UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

For the quarterly period ended August 1, 2004

OR

Commission file number 001-16485

KRISPY KREME DOUGHNUTS, INC.

(336) 725-2981

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 12 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 x No o

Indicate by check mark whether the registrant is an accelerated filer
(as defined in Rule 12b-2 of the Exchange Act).     Yes x No o

Indicate the number of shares outstanding of each of the issuer’s classes of
common stock, as of the latest practicable date.

1

Krispy Kreme Doughnuts, Inc.

FORM 10-Q

For the Quarter Ended August 1, 2004

INDEX

2

Part I. Financial Information

Krispy Kreme Doughnuts, Inc.
Consolidated Balance Sheets
(in thousands)

The accompanying condensed notes are an integral part of these consolidated financial statements.

3

Krispy Kreme Doughnuts, Inc.
Consolidated Statements of Operations
(in thousands, except per share amounts)
(Unaudited)

The accompanying condensed notes are an integral part of these consolidated financial statements.

4

Krispy Kreme Doughnuts, Inc.
Consolidated Statement of Shareholders’ Equity
(in thousands)
Unaudited

The accompanying condensed notes are an integral part of these consolidated financial statements.

5

Krispy Kreme Doughnuts, Inc.
Consolidated Statements of Cash Flows
(in thousands)
(Unaudited)

6

The accompanying condensed notes are an integral part of these consolidated financial statements.

7

Krispy Kreme Doughnuts, Inc.
Notes to Unaudited Consolidated Financial Statements

Note 1: Summary of Significant Accounting Policies

Basis of Presentation

The accompanying consolidated financial statements are presented in accordance with the requirements of Article 10 of Regulation S-X and, consequently, do not include all the disclosures normally required by generally accepted accounting principles and should be read together with the Company’s Annual Report for the year ended February 1, 2004. The financial information has been prepared in accordance with the Company’s customary accounting practices and has not been audited. In the opinion of management, the financial information includes all adjustments, consisting of normal recurring adjustments, necessary for a fair presentation of interim results. Certain amounts in the fiscal 2004 financial statements have been reclassified to conform to the fiscal 2005 presentation.

On August 30, 2004, the Audit Committee retained an independent law firm to perform an investigation regarding a specific matter relating to an acquisition in fiscal 2004. The dollar amount involved relating to such matter was immaterial from a quantitative standpoint to the Company’s financial statements. Following its investigation, the independent law firm concluded that neither the Company nor any of its employees engaged in any intentional misconduct related to the matter. Our independent auditors subsequently requested that the independent law firm perform certain additional procedures and have advised us that their review of our financial statements contained in this filing is not complete and will not be completed prior to the independent law firm completing such additional procedures, which are currently underway. Such request was not made in response to any findings made by the independent law firm in connection with the investigation. Although the Company and its Audit Committee believe that the procedures performed to date are sufficient to conclude the matter, the Audit Committee has authorized the independent law firm to perform the additional procedures, primarily related to a further review of certain electronic files, referenced above in response to our independent auditors’ request.

Basis of Consolidation

The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All significant intercompany accounts and transactions are eliminated in consolidation. Generally, unconsolidated investments greater than 50 percent in affiliates for which the Company maintains control are also consolidated and the portion not owned by the Company is shown as a minority interest. The Company invests in several joint ventures to develop and operate Krispy Kreme stores. The Company consolidates the accounts of three of these joint ventures: Freedom Rings, LLC (“Freedom Rings”), the joint venture with the rights to develop stores in Eastern Pennsylvania, Delaware and Southern New Jersey; Glazed Investments, LLC (“Glazed Investments”), the joint venture with the rights to develop stores in Colorado, Minnesota and Wisconsin; and New England Dough, LLC (“New England Dough”), the joint venture with the rights to develop stores in Connecticut, Maine, Massachusetts, Rhode Island, New Hampshire and Vermont. The Company began consolidating the accounts of New England Dough at the end of the first quarter of fiscal 2005 as a result of the implementation of Financial Accounting Standards Board (“FASB”) Interpretation No. 46-R (“FIN 46-R”), which addresses the consolidation of business enterprises. See further discussion under “Recent Accounting Pronouncements” below. The accompanying consolidated financial statements also include the accounts of Golden Gate Doughnuts, LLC (“Golden Gate”), a joint venture which owned the rights to develop stores in Northern California, for periods prior to January 30, 2004. The Company acquired the remaining 33% minority interest in this joint venture effective January 30, 2004. Generally, investments in 20- to 50-percent owned affiliates for which the Company has the ability to exercise significant influence over operating and financial policies are accounted for by the equity method of accounting, whereby the investment is carried at the cost of acquisition, plus the Company’s equity in undistributed earnings or losses since acquisition, less any distributions received by the Company. Accordingly, the Company’s share of the net income or loss of these companies is included in consolidated net income. Investments in less than 20-percent owned affiliates are generally accounted for by the cost method of accounting.

Goodwill and Intangible Assets

Goodwill represents the excess of the purchase price over the net assets, including other identified intangible assets, acquired in connection with acquisitions. Goodwill has an indefinite life and is reviewed at least annually for impairment or whenever events or circumstances indicate the carrying amount may be impaired.

Other intangible assets consist primarily of reacquired franchise rights, trademarks and trade names and recipes. Reacquired franchise rights represent the value assigned to the rights acquired in connection with acquisitions of franchise markets from existing franchisees. The Company has determined that reacquired franchise rights and trademarks and trade names have indefinite lives and are not subject to amortization. Recipes have a definite life and are amortized on a straight-line basis over an estimated useful life of 10 years. Reacquired franchise rights and trademarks and trade names are reviewed at least annually for impairment or whenever events or circumstances indicate the carrying amount of the assets may be impaired. Recipes are tested for impairment whenever events or circumstances indicate their carrying amount may be impaired.

8

The Company performs its annual test of impairment as of December 31. The Company performs additional impairment tests with respect to goodwill and other indefinite lived intangible assets on an interim basis when there are changes in facts and circumstances or specific events which indicate these assets may be impaired.

Asset Impairment

When a store is identified as underperforming or a decision is made to close a store, the Company makes an assessment of the potential impairment of the related assets. The assessment is based upon a comparison of the carrying amount of the assets, primarily property and equipment, to the estimated undiscounted cash flows expected to be generated from those assets. To estimate cash flows, management projects the net cash flows anticipated from continuing operation of the store until its closing as well as cash flows anticipated from disposal of the related assets, if any. If the carrying amount of the assets exceeds the sum of the undiscounted cash flows, the Company records a charge for impairment measured as the excess of the carrying value over the fair value of the assets. The resulting net book value of the assets, less estimated net realizable value at disposition, is depreciated over the remaining term that the store will continue in operation. At the store closing date, the Company discontinues depreciation on all assets related to closed store properties.

