of 4.77%; and a dividend yield of zero. These options, as well as a companion grant of 300,000 shares of common stock, vest in installments over three years.

Expected volatility is based on a combination of the historical and implied volatility of the Company’s common shares and the shares of a group of peer companies. The risk-free rate of interest is based on the yield of a zero-coupon U.S. Treasury bond on the date the award is granted with a maturity equal to the expected term of the award. The expected life of stock option awards is estimated by reference to historical experience, published data and any relevant characteristics of the option, and represents the period of time that awards are expected to be outstanding. The Company uses historical data to estimate forfeitures of awards prior to vesting.

Had compensation cost for the Company’s stock option plans for the three months and nine months ended October 30, 2005 been determined based on the estimated fair value of the awards at their grant dates in accordance with the provisions of Statement of Financial Accounting Standards No. 123, “Stock-Based Compensation,” rather than using the intrinsic value method of APB 25, the Company’s earnings would have been affected as set forth in the table below:


	Three Months			Nine Months
	Ended			Ended
	October 30,			October 30,
	2005			2005
	(In thousands, except per share
	amounts)
Net (loss), as reported	$	(29,735	)	$	(98,033	)
Add: Stock-based compensation expense charged (credited) to earnings		(315	)		5,816
Deduct: Stock-based compensation expense determined under fair value method for all awards		(2,729	)		(14,286	)

Pro forma net (loss)	$	(32,779	)	$	(106,503	)

(Loss) per share:
Reported (loss) per share — basic	$	(0.48	)	$	(1.59	)
Pro forma (loss) per share — basic	$	(0.53	)	$	(1.72	)
Reported (loss) per share — diluted	$	(0.48	)	$	(1.59	)
Pro forma (loss) per share — diluted	$	(0.53	)	$	(1.72	)

The only incentive compensation plan pursuant to which SBP grants currently may be awarded is the Company’s 2000 Stock Incentive Plan (the “2000 Plan”), under which incentive stock options, nonqualified stock options, stock appreciation rights, performance units, restricted stock (or units) and common shares may be awarded. The maximum number of shares of common stock

with respect to which awards may be granted under the 2000 Plan is 9,996,000, of which 6,062,600 remained available for grant after fiscal 2006.

Share-based compensation for the nine months ended October 29, 2006 and the three months and nine months ended October 30, 2005 includes approximately $3.9 million, ($315,000) and $1.8 million, respectively, representing a portion of the estimated fair value of a warrant to purchase 1.2 million shares of the Company’s common stock at a price of $7.75 per share issued during the quarter ended May 1, 2005 to Kroll Zolfo Cooper LLC (“KZC”), a corporate recovery and advisory firm engaged by the Company to perform interim management services. The warrant expires on January 31, 2013. The cost of the warrant was charged to earnings during the period from January 18, 2005, the date on which the advisory firm was engaged, to April 6, 2006, the date on which the warrant became exercisable and non-forfeitable. The substantial charge to earnings related to the warrant for the nine months ended October 29, 2006 reflects an increase in its estimated fair value as of April 6, 2006, the date on which the value of the warrant was fixed for accounting purposes, compared to its estimated fair value at January 29, 2006. The credit to earnings related to the warrant for the three months ended October 30, 2005 reflects a decrease in the estimated aggregate fair value of the warrant at that date compared to July 31, 2005. The aggregate $6.7 million estimated fair value of the warrant as of April 6, 2006 was reclassified from accrued liabilities to common stock as of that date. The fair value of the warrant was estimated using the Black-Scholes option-pricing model with the following assumptions: volatility of 55%; expected term of 6.8 years; a risk free rate of return of 4.91%; and a dividend yield of zero.

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

In performing such procedures, the Company identified certain grants of stock options with respect to which the Company was unable to substantiate that the grant date specified in the options was the appropriate date on which compensation cost should have been measured under APB 25. Each of the stock options was dated August 2, 2000 and had an exercise price equal to the closing price of the Company’s common stock on that date. The closing price on August 2, 2000 was the lowest closing price of the Company’s common stock during the fiscal quarter. Because the Company was unable to substantiate August 2, 2000 as the measurement date, the Company considered all available relevant information and concluded that it should use September 12, 2000, the approximate date on which the optionees were informed of the principal terms of the grants, as the measurement date.

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

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

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

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

Recent Accounting Pronouncements

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

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

In November 2004, the FASB issued Statement No. 151, “Inventory Costs” (“FAS 151”), which amends the guidance in Accounting Research Bulletin No. 43, “Inventory Pricing,” to clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs and wasted material (spoilage). FAS 151 requires that those items be recognized as current period charges and that the allocation of fixed production overheads to the cost of converting work in process to finished goods be based on the normal capacity of the production facilities. The Company adopted FAS 151 in fiscal 2007, but adoption had no material effect on the Company’s consolidated financial statements.

In May 2005, the FASB issued Statement No. 154, “Accounting Changes and Error Corrections” (“FAS 154”) to replace Accounting Principles Board Opinion No. 20, “Accounting Changes” and FAS 3, “Reporting Accounting Changes in Interim Periods.” FAS 154 provides guidance on the accounting for and reporting of accounting changes and error corrections, and establishes retrospective application as the required method for reporting a change in accounting principle. FAS 154 provides guidance for determining whether retrospective application of a change in accounting principle is impracticable, and for reporting a change when retrospective application is determined to be impracticable. FAS 154 also addresses the reporting of a correction of an error by restating previously issued financial statements. The Company adopted FAS 154 in fiscal 2007, but adoption had no effect on the Company’s consolidated financial statements.

Note 2 — Business Conditions, Uncertainties and Liquidity

The Company incurred a net loss of $198.3 million in fiscal 2005 and $135.8 million in fiscal 2006. These losses reflect impairment and lease termination costs of $197.0 million in fiscal 2005 and $55.1 million in fiscal 2006. Fiscal 2006 results also reflect a non-cash charge of $35.8 million for the anticipated settlement of certain litigation as described in Note 6. Cash provided by operating activities declined from $84.9 million in fiscal 2005 to $1.9 million in fiscal 2006.

Beginning in fiscal 2005, the Company experienced initially a slowing in the rate of growth in sales in its Company Stores segment, followed by declines in sales compared to the prior periods. The Company’s Franchise and KKM&D segments experienced revenue trends similar to those experienced in the Company Stores segment. These sales declines continued in the first nine months of fiscal 2007, during which the Company’s revenues declined to $349.0 million from $421.1 million in the first nine months of fiscal 2006, reflecting, among other things, lower revenues at KKM&D and the effects of store closures. While total revenues declined in the first nine months of fiscal 2007, average weekly sales per Company store increased compared to the first nine months of fiscal 2006.

Investigations of the Company have been initiated by the Commission and the United States Attorney for the Southern District of New York, and other litigation and investigations are pending as described in Note 6. In October 2004, the Company’s Board of Directors elected two new independent directors and appointed them the members of a Special Committee to investigate the matters raised by the Commission, the allegations in certain litigation, issues raised by the Company’s independent auditors and other matters relevant to the foregoing. The Special Committee issued its report in August 2005.

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

Since January 2005, the Company has undertaken a number of initiatives designed to improve the Company’s operating results and financial position. Such initiatives include closing a substantial number of underperforming stores, reducing corporate overhead and other costs to bring them more in line with the Company’s current level of operations, recruiting new management personnel for certain positions, obtaining the Secured Credit Facilities described in Note 5, restructuring certain financial arrangements associated with franchisees in which the Company has an ownership interest and with respect to which the Company has financial guarantee obligations, and selling certain non-strategic assets. In March 2006, the Company appointed a new chief executive officer having over 20 years experience in the food industry and with particular experience in consumer packaged goods.

While the Company believes that these actions have enhanced the likelihood that the Company will be able to improve its business, the Company remains subject to a number of risks, many of which are not within the control of the Company. Among the more significant of those risks are pending litigation and governmental investigations, the outcome of which cannot be predicted, the costs of defending such pending litigation and cooperating with such investigations, and the magnitude of indemnification expenses which the Company will incur under indemnification provisions of North Carolina law, the Company’s bylaws and certain indemnification agreements. The Company has reached a proposed settlement with respect to the federal securities class action and a proposed partial settlement with respect to the shareholder derivative actions. However, these settlements are subject to the approval of the relevant courts. Any of these risks could cause the Company’s operations to fail to improve or to continue to erode.

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

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

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

In the event that credit under the Secured Credit Facilities were not available to the Company, there can be no assurance that alternative sources of credit will be available to the Company or, if they are available, under what terms or at what cost. The Company currently is planning a potential refinancing of the Secured Credit Facilities in order to reduce the Company’s financing costs, but there can be no assurance that any refinancing will be accomplished. Until such time as the Company is current in filing with the Commission all periodic reports required to be filed by the Company under the Securities Exchange Act of 1934 (the “Exchange Act”), the Company will not be able to obtain capital by issuing any security whose registration would be required under the Securities Act of 1933. The Company has not filed its Quarterly Report on Form 10-Q for the third quarter of fiscal 2005, but expects to file such report by January 31, 2007.

Note 3 — Receivables

The components of receivables are as follows:


	Oct. 29,			Jan. 29,
	2006			2006
	(In thousands)
Trade receivables:
Wholesale doughnut customers	$	15,782		$	17,667
Unaffiliated franchisees		19,806			21,515
Current portion of notes receivable		812			1,151
Less — allowance for doubtful accounts		(3,976	)		(13,656	)

	$	32,424		$	26,677


Receivables from Equity Method Franchisees:
Trade	$	6,675		$	10,664
Current portion of notes receivable		24			4,647
Less — allowance for doubtful accounts		(4,676	)		(3,160	)

	$	2,023		$	12,151


Non-current portion of notes receivable	$	—		$	42

Note 4 — Inventories

The components of inventories are as follows:


	Oct. 29,		Jan. 29,
	2006		2006
	(In thousands)
Raw materials	$	6,892	$	7,009
Work in progress		25		18
Finished goods		5,048		4,717
Purchased merchandise		9,266		11,853
Manufacturing supplies		170		164

	$	21,401	$	23,761

Note 5 — Long Term Debt

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


	Oct. 29,			Jan. 29,
	2006			2006
	(In thousands)
Secured Credit Facilities	$	116,957		$	119,400
Capital lease obligations		1,168			3,273

		118,125			122,673
Less: current maturities		(2,368	)		(4,432	)

	$	115,757		$	118,241

Secured Credit Facilities

On April 1, 2005, the Company closed new secured credit facilities totaling $225 million (collectively, the “Secured Credit Facilities”). The description of the Secured Credit Facilities contained herein reflects post-closing amendments, the most recent of which was effective October 30, 2006. KKDC is the borrower under the Secured Credit Facilities, and KKDI and certain of its domestic subsidiaries are guarantors. The facilities consist of a $75 million revolving credit facility maturing April 1, 2008, secured by a first lien on substantially all of the assets of KKDC and the guarantors (the “First Lien Revolver”), and a $150 million credit facility maturing April 1, 2010, secured by a second lien on those assets (the “Second Lien Facility”). Effective November 27, 2006, the Company elected to reduce the commitments under the First Lien Revolver (the “First Lien Commitments”) from $75 million to $25 million. The Second Lien Facility consists of a $120 million term loan (the “Term Loan”) and a $30 million revolving credit facility (the “Second Lien Revolver”). At closing, the Company borrowed the full $120 million available under the Term Loan, and used the proceeds to retire approximately $88 million of indebtedness outstanding under a bank credit facility (which was then

terminated) and to pay fees and expenses associated with the Secured Credit Facilities. The balance of the term loan proceeds were retained for general corporate purposes.

