Rocky Mountain Chocolate Factory, Inc. — FY2018 Form 10-K
Reporting period: Fiscal year ended February 28, 2018. The filing is an annual report, not a standalone quarterly report; it also reports fourth-quarter results.
Business context
The company manufactures and sells confectionery products, operates a small number of retail locations, and earns revenue from franchising and licensing, including its U-Swirl frozen-yogurt brands. At March 31, 2018, its Rocky Mountain Chocolate Factory system had 250 franchised, 87 licensee-owned and four company-owned stores; U-Swirl had 82 franchised, 33 licensed and five company-owned locations.
Financial results and liquidity
- Revenue: $38.07 million, down 0.6% from $38.30 million in FY2017. Factory sales rose 2.5% to $26.06 million; retail sales fell 7.7% to $4.11 million; royalties and marketing fees declined 10.7% to $7.23 million. Franchise fees increased to $0.68 million, largely reflecting international license fees.
- Profit: Operating income was $5.22 million, down 5.5%; net income was $2.96 million, down 14.1%. Diluted EPS was $0.50 versus $0.58. The effective tax rate was 42.2%; tax expense included about $421,000 from remeasuring deferred tax balances after the Tax Cuts and Jobs Act.
- Margins: Reported total gross margin was $8.99 million, or 29.8%, versus $9.14 million, or 30.6%, in FY2017. Factory gross margin was 24.4% of revenue versus 24.6%; retail margin was 64.2% versus 65.1%.
- Cash flow: Operating activities provided $4.76 million, compared with $5.32 million in FY2017. Investing activities used $0.34 million, including $0.54 million of property and equipment purchases. Financing activities used $4.12 million, including $2.82 million of dividends and $1.30 million of debt repayment. Cash increased $0.29 million to $6.07 million.
- Liquidity and debt: Working capital was $7.36 million and the current ratio was 1.9. Long-term debt, including current maturities, totaled $2.53 million; $1.35 million was current. The company had no borrowings on its $5 million credit line, subject to borrowing-base limitations, and was in covenant compliance.
- Shareholder returns: The company declared $0.48 per share in annual dividends. It made no share repurchases in FY2018; approximately $638,000 remained authorized under its repurchase plan.
Material changes and management commentary
- Average franchise locations in operation fell to 317 from 371; domestic closures exceeded openings. Franchise and company-owned system same-store sales declined 3.3% and 3.9%, respectively. Rocky Mountain Chocolate Factory franchise same-store retail sales fell 2.9%; frozen-yogurt franchise same-store sales fell 4.3%.
- Same-store pounds purchased from the factory declined 4.9%. Shipments to franchise and licensed locations fell 2.7%, while shipments to customers outside the system increased 14.2%.
- U-Swirl revenue declined 20.6% to $4.14 million, principally due to fewer domestic franchised and licensed cafés. U-Swirl segment profit fell to $0.54 million from $1.02 million.
- Management described the U.S. market as challenging, citing online shopping shifts and continued weakness in malls and outlet centers. It expects to maintain a conservative approach in FY2019 and pursue co-branding, international development, specialty-market sales, licensing and selected acquisitions. No quantified revenue or earnings guidance was provided.
- For FY2019, management anticipated approximately $1.1 million in capital expenditures and expected operating cash flow to cover capital spending and working-capital needs.
Risks, contingencies and unusual items
- One manufacturing customer represented about $5.1 million, or 13.4% of external revenue. One customer also represented approximately 58% of shipments to specialty markets, which accounted for about 34% of product sales.
- Franchise closures, declining same-store sales and reduced factory purchases could pressure royalties, product sales and profitability. U-Swirl has a history of losses; its goodwill was fully impaired in FY2016.
- Ingredient, labor and lease-cost inflation, seasonal demand, competition, franchisee financing and execution, and dependence on a single Durango manufacturing facility are material disclosed risks.
- The filing reports an immaterial revision to FY2017 financial information for an earlier income-tax/deferred-tax error; the correction reduced beginning retained earnings by $492,766. Management said prior annual statements were not materially misstated.
- The company disclosed one potentially adverse legal proceeding in its risk factors, but the supplied filing text does not identify the matter or quantify potential exposure. Management said ordinary-course proceedings were not expected to materially affect financial position, results or cash flows.
- Adoption of the new revenue-recognition standard was expected to defer recognition of initial franchise, license and renewal fees over contract terms; the company estimated the adoption adjustment would increase contract liabilities by approximately 15% of consolidated liabilities. The company also expected the new lease standard to materially increase balance-sheet assets and liabilities.
Important facts for investors to verify
- Whether franchise openings can outpace closures and reverse the decline in royalty revenue and same-store sales.
- The durability and terms of the major specialty-market customer relationship, including the customer’s share of specialty shipments.
- U-Swirl’s ongoing profitability and unit trends, and the potential effect on consolidated results.
- The actual effect of revenue-recognition and lease-accounting changes, and the status of the disclosed legal proceeding.
- Debt repayment schedule, credit-line availability under borrowing-base limits, covenant compliance, and the sustainability of dividends amid lower earnings.