Revenue Recognition

A summary of the revenue recognition policies for each segment of the Company (see Note 10 — Business Segment Information) is as follows:

•

Company Store Operations revenue is derived from the sale of doughnuts and related items to on-premises and off-premises customers. Revenue is recognized at the time of sale for on-premises sales. For off-premises sales, revenue is recognized at the time of delivery.

•

Franchise Operations revenue is derived from: (1) development and franchise fees from the opening of new stores; and (2) royalties charged to franchisees based on sales. Development and franchise fees are charged for certain new stores and are deferred until the store is opened and the Company has performed substantially all of the initial services it is required to provide. The royalties recognized in each period are based on the sales in that period.

•

KKM&D revenue is derived from the sale of doughnut-making equipment, mix, coffee and other supplies needed to operate a doughnut store to Company-owned and franchised stores. Revenue is recognized at the time the title and the risk of loss pass to the customer, generally upon delivery of the goods. KKM&D revenue derived from Company-owned stores and consolidated joint venture stores is eliminated in consolidation.

Comprehensive Income

Statement of Financial Accounting Standards (“SFAS”) No. 130, “Reporting Comprehensive Income,” requires that certain items such as foreign currency translation adjustments and unrealized gains and losses on certain investments in debt and equity securities be presented as separate components of shareholders’ equity. Total comprehensive income (loss) for the three and six months ended August 3, 2003 was $13,439,000 and $26,661,000, respectively, and for the three and six months ended August 1, 2004 was $5,779,000 and $(18,127,000), respectively.

Foreign Currency Translation

For all non-U.S. joint ventures, the functional currency is the local currency. Assets and liabilities of those operations are translated into U. S. dollars using exchange rates at the balance sheet date. Revenue and expenses are translated using the average exchange rates for the reporting period. Translation adjustments are reported in accumulated other comprehensive loss, a separate component of shareholders’ equity. Transaction gains and losses resulting from remeasuring transactions denominated in currencies other than the functional currency are included in other income (expense), net.

9

Stock-Based Compensation

The Company accounts for employee stock options in accordance with Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees.” Under APB Opinion No. 25, the Company recognizes no compensation expense related to employee stock options, as no options are granted below the market price on the grant date. SFAS No. 123, “Accounting for Stock-Based Compensation,” requires the recognition of compensation expense based on the fair value of options on the grant date, but allows companies to continue applying APB Opinion No. 25 if certain pro forma disclosures are made assuming hypothetical fair value method application.

Had compensation expense for the Company’s stock options been based on the fair value at the grant date under the methodology prescribed by SFAS No. 123, the Company’s net income (loss) and earnings (loss) per share for the three and six months ended August 3, 2003 and August 1, 2004 would have been impacted as follows:

Recent Accounting Pronouncements

In January 2003, the FASB issued Interpretation No. 46 (“FIN 46”), “Consolidation of Variable Interest Entities,” and amended it by issuing FIN 46-R in December 2003. FIN 46-R addresses the consolidation of business enterprises (variable interest entities) to which the usual condition of consolidation, a controlling financial interest, does not apply. FIN 46-R requires an entity to assess its equity investments and certain other contractual interests to determine if they are variable interest entities. As defined in FIN 46-R, variable interests are contractual, ownership or other interests in an entity that change with changes in the entity’s net asset value. Variable interests in an entity may arise from financial instruments, service contracts, guarantees, leases or other arrangements with the variable interest entity. An entity that will absorb a majority of the variable interest entity’s expected losses or expected residual returns, as defined in FIN 46-R, is considered the primary beneficiary of the variable interest entity. The primary beneficiary must include the variable interest entity’s assets, liabilities and results of operations in its consolidated financial statements. FIN 46-R was effective for all non-special purpose variable interest entities for the first interim or annual period ending after March 15, 2004.

The Company currently has equity interests in joint ventures with other entities to develop and operate Krispy Kreme stores. For those joint ventures where the Company does not have the ability to control the joint venture’s management committee, the Company accounts for its investment under the equity method of accounting. For certain of these joint ventures, the Company holds variable interests, such as providing guarantees of the joint venture’s debt or leases. Based on analysis of FIN 46-R, the Company began consolidating the accounts of New England Dough, the joint venture in which the Company holds a 57% interest, effective May 2, 2004. Historically, the Company accounted for its investment in New England Dough using the equity method. The initial consolidation of New England Dough did not have a material impact on the net operating results of the Company, although it did result in increases in individual line items in the Company’s financial statements. The amounts included in the Company’s consolidated balance sheet upon the initial consolidation of New England Dough are summarized below.

10

Note 2: Discontinued Operations

In the first quarter of fiscal 2005, the Company adopted a plan, approved by the Board of Directors, to divest the existing Montana Mills Bread Co., Inc. (“Montana Mills”) operations. The Company acquired Montana Mills, an owner and operator of upscale “village bread stores” in the Northeastern United States, in April 2003 and had historically reported the results of operations of Montana Mills as a separate segment of the business. During the second quarter of fiscal 2005, the Company closed seven Montana Mills locations. The Company plans to close additional underperforming Montana Mills stores and is actively marketing for sale the operations that will remain. The Company intends to complete the sale during fiscal 2005, although there can be no assurance that such a sale will be consummated. The Company will have no continuing interest in the business of Montana Mills subsequent to its disposal.

The disposition of Montana Mills meets the criteria of and is accounted for as a discontinued operation in accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” The results of operations and cash flows of this segment are separately presented as discontinued operations in the accompanying consolidated financial statements. All prior periods have been reclassified to conform to this accounting treatment.

In connection with the decision to divest Montana Mills, the Company recorded an impairment charge and store closing costs of $34,707,000 in the six months ended August 1, 2004. The impairment charge consists of the write-off of goodwill recorded in connection with the acquisition of $19,664,000, the write-off of amounts recorded as the value of trademarks and trade names and recipes acquired of $12,081,000 and provisions, totaling $2,786,000, to reduce the carrying amount of other Montana Mills’ assets and liabilities, primarily property and equipment, to their estimated recoverable value. Store closing costs consist of costs to exit leases for certain closed locations and severance payments totaling $176,000. The Company recorded a gain on the disposition of the related assets held for sale of $53,000 in the second quarter of fiscal 2005. During the second quarter of fiscal 2005, the Company provided funding to Montana Mills of $893,000, to fund operations and the costs associated with the closing of the locations.

At August 1, 2004, the assets related to the discontinued operations are recorded at their estimated net realizable value of $1,574,000. These assets represent primarily leasehold improvements and equipment related to the stores and are included in assets held for sale in the accompanying consolidated balance sheet.

Summarized operating results from discontinued operations for the three and six months ended August 3, 2003 and August 1, 2004 are as follows:

The Company expects to continue to incur additional charges in subsequent periods in connection with the plan to divest the Montana Mills business. The majority of these charges will be for severance, lease termination and other store closing costs associated with the closed stores or those planned to be closed.

