Friday, September 25, 2009

Rocky Mountain Chocolate Factory

Here's a recent article that compares Rocky Mountain Chocolate Factory (RMCF) to See's Candy. The article describes RMCF's franchising model as being an advantage over See's. I do not necessarily agree with this. It has the advantage of lowering RMCF's capital requirements but adds risk in terms of quality control. Considering the relative lack of capital (at least compared to Berkshire Hathaway) that RMCF has to work with, the franchising model probably makes sense strategically for them.

Still, in a perfect world, I would prefer the company-owned approach even though more capital is needed. Owning the stores allows more careful control of service and product quality and ultimately how the brand is perceived.

It takes almost no capital to open a new See's Candy store. We're drowning in capital of our own that has almost no cost. It would be crazy to franchise stores like some capital-starved pancake house. We like owning our own stores as a matter of quality control. - Charlie Munger at the 2001 Wesco annual meeting

Given RMCF's capital constraints during most of its existence, growing this way appears pretty smart to me as long as they control quality and franchisees share in the success. As their financial flexibility increases over time they could always tilt the model toward the See's approach.

So the franchise approach is not a fatal flaw but, at the margin, company-owned is my preference.

I continue to find RMCF to be a solid company with what looks like potentially attractive long-term economics.

Over time, I would like to learn whether the franchisees are also reasonably successful economically. Distribution has been a concern of mine but may not be problematic. It's just that franchisees need to be successful if the model is going to be sustainable and, service/product quality must be consistently good to reinforce the brand.

I'd also like to better understand why they need a 300+ store footprint to produce approximately $ 30 million in sales. The economics seem to work for RMCF but this, for me, is still an open question. See's has more like 200+ stores.

According to the most recent 10-K:

The Company believes that, on average, approximately 40% of the revenues of Rocky Mountain Chocolate Factory stores are generated by products manufactured at the Company’s factory, 55% by products made in the store using Company recipes and ingredients purchased from the Company or approved suppliers and the remaining 5% by products, such as ice cream, coffee and other sundries, purchased from approved suppliers.

Considering the different models, an apples-to-apples comparison with See's can't easily be made.

Buffett calls See's his "prototype of a dream business". While RMCF has solid economics, it's still worth comparing its numbers to See's to understand just how good a business it is.

RMCF has no debt and had $ 5.8 million of pre-tax profits (mostly during the recession) and $ 7.9 million of pre-tax profits (pre-recession) while capital requirements, in its current form, are currently less than $15 million. Not too bad.

We'll see how that changes over time.

As Buffett points out, See's produced around $ 82 million of pre-tax profits (pre-recession) on roughly $ 40 million of capital in 2007.

Exceptional.

The franchising model may end up working beautifully for RMCF.

I'm just not completely comfortable with it.

Just wish the stock would come down 20-30% to make it more attractive.

Adam

Long position in RMCF

* Return on capital: "If the business earns 6% o­n capital over 40 years and you hold it for that 40 years, you're not going to make much different than a 6% return - even if you originally buy it at a huge discount. Conversely, if a business earns 18% o­n capital over 20 or 30 years, even if you pay an expensive looking price, you'll end up with a fine result." Charlie Munger at USC Business School in 1994
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