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

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

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

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

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

As required by the Secured Credit Facilities, the Company has entered into an interest rate derivative contract having a notional principal amount of $75 million. The derivative contract eliminates the Company’s exposure, with respect to such notional amount, to increases in three month LIBOR beyond 4.0% through April 2006, 4.5% from May 2006 through April 2007 and 5.0% from May 2007 through March 2008. This derivative has been accounted for as a cash flow hedge from its inception in fiscal 2006.

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

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

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

The Secured Credit Facilities are required to be repaid with the net proceeds of certain equity issuances, debt incurrences, asset sales and casualty events. Pursuant to these requirements, the Company prepaid $1.5 million of the Term Loan in the third quarter of fiscal 2007 and repaid an additional $8.9 million of the Term Loan subsequent to quarter end. In addition, the First Lien Revolver is required to be repaid on a daily basis to the extent the Company’s Net Liquidity (as defined in the First Lien Revolver) is below $20 million. Mandatory repayments under the First Lien Revolver do not reduce commitments under the First Lien Revolver. Net proceeds are generally required to be first applied to repay amounts outstanding under the First Lien Revolver and then (without giving effect to the amount repaid under the First Lien Revolver) to be offered to the holders of the Term Loan. To the extent application of these mandatory prepayment provisions results in prepayment of amounts outstanding under the Term Loan, such prepaid amounts cannot be reborrowed, and any such prepayments are not subject to the prepayment fees described in the following paragraph.

The Company may permanently reduce the commitments under both the First Lien Revolver and the Second Lien Revolver. With respect to the Second Lien Revolver, the Company must pay a fee of 3% of the amount of any such reduction which occurs on or before August 1, 2007; such fee declines to 2% on August 2, 2007, to 1% on August 2, 2008 and to zero on August 2, 2009. Effective November 27, 2006, the Company reduced the commitments under the First Lien Revolver to $25 million; the Company has not reduced the commitments under the Second Lien Revolver. The Company may prepay the Term Loan on or after August 1, 2006; prepayment fees equal to the commitment termination fees for the Second Lien Revolver apply to any such Term Loan prepayments.

The Secured Credit Facilities require the Company to meet certain financial tests, including a maximum leverage ratio (expressed as a multiple of Consolidated EBITDA) and a minimum interest coverage ratio (expressed as a ratio of Consolidated EBITDA to net interest expense), computed based upon Consolidated EBITDA and net interest expense for the most recent four fiscal quarters. As of October 29, 2006, these tests were set at 4.8 to 1.0, in the case of the maximum leverage ratio, and 2.05 to 1.0, in the case of the minimum interest coverage ratio. As of October 29, 2006, the Company’s leverage ratio was approximately 4.0 to 1.0 and the Company’s interest coverage ratio was approximately 2.5 to 1.0. After giving effect to the October 30, 2006 amendments to the Secured Credit Facilities, the maximum leverage ratio for years after fiscal 2006 ranges from 5.4 to 1.0 to 3.7 to 1.0, and the minimum interest coverage ratio ranges from 2.05 to 1.0 to 3.4 to 1.0. In addition, the Secured Credit Facilities contain other covenants which, among other things, limit the incurrence of additional indebtedness (including guarantees), liens, investments (including investments in and advances to franchisees which own and operate Krispy Kreme stores), dividends, transactions with affiliates, asset sales, acquisitions, capital expenditures, mergers and consolidations, prepayments of other indebtedness and other matters customarily restricted in such agreements. The Secured Credit Facilities also prohibit the transfer of cash or other assets to KKDI from its subsidiaries, whether by dividend, loan or otherwise, but provide for exceptions to enable KKDI to pay taxes and operating expenses and certain judgment and settlement costs.

As of October 29, 2006, the maximum additional borrowings available to the Company under the Secured Credit Facilities were approximately $32 million. Such amount reflects the effects of application of the restrictive financial covenants described in the preceding paragraph.

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

Note 6 — Commitments and Contingencies

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

Litigation and Investigations Settled or Pending Settlement

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

On May 12, 2004, a purported securities class action was filed on behalf of persons who purchased the Company’s publicly traded securities between August 21, 2003 and May 7, 2004 against the Company and certain of its current and former officers in the United States District Court for the Middle District of North Carolina. Plaintiff alleged that defendants violated Sections 10(b) and 20(a) of

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

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

The defendants in one or more of these actions include all current and certain former directors of the Company (other than members of the Special Committee and two other directors first elected to the Board in 2006), certain current and former officers of the Company, including Scott Livengood (the Company’s former Chairman and Chief Executive Officer), John Tate (the Company’s former Chief Operating Officer) and Randy Casstevens (the Company’s former Chief Financial Officer), and certain persons or entities that sold franchises to the Company. The complaints in these actions allege that the defendants breached their fiduciary duties in connection with their management of the Company and the Company’s acquisitions of certain franchises. The complaints sought damages, rescission of the franchise acquisitions, disgorgement of the proceeds from these acquisitions and other unspecified relief.

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

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

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

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

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

With respect to the securities class action, the Stipulation provides for the certification of a class consisting of all persons who purchased the Company’s publicly-traded securities between March 8, 2001 and April 18, 2005, inclusive. The settlement class will receive total consideration of approximately $75 million, consisting of a cash payment of $34,967,000 to be made by the Company’s directors’ and officers’ insurers, a cash payment of $100,000 to be made by Mr. Tate, a cash payment of $100,000 to be made by Mr. Casstevens, a cash payment of $4,000,000 to be made by the Company’s independent registered public accounting firm and common stock and warrants to purchase common stock to be issued by the Company having an aggregate value of $35,833,000 (based on the market price of the Company’s common stock as of late October and early November 2006). Claims against all defendants will be dismissed with prejudice; however, claims that the Company may have against Mr. Livengood that may be asserted by the Company in the derivative action for contribution to the securities class action settlement or otherwise under applicable law are expressly preserved. The Stipulation contains no admission of fault or wrongdoing by the Company or the other defendants. On November 16,

2006, the court entered an order granting preliminary approval to the settlement. The settlement is subject to final approval of the court.

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

The Company expects to issue approximately 1,835,000 shares of its common stock and warrants to purchase approximately 4,300,000 shares of its common stock in connection with the Stipulation. The exercise price of the warrants will be approximately $12.21 per share.

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

State Court Shareholder Derivative Actions

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

ERISA Class Action

On March 16, 2005, KKDC was served with a purported class action lawsuit filed in the United States District Court for the Middle District of North Carolina that asserted claims for breach of fiduciary duty under ERISA against KKDC and certain of its current and former officers and employees. Plaintiffs purported to represent a class of persons who were participants in or beneficiaries of KKDC’s retirement savings plan or profit sharing stock ownership plan between January 1, 2003 and the date of filing and whose accounts included investments in the Company’s common stock. Plaintiffs contended that defendants failed to manage prudently and loyally the assets of the plans by continuing to offer the Company’s common stock as an investment option and to hold large percentages of the plans’ assets in the Company’s common stock; failed to provide complete and accurate information about the risks of the Company’s common stock; failed to monitor the performance of fiduciary appointees; and breached duties and responsibilities as co-fiduciaries. On May 15, 2006, the Company announced that a proposed settlement had been reached with respect to this matter. The settlement includes a one-time cash payment to be made to the settlement class by the Company’s insurer in the amount of $4.75 million. The Company and the individual defendants deny any and all wrongdoing and paid no money in the settlement, which was granted final approval by the United States District Court on January 10, 2007. Accrued litigation settlements and insurance recoveries receivable in the accompanying consolidated balance sheet as of October 29, 2006 include the $4.75 million settlement amount and related receivable from the Company’s insurer. The settlement amount was included in other assets and other long-term obligations in the accompanying consolidated balance sheet as of January 29, 2006.

Department of Labor Review

On March 9, 2005, and March 21, 2005, the DOL informed the Company that it was commencing a “review” of the Krispy Kreme Doughnut Corporation Retirement Savings Plan and the Krispy Kreme Profit Sharing Stock Ownership Plan to determine whether any

violations of Title I of ERISA have occurred. On November 7, 2006, the DOL issued a letter indicating that it was satisfied that the settlement in the ERISA class action is favorable to the ERISA plans at issue, and that it is closing its investigation of the plans.

Franchisee Litigation

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

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

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

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

Pending Litigation and Investigations

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

SEC Investigation

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

United States Attorney Investigation

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

State Franchise/FTC Inquiry

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

State Court Books and Records Action

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

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

Other Contingencies and Commitments

The Company has guaranteed certain leases and loans from third-party financial institutions on behalf of franchisees, primarily to assist the franchisees in obtaining third-party financing. The loans are collateralized by certain assets of the franchisee, generally the Krispy Kreme store and related equipment. The Company’s contingent liabilities related to these guarantees totaled approximately $17.5 million and $25.1 million at October 29 and January 29, 2006, respectively, and are summarized in Note 9. For leases, the guaranteed amount was determined based upon the gross amount of remaining lease payments due and, for debt, the guaranteed amount was determined based upon the principal amount outstanding under the related agreement. The percentage of the aggregate franchisee obligation guaranteed by the Company generally approximates the Company’s percentage ownership in the franchisee. These guarantees require payment from the Company in the event of default on payment by the respective debtor and, if the debtor defaults, the Company may be required to pay amounts outstanding under the related agreements in addition to the principal amount guaranteed, including accrued interest and related fees. At the time the guarantees were issued, the Company determined the fair value of the guarantees was immaterial and, accordingly, no amount was reflected for the liabilities in the consolidated balance sheet. During the quarter ended July 30, 2006, the Company recorded a provision of approximately $450,000 for potential payments under a Company guarantee of indebtedness of an Equity Method Franchisee; such provision is included in “other income (expense), net” in the accompanying consolidated statement of operations.