Note 3: Impairment Charge and Store Closing Costs

In the six months ended August 1, 2004, the Company recorded impairment charges and store closing costs totaling $9,345,000. The costs are primarily related to the closure of five Company

11

factory stores, including one commissary, and three satellites and consists of the adjustment necessary to reduce the recorded value for the assets related to these stores, including land, buildings and equipment, to their estimated net realizable value of approximately $5.6 million, charges representing the estimated cost to exit leases associated with the closed stores, net of anticipated sublease income, of approximately $1.7 million and severance payments and other related store closing costs of approximately $100,000. The charge also includes approximately $1.9 million in costs primarily associated with certain ancillary facilities, including a provision related to the Company’s investment in and certain other amounts due from a joint venture, Entrepreneurship and Economic Development Investment, LLC, and charges associated with the write-off of certain property and equipment located at non-store facilities acquired in connection with certain acquisitions, primarily the acquisition of the minority interest in Golden Gate completed at the end of fiscal 2004, as well as charges related to certain store equipment that the Company intends to replace to improve performance.

The following table details the activity in the provision for store closing costs for the six months ended August 1, 2004:

In connection with the store closures, the Company may incur additional charges in future periods, principally related to the closure in the third quarter of one additional store and costs associated with leases for the closed stores, as actual costs to exit leases may differ from initial estimates.

Note 4: Inventories

Inventories are stated at the lower of average cost or market. The components of inventories are as follows:

12

Note 5: Property and Equipment

Property and equipment consists of the following:

Note 6: Goodwill and Other Intangible Assets

The changes in the carrying amount of goodwill by segment for the six months ended August 1, 2004 are as follows:

(1)

Amounts have been reclassified to conform with fiscal 2005 presentation.

     Other intangible assets consist of the following:

(1)

Amounts have been reclassified to conform with fiscal 2005 presentation.

The carrying amount of the recipes represents primarily the recipes related to the development of certain beverages. Recipes were determined to have a definite life and are amortized on a straight-line basis over an estimated useful life of 10 years. Amortization expense associated with recipes for the three and six months ended August 1, 2004 was $3,000. The estimated annual amortization expense for each of the next five years following fiscal 2005 is $18,000.

13

As discussed further in Note 2 – Discontinued Operations, in the first quarter of fiscal 2005, the Company wrote off the goodwill, trademarks and trade names and recipes recorded in connection with an acquisition completed in April 2003 as a result of its decision to divest the related business. The charge is included in discontinued operations in the accompanying consolidated statements of operations and the corresponding amounts for the goodwill and other intangible assets at February 1, 2004 were reclassified to assets held for sale in the accompanying consolidated balance sheet. The Company recorded no other impairment loss related to goodwill or other intangible assets during the six months ended August 1, 2004 and none was recorded in the six months ended August 3, 2003.

Note 7: Accrued Expenses and Other Current Liabilities

Accrued expenses and other current liabilities are as follows:

Note 8: Debt

The Company’s debt consists of the following:

$150 Million Credit Agreement

On October 31, 2003, the Company entered into a $150,000,000 unsecured bank credit facility (“Credit Facility”) to refinance certain existing debt and increase borrowing availability for general working capital purposes and other financing and investing activities. The Credit Facility consists of a $119,338,000 revolving credit facility (“Revolver”) and a $30,662,000 term loan (“Term Loan”). Initial borrowings under the Revolver were used to repay amounts outstanding, including interest, under a $55,000,000 short-term promissory note entered into during June 2003 to partially finance an acquisition and to repay bank debt of Freedom Rings and Golden Gate. From the proceeds of the Revolver borrowings, the Company provided loans to these consolidated joint ventures to enable them to repay this debt. Given its significant ownership interest, the Company will continue to make financing available to its consolidated joint ventures to fund their capital needs as this process provides a lower cost of capital

14

and administrative efficiencies. Borrowings under the Term Loan were used to refinance an existing term loan (“$33 Million Term Loan”) entered into to fund the initial purchase and completion of a mix and distribution facility.

The amount available under the Revolver is reduced by letters of credit and was $48,096,000 at August 1, 2004. Outstanding letters of credit, primarily for insurance purposes, totaled $9,242,000 at August 1, 2004. The Company may request, on a one-time basis, an increase in the availability under the Revolver of up to $50,000,000, which would increase total availability under the Revolver to $169,338,000.

Under the Credit Facility, the Company may prepay amounts outstanding without penalty. Amounts outstanding under the Revolver are due in full on October 31, 2007, when the Credit Facility terminates. The Term Loan requires monthly payments of principal of $137,500 through October 31, 2007, at which time a final payment of all outstanding principal and accrued interest will be due. Interest on amounts outstanding under the Revolver is generally payable quarterly and interest on the Term Loan is payable monthly and is charged, at the Company’s option, at either the Base Rate, as defined within the Credit Facility agreement, plus an Applicable Margin, as defined, or Adjusted LIBOR, as defined, plus an Applicable Margin. The Applicable Margin ranges from 0.0% to 0.75% for Base Rate borrowings and from 1.0% to 2.0% for Adjusted LIBOR borrowings and is determined based upon the Company’s performance under certain financial covenants contained in the Credit Facility. The interest rate applicable at August 1, 2004 was 2.43% on the Revolver and 2.61% on the Term Loan. A fee on the unused portion of the Revolver is payable quarterly and ranges from 0.20% to 0.375%, which is also determined based upon the Company’s performance under certain financial covenants contained in the Credit Facility.

The Company is counterparty to an interest rate swap agreement with a bank, which was initially entered into in May 2002 to convert variable rate payments due under the $33 Million Term Loan to fixed amounts, thereby hedging against the impact of interest rate changes on future interest expense (forecasted cash flow). The Company formally documents all hedging instruments and assesses, both at inception of the contract and on an ongoing basis, whether they are effective in offsetting changes in cash flows of the hedged transaction. The swap had an initial notional amount of $33,000,000. The notional amount declines by $137,500 each month, originally to correspond with the reduction in principal of the $33 Million Term Loan and which now corresponds with the reduction in principal of the Term Loan. The notional amount of the swap at August 1, 2004 was $29,288,000. Under the terms of the swap, the Company makes fixed rate payments to the counterparty of 5.09% and in return receives payments at LIBOR. Monthly payments continue until the swap terminates May 1, 2007. The Company is exposed to credit loss in the event of nonperformance by the counterparty to the swap agreement; however, the Company does not anticipate nonperformance. At February 1, 2004 and August 1, 2004, the fair value carrying amount of the swap was a liability of $2,160,000 and $1,396,000, respectively. Accumulated other comprehensive loss for the three and six months ended August 3, 2003 includes a gain, net of tax, of $309,000 and $265,000, respectively, and for the three and six months ended August 1, 2004 includes a gain, net of tax, of $175,000 and $462,000, respectively, related to the swap.

The Credit Facility contains provisions that, among other requirements, restrict the payment of dividends and require the Company to maintain compliance with certain covenants, including the maintenance of certain financial ratios. At August 1, 2004, the Company was in compliance with each of these covenants.

