Security: NASDAQ:RMCF
Date of first purchase: November 11, 2008
I am buying shares of chocolate maker and franchisor Rocky Mountain Chocolate Factory (RMCF) at $6.45 share because I believe the business is actually worth at least $9 to $11 per share. This implies that equity markets are pricing a company at $40MM when it is worth at least $55MM to $65MM. The business is underpriced because of two investor concerns. One is a concern that RMCF may face negative revenue growth, and the other is a concern that RMCF’s profit margins may contract.
RMCF’s earnings in its most recent quarters decreased, which investors likely attributed to two causes: tighter credit markets and decreased discretionary consumer spending. Tighter credit markets decrease the lending available for new and existing franchisees in the near term, which is no small matter. New franchisees are a significant source of high margin revenue for the company and the survival of existing franchisees is crucial to attracting future ones. Additionally, decreased discretionary spending lowers sales for existing franchisees, reducing RMCF’s manufacturing revenue. Making matters worse, a large number of RMCF’s 300 existing franchisees are located in tourist destinations that the recession is sure to hurt.
While these expectations are rational and likely to come about, they are being too heavily weighted in the market price of RMCF's shares at the ignorance of RMCF's strong financial profile and business model. Rocky Mountain Chocolate Factory currently has no long-term debt, a negligible amount of short-term debt (less than $0.2MM), little capital expenditures (approximately $0.5MM per annum), and strong free cash flow from operations ($3MM to $5MM). Moreover, RMCF's contractual cash obligations (e.g., rental, warehouse, and trucking operating leases) over the next few years are covered by the company's cash flows from operations many times over.
Should the worst arise, and a large number of RMCF's existing franchisees go out of business and no new franchisees emerge, RMCF’s revenue and profit margins will decrease. However, the business will still profit from the confection orders of its surviving franchisees, and when an eventual U.S. economic recovery occurs and small business lending and discretionary consumer spending increase, RMCF's operations and profits will be well-positioned to expand again. For these reasons, I believe a near-term investment in RMCF with a sizable margin of safety will eventually turn a substantial profit.