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

Note 7 — Impairment Charges and Lease Termination Costs

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


	Three Months Ended						Nine Months Ended
	Oct. 29,			Oct. 30,			Oct. 29,			Oct. 30,
	2006			2005			2006			2005
	(In thousands)
Impairment charges:
Impairment of long-lived assets	$	4,628		$	15,293		$	4,986		$	28,293
Impairment of reacquired franchise rights		80			120			120			160
Other		137			—			137			—

Total impairment charges		4,845			15,413			5,243			28,453

Lease termination costs:
Provision for termination costs		934			369			1,673			1,804
Less — reversal of previously recorded deferred rent expense		(356	)		(87	)		(356	)		(539	)

Net provision		578			282			1,317			1,265

	$	5,423		$	15,695		$	6,560		$	29,718

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

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

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


	Three Months Ended						Nine Months Ended
	Oct. 29,			Oct. 30,			Oct. 29,			Oct. 30,
	2006			2005			2006			2005
	(In thousands)
Balance at beginning of period	$	1,714		$	1,804		$	1,981		$	2,281

Provision for lease termination costs:
Provisions associated with store closings, net of estimated sublease rentals		122			164			122			1,319
Adjustments to previously recorded provisions resulting from settlements with lessors and adjustments of previous estimates		768			184			1,418			416
Accretion of discount		44			21			133			69

Total provision		934			369			1,673			1,804


Accrual related to KremeKo (Note 1)		—			—			—			(862	)
Accrual related to Freedom Rings (Note 1)		—			(150	)		—			(150	)
Payments		(1,018	)		(250	)		(2,024	)		(1,300	)

Balance at end of period	$	1,630		$	1,773		$	1,630		$	1,773

Note 8 — Segment Information

The Company’s reportable segments are Company Stores, Franchise and Krispy Kreme Manufacturing and Distribution (“KKM&D”). The Company Stores segment is comprised of the operating activities of the stores owned by the Company and by Consolidated Franchisees. These stores sell doughnuts and complementary products through both on-premises and off-premises sales channels. The majority of the ingredients and materials used by Company Stores are purchased from the KKM&D segment. The

Franchise segment represents the results of the Company’s franchise program. Under the terms of the franchise agreements, the franchisees pay royalties and fees to the Company in return for the use of the Krispy Kreme name and ongoing brand and operational support. Expenses for this segment include costs incurred to recruit new franchisees and to open, monitor and aid in the performance of these stores and direct general and administrative expenses. The KKM&D segment supplies mix, equipment, coffee and other items to both Company and franchisee-owned stores.

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

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


	Three Months Ended						Nine Months Ended
	Oct. 29,			Oct. 30,			Oct. 29,			Oct. 30,
	2006			2005			2006			2005
	(In thousands)
Revenues:
Company Stores	$	82,078		$	93,668		$	247,013		$	309,248
Franchise		5,716			4,121			15,319			14,100
KKM&D		55,531			60,982			167,609			196,321
Intersegment sales eliminations		(26,218	)		(29,953	)		(80,934	)		(98,554	)

Total revenues	$	117,107		$	128,818		$	349,007		$	421,115

Operating income (loss):
Company Stores	$	1,983		$	(3,529	)	$	3,852		$	(1,375	)
Franchise		4,727			3,231			12,566			10,213
KKM&D		9,368			6,654			27,297			25,541
Unallocated general and administrative expenses		(12,797	)		(15,654	)		(42,365	)		(52,073	)
Impairment charges and lease termination costs		(5,423	)		(15,695	)		(6,560	)		(29,718	)
Settlement of litigation		—			—			—			(35,833	)

Total operating (loss)	$	(2,142	)	$	(24,993	)	$	(5,210	)	$	(83,245	)

Depreciation and amortization expense:
Company Stores	$	3,937		$	5,555		$	12,259		$	18,257
Franchise		32			32			95			113
KKM&D		868			880			2,613			2,624
Corporate administration		340			448			1,147			1,406

Total depreciation and amortization expense	$	5,177		$	6,915		$	16,114		$	22,400

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

Note 9 — Investments in Franchisees

Consolidated Franchisees

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

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

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

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

On February 3, 2006, Glazed Investments filed for bankruptcy protection, and the Company thereafter discontinued consolidation of Glazed Investments’ financial statements. Under the supervision of the court, on March 31, 2006, the majority of Glazed Investments’ stores were sold to another of the Company’s franchisees for $10 million cash. Glazed Investments closed the balance of its stores. As part of this transaction, the Company assigned its membership interest in KK Wyotana, LLC (“KK Wyotana”) to the purchaser of the Glazed Investments stores, which also was the majority owner of KK Wyotana. While the proceeds of the sale and the proceeds from liquidation of Glazed Investments’ other assets were sufficient to retire a substantial majority of Glazed Investments’ outstanding debt, in the second and third quarters of fiscal 2007 the Company paid a total of approximately $1.1 million of Glazed Investments’ debt pursuant to the Company’s guarantee of certain of such indebtedness.

Equity Method Franchisees

As of October 29, 2006, the Company has investments in eight franchisees. Investments in these franchisees have been made in the form of capital contributions and, in certain instances, loans evidenced by promissory notes.

The Company’s financial exposures related to franchisees in which the Company has an investment are summarized in the table below. The consolidated balance sheet at October 29, 2006 includes an accrual for potential payments under the loan and lease guarantees of approximately $450,000 recorded in the second quarter of fiscal 2007 upon the Company’s receipt of a payment demand with respect to a guaranteed obligation. There is no liability reflected for other guarantees as of October 29, 2006 because the Company did not believe it was probable that the Company would be required to perform under any other guarantees at that date.


	October 29, 2006
	Company			Investment									Loan and
	Ownership			and			Trade		Notes Receivable				Lease
	Percentage			Advances			Receivables		Current		Long-term		Guarantees
	(Dollars in Thousands)
A-OK, LLC		30.3	%	$	(282	)	$	1,539	$	6	$	—	$	2,608
KK-TX I, L.P		33.3	%		(271	)		161		—		—		1,375
Kremeworks, LLC		25.0	%		1,534			464		—		—		2,667
Kremeworks Canada, LP		24.5	%		610			84		—		—		—
Krispy Kreme of South Florida, LLC		35.3	%		—			1,832		—		—		10,447
Krispy Kreme U.K. Limited		35.1	%		829			1,102		—		—		—
Krispy Kreme Mexico, S. de R.L. de C.V		30.0	%		1,853			349		—		—		—
Priz Doughnuts, LP		33.3	%		—			1,144		18		—		450

				$	4,273		$	6,675	$	24	$	—	$	17,547


	January 29, 2006
	Company			Investment									Loan and
	Ownership			and			Trade		Notes Receivable				Lease
	Percentage			Advances			Receivables		Current		Long-term		Guarantees
	(Dollars in Thousands)
A-OK, LLC		30.3	%	$	(96	)	$	1,600	$	55	$	—	$	2,787
Amazing Hot Glazers, LLC		33.3	%		163			164		22		—		874
Caribbean Glaze Corporation		30.0	%		90			—		—		—		—
Freedom Rings, LLC (accounted for using the cost method)		100.0	%		2,000			27		500		—		—
KK-TX I, L.P		33.3	%		(152	)		135		—		—		1,474
KK Wyotana, LLC		33.3	%		—			33		—		—		—
KKNY, LLC		30.3	%		(7	)		412		—		—		—
Kremeworks, LLC		25.0	%		1,490			398		—		—		2,667
Kremeworks Canada, LP (1)		24.5	%		723			65		—		—		—
Krispy Kreme Australia Pty Limited		(2	)		—			592		4,050		42		4,714
Krispy Kreme of South Florida, LLC (3)		35.3	%		—			1,417		—		—		11,122
Krispy Kreme U.K. Limited		35.1	%		2,780			3,285		—		—		1,054
Krispy Kreme Mexico, S. de R.L. de C.V		30.0	%		1,610			1,548		—		—		—
Priz Doughnuts, LP		33.3	%		—			988		20		—		424

				$	8,601		$	10,664	$	4,647	$	42	$	25,116


(1)		Previously reported on a combined basis with Kremeworks, LLC.

(2)		On November 30, 2005, the Company sold its equity interest in Krispy Kreme Australia Pty Limited as described below.

(3)		Reflects a correction to the previously reported guarantee amount of $7,760 reflected in the 2006 Form 10-K.

The aggregate loan and lease guarantees at October 29 and January 29, 2006 shown in the preceding tables include $9.9 million and $10.4 million, respectively, representing guarantees of lease obligations; the balance of the guarantee amounts represents guarantees of outstanding loans.

In November 2005, the Company sold its 35% equity investment in Krispy Kreme Australia Pty Limited (“KK Australia”) to the majority investor in the franchise for AUS$3,500,000 cash (approximately US$2.5 million at the time of the transaction), and in May 2006, the majority investor purchased from the Company, for cash and at par, the Company’s notes receivable from KK Australia totaling AUS$5,075,000 (approximately US$3.8 million at the time of the transaction) and, in connection therewith, all of the Company’s guarantees of certain of KK Australia’s indebtedness were released. The Company realized a gain of approximately $3.5 million on the sales of these interests, which is reflected in “other income (expense), net” in the accompanying consolidated statement of operations for the nine months ended October 29, 2006.

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

In May 2006, the Company entered into an agreement to sell the Company’s 35% equity investment in and notes receivable from Krispy Kreme U.K. Limited (“KK UK”) to KK UK’s majority shareholder for $5.6 million. In October 2006, the Company received $2.0 million from the purchasers, representing the purchase price of the notes, and in November 2006 received the $3.6 million balance of the sales price. The Company realized a gain of approximately $3.4 million on the sales of these interests, which will be reflected in earnings in the fourth quarter of fiscal 2007. In connection with the sale, all of the Company’s obligations with respect to guarantees related to KK UK were terminated.

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

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

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

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

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

As of October 29, 2006, there were 381 Krispy Kreme stores operated systemwide in the United States, Australia, Canada, Mexico, South Korea, the United Kingdom, Hong Kong, Indonesia and Kuwait of which 114 were owned by the Company and 267 were owned by franchisees. Of the 381 total stores, there were 293 factory stores and 88 satellites; 280 stores were located in the United States and 101 were located in other countries.

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

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

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

During fiscal 2006, the Company experienced declines in average weekly sales per factory store in each quarter compared to the comparable quarters of fiscal 2005. Most of the Company’s domestic franchisees experienced similar sales declines. The Company responded to this trend by closing relatively poorer performing stores and consolidating production of doughnuts for off-premises distribution into a smaller number of factory stores. In the first nine months of fiscal 2007, Company and systemwide average weekly sales per factory store increased approximately 11.0% and 6.3%, respectively, compared to the first nine months of fiscal 2006. Company average sales per store increased 9.4% in the first nine months of fiscal 2007 compared to the first nine months of fiscal 2006, while systemwide average sales per store declined 6.8%. Systemwide average sales per store declined while Company average sales per store increased because substantially all of the growth in satellite stores, which typically have lower average weekly sales than do factory stores, has occurred in franchise operations and not in Company Stores. Store closures by the Company and franchisees caused a decrease in Company and systemwide sales in the first nine months of fiscal 2007 compared to the first nine months of fiscal 2006. Lower sales to franchisees adversely affected the KKM&D segment and lower sales by franchise stores adversely affected the Franchise segment. The Company was also adversely affected by the substantial costs associated with the legal and regulatory matters discussed in Notes 2 and 6 to the consolidated financial statements appearing elsewhere herein.