Consolidated Joint Ventures — Glazed Investments

In December 2003, Glazed Investments entered into a $12.0 million credit facility (“Glazed Credit Facility”) to provide working capital and funding for the construction of stores and the purchase of related equipment. The Glazed Credit Facility provides a $500,000 working capital line of credit, up to $8,000,000 for the funding of the construction of stores and up to $3,500,000 for the purchase of related equipment. Amounts outstanding under the Glazed Credit Facility bear interest at one-month LIBOR plus 1.50% (2.87% at August 1, 2004), which is payable monthly. Upon completion of a store, amounts advanced to fund construction are converted to construction term loans (“Construction Notes”) and amounts advanced to fund the related equipment purchased are converted to equipment term loans (“Equipment Notes”). The Construction Notes require fixed monthly principal payments, based upon a term of ten years, plus interest, with a final payment of all outstanding amounts due on the earlier of June 30, 2010; two months prior to the final maturity of the subordinated debt discussed below; or five years after commencement of monthly payments of principal and interest. The Equipment Notes require monthly payments of principal and interest for a term of five years, with a final payment of all outstanding amounts on the earlier of

15

June 30, 2009; two months prior to the final maturity of the subordinated debt discussed below; or five years after commencement of monthly payments of principal and interest. The working capital line of credit expired on June 30, 2004 with no amounts outstanding. The loans are secured by the related property and equipment. The Company has also guaranteed approximately 75% of the amounts outstanding under the Glazed Credit Facility.

Prior to entering into the Glazed Credit Facility discussed above, Glazed Investments entered into arrangements with a non-bank financing institution that provided funding for the construction of stores and the purchase of the related equipment. While individual promissory notes exist for the financing of each store’s construction (“Real Estate Loans”) and related equipment purchases (“Equipment Loans”) for which funding was provided through these arrangements, the terms of each are substantially the same. Generally, Real Estate Loans require monthly payments of principal and interest for a fixed term of fifteen years and Equipment Loans require monthly payments of principal and interest for a fixed term of seven years. Interest is payable at rates based on either a fixed rate, which ranges from 7% to 8.65%, or a variable rate based on the one-month LIBOR rate or a commercial paper rate, plus a premium. The premium charged on variable rate loans ranges from 3.05% to 3.6%. At August 1, 2004, interest rates applicable to the Real Estate Loans and Equipment Loans range from 4.32% to 8.65%. The loans are secured by the related property and equipment. The Company has also guaranteed approximately 75% of the amounts outstanding under the loans.

In July 2004, Glazed Investments completed a sale-leaseback transaction related to six store locations. The transaction included the sale of the land, buildings and improvements associated with the stores for total proceeds of $17,300,000. Each location will be leased under an operating lease with a term of twenty years with the option to terminate the lease, if the franchise agreement for the location is not renewed by the Company, with six months written notice after fifteen years. The proceeds from the sale-leaseback were utilized to repay $3,531,000 of the amounts outstanding under the Glazed Credit Facility and $6,934,000 of amounts outstanding under Real Estate Loans and Equipment Loans. In connection with the repayment of these amounts, Glazed Investments recorded a charge of $435,000, representing costs associated with the early retirement of the debt and the write-off of deferred financing costs. The gain on the sale of the property, net of transaction costs, totaled $550,000. The gain was deferred and will be amortized over the minimum term of the related leases.

The Glazed Credit Facility and non-bank financing discussed above contain provisions requiring Glazed Investments to maintain compliance with certain financial and non-financial covenants, including maintenance of certain financial ratios. At August 1, 2004, Glazed Investments was in compliance with these covenants.

In July 2000, Glazed Investments issued $4,520,000 in senior subordinated notes (“Notes”) to fund, in part, expenses associated with the start-up of its operations. The Company purchased $1,007,000 of the Notes at the time of the initial offering. In connection with the Company’s acquisition of additional interests in Glazed Investments in fiscal 2003, the Company acquired an additional $3,377,000 in Notes. As a result, approximately $4,384,000 of the Notes are payable to the Company. The Notes outstanding at August 1, 2004 totaling $136,000 represent the amount of the original $4,520,000 issued that remains payable to a third party. The Notes bear interest at 12.0% payable semi-annually each April 30 and October 31 through April 30, 2010, at which time a final payment of outstanding principal and accrued interest is due.

Consolidated Joint Ventures — New England Dough

In April 2003, New England Dough entered into a $17,685,000 credit facility (“New England Dough Facility”) with a bank to provide general working capital and funding for the construction of stores and the purchase of related equipment. In April 2004, the amount available under the New England Dough Facility was increased to approximately $26,400,000 and consists of a $12,000,000 revolving line of credit and two term loans with initial balances totaling approximately $14,400,000. The revolving line of credit matures on April 21, 2005 and bears interest at one-month LIBOR plus 1.25%. Borrowings under the revolving line of credit are generally used to fund store construction. Amounts outstanding under the revolving line of credit may be converted to term loans with maturities of five years. The term loans require monthly principal payments and bear interest at one-month LIBOR plus 1.25% (2.62% at August 1, 2004). At August 1, 2004, the amount available under the New England Dough Facility was $12,000,000. The New England Dough Facility is secured by inventory, receivables and property and equipment of the joint venture. The Company has also guaranteed 57% of the amounts outstanding.

16

The New England Dough Facility contains provisions requiring the joint venture to maintain compliance with certain financial and non-financial covenants, including maintenance of certain financial ratios. At August 1, 2004, New England Dough was in compliance with these covenants.

New England Dough is counterparty to interest rate swap agreements with a bank, which were initially entered into upon inception of each term loan to convert variable rate payments due under the term loans to fixed amounts, thereby hedging against the impact of interest rate changes on future interest expense (forecasted cash flow). The initial notional amount of the swaps corresponded to the related amount of each term loan, $5,685,000 and $8,725,000, respectively. The notional amount declines by $31,600 and $48,500, respectively, each month corresponding to the reduction in principal of the term loans. The notional amount of the swaps at August 1, 2004 totaled $13,967,000. Under the terms of the swap agreements, the Company makes fixed rate payments to the counterparty of 4.1% and 4.865%, respectively, and in return receives payments at LIBOR. Monthly payments continue until the maturity of each term loan. New England Dough is exposed to credit loss in the event of nonperformance by the counterparty to the swap agreement; however, New England Dough does not anticipate nonperformance.

For franchisees in which we have an ownership interest, the Company will sometimes guarantee an amount of the debt or leases, generally equal to the Company’s ownership percentage. The amounts guaranteed by the Company are disclosed in Note 11 – Joint Ventures.

