Conflict And Stagnation Cost Millions In Rocky Mountain Chocolate Factory (NASDAQ:RMCF)

Rocky Mountain Chocolate Factory (RMCF) is a chocolate, confectionery and ice cream manufacturer and franchisor based in Colorado.

The company was able to pull $40 million in revenues and $4.5 million in net income in 2016, with 600 stores across the US and Canada. Since then, RMCF has seen its market shrink year after year. During the last decade the company paid as much as $3 million in yearly dividends until COVID.

Today the company trades at $40 million and many investors consider it good value, given its history of earnings and dividends. However, we believe that lack of a growth strategy and a year marked by conflict cast doubt on the possibility of RMCF recovering profitability.

Note: Unless otherwise stated, all information has been obtained from RMCF’s filings with the SEC.

RMCF’s chocolate and ice cream “factories”

RMCF has two franchises that constitute the core of its business model.

First, the Rocky Mountain chocolate factories, the little cafés and chocolate stores that prepare as much as 50% of the chocolate they sell inside the store.

Each “factory” pays a one-time franchise fee to RMCF, buys 50% of the chocolate it sells and the ingredients to manufacture the other 50% from RMCF’s factory in Durango, Colorado, and pays 10% of gross sales to RMCF.

According to the 10-K from 2015, at that time there were 277 stores in the US and 63 in Canada. The latest 10-Q shows that the US stores remain but that the Canadian operation is gone (more on this later).

The second franchise is U-Swirl, a similar concept applied to frozen yogurt. Customers can choose their yogurt flavor, how much to eat, and the toppings. The franchise model is also similar. Franchisees pay an upfront fee, buy the product from RMCF and pay a 10% of gross sales from outside acquired products.

U-Swirl also has acquired several similar concepts with locally appreciated brands like Aspen Leaf Yogurt, CherryBerry, Yogli Mogli, Fuzzy Peach. This practice is known as trade dressing.

U-Swirl has truly seen its market shrink in terms of franchisees. In 2015, there were 249 U-Swirl (and associated brands) stores, mostly in the US. Today there are only 71 stores.

And although the chocolate factories’ operations have not shrunk as much as that of frozen yogurt, its revenues and profits have. While in 2015 chocolate related revenues were $35.4 million and net profits were $9.1 million (25% net margin), today the segment produces $22.7 million and net profits were $2 million (10% net margin).

How to stop the fall and grow again?

The reasons for the fall are not quite clear but probably have to do with customer taste changes and lack of innovation. To put an example, the design in the stores is not great and could be improved.

The strategy the company seems to be following is to co-brand and license the chocolate products for which it is famous. They call this strategy specialty markets.

For example, in 2009 RMCF entered into a co-branding agreement with Cold Stone Creamery, an ice cream franchise, for its chocolate stores. While between 2015 and 2021, 30 US franchised stores have closed in the chocolate segment, other 30 stores have opened thanks to co-branding, evening out the result. There was not a similar arrangement that could improve the fate of U-Swirl.

Later the company licensed the Rocky Mountain Chocolate Factory brand to Kellogg’s to produce a special chocolate almond cereal. This is a great way to improve both brand awareness and revenues. Unfortunately this is the only example we have of licensing.

In 2019 the company opened a very interesting avenue for growth, online retailing, by associating with Edible Arrangements, a company dedicated to food presents, flower bouquets, etc. The agreement was originally successful, with sales growing from $320 thousand in 2019 to $3.2 million in 2020 (2021 fiscal year ended in February 2021).

Growth is much needed and can be accommodated, given that RMCF’s facilities have capacity to produce 5.3 million pounds of chocolate products yearly, against a yearly production of 1.9 million pounds in 2019.

Conflict with partners and shareholders

This could have been the beginning of a new era for RMCF. However, by the end of 2020 the relationship with Edible was deteriorating. The director appointed by Edible in RMCF resigned in January 2021. For the nine months up to November 2021, Edible has only purchased $1.2 million in products from RMCF.

Unfortunately, this is not the only case where RMCF has conflict with its partners. As we mentioned previously, this year RMCF lost 65 stores in Canada because it was not able to solve a trademark and intellectual property issue with its partner in the country since 1992, Immaculate Confection.

