NEW YORK (CNN/Money) -
Krispy Kreme Doughnuts Inc. said Friday it has been informed by the Securities and Exchange Commission that the agency's investigation of the company has now become a formal probe.
Shares of Krispy Kreme (KKD: Research, Estimates) fell about 4 percent on the New York Stock Exchange. Krispy Kreme's stock is down 65 percent year-to-date.
Krispy Kreme announced in July that the SEC was conducting an informal, non-public probe into the company's accounting.
At the time, the Winston-Salem, N.C.-based chain, which is struggling to right its slowing sales, said that the investigation involved the way it accounted for its repurchased franchises and its previously announced reduction in earnings guidance.
Scott Livengood, the company's CEO and chairman, had said the company would cooperate with authorities.
"This is definitely very bad news," said Carl Sibilski, analyst with Morningstar wrote in a research note Friday. "Until now, we had given the company's management the benefit of the doubt with respect to certain franchise-acquisition activities. We believe that the SEC's decision indicates that, for some reason, cooperation between the company and the agency in the preceding informal investigation broke down, leading the commission to seek the greater legal powers of a formal investigation."
Sibilski removed his investment rating on the company following Friday's announcement. He previously had a "buy" rating and a $23 price target on the stock.
"We continue to believe that the Krispy Kreme brand has value that may be realized upon clearance of the investigation," Sibilski added. "However, the risk of not knowing exactly what's going on inside the company has escalated to the extent that we no longer have the reasonable confidence necessary to issue an investment rating at this time."
In May, Krispy Kreme issued its first-ever profit warning, citing the adverse effect of the low-carb diet trend on its business. Krispy Kreme also pulled back its forecasts for the rest of this year and fiscal 2005 and put the brakes on new store openings.
The profit warning was followed subsequently by a number of shareholder lawsuits alleging that Krispy Kreme had misled investors about the direction its business was headed.
Bala Cynwyd, Pa.-based law firm Schiffrin & Barroway LLP, filed a lawsuit in May on behalf of all purchasers of Krispy Kreme shares from Aug. 21, 2003 through May 7, 2004.
The complaint named members of Krispy Kreme's senior management as defendants, and charged that they disregarded signs that the company had expanded too quickly, that its wholesale business undermined sales at its retail stores, and that it faced stiff competition from rival doughnut chain Dunkin' Donuts.
Earlier this week, the company appointed two new directors to lead an internal investigation of accounting practices and claims made in shareholder lawsuits against the company as well as issues raised by Krispy Kreme's auditors, PricewaterhouseCoopers.