Note 9: Earnings Per Share

The computation of basic earnings (loss) per share is based on the weighted average number of common shares outstanding during the period. The computation of diluted earnings (loss) per share reflects the potential dilution that would occur if stock options were exercised and the dilution from the issuance of restricted shares. The treasury stock method is used to calculate dilutive shares. This reduces the gross number of dilutive shares by the number of shares purchasable from the proceeds of the options assumed to be exercised, the proceeds of the tax benefits recognized by the Company in conjunction with nonqualified stock plans and from the amounts of unearned compensation associated with the restricted shares.

The following table sets forth the computation of the number of shares outstanding:

Stock options and warrants in the amount of 475,400 shares and 828,800 shares for the three and six months ended August 3, 2003, respectively, and stock options and warrants in the amount of 4,096,000 and 3,968,000 shares for the three and six months ended August 1, 2004, respectively, have been excluded from the diluted shares calculation as the inclusion of these options would be anti-dilutive.

Note 10: Business Segment Information

The Company’s reportable segments are Company Store Operations, Franchise Operations and KKM&D. The Company Store Operations segment is comprised of the operating activities of the stores owned by the Company and those in consolidated joint ventures. 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 Store Operations are purchased from the KKM&D business segment and Company Store Operations operating income reflects the benefit of the Company’s vertical integration. The Franchise Operations segment represents the results of the Company’s franchise program. Under the terms of the franchise agreements, the licensed operators pay

17

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 business 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 intersegment transactions between the KKM&D business segment and the Company Store Operations segment are at prices intended to reflect an arms-length transfer price and are eliminated in consolidation. Profit from KKM&D’s sales to Company Store Operations is classified as a reduction of Company Store Operations operating expenses, generally based on the proportion of sales to Company Stores relative to total KKM&D sales.

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.

The following table presents the results of the Company’s operating segments for the three and six months ended August 3, 2003 and August 1, 2004. Segment operating income is income before general corporate expenses and income taxes.

Note 11: Joint Ventures

From time to time, the Company enters into joint venture agreements with partners to develop and operate Krispy Kreme stores. Each party’s investment is determined based on their proportionate share of equity obtained. The Company’s ability to control the management committee of the joint venture is the primary determining factor as to whether or not the joint venture results are consolidated with the Company. See “Basis of Consolidation” under Note 1 – Summary of Significant Accounting Policies.

At August 1, 2004, the Company had invested in 18 area developer joint ventures and held interests ranging from 25.0% to 74.7%. The Company will continue to seek opportunities to develop markets through joint ventures or to adjust its ownership in existing joint ventures when there are sound business reasons to do so.

Consolidated Joint Ventures

The Company owns a 74.7% interest in Glazed Investments, the joint venture with the rights to develop the Colorado, Minnesota and Wisconsin markets, and a 70% interest in Freedom Rings, the joint venture with the rights

18

to develop the Eastern Pennsylvania, Delaware and Southern New Jersey markets. Effective at the end of the first quarter of fiscal 2005, the Company began consolidating the accounts of New England Dough, the joint venture with the rights to develop the Connecticut, Maine, Massachusetts, Rhode Island, New Hampshire and Vermont markets, as a result of the implementation of FIN 46-R, as discussed in “Recent Accounting Pronouncements” under Note 1 — Summary of Significant Accounting Policies. The Company owns a 57% interest in New England Dough. Although the Company’s ownership interest in New England Dough exceeds 50%, the Company historically accounted for this interest under the equity method as the Company does not have the ability to designate a majority of the members of the joint venture’s management committee.

The Company has provided guarantees of outstanding third party debt and/or certain leases for each of its consolidated joint ventures. The guarantees are generally in proportion to the Company’s ownership interest in the joint venture.

Summarized information for the Company’s investments in consolidated joint ventures as of August 1, 2004, including outstanding loan and lease guarantees, is as follows:

Equity Method Joint Ventures

As of August 1, 2004, the Company had invested in 15 joint ventures as a minority interest party. Investments in these joint ventures have been made in the form of capital contributions and/or notes receivable. Notes receivable bear interest, payable semi-annually, at rates ranging from 9.0% to 10.0% per annum, and have maturity dates ranging from March 2011 to the dissolution of the joint venture. These investments and notes receivable are recorded in investments in unconsolidated joint ventures in the consolidated balance sheets.

The Company has provided guarantees of outstanding third party debt and/or certain leases for certain of its equity method joint ventures. The guarantees are generally in proportion to the Company’s ownership interest in the joint venture.

Information related to the markets, ownership interests, manager allocations and loan and lease guarantees as of August 1, 2004 for joint ventures which are accounted for by the equity method is summarized as follows:

19

(1)		The amount shown as “Total Stores to be Developed” represents the number of stores in the initial development agreement with the joint venture as well as commissary locations which have been opened. The number of stores in the initial development agreement, as amended, will be re-evaluated as the market is developed and the number of stores to be opened may change.
(2)		KK-TX I, L.P. and PRIZ Doughnuts, LP are limited partnerships. The Company holds a 33.3% interest in each of these joint ventures as a limited partner. Under the terms of the partnership agreements, the general partner has full responsibility for managing the business of the partnership.
(3)		KremeKo’s shareholders’ agreement requires that its board consist of eleven directors. The Company has the right to designate two of the directors and three other shareholders each have the right to designate one director. The remaining six directors are nominated by the board and elected by the shareholders.

Note 12: Commitments and Contingencies

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

20

range from 2 to 20 years. The Company’s contingent liability related to these guarantees was approximately $15,351,000 at February 1, 2004 and $24,497,000 at August 1, 2004. For leases, the guaranteed amount was determined based upon the gross amount of remaining lease payments due and for debt the guaranteed amount was determined based upon the principal amount outstanding under the respective agreement. Of the total guaranteed amount at August 1, 2004, $23,594,000 is for franchisees in which we have less than a controlling ownership interest and is summarized in Note 11 – Joint Ventures. The percentage guaranteed is generally equivalent to the Company’s ownership percentage in the joint venture. The guarantees expire between fiscal 2005 and fiscal 2025. The remaining guarantees of $903,000 consist of guarantees totaling $503,000 for franchisees in which we have no ownership interest and the guarantee of $400,000 in bank debt for a non-profit organization for which Scott Livengood, the Company’s Chairman, President and CEO, serves as chairman of the governing board. The guarantees for franchisees in which we have no interest expire between fiscal 2007 and fiscal 2009 and the guarantee for the non-profit organization expires in fiscal 2009. These guarantees require payment from the Company in the event of default on payment by the respective debtor. If the debtor defaults, the Company may be required to pay a proportionate share of other amounts outstanding under the respective agreements, such as accrued interest and related fees. The Company cannot estimate the amount of any such additional payments that could be required. The Company has not experienced any losses in connection with these guarantees and management believes the likelihood that material payments will be required under these guarantees is remote. With respect to guarantees that the Company issued during the first six months of fiscal 2005, the Company assessed the fair value of its obligation to perform under these guarantees if required to do so by considering the likelihood of certain triggering events or other conditions requiring performance. The Company determined that the fair value of these guarantees was not material to the Company’s financial position or results of operations.

