Rocky Mountain Chocolate Factory, Inc. — Q3 FY2018 Form 10-Q
Business context and reporting period. This unaudited quarterly report covers the three and nine months ended November 30, 2017; the fiscal year ends February 28. The company manufactures confectionery, operates retail stores, and franchises/licences chocolate and frozen-yogurt concepts. At quarter-end, it reported 503 open or sold-not-yet-open locations across its brands, including 197 domestic RMCF franchise stores and kiosks, 84 international RMCF license stores, and 121 open U-Swirl-related franchise/license cafés. Results are seasonal, with chocolate sales historically strongest from the Christmas holiday through Mother’s Day.
Financial performance
| Metric | Three months ended Nov. 30, 2017 | Three months ended Nov. 30, 2016 | Nine months ended Nov. 30, 2017 | Nine months ended Nov. 30, 2016 |
|---|---|---|---|---|
| Total revenue | $9.96 million | $9.96 million | $27.57 million | $27.93 million |
| Operating income | $1.20 million | $1.62 million | $3.99 million | $4.35 million |
| Net income | $751,056 | $1.01 million | $2.49 million | $2.72 million |
| Basic EPS | $0.13 | $0.17 | $0.42 | $0.47 |
| Operating cash flow | Not provided for the quarter | Not provided for the quarter | $1.65 million | $3.00 million |
- Revenue mix and trends: Quarterly factory sales rose 1.2% and retail sales rose 1.7%, while royalty and marketing fees fell 9.8%; franchise fees increased 74.7%. For the nine months, factory sales rose 2.3%, but retail sales fell 11.3% and royalty/marketing fees fell 11.6%; franchise fees rose 133.1%, primarily due to international license fees.
- Margins: Reported combined factory and retail gross margin was 27.7% in the quarter versus 32.8% a year earlier, and 31.1% for nine months versus 33.4%. Factory gross margin fell to 24.1% from 29.7% for the quarter and to 25.6% from 27.3% for nine months. Management attributed factory margin pressure mainly to higher production costs and product mix. Adjusted gross margin is a non-GAAP measure and excludes depreciation and amortization.
- Cash flow and investment: Nine-month operating cash flow was $1.65 million, down from $3.00 million. Working-capital outflows included increases in accounts receivable ($1.31 million) and inventory ($990,398). Investing activities used $274,052, including $446,935 of capital expenditures. Financing activities used $3.09 million, including $972,421 of debt payments and $2.11 million of dividends.
- Liquidity and debt: Cash was $4.07 million at November 30, down from $5.78 million at February 28, 2017. Working capital was $7.0 million; the current ratio was 1.9:1. Debt totaled $2.86 million, including $1.34 million current, compared with $3.83 million at fiscal year-end. The promissory note bears fixed interest of 3.75% and matures January 15, 2020. A $5.0 million working-capital line was fully available, with no amount drawn; the company reported compliance with covenants.
Material changes and management commentary
- Quarterly revenue was essentially flat, but operating income fell 25.7% and net income fell 25.8%. Management cited higher cost of sales, partly offset by lower operating costs. Factory cost of sales rose 9.2% while factory sales rose 1.2%.
- For the nine months, revenue declined 1.3%, operating income declined 8.2%, and net income declined 8.3%. The filing attributes the profit decline to lower revenue and higher operating expenses. Basic EPS fell 10.6%.
- Domestic franchise-store closures exceeded openings. Average domestic franchise units in the quarter declined to 312 from 365, and same-store sales fell 4.3% across franchise stores and cafés. Domestic RMCF franchise/license same-store pounds purchased fell 8.7%. Company-owned store and café same-store sales declined 0.8% in the quarter and 3.9% for nine months.
- Management said operating cash flows and available financing should fund operations for at least the next 12 months. The company did not repurchase shares during the period; approximately $638,000 remained authorized under its repurchase plan.
Outlook, risks, contingencies, and unusual items
- No quantified revenue or earnings guidance was provided. Management highlighted risks including seasonality, franchisee attraction and retention, store closures, consumer demand, competition, commodity and labor costs, international expansion, co-branding, and regulation. The filing reported no material changes to the risk factors in the prior Form 10-K.
- The Tax Cuts and Jobs Act was enacted December 22, 2017. The company was evaluating its effects and said a material impact, including a one-time non-cash expense from reducing the value of deferred tax assets, was possible.
- Revenue standard ASC 606 was expected to take effect for the company’s fiscal year beginning March 1, 2018. Management expected initial franchise, license, and renewal fees to be recognized over agreement terms rather than generally upfront; the cumulative contract-liability adjustment was estimated at approximately 15% of total liabilities. The filing said the full impact was still being evaluated.
- A CherryBerry-related lawsuit was resolved in the company’s favor: summary judgment was granted for the company and SWRL on the plaintiffs’ claims, and SWRL’s counterclaims were dismissed. Management expected no further proceedings. Other ordinary-course legal matters were not expected to have a material adverse effect.
- The company disclosed no off-balance-sheet arrangements. It held ingredient purchase contracts; management estimated a 10% price change in contracted ingredients would produce about a $100,000 favorable or unfavorable effect. A material portion of nine-month external revenue—10.3%—came from one manufacturing customer.
Important facts for investors to verify
- Whether factory production costs and product mix continue to pressure gross margins, and whether franchise purchasing and same-store sales stabilize.
- Whether store closures, particularly in frozen yogurt, continue to reduce royalty and marketing-fee revenue.
- Whether operating cash flow recovers as receivables and inventory are converted to cash, while dividends and debt repayments continue.
- The final Tax Cuts and Jobs Act impact and the quantified effects and transition accounting for ASC 606.
- The status and collectability of notes and receivables, exposure to the concentrated manufacturing customer, and covenant compliance.