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Rocky Mountain Chocolate Factory, Inc. (NASDAQ:RMCF)

Q1 2015 Earnings Conference Call

July 15, 2014 4:15 p.m. ET

Executives

Bryan Merryman - CFO, COO and Treasurer

Analysts

Jeremy Hellman - Singular Research

Matt Karr - Symons Capital Management

Jeff Geygan - Milwaukee Private Wealth Management

Operator

Hello and welcome to the Rocky Mountain Chocolate Factory first quarter fiscal 2015 earnings conference call. (Operator Instructions)

Some of the statements made during this call may be considered forward-looking statements that involve a number of risks and uncertainties. There are several factors that could cause actual results of Rocky Mountain Chocolate Factory to differ materially from these forward-looking statements. These factors include, but are not limited to, the potential need for additional financing, the availability of suitable locations for new stores, and the availability of qualified franchisees to support new stores, customer acceptance of new products, dependence upon major customers, economic and consumer spending trends, and such other factors listed from time to time in the public announcements and in Rocky Mountain Chocolate Factory's SEC reports.

In addition, please be advised that the financial results for the fiscal periods presented in this call do not necessarily indicate the results that may be expected for any future quarters or the upcoming fiscal year. To Rocky Mountain Chocolate Factory's knowledge, the information relayed in this conference call is correct as of the date of its transmission and the company does not undertake any obligation to update this information in the future.

I would now like to turn the conference over to Bryan Merryman, Chief Operating Officer and Chief Financial Officer. Please go ahead.

Bryan Merryman

Thank you. I’d like to welcome everybody to today’s call. Our Chairman and Chief Executive Officer Frank Crail could not make the call today. He is at the hospital, welcoming in his ninth grandchild into the world, so thanks for attending the call. I am going to start off with some brief commentary and then get into the detailed operating results for our first quarter of fiscal 2015.

While our operating results for the first quarter of 2015 compared unfavorably with last year's record first quarter, we remain optimistic that revenue and adjusted net income for the full year has the potential to increase to record levels. The first quarter was negatively impacted by harsh winter storms and a soft retail environment that resulted in lower foot traffic and a reduction in same-store sales and same store pounds purchased and lower sales to third party customers.

In addition, last year's first quarter benefited from international master license fees, whereas no international licensing agreements were signed in the current quarter. Finally, the expiration of our previous chocolate contract resulted in an increase in raw material costs in the most recent quarter.

In light of the above factors, we are quite pleased that our adjusted EBITDA, a non-GAAP measure that does not include depreciation and amortization, equity compensation expense, and the impairment and restructuring charges, declined less than 4% in the first quarter of fiscal 2015, when compared with the corresponding quarter in the previous fiscal year.

Revenue increased 1.4%, driven by a 40% increase in royalty and marketing fees offsetting declines in factory sales and franchise fees.

Our frozen yogurt operations increased adjusted EBITDA from $316,000 in the prior year first quarter to adjusted EBITDA of $812,000 in the current first quarter, an increase of 157%, validating expectations that the transactions consolidating our yogurt operations would create scale and a profitable company capable of becoming a consolidation force in the frozen yogurt industry.

We opened 18 stores in the first quarter. On June 13, we paid our 44th consecutive quarterly cash dividend. Also our Board approved repurchase of up to $3 million of our common stock and we finished the quarter with nearly $10 million in cash.

I will now get into more detailed financial results. Total revenues, as I said earlier, for the quarter increased 1.4%. This was driven by a decrease in factory revenues of 6.6%. We had three factors that contributed to the decrease: a 10.8% decline in shipments to customers outside of our network of franchise stores; a decrease in same-store pounds purchased by our franchise system of 4.9% and a decline of 6.2% in the average number of domestic Rocky Mountain Chocolate Factory franchised stores in operation. The 10.8% decline in shipments to customers outside of our network of franchised stores and the 4.9% decrease in same-store pounds purchased, we expect much of that to reverse in the balance of the year, as you know weather-related issues caused most of those declines, and it is our experience that weather-related issues generally reverse.

