Rocky Mountain Chocolate Factory, Inc. quarterly report, Q1 FY2019

Rocky Mountain Chocolate Factory, Inc. — Q1 FY2019 Form 10-Q

Reporting period: Three months ended May 31, 2018; balance-sheet comparisons are against February 28, 2018. The company is a confectionery manufacturer, franchisor and retail operator, with frozen-yogurt operations through U-Swirl. Results are unaudited and the company cautions that seasonal quarterly results are not necessarily indicative of the full year.

Financial results

Metric	Q1 FY2019	Q1 FY2018	Change
Total revenue	$8.37 million	$9.35 million	Down 10.5%
Operating income	$783,236	$1,293,874	Down 39.5%
Net income	$576,944	$813,672	Down 29.1%
Basic and diluted EPS	$0.10	$0.14	Down 28.6% in basic EPS
Cash from operating activities	$1.37 million	$2.91 million	Down about 53%

• Revenue declines reflected factory sales down 10.1%, royalty and marketing fees down 10.6%, and franchise fees down 62.6%. Retail sales were approximately flat.
• Factory gross margin was 23.2%, versus 24.7%; retail gross margin was 61.4%, versus 65.2%. Total gross margin was 29.1%, versus 30.4%. Management attributed factory margin pressure to material costs and lower production efficiency, and retail pressure to discounting before certain store closures.
• Costs and expenses included $58,188 of restructuring charges related to closing or planning to close underperforming company-owned locations. Depreciation and amortization outside cost of sales rose to $301,000 from $195,000, mainly due to accelerated amortization of certain U-Swirl intangible assets.
• The effective tax rate fell to 24.6% from 35.7%, primarily reflecting the lower U.S. corporate tax rate under the Tax Cuts and Jobs Act.

Liquidity, cash flow and debt

• Cash was $6.30 million at May 31, compared with $6.07 million at February 28. Operating activities generated $1.37 million; investing used $102,000, including $131,000 of capital spending; financing used $1.04 million, primarily for debt payments and dividends. Cash increased by $230,000.
• Management reported working capital of $9.7 million and a current ratio of 2.7 to 1, versus $7.4 million and 1.9 to 1 at February 28. The working-capital improvement partly reflects accounting-standard adoption, including the reduction in gift-card liabilities.
• Total promissory-note debt was $2.20 million, including $1.37 million current and $830,000 long-term, down from $2.53 million at February 28. The note bears fixed interest of 3.75% and financed prior SWRL acquisitions.
• The $5 million bank credit line was undrawn and fully available subject to borrowing-base limits. The company reported compliance with its debt and credit-line covenants; the credit line is subject to renewal in September 2019.
• The company paid a quarterly dividend of $0.12 per share and declared another $0.12 dividend payable June 15, 2018. Management said operating cash flow and available financing should fund operations for at least 12 months.

Material changes, outlook and risks

• The company adopted ASC 606 on March 1, 2018 using the modified retrospective method; prior-year comparisons were not restated. Initial franchise and renewal fees are now generally recognized over the 10–15-year agreement term, rather than at opening or renewal. This contributed about $93,000 of current-quarter franchise-fee revenue. Adoption also reduced the opening gift-card liability by about $2.25 million and increased retained earnings by about $926,000.
• Management attributed lower royalties to the purchase-based royalty structure, a 4.2% decline in domestic franchise units, and lower franchisee same-store sales. Average total franchise units in operation fell from 331 to 317; franchise-store and café same-store sales declined 1.4%. Company-owned same-store sales declined 1.8%.
• Factory sales outside the franchise network fell 29.7%, partly offset by 0.8% growth in shipments to franchised and licensed locations. One manufacturing customer accounted for 15.2% of external revenue, compared with 20.3% a year earlier.
• No specific numerical earnings or revenue guidance was provided. Management identified seasonality, consumer demand, competition, raw-material and labor costs, franchise and international expansion, co-branding, and regulation as factors that could affect results. It noted that it may not be able to pass through increased costs.
• The company reported no material changes to the risk factors in its latest Form 10-K, no off-balance-sheet arrangements, and no subsequent events requiring disclosure. It is party to ordinary-course legal proceedings; management does not expect their resolution to have a material adverse effect.

Key facts for investors to verify

• Whether the drop in factory sales, franchise units, royalties and same-store sales continues in subsequent quarters.
• How the ASC 606 transition affects recurring franchise-fee revenue, deferred revenue and gift-card liabilities; prior-year figures are not directly restated.
• Whether margin pressure from material costs, lower manufacturing efficiency, store closures and accelerated intangible amortization persists.
• The concentration and future sales trend of the manufacturing customer that represented 15.2% of quarterly revenue.
• Debt maturities, covenant compliance and credit-line renewal; the company’s liquidity outlook also depends on seasonal cash needs and dividend payments.