Yesterday, while reading some of the content on our website, I came across S.J. Caplan's piece on Rocky Mountain Chocolate Factory (NASDAQ:RMCF). S.J. took a fairly balanced look at the company, though she was a bit too kind.
Still, I can hardly fault S.J., because I did pretty much the same thing about a week ago, when I wrote about the company's earnings. I couldn't justify the company's valuation and mentioned possible risks with franchise models in general, but I, too, was generally kind. I also unfairly tagged my colleague Bill Mann as having said the business is great. Nowhere in what Bill wrote does he say the company is great.
If you haven't guessed it already, I think the bottom line is that I -- and also S.J., but that's her call since I'm done attributing things to people here -- missed what really matters about Rocky Mountain Chocolate and why investors should take a pass and move on.
Numbers look solid
A cursory look at Rocky Mountain chocolate reveals a company that is fairly appealing. The slate has been wiped clean of debt, the company's free cash flow has been fairly strong of late, and the growth in sales and earnings has been strong the last couple of years.
It's after looking deeper that things begin to appear less attractive, but with everything on the financials looking great right now, there's no smoking gun. There is, however, the fact that the company is on the hook for a number of its franchise leases and that, a number of years ago, the company decided to unload its company-owned stores. But let's set that tidbit aside for now. We'll revisit it later.
Hey, want to buy a store?
It would be too easy to just point at Rocky Mountain, say it's a franchiser, and call it too risky. There's nothing inherently nefarious about franchising. In fact, franchising can make sense as part of a measured expansion plan for capital-strapped companies. McDonald's (NYSE:MCD) has operated with franchises for years, even though it's been opening company-owned stores of late. Berkshire Hathaway (NYSE:BRKa) (NYSE:BRKb) company Dairy Queen has a number of franchisees as well, and Berkshire also owns Rocky Mountain competitor See's.
Then there are the franchise stories at Boston Market and KrispyKreme (NYSE:KKD) shareholders -- examples of how horribly wrong things can go in a very short period of time when a franchise operation isn't properly managed.
As it turns out, it is Rocky Mountain's franchise model that has me souring on the company, but not because 21% of the company's revenue stream is from franchise fees and royalty payments. It's because the company has lent money to franchisees on more than one occasion and has already had the not-so-pleasant experience of writing down $1.67 million of these loans, carried as notes receivable on its balance sheet, in 2003. Yes, that's old news, but there's a bit more to it.
Foolish final words
Sometimes it isn't the numbers in the financials that tell you whether an investment is a good long-term opportunity. The valuation, notes receivable, and franchise-store performances are warning flags for those interested in Rocky Mountain shares, but there is a far more simple deal breaker for me, and it's a big one that I can't get past. It is this: In 1998, Rocky Mountain had 37 company-owned stores and 185 franchised stores. In 2001, the company determined that it would abandon the company-owned model and sell its stores. The company now has just eight company-owned stores and 277 franchised stores.
Rocky Mountain had already spent the cash necessary to get those 37 company-owned stores up and running and then decided that for all but four of them, the franchise fees were more attractive to the extent that the company was willing to lend out its own funds to sell the stores. A couple of years later, a purchaser of some of these stores went bankrupt, and Rocky Mountain lost money on the note. The company is still alive and kicking, but given those ugly facts, why should an investor want to be a part owner in the business?
I've thought about that question quite a bit over the past couple of days and then compared the company with well-regarded restaurant industry players such as Outback Steakhouse (NYSE:OSI) and Starbucks (NASDAQ:SBUX), which have been buying out franchisees and joint-venture partners, respectively. They want to own their stores, while Rocky Mountain apparently doesn't. And that tells me more than numbers ever will.
Nathan Parmelee owns shares in Starbucks and Berkshire Hathaway. He has no financial interest in any of the other companies mentioned. You can view his profile here. The Motley Fool has an ironclad disclosure policy.