Retail sales increased 4.6%. We had a change in the mix of units in operation. Royalty and marketing fees increased 40.1%. This was due to a 72.1% increase in domestic franchise units, driven by the U-Swirl acquisitions in January 2014.

Same-store sales at domestic Rocky Mountain Chocolate Factory franchise stores were approximately flat, down slightly 0.3%. Franchise fees decreased 79%. We collected international license fees for two countries in the prior fiscal year with no amounts collected in the current fiscal year.

Factory margins declined 160 basis points to 28.8% from 30.4%. Certain commodities primarily cocoa caused our cost of materials to increase. Also, we had lower efficiencies associated with 14% lower production volumes.

Operating expenses increased 15.4%. This was due to the consolidation of increased U-Swirl Inc. operating expenses and that increasing U-Swirl expenses was primarily from acquisitions.

Adjusted EBITDA was 2,142,000 versus 2,225,000. Non-GAAP adjusted net income was 924,000 versus 1,194,000. GAAP net income was 711,000 versus 1,179,000. Non-GAAP adjusted diluted earnings per shares decreased to $0.14 in the current year versus $0.19 in the prior year. Diluted GAAP EPS decreased to $0.11 in the current year versus $0.19 in the prior year.

We opened 18 stores during the quarter – one Rocky Mountain Cold Stone co-branded store, one domestic Rocky Mountain Chocolate Factory store, one international store and 15 U-Swirl locations two of which were co-branded with Rocky Mountain Chocolate Factory.

During the quarter, despite comparing unfavorably to last year we continued to generate excess cash flow. We finished the quarter with $9.8 million in cash and our current ratio stood at a healthy 2.2 to 1.

And with that, I’ll turn it back over to the operator for questions and answers.

Question-and-Answer Session

Operator

(Operator Instructions) The first question comes from Jeremy Hellman with Singular Research. Please go ahead.

Jeremy Hellman - Singular Research

Just wondered can you dive a little bit, you talked in the release and in listening your prepared remarks about the storm impact and also the soft retail environment. Considering that the end of the quarter is beyond the winter storm season, kind of curious of what kind of commentary you can make, maybe you’re looking at the quarter on a month basis, kind of tease out how much of the year-over-year level you’re talking about was due to the weather, how much is the soft retail environment ultimately? Thanks.

Bryan Merryman

Well, so if you start looking at our fourth quarter and the reason that, that commentary applies to the whole quarter is inventory levels as well in the franchise system as well as inventory levels with our specialty market customers. Starting in December, we went to negative comps. So, December, January, February, March were all negative with March being the largest at over 6%. In April and May, we saw positive comps that was due primarily to the Easter effect. And then in March we also saw positive comps but flattish. June is also flattish in terms of comps. So not only is it the actual weather but it's the inventory levels. We were only down 0.5% in same store pounds purchased in our fourth quarter of last year and that rose to 4.9%, really expect most of that to reverse.

Jeremy Hellman - Singular Research

Okay and so – that’s very helpful. So at this point would you say that in terms of inventories you’re kind of at a normal level? [Indiscernible] used to have a little bit [indiscernible] that you still think needs to work off?

Bryan Merryman

I think we have a little bit that was worked off in June. I think we’re at normal inventory levels in July.

Operator

The next question comes from Matt Karr with Symons Capital Management. Please go ahead.

Matt Karr - Symons Capital Management

So just a couple quick ones on U-Swirl from me. In terms of the cobranding initiatives that you guys have talked about in the past, are you guys willing at all to provide maybe an illustrative commentary on, maybe sales list and margin implications for cobranded stores versus standalone U-Swirl stores?

