Rocky Mountain Gem

Aug. 7.12 | About: Rocky Mountain (RMCF)

Inspired by an article written by Marc Courtenay about Sir John Templeton's investing style, I screened for undervalued small-cap stocks. Many of them were pharmaceuticals or bio-tech companies that seemed a bit too risky and confusing for me. However, there was one that caught my eye. After a quick glance at its profile, I decided it was worth doing some research on.

Rocky Mountain Chocolate Factory, Inc. (RMCF) was co-founded in 1981 by Franklin E. Crail. Today, at 70 years of age, Mr. Crail is still Chairman of the Board, President, and Director. RMCF is an international franchisor and confectionery manufacturer with a market cap of about $80 million, placing it in the micro-cap category. The company also owns frozen yogurt retail company, Aspen Leaf Yogurt, LLC. RMCF derives revenue from sales to franchises, sales at company-owned stores, and the collection of franchise and royalty fees, with stores in 36 states, Canada, and the United Arab Emirates.

Reading the company's 10-K, I learned that the U.S. candy market had sales of $30.6 billion in 2010, $16.6 billion of which were chocolate products. These statistics come from the National Confectioners Association. Another interesting fact is that the national per capita consumption of chocolate in 2010 was 14 pounds. This is a large market with lots of competition that Rocky Mountain Chocolate Factory has put itself in. However, I think that their dedication to high quality products, brand recognition/reputation, and stores with great atmospheres, they have the ability to establish a bigger role in the industry. I see investing in this little company as potentially huge returns, with little downside compared to most micro-caps. Here is my initial thought process:

Risks

Competition: This is the biggest risk facing the company. Of course, the first name that comes to mind when thinking chocolate manufacturers is Hershey (HSY). According to Wikinvest, Hershey has control of 42.5% of the U.S. chocolate market. Other big-name brands like Nestle (OTCPK:NSRGY) and Mars are also big players in the sector. Milton Hershey started making chocolate all the way back in 1894, giving it a nearly a century more of experience than the relatively young Rocky Mountain Chocolate Factory.

Micro-Cap: Of course, with any small, micro, or nano-cap stocks, there is added risk. These stocks are thinly traded and usually have higher volatility due to their size. Many bigger funds are not even allowed to invest in these. Being a smaller company also means that RMCF does not have as much brand recognition as some of the bigger companies, putting them at a disadvantage.

Potential

Fundamentals and Financials: RMCF's P/E ratio is about 19 versus its peer's average of about 23 and industry average 20. That comes after a 40% run up in share price since the beginning of the year. Shares still seem undervalued. Sales have been increasing the last few years with the exception of 2008-09, which management blamed on the economic crisis of '08. The company also has a great balance sheet with zero debt (which is something I always love to see).

Micro-Cap: Like I said earlier, smaller cap stocks have added volatility. However, they also have more potential upside, as their company is not mature and still growing. It is much more feasible for a smaller company to double or triple in size than it is for bigger, large-cap companies. With a beta of .7 and volatility average of 27, RMCF does not seem to have as much risk as most small companies. With such a small market cap, RMCF is also a potential target for a takeover. This is analogous to Kraft (KFT) buying Cadbury Schweppes of Mars buying Wrigley ($23 billion deal). Also, like I said earlier, many funds are not able to invest in the company right now due to the size. If RMCF can continue to grow over the years then eventually the funds will be able to join in. This will make for more positive volume, possibly shooting the stock up.

Dividend: To top it off, RMCF sports a 3.7% dividend yield.

Conclusion

Investing in small-cap or micro-caps isn't for everyone, as they are speculative by nature. You must have patience and a stomach for risk. In my eyes, Rock Mountain Chocolate Factory is worth the risk.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in RMCF over the next 72 hours.