A company that needs large increases in capital to engender its growth may well prove to be a satisfactory investment ... It's far better to have an ever-increasing stream of earnings with virtually no major capital requirements.
-- Warren Buffett
Readers of Warren Buffett's annual reports have often heard him discuss the merits of a small chocolate manufacturer and retailer named See's Candy. In his 2007 letter to the shareholders of Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B), Buffett described See's as "a dream business."
Besides the enduring competitive advantage of See's brand name in California, one major reason for Buffet's exuberance is that See's was able to grow earnings with only a small amount of additional investment. This fact allowed him to take almost all of See's profit out of the business and reinvest it at high rates of return in other businesses such as Coca-Cola (NYSE: KO) and GEICO. Interestingly, Coca-Cola, at the time of Buffett's original purchases, was similar to See's in that it was also able to grow product volumes a great deal with very little additional investment.
One of my favorite businesses, and my largest stock holding, is also in the chocolate business. Rocky Mountain Chocolate Factory (Nasdaq: RMCF) is similar to See's Candy in that it sells premium boxed chocolates and has a high concentration of stores in California. Both companies compete for U.S. chocolate sales that Buffet says are not growing on a per-capita basis. But Rocky Mountain has at least one advantage over See's Candy: It franchises.
In the beginning ...
When company co-founder and CEO Frank Crail moved to Durango, Colo., from California 31 years ago, he wanted to open a See's Candy franchise. He soon discovered that See's didn't offer franchises, so he and a few partners opened their own little chocolate shop in 1981. The next year, the company licensed its first two test stores under franchise agreements.
Crail, hinting at the benefits of the franchise model, said "We had no money when we started the company. Company stores are capital-intensive because you have to build them out." Bingo. Expanding through franchises requires "no money." Well, very little anyway.
Unlike many businesses such as retailers, utilities, railroads, and cruise lines, Rocky Mountain does not need to invest a lot of cash to increase sales volume. This is because the independent owner of a franchise supplies the financing to build out the store, stock inventories, pay rent, etc.
In fact, over the past five fiscal years, the company has increased earnings from $2.3 million to $3.7 million, while average annual capital expenditures were actually less than depreciation expenses by $0.3 million. Magically, Rocky Mountain has been able to grow sustainable earning power without dipping into the earnings pot.
Additionally, because growth did not require a lot of cash, Rocky Mountain's management was able to return $32 million to investors through dividends and share buy-backs during that period. Sometimes, eating the cake means having it, too.
Similarly, businesses such as McDonald's (NYSE: MCD) and Yum Brands (NYSE: YUM) have rewarded shareholders tremendously over the years. Franchisers such as these, if they have room to grow and competitive advantages, exemplify the "ever-increasing stream of earnings with virtually no major capital requirements" that attracted Buffett to See's Candy. In future articles, I hope to dive further into the Rocky Mountain Chocolate Factory story, making a case that this company is poised for another tasty growth spurt as well as some sweet improvements to profit margins.
What do you think? Is Rocky Mountain the next See's Candy?
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