Company Profile

While the shares of Rocky Mountain Chocolate Factory, Inc. (“RMCF” or “the Company”) have recovered along with most market indices during the past year (the stock has risen 60% since we published our previous Research Profile in February 2009), we continue to view RMCF as an attractive investment opportunity for income- and growth-oriented investors.  The Company franchises gourmet chocolate and confection stores and manufactures an extensive line of premium chocolates and other confectionary products.  Although RMCF’s trailing twelve-month revenues of approximately $28 million represent a tiny fraction of the $17 billion market for chocolate in the United States, RMCF has carved out a solid niche as a leading retailer of  “premium” chocolate candies and related products.  The Company’s business model has been highly successful in delivering an outstanding return on beginning shareholders’ equity in recent years (27.0% in FY2010), and we believe Rocky Mountain Chocolate Factory can grow its EPS at a 15%-plus average annual rate once the current economic recession in the U.S. has run its course.  RMCF’s new co-branding relationship with Cold Stone Creamery could develop into a new “growth driver” for the Company, with significant revenue and earnings potential that should result in an expansion in the P/E ratio accorded RMCF shares.  Adding to the current investment appeal of RMCF shares is the fact that the Company’s annualized cash dividend of $0.40 provides a current yield of 4.2% to shareholders.  RMCF started paying cash dividends in September 2003, has increased its dividend payout ten times during the past six years, and recently paid its 27th consecutive quarterly cash dividend.  We believe RMCF shares can significantly outperform the overall stock market on an intermediate- to long-term basis, if our growth expectations prove realistic in coming years.

INVESTMENT HIGHLIGHTS:


% We consider the shares of Rocky Mountain Chocolate Factory, Inc,  which trade on the Nasdaq Global Market, highly attractive for intermediate- to long-term capital appreciation potential over the next several years.  The Company’s diluted earnings per share increased at a compound annual rate of 21% during the four years ended February 2008, and although earnings declined in the fiscal years ending February 28, 2009 and 2010 due to economic recession in the U.S., we believe EPS growth can resume at above-average rates once the economy stabilizes.

% The Company has earned over 24%, after taxes, on beginning shareholders’ equity during each of the past nine years (if a non-recurring charge in FY2003 is excluded from operating results).  This is substantially higher than the ROE of the typical U.S. corporation. In FY2010, the Company’s after-tax ROE on beginning shareholders’ equity approximated 27.0%, well above the ROE achieved by most publicly traded companies.

% RMCF began paying cash dividends in 2003 and has increased its dividend payout ten (10) times during the past six years.  The current dividend of $0.40 per share provides investors with a current yield of 4.2% based on a recent stock price of $9.55.  We expect the Board of Directors to consider further increases in the cash dividend payout once earnings growth resumes.  

% Rocky Mountain Chocolate Factory’s co-branding program with Cold Stone Creamery appears to be generating incremental sales and cash flows to Cold Stone Creamery franchisees sufficient to support an acceleration in the opening and conversion of co-branded stores in FY2011 and future years.  In light of the fact that Cold Stone Creamery has over 1,400 franchised store locations, we believe the co-branding relationship can become a significant source of royalties, product sales and earnings for RMCF over the intermediate-to-long-term.

% During FY2010, which ended February 28, 2010, we estimate that a total of 30-35 franchised stores, including Rocky Mountain Chocolate Factory / Cold Stone Creamery stores, opened or were converted, and we expect franchisees to open 25-40 stores (including Cold Stone Creamery conversions) in the current fiscal year.  Management’s long-term strategy of improving its store concept and merchandising strategies, carefully selecting new site locations, adding co-branded stores with other successful retailers of complementary consumables, producing the highest-quality chocolate candies, and offering an extensive and innovative product and packaging line, should leverage RMCF’s retail brand equity, attract new franchisees, and encourage existing franchisees to open more stores.    

% RMCF’s unique business model, which generates revenue and earnings from factory product sales to franchisees, in addition to franchise fees and royalties, requires little capital for growth and generates strong cash flows from operations.  This has allowed the Company to retire all of its outstanding debt and increase its cash dividend payout, while prompting the Board of Directors to authorize multiple stock repurchase programs in recent years.  During the past nine (9) years, the Company repurchased approximately 3.9 million shares of common stock (adjusted for stock splits and stock dividends) in the open market.   

% During the fiscal year ended February 28, 2010, RMCF’s diluted EPS of $0.58 were approximately 24% below the Company’s record FY2008 earnings of $0.76 per diluted share.  While net income declined during the past two fiscal years due to a nationwide economic recession that significantly impacted retailers with a presence in regional shopping malls, RMCF has continued to generate cash from operations in excess of  the amounts needed for capital expenditures and cash dividend payments.  Once the economy stabilizes, we expect the Company’s earnings growth to resume (probably in the current fiscal year), and average annual EPS growth of 15%-plus would appear to be a realistic expectation during the five years following the end of the current economic recession.