RMCF sued Immaculate Confection because of trademark issues. IC was trying to develop its own variant of the rocky mountain concept. Currently the stores in Canada are open and using the brand name but the relation between the two companies is terminated, and RMCF wrote-off the stores from its accounts. IC holds all the franchises in Canada, meaning that RMCF is risking the brand in the country. It is probable that IC will change names, maybe even to something akin to Rocky Mountain, and continue operating the stores, but without paying royalties or purchasing supplies from RMCF.

Indeed Immaculate Confections generated a very different brand identity using the Rocky Mountain concept. An idea can be grasped from their website, and from the store concept seen below. It seems that the Canadian partners were working on a much needed complete redesign of the brand. We leave to the reader the exercise of choosing which one he likes best, the Canadian proposal or the original.

RMCF is not only losing a new design but 65 stores, out of 390 that the chocolate franchise had, which probably means a significant portion of factory revenue and definitely one sixth of chocolate generated royalty revenue.

So we have two examples. First, RMCF finds a good avenue for revenue growth, and destroys it because it cannot reach an agreement with its partner, losing $2 million in revenue. Second, a 20 year partner of RMCF initiates a much needed brand redesign process, and RMCF sues the partner, ending with closed stores.

The last one is the most terrible. This year, adding to all the problems caused by losing partners, franchisees and facing the pandemic, the company’s management also started a proxy battle with a group of shareholders.

According to Business Wire, a group owning 13% of the company’s stock and led by AB Value Partners (Andrew Berger) initiated a proxy contest to change the company’s board and eliminate a poison pill provision. According to the concerned shareholders, management and the board have not been effective in creating the value the RMCF brand and business can provide.

The current management team ended up winning the battle, and choosing 4 out of 6 directors of the company. However, it was not free. In a difficult year, the company spent $1.7 million in the proxy contest, according to data from the 3Q21.

Additionally, and this may be very important in the future, the company canceled its poison pill provision to create preferred voting shares without shareholder approval. That means the company may be open to being bought or at least change its controlling shareholder.

Not only this, the CEO and president of the board, Bryan Merryman, resigned to both positions. He was replaced as chairman of the board and will remain as CEO until a replacement is found. Mr. Merryman will later continue as RMCF’s CFO, but got $1.9 million in severance payments anyway.

So RMCF, in the same year that lost 70 stores and $2 million in revenue from one partner, spent $3.6 million in a proxy contest and in replacing its CEO.

Current profitability and financing

The sales and profitability data from the 3rd quarter of 2021 (February to November) shows good signs of recovery. Yearly revenue is already at $24 million, the same level it had for the accumulated nine months in 2019 (2020 fiscal year).

Given that a lot of chocolate is sold in December and February, given the holidays, Christmas, the winter and Saint Valentine, we can expect 2022 fiscal year (2021 operating year) revenues to approach $30 million, or the same level as 2019.

Regarding profits, the company could have potentially produced the same level of profits that it generated in 2019, near $1 million after taxes. In actuality though that level will not be achieved because of proxy battle expenses for $3.6 million.

The company’s cash flow position is much better than accrual earnings, because it writes down $1.4 million in depreciation and amortization against only $500 thousand in yearly average fixed asset investments. A significant portion of management compensation is paid with shares, meaning less pressure on cash flows. In total, RMCF has had the ability to generate $3 to $4 million in cash, from which the dividends are paid.

RMCF’s financial position is also very solid. The company has literally zero debt, and a $5 million credit line open with Wells Fargo with no credit balance against the company. This against $9 million in cash and receivables. Therefore the company’s enterprise value is lower than its market cap by almost $6 million.

Summary and future developments

Rocky Mountain Chocolate Factory is a shrinking business that has not found avenues to recover growth yet. In fact, when it has actually found promising avenues, conflict between management and partners has destroyed those avenues.

Today, the company is producing only $1 million in accrual profits, although cash inflows may be more near to $3 million. The company may be able to reinstate its historic $3 million dividend, and in that case a current $46 million market cap may not be very expensive.

However, we believe that given its history of conflict, and the fact that it has yet to find growth avenues, $46 million is too expensive for RMCF. We think that a share price of $5 or below (a market cap below $30 million) would justify speculating on a turnaround with a bigger margin of safety.

We will also follow developments to answer uncertainties about the company’s future. Particularly, whether or not it will redesign its main brand, find another partner to expand its channels to the digital world, and solve the conflicts between its shareholders or change its shareholder structure altogether (now that it does not have poison pills provisions).

Therefore RMCF is an issue to follow closely in the following months, but not to buy, because the company is already trading above its earnings potential.