Bryan Merryman

We’re happy to do that once we have a little bit more data under our belt. We have a lot of data from cobranding with Cold Stone Creamery. And so I can tell you that we wouldn’t expect the results for U-Swirl to be any different than they were with Cold Stone. Both are destination locations with the customer base. They add an impulse product which is our product and it creates generally a double-digit increase in sales and it settles in somewhere between 10% and 15% of sales. So that's what the [cobrand] brings. It really causes no cannibalization of existing yogurt sales and in fact, at less yogurt sales slightly and we believe it's a strong differentiation and ultimately will result in positive comps and the differentiation that distinguishes it from all the competition.

I will say that in a couple of the corporate owned stores at U-Swirl level, we’ve co-branded with Rocky Mountain Chocolate Factory. They’ve executed very well, and in those stores they went from slightly negative comps to positive comps. So we’re seeing with a little bit of data the same results really that we saw with Cold Stone Creamery, so hopefully that answers the question.

Matt Karr - Symons Capital Management

Great, thanks. Yeah, that’s helpful. Second question on U-Swirl, you had mentioned in the past that the idea behind this type of acquisition models is that there's a select number of stores in there that are profitable and that are running generating cash or profitable acquisitions currently. The question that I have is in going through the portfolios that have been acquired through U-Swirl now, is there a sense of the percentage of stores that are in there that have been recently acquired that are currently standalone profitable out of the entire total? Like I'm just wondering, is the number that we’re looking at now for U-Swirl, the profits are ramping and that's great. But how diluted is that based off of work that still has to be done?

Bryan Merryman

Well, that’s a great question. And I don't have a really specific answer for it. But I can tell you that these chains are not too much different in how the top 25, middle 50 and bottom 25 compare to Rocky Mountain Chocolate Factory in terms of profitability. Rocky Mountain has much higher average unit volumes than yogurt. Yogurt has higher margins and much lower rents. And so while we have much lower average unit volumes on the yogurt side, rents are lower and we have acquired a lot of stores and making a cut based on volume is difficult. And so I don't really have a specific answer to that. Our feel for it is that if 30% of the stores that we've acquired closed, we wouldn't be surprised. However we only had two closures in the yogurt stores in the first quarter. The average unit volume for same stores – and we're not reporting same store sales because we haven't owned the stores for long enough period. They’re under previous ownership but we do have sale data for those stores.

The stores that are same stores in yogurt company, now they average about $290,000 in unit volume compared to closer to $400,000 on the Rocky Mountain Chocolate Factory side. So long answer, hopefully that's helpful but the main point is that we do expect a fair number of these stores to close and we priced that in, in terms of the purchase price for these chains.

Matt Karr - Symons Capital Management

Great, and then last one from me is just on the chocolate side in terms of you guys had mentioned before on the grocery channel rollouts. Just kind of curious – do you have some level of expected initial doors that, that rollout will be in and then perhaps a targeted number maybe one, two years down the line? That’s it for me. Thanks.

Bryan Merryman

We don't have a targeted number one, two years down the line. We are going into grocery for the first time. We will know soon just how many doors that's going to be. We don't have that number right now. We're going to be in the candy aisle. We’re going to be right next to the bigger brands. And so we'll see how we perform. We’re going to first go into Colorado where our branding recognition is the strongest. And if we performed favourably, then that would be – what I believe would be a huge opportunity, the biggest opportunity that we have, as a company, would be food drug mass. If we can put our product next to the very large brands, [indiscernible] brands like that perform well, then I think our opportunity in those channels is going to be huge.

Operator

The next question comes from Jeff Geygan with Milwaukee Private Wealth Management. Please go ahead.

Jeff Geygan - Milwaukee Private Wealth Management

I'm curious were there any yogurt stores that were shut down during the quarter?

Bryan Merryman

Two yogurt stores were shut down during the quarter.

Jeff Geygan - Milwaukee Private Wealth Management

I see. On your balance sheet, at least your Feb 28 you have an asset as franchise rights. Can you just help me understand what that really represents?

Bryan Merryman

That’s the fair value that was assigned to the revenue stream that is from the franchise agreements that we've acquired in these acquisitions. So that's what franchise rights are. Franchise rights are basically the franchise agreements we have between the franchisee and ourselves.