% While institutional ownership of the Company’s shares has expanded to 40% in recent years, we believe a growing number of portfolio managers will become intrigued by Rocky Mountain Chocolate Factory’s high levels of cash generation and its opportunity to grow EPS at a 15%-plus average annual rate in coming years.   The price/earnings multiple currently accorded RMCF shares approximates 16.5X trailing 12-month diluted EPS of $0.58, compared with a P/E ratio of more than 40X when the stock price reached its five-year high of $24.50 in 2005.  We consider a P/E ratio of 25X a more realistic valuation once investors (1) begin to anticipate a resumption in growth of earnings and recognize the impressive revenue and earnings potential of RMCF’s co-branding relationship with Cold Stone Creamery, and (2) take into consideration the 4.2% cash dividend yield.  This suggests that the stock has the potential to rise 65% or better (to $16.00-plus) over the next 12 to 18 months.  At their current price of $9.55 and with a dividend yield of 4.2%, we believe RMCF shares are undervalued relative to the Company’s long-term fundamentals and are attractive for growth- and income-oriented investment portfolios.  

Rocky Mountain Chocolate Factory, Inc. (“RMCF”), incorporated in 1981, is a manufacturer of chocolate and other confectionery products, and an international franchiser of retail stores that sell premium-quality chocolate candies and related products.  Franchisees currently operate 344 retail Rocky Mountain Chocolate stores in 36 states, Canada and the United Arab Emirates, and the Company operates 11 stores that allow management to test market new products, store concepts, merchandising strategies, and operational enhancements.  Franchisees of Cold Stone Creamery, a franchiser of premium ice cream retail stores, operate 25 co-branded locations that offer consumers a variety of ice cream-related products, along with RMCF’s chocolates and other confections.  The Company also sells certain products to customers that are not franchisees of either RMCF or Cold Stone Creamery.

Franchised Rocky Mountain Chocolate Factory stores are located in regional shopping malls, lifestyle centers, downtown street fronts, tourist venues, factory outlet malls, airports and mixed-use environments. The Company has also developed a store designed for smaller population centers that has been well-received by customers, and it is moving forward with selective co-branding agreements (e.g., Cold Stone Creamery, The Grove, Häagen-Dazs) under which stores are opened or converted to sell ice cream, other confections and snack products alongside Rocky Mountain Chocolate Factory store-made, bulk assorted and packaged chocolate products.  

RMCF seeks to establish a fun and inviting atmosphere in its store locations, and customers are often drawn into the retail outlets to watch the in-store preparation (from start to finish) of such popular products as fudge and caramel apples.  Ingredients are mixed in old-fashioned copper kettles, fudge is cooled on large granite tables, and customers are often invited to sample the store’s products. Management believes the in-store preparation and aroma of its products (1) enhance the ambiance at Rocky Mountain Chocolate Factory stores, (2) are fun and entertaining, and (3) convey an image of freshness and quality that encourages additional “impulse” purchases by customers.

The Company uses only the finest chocolates, nut meats and other ingredients in its candies.  Several years ago, RMCF’s Valentine’s Day gift-boxed chocolates were awarded Money Magazine’s top rating and were described as having “superior flavor” which is “intense” and “natural”.  Management continually strives to develop new confectionary products in order to maintain the excitement and appeal of its products.  Franchisees set their own retail prices, though the Company recommends prices for all of its products.

RMCF’s franchising philosophy emphasizes service and commitment to its franchise system, and the Company’s concept has consistently been rated as an outstanding franchise opportunity in publications and organizations rating such opportunities. The majority of new franchises are awarded to (1) referrals from existing franchisees, (2) interested consumers who have visited Rocky Mountain Chocolate Factory stores and (3) existing franchisees.   Franchise owners and store managers in the United States are required to complete a comprehensive training program in store operations and management.  The Company has established a training center at its Durango headquarters in the form of a full-sized replica of a properly configured and merchandised Rocky Mountain Chocolate Factory store.  RMCF provides ongoing support to franchisees through its field consultants, who maintain regular and frequent communication with the stores by phone and site visits.

U.S. franchisees of full-sized Rocky Mountain Chocolate Factory stores pay the Company (1) an initial franchise fee of $24,500 for their first location and $14,500 for subsequent stores, (2) royalties approximating 5% of monthly gross sales, and (3) a marketing fee equal to 1% of monthly gross sales. Franchisees are generally granted exclusive territories with respect to the operation of Rocky Mountain Chocolate Factory stores only in the immediate vicinity of their stores.  Confection products not made on the premises by franchisees must be purchased from the Company or approved suppliers.

