Rocky Mountain Chocolate Factory, Inc. (RMCF) is a wonderful little business that most investors have probably never even heard of. Founded in the early 1980s, the company is an international franchiser and confectionery manufacturer. Currently, there are seven company-owned, 56 licensee-owned and 302 franchised Rocky Mountain stores operating in 40 states, Canada, Japan, and the United Arab Emirates. The company produces approximately 300 different candies, of which it offers varying combinations in its stores, with increased variety during the holidays. An interesting aspect about this business is that half of the products sold at the company stores are prepared on the premises. This in-store preparation of products creates a special store ambiance, and the aroma and sight of products being made attracts foot traffic and assures customers that products are fresh.
Rocky Mountain stores are usually located in areas with high levels of foot traffic. Below I have listed six primary environments where the stores can be found:
- Regional Centers (25.5%)
- Outlet Centers (23.9%)
- Festival/Community Centers (18.0%)
- Tourist Areas (15.5%)
- Street Fronts (8.8%)
- Airports (5.0%)
- Other (3.3%)
Rocky Mountain Chocolate Factory is a relatively easy business to understand. The company derives revenues in three ways:
- Factory Sales: Sales to franchisees and other third parties of chocolate and other confectionery products made by the company (68% of sales in 2012).
- Retail Sales: Sales at company-owned stores of chocolates and other confectionery products, including products manufactured by the company (15% of sales in 2012).
- Fees: The collection of initial franchise fees and royalties from franchisees (17% of sales in 2012).
It is also important to mention that currently the company derives almost all of its revenues (approximately 97%) from domestic sources, with the rest being derived from international sources. However, I believe that in the near future this will change because of the company's international expansion.
The company recently announced that it has sold its Aspen Leaf Yogurt and Yogurtini brands in exchange for a 60% controlling equity interest in publicly traded U-Swirl, Inc. (OTCQB:SWRL). According to management, they will no longer be directly involved in self-serve frozen yogurt activities. The good news is that Rocky Mountain shareholders will still have the opportunity to realize the potential for value appreciation in the self-serve frozen yogurt industry. Meanwhile, Rocky Mountain's management team will be able to focus all of its attention on the company's highly profitable chocolate manufacturing operations and retail store franchising business. While Rocky Mountain now owns a majority of U-Swirl's common stock and will be represented on the U-Swirl board of directors, U-Swirl will continue to be operated by its current management team.
The company also announced it has entered an agreement with one of the world's largest consumer food products companies to feature the Rocky Mountain Chocolate Factory brand on certain cereal products. According to the agreement, the Fortune 500 company has agreed to pay Rocky Mountain an earned royalty, subject to a guaranteed minimum, on all ready-to-eat cold cereal products sold, in the United States, its territories and possessions, and U.S. military bases around the world, that display the Rocky Mountain Chocolate Factory trademark. Management believes that this represents an example of the licensing power that the company's brand name is developing as it expands its retail presence throughout the U.S. and internationally. As of this moment, management will not release the name of the cereal company until the product is launched.
Aggressive International Expansion
The way Rocky Mountain conducts its expansion into a new territory is by first opening up a "test store" and seeing how that store performs. In December 2011, the company opened a test store in an upscale mall in Tokyo, Japan. The test store was well received by Japanese consumers and generated strong sales. In fact, it was so successful that the company entered into a master licensing agreement for the development and franchising of new Rocky Mountain stores in Japan. The agreement requires at least ten new stores to open each year for the next ten years, for a total minimum of 100 stores to be opened in Japan by the expiration of the initial term of the agreement. Considering that the company currently has 302 franchised Rocky Mountain stores, this expansion into Japan will increase its franchised store count by 33%. As of November 2012, five stores were operating under the agreement.
The company is currently opening test stores in China and also has plans to open test stores in Taiwan, South Korea and other Southeast Asian countries. If these test stores turn out to be as successful as the one in Japan, the company could eventually open over a thousand stores in these countries. Management believes that its current international expansion in Asia and other territories will play a very significant role in the company's growth for the foreseeable future.
The company's manufacturing operations and corporate headquarters are both located in a single location in Durango, Colorado. If anything happened to this facility such as a fire, flood, or any other disaster, it would cause enormous problems for the company and adversely impact its sales, earnings and cash flows.
Another risk is that the company's growth is dependent upon attracting and retaining qualified franchisees and their ability to operate their franchised stores successfully.
It is also important to mention that one customer represented 13% of revenue during the most recent fiscal year. The company's future results could be adversely impacted by a change in the purchases of this customer.
One final risk that I want to mention is competition. When it comes to this industry the first name that comes to mind is Hershey (HSY), which controls almost half of the U.S. chocolate market. Milton Hershey started making chocolates in the early 1890s, giving the company nearly a century more experience than the relatively young Rocky Mountain Chocolate Factory.
Franklin E. Crail is the company's CEO and sits on its board. Mr. Crail co-founded the first Rocky Mountain Chocolate Factory store in 1981. In my opinion the management team has done an excellent job. The company is managed very conservatively and is financially strong. Management returns all excess cash to shareholders through buybacks and quarterly dividend payments (yielding close to 4% annually). It is also encouraging to see that insiders own 16% of the company, which means that their significant holding will motivate them to profitably grow the business.