RESULTS OF OPERATIONS

The following table presents the Company’s operating results for the three months and nine months ended October 29, 2006 and October 30, 2005, expressed as a percentage of revenues (amounts may not add to totals due to rounding).


	Three months ended						Nine months ended
	Oct. 29,			Oct. 30,			Oct. 29,			Oct. 30,
	2006			2005			2006			2005
Revenues		100.0	%		100.0	%		100.0	%		100.0	%
Operating expenses:
Direct operating expenses		82.1			90.0			83.2			86.9
General and administrative expenses		10.6			11.8			11.8			12.0
Depreciation and amortization expense		4.4			5.4			4.6			5.3
Impairment charges and lease termination costs		4.6			12.2			1.9			7.1
Settlement of litigation		—			—			—			8.5

Operating (loss)		(1.8	)%		(19.4	)%		(1.5	)%		(19.8	)%

To facilitate an understanding of the Company’s operating results, data on the number of factory stores appear in the table below. The number of factory stores includes commissaries but excludes satellite stores. Transferred stores for the nine months ended October 29, 2006 represent 12 stores operated by Glazed Investments which were sold to another franchisee and one store operated by KKNY acquired by the Company. Transferred stores for the nine months ended October 30, 2005 represent stores operated by KremeKo, a Consolidated Franchisee which filed for bankruptcy protection in April 2005; the Company ceased consolidation of the financial statements of KremeKo following the bankruptcy filing.


	NUMBER OF FACTORY STORES (1)
	COMPANY			FRANCHISE			TOTAL
Three months ended October 29, 2006:
JULY 30, 2006		112			191			303
Opened		—			10			10
Closed		(3	)		(17	)		(20	)

OCTOBER 29, 2006		109			184			293


Nine months ended October 29, 2006:
JANUARY 29, 2006		128			195			323
Opened		—			18			18
Closed		(8	)		(40	)		(48	)
Transferred		(11	)		11			—

OCTOBER 29, 2006		109			184			293


Three months ended October 30, 2005:
JULY 31, 2005		151			216			367
Opened		—			6			6
Closed		(5	)		(17	)		(22	)

OCTOBER 30, 2005		146			205			351


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

OCTOBER 30, 2005		146			205			351


(1)		Excludes satellites.

The table below presents average weekly sales per factory store (which represents, on a company or systemwide basis, total sales of all stores divided by the number of operating weeks for factory stores) and average weekly sales per store (which represents, on a

company or systemwide basis, total sales of all stores divided by the number of operating weeks for both factory stores and satellites). Operating weeks represents the aggregate number of weeks in a period that factory stores or all stores were in operation.

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


	Three months ended				Nine months ended
	Oct. 29,		Oct. 30,		Oct. 29,		Oct. 30,
	2006		2005		2006		2005
	(Dollars in thousands)
Average weekly sales per factory store (1):
Company	$	55.0	$	47.3	$	54.3	$	48.9
Systemwide	$	50.7	$	45.4	$	49.3	$	46.4
Factory Store operating weeks:
Company		1,491		1,967		4,488		6,249
Systemwide		3,820		4,669		11,950		14,672
Average weekly sales per store (1):
Company	$	53.1	$	46.7	$	52.5	$	48.0
Systemwide	$	40.1	$	40.3	$	39.5	$	42.4
Store operating weeks:
Company		1,543		1,993		4,636		6,370
Systemwide		4,825		5,257		14,898		16,063


(1)		Excludes sales between Company and franchise stores.

THREE MONTHS ENDED OCTOBER 29, 2006 COMPARED TO THREE MONTHS ENDED OCTOBER 30, 2005

Overview

Systemwide sales for the third quarter of fiscal 2007 decreased 8.9% compared to the third quarter of fiscal 2006. The decrease was attributable to a decline in the number of store operating weeks, as systemwide average weekly sales per store were flat. The systemwide sales decrease reflects a 12.4% decrease in Company Stores sales and a 6.2% decrease in franchise store sales.

Revenues

Total revenues decreased 9.1% to $117.1 million for the three months ended October 29, 2006 from $128.8 million for the three months ended October 30, 2005. This decrease resulted from a 12.4% decrease in Company Stores revenues to $82.1 million and a 5.5% decrease in KKM&D revenues to $29.3 million, partially offset by a 38.7% increase in franchise revenues to $5.7 million.

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). KKM&D revenues exclude intersegment sales eliminated in consolidation.


	Three months ended
	Oct. 29,		Oct. 30,
	2006		2005
	(Dollars in thousands)
REVENUES BY BUSINESS SEGMENT:
Company Stores	$	82,078	$	93,668
Franchise		5,716		4,121
KKM&D		29,313		31,029

Total revenues	$	117,107	$	128,818


	Three months ended
	Oct. 29,			Oct. 30,
	2006			2005
	(Dollars in thousands)
PERCENTAGE OF TOTAL REVENUES:
Company Stores		70.1	%		72.7	%
Franchise		4.9			3.2
KKM&D		25.0			24.1

Total revenues		100.0	%		100.0	%

Company Stores Revenues. Company Stores revenues decreased 12.4% to $82.1 million in the third quarter of fiscal 2007 from $93.7 million in the third quarter of fiscal 2006. The decrease reflects a 22.6% decrease in store operating weeks, partially offset by a 13.7% increase in average weekly sales per store. The decrease in store operating weeks reflects the sale or closure of 42 factory stores since the end of the second quarter of fiscal 2006. The increase in the average weekly sales per store principally reflects the closure of relatively poorer performing locations, the benefits of consolidating production for wholesale customers into a smaller number of factory stores and the effects of certain price increases implemented late in the second quarter of fiscal 2007 on products sold through certain off-premises distribution channels.

Franchise Revenues. Franchise revenues, consisting principally of franchise fees and royalties, increased 38.7% to $5.7 million in the third quarter of fiscal 2007 from $4.1 million in the third quarter of fiscal 2006. Franchisee fees rose approximately $640,000 year-over-year, of which approximately $270,000 represents revenue arising from amendments to agreements with certain international franchisees. The development and franchise agreements with these franchisees contemplated development only of factory stores, and were amended to provide for initial franchise fees for satellite stores and to provide for development of satellite stores to be partially creditable against the franchisees’ store development obligations. The Company did not record initial franchisee fees related to these franchisees’ satellite stores until the Company agreed with the franchisees on the amount of initial franchise fee to be paid with respect to these stores. The balance of the increase in franchise fees reflects an increase in new store openings in the third quarter of fiscal 2007 compared to the third quarter of fiscal 2006. In addition, royalty revenues rose to $4.7 million in the third quarter of fiscal 2007 from $3.8 million in the third quarter of fiscal 2006. While sales by franchise stores fell to approximately $112 million in the third quarter of fiscal 2007 compared to approximately $119 million in the third quarter of fiscal 2006, the resolution of disputes with two major franchisees substantially eliminated collectibility concerns with respect to royalties accruing on sales by these franchisees during the third quarter of fiscal 2007. The amount of royalty revenue not recognized during the third quarter of fiscal 2007 due to collectibility concerns fell to approximately $250,000 from approximately $1.4 million in the third quarter of fiscal 2006.

KKM&D Revenues. KKM&D sales to franchise stores decreased 5.5% to $29.3 million in the third quarter of fiscal 2007 from $31.0 million in the third quarter of fiscal 2006. The most significant reason for the decrease in revenues was lower sales by franchisees, which resulted in an approximate 11% decrease in sales of mixes, icings and fillings, sugar, shortening, coffee and supplies by KKM&D. In addition, an increasing percentage of franchisee sales is attributable to sales by franchisees outside North America; while the Company sells the doughnut mixes used by such franchisees, many of the other ingredients and supplies used by these franchisees are acquired locally instead of from KKM&D. The decline in sales of mixes and other supplies partially was offset by an increase in sales of equipment and equipment services in the third quarter of fiscal 2007 compared to the third quarter of fiscal 2006. The increase in equipment and equipment service revenues reflects an increase in franchise store openings, virtually all of which were in markets outside the United States.

Direct Operating Expenses

Direct operating expenses, which exclude depreciation and amortization expense, were 82.1 % of revenues in the third quarter of fiscal 2007 compared to 90.0% of revenues in the third quarter of fiscal 2006. Direct operating expenses by business segment (expressed in dollars and as a percentage of applicable segment revenues) are set forth in the table below. The estimated profit earned by the KKM&D segment on sales to the Company Stores segment has been deducted from Company Stores direct operating expenses in the table below to illustrate the effects of the Company’s vertical integration on the overall profit earned on Company Stores revenues. However, the profit earned by KKM&D on sales to Company Stores is included in KKM&D operating income in the segment information which appears in Note 8 to the Company’s consolidated financial statements appearing elsewhere herein.


	Three months ended
	Oct. 29,			Oct. 30,
	2006			2005
	(Dollars in thousands)
DIRECT OPERATING EXPENSES BY BUSINESS SEGMENT:
Company Stores	$	71,268		$	88,208
Franchise		957			858
KKM&D		23,967			26,929

Total direct operating expenses	$	96,192		$	115,995


DIRECT OPERATING EXPENSES AS A PERCENTAGE OF SEGMENT REVENUES:
Company Stores		86.8	%		94.2	%
Franchise		16.7	%		20.8	%
KKM&D		81.8	%		86.8	%
Total direct operating expenses		82.1	%		90.0	%

Direct operating expenses as a percentage of revenues for the Company Stores segment fell in the third quarter of fiscal 2007 compared to the third quarter of fiscal 2006. The improvement reflects the benefits of the sale or closure of relatively poorer performing locations, the benefits of higher average weekly sales per store resulting, in part, from consolidating production of products for sale through off-premises channels into a smaller number of factory stores, and the effects of certain price increases implemented late in the second quarter of fiscal 2007 on products sold though certain off-premises distribution channels. Many store operating costs are fixed or semi-fixed in nature and, accordingly, store profit margins are sensitive to changes in sales volumes.

Franchise segment direct operating expenses rose slightly in the third quarter of fiscal 2007 compared to the comparable quarter of the preceding year, but declined as a percentage of franchise revenue due to the increase in royalty revenues resulting principally from the resolution of disputes with certain franchisees as discussed under “Franchise Revenues” above.