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“Because growth did not require a lot of cash, Rocky Mountain’s management
was able to return $32 million to investors through dividends and share
buy-backs during the past five fiscal years.”

Joseph Allen
“Repeat Buffett’s Success With This Stock”
The MotleyFool.com
September 18, 2009

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System sales generated by all Rocky Mountain Chocolate Factory stores (franchised + company-operated) open during FY2010 totaled approximately $111 million.

RMCF’s earnings improved dramatically following a shift in management philosophy away from company-operated stores and a renewed emphasis upon franchising, from a FY1997 loss of ($1.4 million), or ($0.15) per diluted share, to a profit of approximately $5.0 million, or $0.76 per diluted share, in FY2008. Although earnings declined in FY2009 and FY2010 due to economic recession in the U.S., net income during the twelve months ended February 28, 2010 still represented a 27.0% after-tax return on beginning shareholders’ equity.

Management is constantly seeking ways to improve the average performance of its franchised and company-owned stores, and recently the Company has entered into co-branding relationships that  offer the potential to attract more customers into its retail locations.  The most dynamic of these relationships appears to stem from a co-branding agreement with Cold Stone Creamery.  In addition, an agreement with The Grove targets airport locations, which typically generate significantly higher sales than stores in other retail venues; and a few stores have been opened that sell Häagen-Dazs ice cream products alongside RMCF’s traditional chocolate and confectionary products.

Currently, the Company itself operates 11 stores that are used primarily to test and refine new products, operational procedures and merchandising strategies before offering them to its franchisees.  Franchisees currently operate 344 stores in 36 states, Canada and the United Arab Emirates.  Franchised stores currently include 25 co-branded Cold Stone Creamery stores.

We believe the co-branding relationship with Cold Stone Creamery has the potential to develop into a significant profit center for RMCF, given (1) the fact that Cold Stone Creamery franchisees currently operate almost 1,400 stores and (2) the favorable impact of Rocky Mountain Chocolate Factory product sales upon stores that have been opened or converted as co-branded locations.  To date, the annualized increase in Cold Stone Creamery same-store sales for those units that have been converted to co-branded units suggests that franchisees may recoup their conversion costs in two years or less, through increased cash flow generation.  Rocky Mountain Chocolate Factory and Cold Stone Creamery have moved beyond the “testing” stage of their relationship and have identified several hundred Cold Stone Creamery stores as candidates for conversion to co-branded status.

Summary and Conclusion


While FY2010 (ended 2/28/2010) EPS continued to reflect the U.S. economic recession, we believe RMCF is poised to grow its revenues at a 10%-12% average annual rate and its earnings per share at a 15%-plus average annual rate, on a longer-term basis, by (1) expanding its franchised store network and thus its recurring stream of royalties and product sales, (2) leveraging the potential of its co-branding relationship with Cold Stone Creamery, and (3) increasing the utilization and profitability of its manufacturing plant in Durango, Colorado.  The Company generated an impressive 27.0% after-tax return on beginning shareholders’ equity during FY2010, and it has earned over 24% after-taxes on beginning shareholders’ equity during each of the past nine fiscal years (if a non-recurring charge is excluded from FY2003 results). This represents an accomplishment that can be claimed by a very small minority of America’s corporations (the “normalized” ROE for the Dow Jones Industrial Average approximates 14%).

The Company paid its first quarterly cash dividend in September 2003.  The cash dividend payout has been increased 10 times during the past six years and has never been reduced.  The Company recently paid its 27th consecutive quarterly cash dividend. The current annualized dividend payout of $0.40 is 223% higher than the initial annualized cash dividend or $0.124 paid in September 2003, and we expect the Board of Directors to consider increasing the dividend payout when earnings growth resumes, once the U.S. economy regains its footing.  At the recent RMCF share price of $9.55, the cash dividend provides investors with an attractive current yield of 4.2%.

We believe the Company’s prospects for long-term earnings growth at a 15%-plus average annual rate, combined with a growing recognition by investors of the earnings potential presented by the Cold Stone Creamery co-branding relationship and management’s stated intention to increase cash dividends as earnings increase, will provide outstanding returns to investors in coming years.  While RMCF shares are currently trading at 16.5X trailing twelve-month diluted EPS of $0.58, we believe a P/E ratio of 25X represents a more reasonable valuation, once the Company’s earnings growth resumes.  This suggests that RMCF shares have the potential to appreciate 65% or more (to $16.00-plus) over the next 12-18 months.  The stock, which is currently selling more than 60% below its five-year high of approximately $24.50, is considered very attractive for both income- and growth-oriented investors.