Jeff Geygan - Milwaukee Private Wealth Management

Do you depreciate that over time?

Bryan Merryman

Yeah, we’ve assigned a 20 year life to it. And then it’s also periodically reviewed for impairments. So you do both. You amortize it, the reason – contracts are generally for 10 years but the contracts are generally renewed. So it’s amortized over 20 years and then it’s reviewed for impairment. So if we see like a huge acceleration in closures on the yogurt side, we would review that number for impairment.

Jeff Geygan - Milwaukee Private Wealth Management

Should we be concerned if 30% or so of the yogurt stores are kind of quasi profitable or not that, that might imply a sooner than later impairment to the franchise rights asset?

Bryan Merryman

No, that was -- that factor was considered in allocating the purchase price.

Jeff Geygan - Milwaukee Private Wealth Management

I see, all right. And then because this is the yogurt starting to take on a life of its own, at what point do you and Frank envision considerable difference between the chocolate and the yogurt business where you’ve potentially split these into two separate entities and spin them off to shareholders appropriately?

Bryan Merryman

Well, no plans to do that right now. Again when we went into mere [ph] investment in U-Swirl, the idea was to also grow Rocky Mountain Chocolate Factory through all of these yogurt locations to cobrand as many of them as we can. We think that's just a really important differentiation that ties that two entities together. And we believe there is further economies of scale to have from Rocky Mountain Chocolate Factory’s infrastructure. And so it really depends on scale and we don't know at really exactly at what level of units – is it a thousand or is it 2000, if that would be an appropriate action to take.

Jeff Geygan - Milwaukee Private Wealth Management

Fair enough. And kind of the final question here then, if -- when you set out on this journey you had an expectation of the synergies that you might achieve. To date, how have you performed to expectation with respect to those synergies and other financial benefits you expected to accomplish?

Bryan Merryman

I think that so far what we fully integrated into Rocky is the financial function and the IT function. And there is still synergies to be had in the cost structure of U-Swirl and I think we’re on track to what our expectations were and we will continue to see progress throughout the year.

Jeff Geygan - Milwaukee Private Wealth Management

Appreciate it. And did you just say 2000 stores as your critical level?

Bryan Merryman

No, I said I don't know what the level is whether it would be 1000 or 2000. As an appropriate level, to then spin that company off.

Operator

(Operator Instructions) The next question comes from Charles Haskell, a private investor. Please go ahead.

Unidentified Analyst

Hi Bryan, Chuck Haskell over in Denver. Did you mention – a two-part question -- did you mention 3 million shares on the buyback or $3 million?

Bryan Merryman

There was three references to the buyback in the press release, the headline which said $3 million, and the narrative which said $3 million. In the very first paragraph there was a typo and it said 3 million shares.

Unidentified Analyst

No problem. Then the second one, I believe Russell Stover announced an acquisition in your industry. Do you see consolidation getting more prevalent in the fine chocolate candy market?

Bryan Merryman

Yes, we do. I think consolidation as it relates to Rocky Mountain Chocolate Factory is really not applicable, at least not while the majority of our revenues and profitability comes from our franchise system. I think you see consolidation in the food drug mass – the mass market companies which is not what we do. I think if our brand – if brand grew substantially in food, drug, mass, then we would be a consolidation candidate as well. However I don’t believe we are right now.

Operator

(Operator Instructions) As we show no further questions at this time, I would like to turn the conference back over to management for any closing remarks.

Bryan Merryman

Just want to thank everyone very much for attending the call today. We look forward to talking to you at the completion of our second fiscal quarter. And thank you again for your participation.

Operator

To access a digital replay of this conference, you may dial 1-877-344-7529 or 1-412-317-0088 beginning at approximately 5:45 pm Eastern Time today. You will be prompted to enter a conference number which will be 10049158. Please record your name and company when joining. The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.

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