Direct operating expenses as a percentage of KKM&D revenues declined significantly in the third quarter of fiscal 2007 compared to the third quarter of fiscal 2006. The improvement reflects the benefit of certain price increases instituted in the first quarter of fiscal 2007 to offset higher costs, as well as lower bad debt provisions in the third quarter of fiscal 2007 compared to the comparable quarter of the preceding year. KKM&D direct operating expenses for the three months ended October 29, 2006 reflect a net credit in bad debt expense of approximately $500,000, which includes a reversal of approximately $1.1 million of previously recorded reserves for franchise receivables arising from the settlement of a dispute with a franchisee. KKM&D direct operating expenses for the three months ended October 30, 2005 include approximately $2.1 million of bad debt provisions related to receivables from franchisees. These benefits were partially offset by the adverse effects of lower operating levels in the third quarter of fiscal 2007 compared to the third quarter of fiscal 2006 resulting from lower revenue levels.

General and Administrative Expenses

General and administrative expenses decreased to $12.5 million, or 10.6% of total revenues, in the third quarter of fiscal 2007 from $15.2 million, or 11.8% of total revenues, in the third quarter of fiscal 2006. General and administrative expenses include fees paid to the interim management firm engaged by the Company in January 2005, and professional fees related to the internal and external investigations and litigation described in Notes 2 and 6 to the consolidated financial statements included elsewhere herein, totaling approximately $750,000 (net of estimated insurance recoveries of approximately $70,000) for the third quarter of fiscal 2007 and $7.2 million (net of estimated insurance recoveries of approximately $3.6 million) for the third quarter of fiscal 2006. Exclusive of these costs, general and administrative expenses for the third quarter of fiscal 2007 and 2006 were approximately 10.0% and 6.2% of total revenues, respectively. The increase in these costs in absolute terms and as a percentage of revenue reflects, among other things, approximately $770,000 of stock compensation costs incurred in the third quarter of fiscal 2007 and included in general and administrative expenses (resulting, in part, from the adoption of FAS 123(R) as described in Note 1 to the consolidated financial statements appearing elsewhere herein), increased legal and other costs associated with work on the Company’s financial statements and filings with the Commission, the initial cost of strategic initiatives related to product, customer and market research and initiatives designed to achieve cost reductions related to the procurement of goods and services, higher cash compensation costs, and the effects of the fixed nature of many of these costs on a smaller revenue base.

Depreciation and Amortization Expense

Depreciation and amortization expense decreased to $5.2 million, or 4.4% of total revenues, in the third quarter of fiscal 2007 from $6.9 million, or 5.4% of total revenues, in the third quarter of fiscal 2006. The decrease in depreciation and amortization expense relates almost entirely to the Company Stores segment, in which depreciation and amortization expense declined principally due to store sales and closures.

Impairment Charges and Lease Termination Costs

The Company recorded impairment charges and lease termination costs of $5.4 million in the third quarter of fiscal 2007 compared to $15.7 million in the third quarter of fiscal 2006. Substantially all of the charges arose from store closing decisions, and included approximately $4.8 million and $15.4 million in the third quarter of fiscal 2007 and 2006, respectively, of impairment charges related principally to long-lived assets, with the balance of the charges representing lease termination costs. The Company closed three factory stores in the third quarter of fiscal 2007 compared to five factory stores in the third quarter of fiscal 2006. The Company generally records impairment charges associated with a decision to close a store in the accounting period in which the closing decision is made; lease termination costs are recorded when the lease contract is terminated or, if earlier, the date on which the Company ceases use of the leased property.

Interest Expense

Interest expense increased to $5.2 million in the third quarter of fiscal 2007 from $4.7 million in the third quarter of fiscal 2006. The aggregate costs associated with the Company’s Secured Credit Facilities, including interest, fees and amortization of deferred financing costs, increased approximately $1.0 million for the three months ended October 29, 2006 over the comparable quarter of the preceding year, reflecting higher interest rates and lender margin in the third quarter of fiscal 2007 compared to the third quarter of fiscal 2006. Interest expense for the three months ended October 30, 2005 included approximately $400,000 of interest expense associated with Consolidated Franchisees. The Company no longer consolidates the financial statements of any franchisees, as discussed in Notes 1 and 9 to the consolidated financial statements appearing elsewhere herein.

Equity in (Losses) of Equity Method Franchisees

The Company’s share of losses incurred by equity method franchisees totaled $65,000 in the third quarter of fiscal 2007 compared to $488,000 in the third quarter of fiscal 2006. This caption represents the Company’s share of operating results of unconsolidated franchisees which develop and operate Krispy Kreme stores. The Company’s equity in the losses of equity method franchisees has declined principally as a result of the Company’s sale or other disposal of these investments in fiscal 2006 and 2007.

Minority Interests in Results of Consolidated Franchisees

The minority interest in the results of operations of consolidated franchisees represents the portion of the income or loss of Consolidated Franchisees allocable to other investors’ interests in those franchisees. In the third quarter of fiscal 2006, minority investors absorbed losses incurred by Consolidated Franchisees totaling $563,000, substantially all of which relates to New England Dough; the interests of minority investors in KremeKo and Freedom Rings previously had been reduced to zero and, accordingly, no portion of these entities’ losses was absorbed by minority interests in the quarter. There were no minority interests in the results of operations of consolidated subsidiaries in the third quarter of fiscal 2007 because the Company no longer consolidated the financial statements of any less than wholly-owned subsidiaries. See Notes 1 and 9 to the consolidated financial statements appearing elsewhere herein.

Provision for Income Taxes

The provision for income taxes was $431,000 in the third quarter of fiscal 2007 and $308,000 in the third quarter of fiscal 2006. Each of these amounts includes adjustments to the valuation allowance for deferred income tax assets to maintain such allowance at an amount sufficient to reduce the Company’s aggregate net deferred income tax assets to zero, as well as a provision for income taxes estimated to be payable currently.

Net (Loss)

The Company incurred a net loss of $7.2 million for the third quarter of fiscal 2007, compared to a net loss of $29.7 million for the third quarter of fiscal 2006.

NINE MONTHS ENDED OCTOBER 29, 2006 COMPARED TO NINE MONTHS ENDED OCTOBER 30, 2005

Overview

Systemwide sales for the first nine months fiscal 2007 decreased 13.6% compared to the first nine months of fiscal 2006. This decrease was attributable to a 6.8% decrease in average weekly sales per store and a 7.3% decrease in store operating weeks. The systemwide sales decrease reflects a 20.1% decrease in Company Stores sales and a 8.4% decrease in franchise store sales.

Revenues

Total revenues decreased 17.1% to $349.0 million for the nine months ended October 29, 2006 from $421.1 million for the nine months ended October 30, 2005. This decrease resulted from a 20.1% decrease in Company Stores revenues to $247.0 million and an 11.3% decrease in KKM&D revenues to $86.7 million, partially offset by an 8.6% increase in franchise revenues to $15.3 million.


	Nine months ended
	Oct. 29,			Oct. 30,
	2006			2005
	(In thousands)
				(restated)
REVENUES BY BUSINESS SEGMENT:
Company Stores	$	247,013		$	309,248
Franchise		15,319			14,100
KKM&D		86,675			97,767

Total revenues	$	349,007		$	421,115


PERCENTAGE OF TOTAL REVENUES:
Company Stores		70.8	%		73.4	%
Franchise		4.4			3.3
KKM&D		24.8			23.2

Total revenues		100.0	%		100.0	%

Company Stores Revenues. Company Stores revenues decreased 20.1% to $247.0 million in the first nine months of fiscal 2007 from $309.2 million in the first nine months of fiscal 2006. The decrease reflects a 27.2% decrease in store operating weeks, partially offset by a 9.4% increase in average weekly sales per store. The decrease in store operating weeks reflects the sale or closure of 66 factory stores since the end of fiscal 2005. The increase in the average weekly sales per store principally reflects the closure of relatively poorer performing locations and the benefits of consolidating production for wholesale customers into a smaller number of factory stores.

Franchise Revenues. Franchise revenues, consisting principally of franchise fees and royalties, increased 8.6% to $15.3 million in the first nine months of fiscal 2007 from $14.1 million in the first nine months of fiscal 2006. Of this $1.2 million increase, approximately $730,000 represents revenue recorded in the second and third quarters arising from amendments to agreements with certain international franchisees. The development and franchise agreements with these franchisees contemplated development only of factory stores, and were amended to provide for initial franchise fees for satellite stores and to provide for development of satellite stores to be partially creditable against the franchisees’ store development obligations. The Company did not record initial franchisee fees related to these franchisees’ satellite stores until the Company agreed with the franchisees on the amount of initial franchise fee to be paid with respect to these stores. The balance of the increase in franchise fees reflects an increase in new store openings in the first nine months of fiscal 2007 compared to the first nine months of fiscal 2006. Royalty revenues totaled $13.2 million for the first nine months of fiscal 2007 compared to $13.3 million for the first nine months of fiscal 2006. While sales by franchise stores fell to approximately $343 million for the first nine months of fiscal 2007 compared to approximately $374 million for the first nine months of fiscal 2006, the resolution of disputes with two major franchisees substantially eliminated collectibility concerns with respect to royalties accruing on sales by these franchisees during the third quarter of fiscal 2007. The amount of royalty revenue not recognized during the first nine months of fiscal 2007 due to collectibility concerns fell to approximately $2.1 million from approximately $2.7 million for the first nine months of fiscal 2006.

KKM&D Revenues. KKM&D sales to franchise stores decreased 11.3% to $86.7 million in the first nine months of fiscal 2007 from $97.8 million in the comparable period of fiscal 2006. The most significant reason for the decrease in revenues was lower sales by franchisees, which resulted in an approximate 13% decrease in sales of mixes, icings and fillings, sugar, shortening, coffee and supplies by KKM&D. In addition, an increasing percentage of franchisee sales is attributable to sales by franchisees outside North America; while the Company sells the doughnut mixes used by such franchisees, many of the other ingredients and supplies used by these franchisees are acquired locally instead of from KKM&D. The decline in sales of mixes and other supplies partially was offset by a slight increase in sales of equipment and equipment services in the fiscal 2007 period compared to the prior year period.

Direct Operating Expenses

Direct operating expenses, which exclude depreciation and amortization expense, were 83.2% of revenues in the first nine months of fiscal 2007 compared to 86.9% of revenues in the first nine months of fiscal 2006. Direct operating expenses by business segment (expressed in dollars and as a percentage of applicable segment revenues) are set forth in the table below. The estimated profit earned by the KKM&D segment on sales to the Company Stores segment has been deducted from Company Stores direct operating expenses in the table below to illustrate the effects of the Company’s vertical integration on the overall profit earned on Company Stores revenues. However, the profit earned by KKM&D on sales to Company Stores is included in KKM&D operating income in the segment information which appears in Note 8 to the Company’s consolidated financial statements appearing elsewhere herein.