The Company also guarantees leases and debt owed to financial institutions for consolidated joint ventures. The maximum amount guaranteed for these joint ventures at August 1, 2004 is $17,798,000 and is summarized in Note 11 – Joint Ventures. At August 1, 2004, the outstanding debt under the loans guaranteed, which is included in long-term debt and current maturities of long-term debt in the accompanying consolidated financial statements, is $26,277,000. These guarantees expire in fiscal 2006 through fiscal 2019.

The Company issues indemnifications in certain instances when it sells assets or real estate and in the ordinary course of business with customers, suppliers and service providers. The Company also indemnifies its directors and officers in accordance with the terms of its bylaws. The Company cannot predict the maximum potential amount of future payments, if any, that may be required under these or similar indemnifications, due to the conditional nature of the Company’s obligations and the unique facts and circumstances involved.

At August 1, 2004, the Company had outstanding letters of credit totaling $9,242,000. Of this amount, $8,951,000 represents letters of credit issued primarily to ensure payment by the Company of possible casualty and workers’ compensation claims. The remaining $291,000 represents primarily letters of credit provided in lieu of security deposits for leases on certain stores operated by a joint venture. Letters of credit have terms of one year or less.

In connection with the Company’s acquisition of an additional interest in Glazed Investments in fiscal 2003, the Company entered into a put option agreement with certain members of management who collectively own an approximate 22% interest in the joint venture. The agreement gives each of these members of management the option to sell to the Company ultimately up to 100% of their respective interests in Glazed Investments during certain defined exercise periods, subject to certain limitations. The purchase price for the individual’s respective interests is determined based upon a formula defined in the agreement, which is generally based upon earnings growth and cash flows of Glazed Investments’ operations. The options became exercisable, in part, in April 2004. If exercised, the Company has the option to pay the purchase price in cash or shares of the Company’s common stock. The Company has been notified by members of management that they intend to sell an approximate 11% interest to the Company. Under the terms of the agreement, the purchase price for this interest may not exceed $5,000,000 and is expected to be less than this amount. The Company expects to complete the acquisition of this additional 11% interest in Glazed Investments in the third quarter of fiscal 2005. The Company cannot estimate the likelihood of the options relating to the remaining approximate 11% interest being exercised or the maximum amount the Company would be required to pay upon exercise.

In the normal course of business, the Company is exposed to the impact of commodity price fluctuations affecting the cost of flour, sugar, soybean oil, coffee beans and other ingredients. In order to secure adequate supplies of product and bring greater stability to the cost of ingredients, the Company routinely enters into long-term purchase agreements and other purchase arrangements with its suppliers. These commitments generally range from one to

21

three years. As of August 1, 2004, the Company had approximately $146,267,000 in such long-term purchase commitments. Because the Company enters into these long-term contracts with its suppliers, in the event that any of these relationships terminate unexpectedly, even where it has multiple suppliers for the same ingredient, the Company’s ability to obtain adequate quantities of the same high quality ingredient at the same competitive price could be negatively impacted.

In the second quarter of fiscal 2005, the Securities and Exchange Commission (the “SEC”) commenced an informal, non-public inquiry regarding the Company. The inquiry generally concerns the Company’s franchise reacquisitions and the Company’s previously announced reduction in earnings guidance. The SEC may expand the scope of its inquiry or obtain a formal order of investigation. The Company is fully cooperating with the SEC in response to its request for information.

Note 13: Legal Contingencies

On May 12, 2004, Eastside Investors, on behalf of itself and purportedly on behalf of a class of the Company’s investors who purchased the Company’s publicly traded securities between August 21, 2003 and May 7, 2004, filed an action in the United States District Court for the Middle District of North Carolina against the Company and certain of its current and former officers. This action alleges violations of Section 10(b) of the Securities Exchange Act of 1934 (the “Exchange Act”), Rule 10b-5 promulgated under the Exchange Act and Section 20(a) of the Exchange Act in connection with various public statements made by the Company and seeks an order that the action may proceed as a class action and an award of compensatory damages in favor of the plaintiff and the other class members in an unspecified amount, together with interest and reimbursement of costs and expenses of the litigation. To date, fourteen follow-on actions have been filed in the same court alleging substantially similar claims. The Company believes the allegations in these actions are without merit and intends to defend vigorously against these claims.

In March 2000, a lawsuit was filed against the Company, management and Golden Gate in Superior Court in the State of California. The lawsuit was filed as a result of joint venture discussions between the Company and the plaintiffs to develop the Northern California market. The plaintiffs were offered to participate in the Northern California joint venture but declined. They instead brought suit contending that they had a right to a larger percent of the joint venture and on different terms. The plaintiffs alleged, among other things, breach of contract and sought compensation for damages and punitive damages. In September 2000, after the case was transferred to Sacramento Superior Court, that court granted the motion to compel arbitration of the action and stay the lawsuit pending the outcome of arbitration. In October 2001, after an appeal to the California appellate courts, plaintiffs filed a demand for arbitration with the American Arbitration Association against KKDC, Golden Gate and others. In February 2003, after an extended series of arbitration hearings, the Arbitration Panel dismissed all claims against all parties, except the claim for breach of contract against KKDC and Golden Gate. The Arbitration Panel entered a preliminary award of $7,925,000 against KKDC and Golden Gate, which was substantially less than the damages claimed. The Company accrued a provision of $9,075,000 in fiscal 2003, which consisted of the preliminary award and an estimate of the anticipated award of legal fees and other costs. After further negotiations, all claims were settled for $8,550,000, and the settlement was completed in May 2003. The accompanying statement of operations for the six months ended August 3, 2003 reflects the $525,000 reversal of the accrual remaining after settlement. While the Company continues to discuss potential joint ventures with others to develop markets, the Company does not expect to have exposure from similar situations.

The Company is engaged in various legal proceedings incidental to its normal business activities. In the opinion of management, the outcome of these matters is not expected to have a material effect on the Company’s consolidated financial statements.

22

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion of our financial condition and our results of operations should be read together with the financial statements and the accompanying notes. This discussion contains statements about future events and expectations, including anticipated store and market openings, planned capital expenditures and trends in or expectations regarding the Company’s operations and financing abilities 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, taking into account 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. Factors that could contribute to these differences include, but are not limited to: the Company’s ability to continue and manage growth; delays in store openings; the quality of franchise store operations; the price and availability of raw materials needed to produce doughnut mixes and other ingredients; changes in customer preferences and perceptions; risks associated with competition; risks associated with fluctuations in operating and quarterly results; compliance with government regulations; and other factors discussed in Krispy Kreme’s periodic reports, proxy statement and other information statements filed with the Securities and Exchange Commission. 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 entirely by these cautionary factors.

