Rocky Mountain Chocolate Factory, Inc. — Q2 FY2019 Form 10-Q
Reporting period: Three and six months ended August 31, 2018. Financial statements are unaudited. The company is a confectionery manufacturer, franchisor and retailer, with frozen-yogurt operations through U-Swirl.
Business context and performance
At August 31, 2018, the company reported 452 operating stores and cafés across its Rocky Mountain Chocolate Factory and U-Swirl brands, plus 17 sold but not yet open. Its network includes franchised, licensed and company-owned locations.
| Metric | Three months 2018 | Three months 2017 | Six months 2018 | Six months 2017 |
|---|---|---|---|---|
| Revenue | $7.80 million | $8.27 million | $16.17 million | $17.61 million |
| Operating income | $1.04 million | $1.50 million | $1.82 million | $2.80 million |
| Net income | $751,000 | $928,000 | $1.33 million | $1.74 million |
| Basic EPS | $0.13 | $0.16 | $0.22 | $0.30 |
| GAAP total gross margin | 32.3% | 36.5% | 30.6% | 33.2% |
Quarterly revenue fell 5.6%; six-month revenue fell 8.2%. For the six months, lower revenue and margins drove operating income down 34.8% and net income down 23.8%. Six-month adjusted gross margin, a non-GAAP measure, was 32.8%, versus 35.1% a year earlier.
Key changes and management commentary
- Factory sales declined 6.5% in the first half. Management attributed the decline partly to lower purchases by its largest customer, whose contribution fell to $1.4 million, or 8.8% of revenue, from $2.2 million, or 12.3%. Management cautioned that sales could decline further if orders remain low.
- Domestic franchise store closures exceeded openings: average domestic franchise units fell to 293 in the first half from 327. Royalties and marketing fees declined 7.2%; same-store sales at franchise stores and cafés declined 0.6%. Company-owned same-store sales were down 0.1%.
- Factory gross margin fell 2.5 percentage points in the first half. Management cited lower production volume and reduced factory efficiency; higher transportation fuel costs also pressured the second quarter. Retail margin was affected by inventory discounts before underperforming locations closed.
- General and administrative expense declined 17.9% in the first half, mainly from lower legal and professional expense. Depreciation and amortization outside cost of sales rose 53.3%, following a change in estimates for U-Swirl intangible values and accelerated amortization.
- The company recorded $177,000 of restructuring and acquisition-related charges in the first half, including charges for closing underperforming company-owned locations.
Cash flow, liquidity and debt
- Six-month operating cash flow was $1.39 million, down from $2.19 million. The increase in inventory used $1.58 million of cash.
- Investing activities used $201,000, primarily for property and equipment. Financing activities used $2.09 million, including $1.42 million in dividends and $670,000 in debt repayments.
- Cash declined to $5.17 million at August 31 from $6.07 million at February 28, 2018. Working capital was $10.0 million and the current ratio was 2.9:1.
- Debt was $1.86 million, including $1.38 million current maturities; the note bears fixed interest at 3.75%. The company also had a $5.0 million credit line entirely available and no borrowings outstanding. It reported compliance with debt and credit-line covenants.
- Management stated that operating cash flows and available financing should fund operations for at least the next 12 months. Quarterly dividends were $0.12 per share; no shares were repurchased during the period.
Accounting, outlook and risks
- The company adopted ASC 606 on March 1, 2018 using the modified retrospective method; comparative periods were not restated. Initial franchise and renewal fees are now recognized over the agreement term, generally 10–15 years. Adoption also changed gift-card breakage accounting and produced a $926,000 cumulative increase to retained earnings. These accounting changes affect comparability.
- The company expected the upcoming lease-accounting standard to have a material impact on its balance sheet, while not affecting cash flows. No specific revenue or earnings guidance was provided. Management cautioned that interim results are seasonal and not necessarily indicative of full-year results.
- Risks highlighted include customer concentration, continued franchise closures, ingredient and labor cost inflation, commodity-price exposure, competition, consumer demand, seasonality, and regulatory requirements. A 10% change in contracted ingredient prices was estimated to produce a $199,000 favorable or unfavorable cost impact.
- Management reported no material change in risk factors from its latest annual report. Ordinary-course legal proceedings were not expected to have a material adverse effect. Disclosure controls were reported effective, with no material internal-control changes during the quarter.
Important facts for investors to verify
- Whether the largest manufacturing customer’s purchases recover or continue to decline.
- Whether franchise closures stabilize and whether store openings and same-store sales improve.
- Whether lower production volume, input costs and factory margins continue to pressure profitability.
- How inventory levels and operating cash generation develop, given the first-half inventory cash use and dividend outflows.
- The ongoing effects of ASC 606 on reported franchise revenue, gift-card liabilities and period-to-period comparisons.
- The eventual balance-sheet impact of lease accounting and the company’s continued compliance with debt covenants.