	Nine months ended
	Oct. 29,			Oct. 30,
	2006			2005
	(In thousands)
DIRECT OPERATING EXPENSES BUSINESS SEGMENT:
Company Stores	$	216,664		$	278,720
Franchise		2,658			3,774
KKM&D		71,003			83,248

Total direct operating expenses	$	290,325		$	365,742


DIRECT OPERATING EXPENSES AS A PERCENTAGE OF SEGMENT REVENUES:
Company Stores		87.7	%		90.1	%
Franchise		17.4	%		26.8	%
KKM&D		81.9	%		85.1	%
Total direct operating expenses		83.2	%		86.9	%

Direct operating expenses as a percentage of revenues for the Company Stores segment decreased in the first nine months of fiscal 2007 compared to the comparable period of fiscal 2006. The improvement reflects the benefits of the sale or closure of relatively poorer performing locations, the benefits of higher average weekly sales per store resulting, in part, from consolidating production of products for sale through off-premises channels into a smaller number of factory stores, and the effects of certain price increases implemented late in the second quarter of fiscal 2007 on products sold though certain off-premises distribution channels. Many store operating costs are fixed or semi-fixed in nature and, accordingly, store profit margins are sensitive to changes in sales volumes.

Franchise segment direct operating expenses decreased principally as a result of lower provisions for potentially uncollectible royalties and due to lower allocated corporate costs.

Direct operating expenses as a percentage of KKM&D revenues declined for the first nine months of fiscal 2007 compared to the first nine months of fiscal 2006. The improvement reflects the benefit of certain price increases instituted in the first quarter of fiscal 2007 to offset higher costs, as well as lower bad debt provisions in the fiscal 2007 period compared to the prior year. KKM&D direct operating expenses include bad debt provisions relating to receivables from franchisees of approximately $1.5 million (approximately 1.7% of KKM&D revenues) and $4.7 million (approximately 4.8% of KKM&D revenues) for the nine months ended October 29, 2006 and October 30, 2005, respectively. These benefits were partially offset by the adverse effects of lower operating levels in the third quarter of fiscal 2007 compared to the third quarter of fiscal 2006 resulting from lower revenue levels.

General and Administrative Expenses

General and administrative expenses decreased to $41.2 million, or 11.8% of total revenues, in the first nine months of fiscal 2007 from $50.7 million, or 12.0% of total revenues, in the first nine months of fiscal 2006. General and administrative expenses include fees paid to the interim management firm engaged by the Company in January 2005 and professional fees related to the internal and external investigations and litigation described in Notes 2 and 6 to the consolidated financial statements included elsewhere herein totaling approximately $11.1 million (net of estimated insurance recoveries of approximately $2.6 million) for the nine months ended October 29, 2006 and approximately $23.5 million (net of estimated insurance recoveries of approximately $12.0 million) for the first nine months of fiscal 2006. The unusual professional fees for the first nine months of fiscal 2007 and fiscal 2006 include approximately $3.9 million and $1.8 million, respectively, related to the warrant to acquire 1.2 million shares of the Company’s common stock issued to KZC as part of its compensation for services rendered to the Company, as more fully described in Note 1 to the consolidated financial statements appearing elsewhere herein. In addition, general and administrative expenses in the first nine months of fiscal 2006 include approximately $4.0 million of out-of-period costs related to stock-based compensation. The Company erroneously failed to record these costs in prior years, but concluded that such error was not material to the consolidated financial statements of the affected periods or to the fiscal 2006 consolidated financial statements. Accordingly, the Company recorded the costs in the first quarter of fiscal 2006 rather than restating prior periods’ financial statements, as more fully described in Note 1 to the consolidated financial statements. Exclusive of these costs, general and administrative expenses were 8.6% of revenues in the first nine months of fiscal 2007 compared to 5.5% in the first nine months of fiscal 2006. The increase in these costs in absolute terms and as a percentage of revenue reflects, among other things, approximately $2.5 million of stock compensation costs incurred in the first nine months of fiscal 2007 and included in general and administrative expenses (resulting, in part, from adoption of FAS 123(R) as described in Note 1 to the consolidated financial statements appearing elsewhere herein), increased legal and other costs associated with work on the Company’s financial statements and filings with the Commission, the initial cost of strategic initiatives related to product, customer and market research and initiatives designed to achieve cost reductions related to the procurement of goods and services, higher cash compensation costs, and the effects of the fixed nature of many of these costs on a smaller revenue base.

Depreciation and Amortization Expense

Depreciation and amortization expense decreased to $16.1 million, or 4.6% of total revenues, for the first nine months of fiscal 2007 from $22.4 million, or 5.3% of total revenues, in the first nine months of fiscal 2006. The decrease in depreciation and amortization expense relates almost entirely to the Company Stores segment, in which depreciation and amortization expense declined principally due to store sales and closures.

Impairment Charges and Lease Termination Costs

The Company recorded impairment charges and lease termination costs of $6.6 million in the first nine months of fiscal 2007 compared to $29.7 million in the first nine months of fiscal 2006. Substantially all of the charges arose from store closing decisions, and included approximately $5.2 million and $28.5 million in fiscal 2007 and 2006, respectively, of impairment charges related principally to long-lived assets, with the balance of the charges representing lease termination costs. The Company closed eight factory stores in the first nine months of fiscal 2007 and 24 factory stores in the first nine months of fiscal 2006. The Company generally records impairment charges associated with a decision to close a store in the accounting period in which the closing decision is made; lease termination costs are recorded when the lease contract is terminated or, if earlier, the date on which the Company ceases use of the leased property.

Settlement of Litigation

On October 31, 2006, the Company agreed to settle a federal securities class action and to settle, in part, certain shareholder derivative actions, as more fully described in Note 6 to the consolidated financial statements appearing elsewhere herein. As part of the settlement, the Company agreed to issue to the plaintiffs a combination of common stock and warrants to acquire common stock. In the first quarter of fiscal 2006, the Company recorded a charge for the anticipated settlement of $35.8 million, representing the estimated fair value as of late October 2006 of the approximately 1,835,000 shares of common stock and warrants to acquire approximately 4,300,000 shares of common stock estimated to be issued by the Company. The provision for settlement costs will be adjusted in periods after October 2006 to reflect changes in the fair value of the securities until they are issued following final court approval of the settlement, which the Company anticipates will occur in early calendar 2007.

Interest Expense

Interest expense increased to $15.4 million for the nine months ended October 29, 2006, from $15.2 million for the nine months ended October 30, 2005. The aggregate costs, including interest, fees and amortization of deferred debt issue costs, associated with

the Company’s primary credit facilities (the Secured Credit Facilities and, prior to April 1, 2005, a bank credit facility which was retired using proceeds of the Secured Credit Facilities) increased approximately $4.6 million for the nine months ended October 29, 2006 over the nine months ended October 30, 2005, principally reflecting higher interest rates and lender margin in the first nine months of fiscal 2007 compared to the first nine months of fiscal 2006. In addition, interest expense for the first nine months of fiscal 2006 included one-time fees and expenses of approximately $1.2 million associated with the bank credit facility prior to its retirement using proceeds of the Secured Credit Facilities, the write-off of approximately $840,000 of unamortized financing costs associated with the retired bank financing and approximately $640,000 charged to earnings upon termination of an interest rate hedge related to the retired bank financing. Interest expense for the nine months ended October 30, 2005 also included approximately $1.6 million of interest expense associated with Consolidated Franchisees. The Company no longer consolidates the financial statements of any franchisees, as discussed in Notes 1 and 9 to the consolidated financial statements appearing elsewhere herein.

Equity in Losses of Equity Method Franchisees

Equity in losses of equity method franchisees totaled $924,000 in the first nine months of fiscal 2007 compared to $3.8 million for the first nine months of fiscal 2006. This caption represents the Company’s share of operating results of unconsolidated franchisees which develop and operate Krispy Kreme stores. The fiscal 2006 losses included approximately $2.0 million of losses related to KremeKo which arose from impairment provisions associated principally with store closures. In addition, the Company’s equity in the losses of equity method franchisees has declined principally as a result of the Company’s sale or other disposal of these investments in fiscal 2006 and 2007.

Minority Interests in Results of Consolidated Franchisees

The minority interest in the results of operations of consolidated franchisees represents the portion of the income or loss of Consolidated Franchisees allocable to other investors’ interests in those franchisees. In the first nine months of fiscal 2006, minority investors absorbed losses incurred by Glazed Investments and New England Dough totaling $1,485,000; the interests of minority investors in KremeKo and Freedom Rings previously had been reduced to zero and, accordingly, no portion of these entities’ losses was absorbed by minority interests in the period. There were no minority interests in the results of operations of consolidated subsidiaries in the first nine months of fiscal 2007 because, except for Glazed Investments, the Company did not consolidate the financial statements of any less than wholly-owned subsidiaries during the period, and the minority interests in Glazed Investments had been reduced to zero in the third quarter of fiscal 2006. See Notes 1 and 9 to the consolidated financial statements appearing elsewhere herein.

Other Income (Expense), Net

Other income (expense), net for the nine months ended October 29, 2006 includes a gain of approximately $3.5 million realized on the sale of the Company’s investment in Krispy Kreme Australia as described in Note 9 to the consolidated financial statements appearing elsewhere herein, as well as a charge of approximately $450,000 for potential payments under a Company guarantee of certain obligations of an Equity Method Franchisee. Other income (expense), net for the nine months ended October 30, 2005 includes approximately $1.0 million of net gains on sales of property and equipment, reduced by approximately $250,000 of foreign currency exchange losses.

Provision for Income Taxes

The provision for income taxes was $781,000 for the nine months ended October 29, 2006 and a benefit of $1.1 million for the nine months ended October 30, 2005. Each of these amounts includes adjustments to the valuation allowance for deferred income tax assets to maintain such allowance at an amount sufficient to reduce the Company’s aggregate net deferred income tax assets to zero, as well as a provision for income taxes estimated to be payable currently. The provision for income taxes for the first nine months of fiscal 2006 also includes an out-of-period credit of approximately $1.5 million. This credit corrects an overstatement of the valuation allowance for deferred income tax assets recorded by a charge to earnings in fiscal 2005. The Company concluded that this error was not material to the consolidated financial statements of the affected periods or to the fiscal 2006 consolidated financial statements. Accordingly, the Company recorded the credit in the first quarter of fiscal 2006 rather than restating prior periods’ financial statements, as more fully described in Note 1 to the consolidated financial statements appearing elsewhere herein.

Net (Loss)

The Company incurred a net loss of $17.8 million for the first nine months of fiscal 2007, compared to a net loss of $98.0 million the first nine months of fiscal 2006.

LIQUIDITY AND CAPITAL RESOURCES

The following table presents a summary of the Company’s cash flows from operating, investing and financing activities for the first nine months of fiscal 2007 and 2006.


