Glazed & confused: what happened to Krispy Kreme has investors scratching their heads. Here are some hints from beyond the grave.

• Author: Maley, Frank
• Position: Krispy Kreme Doughnuts Inc. - Cover Story

Vernon Rudolph smoked and drank his way into an early grave. His doctor told him to quit--he'd had two heart attacks. But Rudolph, who founded Krispy Kreme Doughnuts Inc. and built it into a $50 million business, was used to giving orders, not taking them, so he followed his doctor's advice his own way. He switched from unfiltered Camel to filtered Benson & Hedges and from bourbon to beer. In 1973, when he was 58, his heart quit.

Less than a year earlier, he had written a letter giving advice on how to run his company. Nothing too specific, just common sense: Hire performers, not friends; don't use the company to do favors; run it with your head, not your heart. Sealing the envelope, he wrote the name of his oldest son, Carver, on it, along with instructions: Don't open this until I'm dead. He stuck it in the company vault.

After he read the letter, Carver felt disappointed. He had heard most of it before, and it wasn't exactly the paint-by-numbers manual a 26-year-old novice needed to run a business that stretched from Miami to Philadelphia and west to Memphis, Tenn. He showed it to his two brothers, then lost track of the letter for more than 30 years. It resurfaced last year.

By then, Krispy Kreme had soared to heights Vernon Rudolph could only have imagined. Now a public company, it boasted 357 shops and reported revenue of $666 million in the fiscal year that had just ended. But the first cracks in the company's facade were starting to appear. In May 2004, it cut its earnings projections for the first quarter and fiscal year. The worst was yet to come. The company had lost its way, and some of Rudolph's admonitions, while not pithy or poetic, never seemed more apt.

Rudolph was a tough-minded man who didn't eat the soft pastries he sold. His typewritten letter to his son covered one page, but its flinty pragmatism might have spared Krispy Kreme much of its agony.

Mistakes by a plant manager can be serious. But when an executive makes a mistake, it can produce extremely serious consequences to the entire organization.

It's July 2005, and the company Rudolph sired lies in intensive care, scorned by shareholders, shunned by Wall Street, haunted by investigators and guided by strangers. The CEO who took it public five years ago has been replaced by a temp, a corporate surgeon who shareholders hope can cut out the cancer and save the company.

Don't rely on our financial statements, the company has warned, and don't expect us to produce proper ones right away. Krispy Kreme still hasn't filed financial statements for the third quarter of the previous fiscal year, due in December, and plans to restate its earnings back to its initial public offering of stock in April 2000. Shares, which once fetched nearly $50, trade for about $7. Its Canadian franchisee, which the company owns 41% of, has declared bankruptcy.

Just a few years earlier, Krispy Kreme seemed to be building stores as fast as it made doughnuts. Between its IPO and the end of 2004, it opened more than 300. Now the company is in retreat. In the first half of 2005, it shuttered about 40 stores, bringing the total to about 400, and some investors weren't shy about using the "B" word.

"If it turns out they need to close a much larger number of locations and if they have too much debt and/or they have a lot of leases they have to get rid of, a prepackaged bankruptcy is a plausible way to solve those problems," says Eric Von der Porten, head of Leeward Investments, a California hedge fund that invests in Krispy Kreme options.

Directors and officers have kept mum about how things got so screwed up, leaving analysts and academics around the country to guess. They wouldn't have been guessing about Krispy Kreme 68 years ago, when Rudolph opened his first bakery in Winston-Salem. They wouldn't have cared. It took him and his successors almost that long to catch their attention.

Rudolph grew up in the Kentucky countryside. In 1933, he joined an uncle who had just bought a Paducah doughnut shop from a Frenchman originally from New Orleans. The sale included a recipe and a name--Krispy Kreme. When the uncle opened a shop in Nashville, Tenn., Rudolph joined him, selling doughnuts door to door. It was the Depression, and times were hard. They helped make Rudolph that way, too.

He wasn't quite 22 when he opened his first store in 1937, the year Krispy Kreme claims as its birth. He had looked at several places in the South and Midwest and was standing on a corner in Peoria, III., wondering what his next move would be...