Rocky Mountain is in excellent financial health. As of November 2012, the company had $3.5 million in cash and no debt. Additionally, the company has had positive free cash flow every year for over a decade. In other words, I do not expect this company to go bankrupt anytime soon.
Rocky Mountain is extremely profitable. The company has an asset-light business model that allows it to earn high returns on invested capital, which have averaged close to 30% over the past decade.
Rocky Mountain is not a capital intensive business. In other words, the company does not need to spend much cash on capital expenditures, which average less than a million per year. This leaves the company with excess cash left over every year, which it distributes to shareholders through dividends and buybacks. In 2004, the company began paying a dividend, which for that year was a total of $0.10 per share. During the last twelve months, the company paid a dividend of $0.43 per share, which represents an increase of 330% since 2004. Considering that the company will have significantly higher cash flows over the next few years, I expect this dividend to keep rising along with the share price.
Investors who put too much focus on looking at past growth rates to predict future growth rates might avoid investing in Rocky Mountain. For example, in 2002 the company had $19.4 million in revenue, compared with $34.6 million in the most recent fiscal year. This represents an annualized growth rate of only 6%, not exactly what one would call a "growth stock." This is why it is so important to understand every aspect about a business, including how management plans on growing and expanding the business.
Recently Rocky Mountain began expanding internationally, which should increase its growth rate significantly in the years to come. During the last ten years, Rocky Mountain only added a total of 69 franchised stores (approximately seven per year). During the next ten year period, the company plans on opening a minimum of 100 stores in Japan alone (ten per year). In a recent conference call, the CEO mentioned that the company will also continue expanding domestically by opening five to ten stores annually. When the potential expansion into other Asian countries is considered, Rocky Mountain could be opening dozens of stores every year. However, in this analysis I want to be conservative, and I will only take into account the store openings I can be sure of. Let us say for a moment that the company will open about five stores per year domestically (CEO's conservative estimate). The total number of stores the company would be opening up will be approximately 15 stores per year (including Japan), which would be almost three times the number of store openings in the past. Now, since the company will be opening about three times as many stores, this means that its growth rate will also be about three times higher. However, once the company expands into China, South Korea and the other Southeast Asian countries, the annual growth rate could exceed 30% for the foreseeable future. This kind of growth will definitely make Rocky Mountain a "growth stock."
Rocky Mountain is a relatively small company ($71 million market capitalization as of this writing). Because of its small size, large institutions do not own a significant percentage of the company. In fact, only 35% of the company's shares are held by institutions, compared with 74% for a company like Hershey. Most investors avoid small companies with low institutional ownership, which is a big mistake. Once the intelligent investor discovers an opportunity such as this, he would be wise to snap up shares early on. As Rocky Mountain continues growing and expanding its franchising business, Wall Street will eventually take notice. Institutions will begin buying shares - causing an increase in demand for the shares - and this higher demand will push up the price of the stock. What makes this story even better is that the insiders own 16% of the company, compared with less than 0.2% for Hershey. This significant ownership by insiders will ensure that they continue to profitably grow and expand the company.
So what is Rocky Mountain worth as a business? My answer to this question is that I have no idea. However, I can say one thing for sure; it is worth a lot more than what it is selling for now. I believe that in the long run this could be a billion dollar company if it continues its expansion. The truth of the matter is that it is extremely hard to put a precise value on any company. Benjamin Graham once pointed out that it is not possible to determine the intrinsic value of a business with exact precision. It is usually a range of values. If you can establish this range, you can then determine if the stock is undervalued, overvalued, or fairly valued. This lack of precision need not be a problem, if you can buy the stock cheap enough. By analogy, Graham says it is quite possible to determine that a man is obese even if we do not know his precise weight, or that a woman is old enough to vote even if we do not know her precise age. In valuing Rocky Mountain the best that I can do is come up with an approximate fair value for the business. Since I know for a fact that my valuation will not be precise, I must use a large margin of safety before purchasing the stock.
I estimate that a conservative fair value for this stock is around $25 per share. I forecast revenues to increase at 20% on a ten-year CAGR basis and profit margins to average around 12% during the ten-year forecast period. The fair value estimate implies a 36 times trailing twelve months price/owner earnings multiple. Net cash on the balance sheet is also taken into account, which adds approximately $0.57 per share to the fair value estimate. With the shares currently trading for around $11.75 per share, this gives us an upside potential of over 110%. Over the long-term, I believe that $25 per share will turn out to be too conservative. As I mentioned earlier, I think this company has the potential to be worth over a billion dollars if it continues on its current growth path. I believe that even paying up to $20 per share is still reasonable for really long-term oriented investors.
Rocky Mountain is the type of business that Warren Buffett would love. In fact, it meets all his criteria: It is a very simple business to understand. The company has a long history of strong earnings and high returns on capital. The company has able and trustworthy management. And, perhaps most important of all, the stock is selling at a bargain price (large margin of safety). Since the company will experience huge growth over the next few years; I believe that patient investors will be greatly rewarded if they buy shares early.