	Nine months ended
	Oct. 29,			Oct. 30,
	2006			2005
	(In thousands)
Net cash provided by operating activities	$	16,401		$	9,280
Net cash provided by (used for) investing activities		7,859			(15,884	)
Net cash provided by (used for) financing activities		(4,054	)		7,834
Effect of exchange rate changes on cash		27			(11	)
Cash balances of subsidiaries at date of deconsolidation		(1,413	)		(1,011	)

Net increase in cash and cash equivalents	$	18,820		$	208

Cash Flows from Operating Activities

Net cash provided by operating activities was $16.4 million and $9.3 million in the first nine months of fiscal 2007 and 2006, respectively. A major component of the improvement was reduced interim management fees and professional fees related to the investigations and litigation described in Note 6 to the consolidated financial statements appearing elsewhere herein, which reduced operating cash flow by $7.3 million and $19.5 million for the first nine months of fiscal 2007 and 2006, respectively.

Cash Flows from Investing Activities

Investing activities provided $7.9 million of cash in the first nine months of fiscal 2007 and used $15.9 million of cash in the first nine months of fiscal 2006. Cash used for capital expenditures declined from $9.0 million for the first nine months of fiscal 2006 to $2.8 million for the first nine months of fiscal 2007 because the Company substantially eliminated store expansion early in fiscal 2006. In the first nine months of fiscal 2007 and 2006, the Company realized proceeds from the sale of property and equipment of $6.2 million and $4.6 million, respectively, most of which relates to closed stores.

During the first nine months of fiscal 2007, the Company recovered $2.5 million related to its investment in Freedom Rings (which filed for bankruptcy protection in October 2005) and received approximately $6.0 million from the sale of notes receivable from the Company’s franchisees in Australia and the United Kingdom and from the sale of the Company’s equity interest in another franchisee (see Note 9 to the consolidated financial statements appearing elsewhere herein).

In addition, in the first nine months of fiscal 2007, the Company paid approximately $1.1 million to settle its obligations under its guarantees of a portion of the indebtedness of Glazed Investments, a subsidiary which filed for bankruptcy protection in February 2006 as described in Note 9 to the consolidated financial statements. In the first nine months of fiscal 2006, the Company paid approximately $9.3 million to settle the its obligations under certain guarantees of indebtedness of KremeKo. Each of these amounts is included in “Investments in and advance to equity method franchisees” in the consolidated statement of cash flows, and the transactions are more fully described in Note 9 to the consolidated financial statements.

During the first nine months of fiscal 2007, the Company purchased three stores from one of its franchisees for $2.9 million cash, as described in Note 6 to the consolidated financial statements.

Cash Flows from Financing Activities

Net cash used by financing activities was $4.1 million in the first nine months of fiscal 2007, compared to net cash provided by financing activities of $7.8 million in the first nine months of fiscal 2006.

During the first nine months of fiscal 2007, the financing activities included net short-term borrowings of $595,000 and scheduled amortization of long-term debt. In addition, pursuant to the provisions of the Secured Credit Facilities described in Note 5 to the

consolidated financial statements appearing elsewhere herein, in the first nine months of fiscal 2007 the Company prepaid approximately $1.5 million of the Term Loan using proceeds from the sale of certain property and equipment, and repaid an additional $8.9 million of the Term Loan subsequent to October 29, 2006.

During the first half of fiscal 2006, the Company closed the Secured Credit Facilities described in Note 5 to the consolidated financial statements. The Company borrowed $120 million under these facilities at closing, and used approximately $87.6 million to repay borrowing outstanding under a prior credit facility (which was terminated). In the first nine months of fiscal 2006, the Company paid approximately $8.8 million of fees, costs and expenses associated with the new facility. Also during the first nine months of fiscal 2006, the Company retired approximately $9.6 million of other long-term indebtedness, including approximately $6.1 million related to Consolidated Franchisees. Cash inflows from financing activities in the first nine months of fiscal 2006 also included $2.6 million of capital contributions to a Consolidated Franchisee by minority investors in that franchisee.

Other Balance Sheet Changes

Other current assets and other accrued liabilities declined by approximately $14.9 million and $27.1 million, respectively, from January 29 to October 29, 2006. The most significant reason for the declines was the deconsolidation of the financial statements of Glazed Investments (see Notes 1 and 9 to the consolidated financial statements appearing elsewhere herein). Other current assets and other accrued liabilities at January 29, 2006 included approximately $13.0 million and $18.5 million, respectively, related to Glazed Investments which was derecognized when the Company ceased consolidation of Glazed Investments’ financial statements during the first quarter of fiscal 2007.

Business Conditions, Uncertainties and Liquidity

The Company incurred a net loss of $198.3 million in fiscal 2005 and $135.8 million in fiscal 2006. These losses reflect impairment and lease termination costs of $197.0 million in fiscal 2005 and $55.1 million in fiscal 2006. Fiscal 2006 results also reflect a non-cash charge of $35.8 million for the anticipated settlement of certain litigation as described in Note 6 to the consolidated financial statements appearing elsewhere herein. Cash provided by operating activities declined from $84.9 million in fiscal 2005 to $1.9 million in fiscal 2006.

Investigations of the Company have been initiated by the Commission and the United States Attorney for the Southern District of New York, and other litigation and investigations are pending as described in Note 6 to the consolidated financial statements appearing elsewhere herein. In October 2004, the Company’s Board of Directors elected two new independent directors and appointed them the members of a Special Committee to investigate the matters raised by the Commission, the allegations in certain litigation, issues raised by the Company’s independent auditors and other matters relevant to the foregoing. The Special Committee issued its report in August 2005.

The Company has incurred substantial expenses to defend the Company and certain of its current and former officers and directors in connection with litigation, to cooperate with the investigations of the Commission, the United States Attorney and the Special Committee of the Company’s Board of Directors, to undertake the Company’s internal investigation of accounting matters, and to indemnify certain current and former officers and directors for certain legal and other expenses incurred by them. These expenses are continuing in fiscal 2007, and could be substantial in future years.

Since January 2005, the Company has undertaken a number of initiatives designed to improve the Company’s operating results and financial position. Such initiatives include closing a substantial number of underperforming stores, reducing corporate overhead and other costs to bring them more in line with the Company’s current level of operations, recruiting new management personnel for certain positions, obtaining the Secured Credit Facilities described in Note 5 to the consolidated financial statements appearing elsewhere herein, restructuring certain financial arrangements associated with franchisees in which the Company has an ownership interest and with respect to which the Company has financial guarantee obligations, and selling certain non-strategic assets. In March

2006, the Company appointed a new chief executive officer having over 20 years experience in the food industry and with particular experience in consumer packaged goods.

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

Recent Accounting Pronouncements

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

In November 2004, the FASB issued Statement No. 151, “Inventory Costs” (“FAS 151”), which amends the guidance in Accounting Research Bulletin No. 43, “Inventory Pricing,” to clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs and wasted material (spoilage). FAS 151 requires that those items be recognized as current period charges and that the allocation of fixed production overheads to the cost of converting work in process to finished goods be based on the normal capacity of the production facilities. The Company adopted FAS 151 in the first quarter of fiscal 2007, but adoption had no material effect on the Company’s consolidated financial statements.

In May 2005, the FASB issued Statement No. 154, “Accounting Changes and Error Corrections” (“FAS 154”) to replace Accounting Principles Board Opinion No. 20, “Accounting Changes” and FAS 3, “Reporting Accounting Changes in Interim Periods.” FAS 154 provides guidance on the accounting for and reporting of accounting changes and error corrections, and establishes retrospective application as the required method for reporting a change in accounting principle. FAS 154 provides guidance for determining whether retrospective application of a change in accounting principle is impracticable, and for reporting a change when retrospective application is determined to be impracticable. FAS 154 also addresses the reporting of a correction of an error by restating previously issued financial statements. The Company adopted FAS 154 in the first quarter of fiscal 2007, but adoption had no effect on the Company’s consolidated financial statements.

Critical Accounting Policies

The following discussion supplements the description of Critical Accounting Policies included in Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” in the 2006 Form 10-K.

Stock-Based Compensation

In the first quarter of fiscal 2007, the Company adopted Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment,” which requires that stock awards, including stock options, granted to employees and which ultimately vest be recognized as compensation expense based on their fair value at the grant date. Because options granted to employees differ from options on the Company’s common shares traded in the financial markets, the Company cannot determine the fair value of options granted to employees based on observed market prices. Accordingly, the Company estimates the fair value of stock options using the Black-Scholes option valuation model, which requires inputs including interest rates, expected dividends, volatility measures and employee exercise behavior patterns. Some of the inputs the Company uses are not market-observable and must be estimated. In addition, the Company must estimate the number of awards which ultimately will vest, and periodically adjust such estimates to reflect actual vesting events. Use of different estimates and assumptions would produce different option values, which in turn would affect the amount of compensation expense recognized.

The Black-Scholes model is capable of considering the specific features included in the options granted to the Company’s employees. However, there are other models which could be used to estimate fair value and, if the Company were to use a different model, the option values would differ despite using the same inputs. Accordingly, using different assumptions coupled with using a different valuation model could have a significant impact on the fair value of employee stock options.

Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.

The Company is exposed to market risk from increases in interest rates on its outstanding debt. All of the borrowings under the Company’s secured credit facilities bear interest at variable rates based upon either the prime rate, the Fed funds rate or LIBOR. The Company has entered into an interest rate derivative contract having a notional principal amount of $75 million which eliminates the Company’s exposure to increases in three month LIBOR, to the extent of such notional amount, beyond 4.5% through April 2007 and 5.0% from May 2007 through March 2008. The interest cost of the Company’s debt is affected by changes in short term interest rates and increases in those rates adversely affect the Company’s results of operations.

As of October 29, 2006, the Company had approximately $119 million in borrowings outstanding. A hypothetical increase of 100 basis points in short-term interest rates would result in an increase in the Company’s annual interest expense of approximately $450,000, after giving effect to additional payments due to the Company from the interest rate hedge described above.

Because the substantial majority of the Company’s revenue, expense and capital purchasing activities are transacted in United States dollars, the exposure to foreign currency exchange risk historically has been minor. In addition to operating revenues and expenses, the Company’s investment in a franchisee operating in the United Kingdom and Mexico and the Company’s operations in

Canada expose the Company to exchange rate risk. The Company historically has not attempted to hedge these exchange rate risks. The Company completed the sale of its interest in the franchisee operating in the United Kingdom in November 2006.

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

In addition to entering into forward purchase contracts, from time to time the Company purchases exchange-traded commodity futures contracts, and options on such contracts, for raw materials which are ingredients of its products or which are components of such ingredients, including wheat, soybean oil and coffee. The Company typically assigns the futures contract to a supplier in connection with entering into a forward purchase contract for the related ingredient. Quantitative information about the Company’s option contracts and unassigned commodity futures contracts and options on such contracts as of October 29, 2006, all of which mature in fiscal 2007, is set forth in the table below.


				Weighted			Aggregate		Aggregate
				Average Contract			Contract Price		Fair
	Contract Volume			or Strike Price			or Strike Price		Value
	(Dollars in thousands, except average prices)
Futures contracts:
Wheat		410,000	bushels	$	4.70	/bushel	$	1,926	$	142
Soybean oil		1,860,000	lbs.	$	0.24	/lb.		440		59

Options contracts:
Call options on coffee futures		150,000	lbs.	$	1.10	/lb.		165		2

									$	203

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

Item 4. CONTROLS AND PROCEDURES.