Company Overview and Industry Outlook

Our principal business, which began in 1937, is owning and franchising Krispy Kreme doughnut stores where we make and sell over 20 varieties of premium quality doughnuts, including our Hot Original Glazed. Each of our traditional stores is a doughnut factory with the capacity to produce from 4,000 dozen to over 10,000 dozen doughnuts daily. Consequently, each factory store (stores which contain a full doughnut-making production line) has significant fixed or semi-fixed costs, and margins and profitability are significantly impacted by doughnut production volume and sales. Our doughnut stores are versatile in that most can support multiple sales channels to more fully utilize production capacity. These sales channels are comprised of:

•

On-premises sales. Sales to customers visiting our stores, including the drive-through windows, along with discounted sales to community organizations that in turn sell our products for fundraising purposes.

•

Off-premises sales. Daily sales of fresh doughnuts on a branded, unbranded and private label basis to convenience and grocery stores and select co-branding customers. Doughnuts are sold to these customers on trays for display and sale in glass-enclosed cases and in packages for display and sale on both stand-alone display units and on our customers’ shelves. “Branded” refers to products sold bearing the Krispy Kreme brand name and is the primary source of off-premises sales. “Unbranded” products are sold unpackaged from the retailer’s display case. “Private label” products carry the retailer’s brand name or some other non-Krispy Kreme brand. Unbranded and private label products are a minor portion of our business.

In addition to our factory stores, we are vertically integrated. We believe our vertical integration allows us to maintain the consistency and quality of our products throughout our system. In addition, through vertical integration, we believe we can utilize volume-buying power, which helps lower the cost of supplies to each of our stores and enhance our profitability. Our Krispy Kreme Manufacturing and Distribution business unit, KKM&D, produces doughnut mixes and coffee and manufactures our doughnut-making equipment, which our factory stores are required to purchase. Additionally, this business unit currently operates three distribution centers that provide Krispy Kreme stores with essentially all supplies for the critical areas of their business. This business unit is volume-driven, and its economics are enhanced by the opening of new stores and the growth of on-premises and off-premises sales by existing stores.

23

One of our focus areas has been on creating a best-in-class beverage program to complement our doughnut offering. With an acquisition in fiscal 2002, we acquired significant coffee roasting expertise. We have since formulated and are in the process of implementing a complete beverage program, including four drip coffees, a complete line of espresso-based coffees including flavors, and both coffee-based and noncoffee-based frozen drinks. These drinks are designed to complement our existing juices, sodas, milks and water. We introduced the first component of this program, the drip coffee offering, to our stores in fiscal 2003, replacing the previous product which was purchased from an unrelated third party, and introduced the frozen beverages to most stores in the second quarter of fiscal 2005. We anticipate introducing espresso in most stores over the next twelve to eighteen months. We believe this new beverage program represents an opportunity to meaningfully increase beverage sales.

In our recent store development efforts, we have focused on opening both Company and franchise factory stores, including commissaries, which are production facilities used to serve off-premises customers, in major metropolitan markets, generally markets with greater than 100,000 households. Our objective is to further enhance our expansion through the opening of factory stores in small markets, with small markets being defined as those markets having fewer than 100,000 households. We are developing a store concept that will utilize doughnut-making technology scaled to accommodate principally on-premises sales in a store approximately one-half the size of a traditional factory store. We continue developing this technology and are testing the equipment which is planned to be used in this concept. We are also in the process of identifying locations to test the concept. We believe that this concept will enhance our ability to enter smaller markets, as well as achieve a higher store density in larger markets.

Additionally, we have begun testing three additional store formats, which we refer to broadly as “Satellites.” Satellites consist of the “doughnut and coffee shop” (“DCS”), the fresh shop and the kiosk formats. During fiscal 2002, we introduced the DCS format. DCS stores typically use the Hot Doughnut Machine technology, which completes the final steps of the production process and requires less space than the full production equipment in our traditional factory store. This technology combines time, temperature and humidity elements to re-heat unglazed doughnuts, provided by a traditional factory store, and prepare them for the glazing process. Once glazed, customers can have the same hot doughnut experience in a DCS as in a factory store. Additionally, the DCS offers our full line of coffee and other beverages. While we continue to test and refine this concept, our experience to date is that this concept functions ideally in locations that accommodate drive-thrus and/or destination locations that have substantial customer foot traffic, such as casinos and airports. As of August 1, 2004, eight DCS’s were open, three of which are owned by the Company. Three Company-owned DCS’s were closed earlier this fiscal year. These three were located in strip shopping centers and could not accommodate drive-thru business. See further discussion in Note 3 – Impairment Charge and Store Closing Costs in the notes to our unaudited consolidated financial statements. We plan to continue testing this concept and believe that this technology and future evolutions of this technology will facilitate our expansion into smaller markets and densely populated urban areas.

In addition to the DCS format, we are testing both the fresh shop and the kiosk formats. In these formats, we typically sell fresh doughnuts, beverages and Krispy Kreme collectibles. The doughnuts will be supplied by a nearby factory store. Both the fresh shop and the kiosk formats require less space than our traditional factory store or the DCS. As a kiosk is a free-standing facility, it will require significantly less space than the fresh shop, expanding the number of potential locations where these facilities may be established. As of August 1, 2004, a combined 28 fresh shops and kiosks were open. We view the fresh shop and kiosk formats as additional ways to achieve market penetration in a variety of market sizes and settings. We began our tests of the new fresh shop concept during fiscal 2004 and our tests of the kiosk format in fiscal 2005.

As stated above, we intend to expand our concept primarily through opening both Company-owned and franchised stores in territories across the United States and Canada, as well as select other international markets as discussed below. We also have entered and intend to continue considering entering into joint ventures with some of our franchisees. As of August 1, 2004, there were 387 Krispy Kreme factory stores, consisting of 154 Company-owned stores (including 35 which are consolidated joint venture stores), 177 Area Developer franchise stores (including 74 in which we have a joint venture interest) and 56 Associate franchise stores. During the second quarter of fiscal 2005, we closed six of our traditional Company-owned factory stores. The majority of these factory stores were originally designed to service primarily retail customers, were generally located in declining trade areas and in most cases were not designed to support off-premises business and, therefore, did not fully utilize their production capacity. See further discussion in Note 3 – Impairment Charge and Store Closing Costs in the notes to our unaudited consolidated financial statements. For fiscal 2005, we anticipate opening approximately 75 new stores

24

systemwide, of which approximately 15 will be Satellites. The store format will be determined by the site opportunities, primarily the space available. The majority of these new stores are expected to be franchise stores.

In connection with our international expansion plans, we are developing the capabilities and infrastructure necessary to support our expansion outside the United States. We currently have 17 stores in Canada, one of which is a commissary, and will open additional stores in the Canadian market in the coming years. These stores are owned and operated by joint ventures. We have also entered into joint ventures to develop the markets in Australia and New Zealand, the United Kingdom and the Republic of Ireland, and Mexico. Each of these joint ventures opened its first retail store in fiscal 2004. In April 2004, we entered into an agreement with a third party to develop stores in the Republic of South Korea. We did not retain an equity interest in this franchisee. We anticipate this franchisee will open its first store in late fiscal 2005 or fiscal 2006. We continue to focus on additional markets outside the United States, including Japan and other potential markets in Asia and Western Europe. Our initial research indicates that these will be viable markets for the Krispy Kreme concept; however, further market research and evaluation are ongoing.