Evaluation of Disclosure Controls and Procedures

As of October 29, 2006, the end of the period covered by this Quarterly Report on Form 10-Q, management performed, under the supervision and with the participation of the Company’s chief executive officer and chief financial officer, an evaluation of the effectiveness of the Company’s disclosure controls and procedures as defined in Rules 13a-15(e) and 15d-15(e) of the Exchange Act. The Company’s disclosure controls and procedures are designed to ensure that information required to be disclosed in the reports the Company files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Commission’s rules and forms, and that such information is accumulated and communicated to management, including the Company’s chief executive officer and chief financial officer, to allow timely decisions regarding required disclosures. Based on this evaluation and the identification of material weaknesses in the Company’s internal control over financial reporting as described in the 2006 Form 10-K, the Company’s chief executive officer and chief financial officer have concluded that, as of October 29, 2006, the Company’s disclosure controls and procedures were not effective. Based on a number of factors, including performance of extensive manual procedures to help ensure the proper collection, evaluation, and disclosure of the information included in the consolidated financial statements, management has concluded that the consolidated financial statements included in this Quarterly Report on Form 10-Q fairly present, in all material respects, the Company’s financial position, results of operations and cash flows for the periods presented in conformity with generally accepted accounting principles (“GAAP”).

Changes in Internal Control Over Financial Reporting

As more fully set forth in Item 9A, “Controls and Procedures,” of the 2006 Form 10-K, management concluded that the Company’s internal controls over financial reporting were not effective as of January 29, 2006 because of the existence at that date of material weaknesses in internal controls. Those material weaknesses are described below (reproduced from Item 9A of the 2006 Form 10-K).

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

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

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

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

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

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

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

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

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

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

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

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

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

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

•

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

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

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

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

During the quarter ended October 29, 2006, there were no material changes in the Company’s system of internal controls over financial reporting.

The Company completed its assessment of the effectiveness of its internal control over financial reporting as of January 29, 2006 in October 2006. Subsequent to January 29, but prior to issuance of the 2006 Form 10-K in October, the Company implemented measures designed to remediate certain of the material weaknesses the Company had identified, and has implemented additional measures since October 2006. While the Company has designed and/or implemented a number of controls designed to remediate some of the material weaknesses in internal control over financial reporting, the Company has not completed testing and evaluating such controls as of October 29, 2006. Accordingly, the Company does not consider any of the material weaknesses identified as of January 29, 2006 to have been remediated as of October 29, 2006.

The Company currently expects that its assessment of its internal controls over financial reporting as of January 28, 2007 will conclude that the Company’s internal control over financial reporting at that date remains ineffective because of the continued existence of material weaknesses at that date.

PART II — OTHER INFORMATION

Item 1. LEGAL PROCEEDINGS.

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

Governmental Investigations

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

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

Department of Labor Review. On March 9, 2005, and March 21, 2005, the DOL informed the Company that it was commencing a “review” of the Krispy Kreme Doughnut Corporation Retirement Savings Plan and the Krispy Kreme Profit Sharing Stock Ownership Plan to determine whether any violations of Title I of ERISA occurred. On November 7, 2006, the DOL issued a letter indicating that it was satisfied that the settlement in the ERISA class action is favorable to the ERISA plans at issue, and that it is closing its investigation of the plans.

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

Litigation

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

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

With respect to the securities class action, the Stipulation provides for the certification of a class consisting of all persons who purchased the Company’s publicly-traded securities between March 8, 2001 and April 18, 2005, inclusive. The settlement class will receive total consideration of approximately $75 million, consisting of a cash payment of $34,967,000 to be made by the Company’s directors’ and officers’ insurers, a cash payment of $100,000 to be made by Mr. Tate, a cash payment of $100,000 to be made by Mr. Casstevens, a cash payment of $4,000,000 to be made by the Company’s independent registered public accounting firm and common stock and warrants to purchase common stock to be issued by the Company having an aggregate value of $35,833,000 (based on the market price of the Company’s common stock as of late October and early November 2006). All claims against defendants will be dismissed with prejudice; however, claims that the Company may have against Mr. Livengood that may be asserted by the Company in the derivative action for contribution to the securities class action settlement or otherwise under applicable law are expressly preserved. The Stipulation contains no admission of fault or wrongdoing by the Company or the other defendants. On November 16, 2006, the court entered an order granting preliminary approval to the settlement. The settlement is subject to final approval of the court.

With respect to the derivative litigation, the Stipulation provides for the settlement and dismissal with prejudice of all claims against defendants except for claims against Mr. Livengood. The Company, acting through its Special Committee, settled claims against Mr. Tate and Mr. Casstevens for the following consideration: Messrs. Tate and Casstevens each agreed to contribute $100,000 in cash to the settlement of the securities class action; Mr. Tate agreed to cancel his interest in 6,000 shares of the Company’s common stock; and Messrs. Tate and Casstevens agreed to limit their claims for indemnity from the Company in connection with future

proceedings before the Commission or the United States Attorney for the Southern District of New York to specified amounts. The Company, acting through its Special Committee, has been in negotiations with Mr. Livengood but has not reached agreement to resolve the derivative claims against him and counsel for the derivative plaintiffs are deferring their application for fees until conclusion of the derivative actions against Mr. Livengood. All other claims against defendants named in the derivative actions will be dismissed with prejudice without paying any consideration, consistent with the findings and conclusions of the Special Committee in its report of August 2005.

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

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

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

ERISA Class Action. On March 16, 2005, the Company’s wholly-owned subsidiary, KKDC, was served with a purported class action lawsuit filed in the United States District Court for the Middle District of North Carolina that asserted claims for breach of fiduciary duty under ERISA against KKDC and certain of its current and former officers and employees. Plaintiffs purported to represent a class of persons who were participants in or beneficiaries of KKDC’s retirement savings plan or profit sharing stock ownership plan between January 1, 2003 and the date of filing and whose accounts included investments in our common stock. Plaintiffs contended that defendants failed to manage prudently and loyally the assets of the plans by continuing to offer the Company’s common stock as an investment option and to hold large percentages of the plans’ assets in the Company’s common stock; failed to provide complete and accurate information about the risks of our common stock; failed to monitor the performance of fiduciary appointees; and breached duties and responsibilities as co-fiduciaries. On May 15, 2006 the Company announced that a proposed settlement had been reached with respect to this matter. The settlement includes a one-time cash payment to be made to the settlement class by the Company’s insurer in the amount of $4,750,000. The Company and the individual defendants deny any and all wrongdoing and paid no money in the settlement, which was granted final approval by the United States District Court on January 10, 2007.

Franchisee Litigation

the merits. A settlement was reached between the parties and on August 25, 2006 a joint stipulation for dismissal of the litigation with prejudice was filed with the court. The court dismissed the case on August 28, 2006.

Item 1A. RISK FACTORS.

See Item 1A, “Risk Factors,” in the 2006 Form 10-K. Under the caption “Risks Relating to the Food Service Industry” in the 2006 Form 10-K, the Company discussed risks associated with regulation and publicity concerning food quality, health and other issues and a proposed amendment to the New York City Health Code. Recently, the New York City Health Department adopted an amendment to the New York City Health Code that will phase out artificial trans fat (which the Company currently uses in its doughnuts) in all New York City restaurants and other food service establishments by July 1, 2008.

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

None.

Item 3. DEFAULTS UPON SENIOR SECURITIES.

None.

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

None.

Item 5. OTHER INFORMATION.

None.

Item 6. EXHIBITS.


Exhibit
Number		Description of Exhibits

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

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

10.1	—	Amendment No. 6, dated as of July 31, 2006, to the First Lien Credit Agreement (the “First Lien Credit Agreement”) dated as of April 1, 2005, as amended, among KKDC, KKDI, the Subsidiary Guarantors party thereto, the Lenders party thereto, Credit Suisse (formerly known as Credit Suisse First Boston), as Administrative Agent and Issuing Lender, and Wells Fargo Foothill, Inc., as Collateral Agent, Issuing Lender and Swingline Lender (incorporated by reference to Exhibit 10.1 to the Registrant’s Current Report on Form 8-K filed August 3, 2006)

10.2	—	Amendment No. 6, dated as of July 31, 2006, to the Second Lien Credit Agreement (the “Second Lien Credit Agreement”) dated as of April 1, 2005, as amended, among KKDC, KKDI, the Subsidiary Guarantors party thereto, the Lenders party thereto, Credit Suisse (formerly known as Credit Suisse First Boston), as Administrative Agent, Paying Agent, Fronting Bank and Collateral Agent (incorporated by reference to Exhibit 10.2 to the Registrant’s Current Report on Form 8-K filed August 3, 2006)

10.3	—	Contractor Services Agreement dated September 11, 2006 by and among Krispy Kreme Doughnuts, Inc., Krispy Kreme Doughnut Corporation and Charles A. Blixt (incorporated by reference to Exhibit 10.1 to the Registrant’s Current Report on Form 8-K filed September 14, 2006)

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


	Page
Index to Financial Statements
Consolidated balance sheet as of October 29, 2006 and January 29, 2006		6
Consolidated statement of operations for the three months and nine months ended October 29, 2006 and October 30, 2005		7
Consolidated statement of cash flows for the nine months ended October 29, 2006 and October 30, 2005		8
Consolidated statement of changes in shareholders’ equity for the nine months ended October 29, 2006 and October 30, 2005		9
Notes to financial statements		10


		Krispy Kreme Doughnuts, Inc.

Date: January 19, 2007	By:	/s/ Daryl G. Brewster

		Name: Daryl G. Brewster
		Title: Chief Executive Officer

Date: January 19, 2007	By:	/s/ Michael C. Phalen

		Name: Michael C. Phalen
		Title: Chief Financial Officer


		Page
FORWARD-LOOKING STATEMENTS			3

PART I – FINANCIAL INFORMATION			5

Item 1.	FINANCIAL STATEMENTS		5
Item 2.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS		27
Item 3.	QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK		40
Item 4.	CONTROLS AND PROCEDURES		41

PART II – OTHER INFORMATION			44

Item 1.	LEGAL PROCEEDINGS		44
Item 1A.	RISK FACTORS		47
Item 2.	UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS		47
Item 3.	DEFAULTS UPON SENIOR SECURITIES		47
Item 4.	SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS		48
Item 5.	OTHER INFORMATION		48
Item 6.	EXHIBITS		48

	SIGNATURES		49
EX-31.1: CERTIFICATION
EX-31.2: CERTIFICATION
EX-32.1: CERTIFICATION
EX-32.2: CERTIFICATION


		/s/ Daryl G. Brewster
		Daryl G. Brewster
		Chief Executive Officer


		/s/ Michael C. Phalen
		Michael C. Phalen
		Chief Financial Officer