As we expand our Krispy Kreme business, we will incur infrastructure costs in the form of additional personnel to support the expansion and additional facilities costs to provide mixes, equipment and other items necessary to operate the various new stores. In the course of building this infrastructure, we may incur unplanned costs which could negatively impact our operating results.

Over the past few years, the overall doughnut market in the U.S. has grown primarily, we believe, as a function of our growth. In recent months, however, consumer demand in several flour-based food categories, including doughnuts, has been affected primarily due, we believe, to the popularity of low carbohydrate diets. Volume sales in the U.S. packaged doughnut market, as measured by Information Resources, Inc. (“IRI”), declined 2.6% for the twelve weeks ended August 8, 2004, the reporting period most closely approximating our fiscal second quarter, compared to the same period a year ago. This IRI data measures packaged doughnut volume sold through domestic grocery stores and does not include volume sold through all other sales channels, including convenience stores and mass merchants.

To intensify our focus on our core business and avoid additional exposure to flour-based food products in the current environment, we elected, in the first quarter of fiscal 2005, to divest the existing Montana Mills Bread Co., Inc. (“Montana Mills”) operations. We completed the acquisition of Montana Mills, an owner and operator of upscale “village bread stores” in the Northeastern United States, in April 2003. Montana Mills’ stores produce and sell a variety of breads and baked goods prepared in an open-view format. When we acquired Montana Mills, we believed that the acquisition would provide an opportunity to leverage our existing capabilities, such as our distribution chain, off-premises sales and coffee-roasting expertise, to expand Montana Mills’ business. We intended to refine and expand the concept and began work on developing a concept prototype. However, as stated above, we intend to divest the existing Montana Mills operations. Since adopting this plan, we have closed seven Montana Mills stores which were underperforming and intend to close additional underperforming stores. We are pursuing a sale of the operations that will remain. See further discussion in Note 2 – Discontinued Operations in the notes to our unaudited consolidated financial statements.

Results of Operations

In order to facilitate an understanding of the results of operations for each period presented, we have included a general overview along with an analysis of business segment activities.

Overview. The discussion of our operating results below includes a discussion of our consolidated operating results, as well as a discussion of our systemwide sales and comparable store sales. Our consolidated financial statements appearing elsewhere in this report include sales of our company stores, including the sales of consolidated joint venture stores, outside sales of our KKM&D business segment, and royalties and fees received from our franchisees, but exclude the sales of our franchised stores. Systemwide sales is a non-GAAP financial measure that includes the sales of both our company and franchised stores and excludes the sales and revenues of our KKM&D and Franchise Operations business segments. We believe systemwide sales data is significant because it shows the overall penetration of the Krispy Kreme brand, consumer demand for our products and the correlation between systemwide sales and our total revenues. Comparable store sales is a measure of sales growth. Generally, we add a traditional

25

factory store to our comparable store base in the store’s nineteenth month of operation. In addition, we utilize a market penetration strategy that often results in transferring the production opportunity for off-premises sales to a different factory store in order to enhance operating efficiencies in the market. Off-premises sales at these stores are included in comparable store sales if there is an existing factory store in the market that is in the comparable store base.

Segment results. In accordance with Statement of Financial Accounting Standards No. 131, “Disclosures about Segments of an Enterprise and Related Information,” we have three reportable segments. A description of each of the segments follows. We reported the results of operations of Montana Mills as a separate segment subsequent to our acquisition of that business in April 2003. As a result of our decision to divest the Montana Mills business, as discussed above and in Note 2 – Discontinued Operations in the notes to our unaudited consolidated financial statements, the results of operations of Montana Mills for the current and prior period are included in discontinued operations.

• Company Store Operations. Represents the results of our company stores and consolidated joint venture stores. These stores make and sell doughnuts and complementary products through the sales channels discussed above. Expenses for this segment include store level expenses along with direct general and administrative expenses. Consolidated joint ventures include Freedom Rings, LLC (“Freedom Rings”), the joint venture with the rights to develop stores in Eastern Pennsylvania, Delaware and Southern New Jersey, Glazed Investments, LLC (“Glazed Investments”), the joint venture with the rights to develop stores in Colorado, Minnesota and Wisconsin and New England Dough, LLC (“New England Dough”), the joint venture with the rights to develop stores in Connecticut, Maine, Massachusetts, New Hampshire, Rhode Island and Vermont. The Company began consolidating New England Dough at the end of the first quarter of fiscal 2005 as a result of the implementation of Financial Accounting Standards Board (“FASB”) Interpretation No. 46-R (“FIN 46-R”), as discussed below under Recent Accounting Pronouncements. Prior to January 30, 2004, consolidated joint ventures also included Golden Gate Doughnuts, LLC (“Golden Gate”), the joint venture with the rights to develop stores in Northern California. Effective January 30, 2004, the Company acquired the remaining minority interest in Golden Gate.

• Franchise Operations. Represents the results of our franchise programs. We have two franchise programs: (1) the associate program, which is our original franchising program developed in the 1940s, and (2) the area developer program, which was developed in the mid-1990s. Associates pay royalties of 3.0% of on-premises sales and 1.0% of all other sales, with the exception of private label sales, for which they pay no royalties. Area developers pay royalties ranging from 4.5% to 6.0% of all sales and development and franchise fees ranging from $20,000 to $50,000 per store. Most associates and area developers also contribute 1.0% of all sales to our national advertising and brand development fund. Expenses for this business segment include costs incurred to recruit new franchisees, costs to open, monitor and aid in the performance of these stores and direct general and administrative expenses.

• KKM&D. Represents the results of our KKM&D business unit. This business unit buys and processes ingredients used to produce doughnut mixes and manufactures doughnut-making equipment that our factory stores are required to purchase. This business unit also includes our coffee roasting operations, which supplies our drip coffee product to our stores. The KKM&D business unit also purchases and sells essentially all supplies necessary to operate a Krispy Kreme store, including all food ingredients, juices, signage, display cases, uniforms and other items. Generally, shipments are made to each of our stores on a weekly basis by common carrier. All intersegment transactions between KKM&D and Company Store Operations are eliminated in consolidation. Expenses for this business unit include all expenses incurred at the manufacturing and distribution level along with direct general and administrative expenses.

Other. Includes a discussion of significant line items not discussed in the overview or segment discussions, including general and administrative expenses, depreciation and amortization expenses, interest expense, equity loss in joint ventures, minority interest in consolidated joint ventures and the provision for income taxes.

The table below shows our operating results expressed as a percentage of total revenues. Certain operating data are also shown for the same periods.

26