Rocky Mountain Chocolate Factory, Inc. (NASDAQ:RMCF) Q1 2023 Earnings Call Transcript May 24, 2023

Operator: Good morning, ladies and gentlemen. Thank you for standing by. Welcome to today’s conference call to discuss the Rocky Mountain Chocolate Factory’s Financial Results and new Strategic Transformation Plan. [Operator Instructions] As a reminder, this conference is being recorded. Joining us on the call today are the company’s CEO, Rob Sarlls; and CFO, Allen Arroyo. Please be advised this conference call will contain statements that are not considered forward-looking statements under the Private Securities Litigation Reform Act of 1995. These forward-looking statements are subject to certain known and unknown risks and uncertainties as well as assumptions that could cause actual results to differ materially from those reflected in those forward-looking statements.

These forward-looking statements are also subject to other risks and uncertainties that are described from time-to-time in the company’s filings with the SEC. Do not place undue reliance on any forward-looking statements, which are being made only as of the date of this call. Except as required by law, the company undertakes no obligation to revise or publicly release the results of any revision to any forward-looking statements. The company’s presentation also includes certain non-GAAP financial measures, including adjusted EBITDA as supplemental measures of performance of the business. All non-GAAP measures have been reconciled to the most directly comparable GAAP measures in accordance with SEC rules. You will find reconciliation tables and other important information in the earnings press release and Form 8-K furnished to the SEC earlier today, which will be available on the company’s Investor Relations section of its website within approximately 24 hours after this call has ended.

And now, I will turn the call over to the company’s CEO, Rob Sarlls. Rob, please go ahead.

Rob Sarlls: Thank you and good morning everyone. I am speaking with you in the presence of our entire leadership team in Chicago as we are all attending the Sweets & Snacks Trade Show. I am excited to kick off today’s call by introducing our Strategic Transformation Plan to revitalize growth and profitability at Rocky Mountain Chocolate Factory. We aim to position our company as America’s preferred premium chocolatier with first class manufacturing and omnichannel retail. Since we assembled this new leadership team in late 2022, we have spent significant time meeting with countless stakeholders across our business. An important objective in our discovery process was determining the key drivers of our businesses underperformance over the better part of the past decade.

No secret that our struggles have been company-specific, best captured by the consistent growth our industry has generated over the past 7 years compared to our chocolate factory sales being down 11% over the same timeframe. The company fell behind its peers and lost market share. Allow me to share what led to the decline. First, a lack of manufacturing discipline contributed to elevated operating expense levels and compressed margins made more challenging by lower pound volume. Franchise stores were underinvested and increasingly dated. As a result, the footprint shrunk meaningfully. The company’s focus drifted away from being customer and franchisee centric and the company made too many investments that straight away from core chocolate manufacturing, brand marketing, franchising and brick-and-mortar retail.

The company ultimately lost its focus on what truly mattered. So the company to be better positioned to benefit from and capture market share in a high fragmented U.S. chocolate confectionery market, a complete transformation is required. A transformation that both brings Rocky Mountain Chocolate back to its roots while evolving to the needs and preferences of today’s consumer. In order to develop and execute this plan, the Board of Directors and leadership team have been near fully overhauled. This new group of highly seasoned executives brings decades of experience in consumer packaged goods, franchising, branding, marketing, retail and most importantly, corporate resurrections. We have worked together over the past year to change our company culture and develop a plan to transform our business over the next 3 to 5 years.

Going through that process, this group leaves me excited and optimistic that we can continue to implement the meaningful changes required to take our company to new and exciting levels of growth and profitability. The three-part plan we have developed is designed to streamline end-to-end operations and exit non-core businesses, revitalize the in-store experience, revamp and expand our digital presence and elevate the Rocky Mountain Chocolate Factory brand. To achieve these outcomes, we need to focus on and win in three key areas. First, we need to do – over the 18 months, our team expects to generate $1.2 million of recurring annualized cost savings in the areas of warehousing and transportation, manufacturing and process improvement. In terms of warehousing, as you saw in this morning’s press release, we have already begun to make progress.

We wrote off nearly $600,000 in obsolete inventory during our fiscal fourth quarter to help us manage inventory levels more effectively going forward. With appropriate inventory levels, we are shedding now unnecessary third-party storage locations, both in Durango and in a nearby state. From a transportation standpoint, we plan to outsource fulfillment of online deliveries as we increase the contribution and importance of our omnichannel selling efforts. Third-party logistical partnerships will provide us with additional distribution centers and market leading technology without the costly CapEx and lengthy timelines associated with getting them up and running. Additionally, we will get fresher products to online purchases faster, increasing the velocity of those efforts.

As to delivery to franchise stores, we see opportunities to utilize cross stock companies to reduce costs, shorten delivery lead times and increased store delivery frequency, which will also benefit our franchisees. Moving on for manufacturing. We are narrowing our focus and allocating our resources to the highest volume SKUs while reducing the excessive degree of variation we have in our products. For perspective, our defects and reworks have been over 6% and our goal is to reduce this to less than 1% over the next 3 to 5 years. Cost savings will come from less labor, manufacturing and waste. And I will provide more color here as we discuss the next pillar of our plan. Moving on to our franchise development and operations, where we also have an opportunity to do more with less, while also improving relations as reflected by our recently established Franchisee Advisory Council.

I recently completed my visit of 50 RMCF stores in 50 weeks. It was an honor and a pleasure to meet a large universe of our dedicated franchisees as well as their hard-working and passionate staffers. Looking ahead, from a do-more-with-less standpoint, we plan to partner with more multiunit operators for new store openings as opposed to having more single store operators. Already, 25% of our franchisees operate more than 1 store. And by focusing on a more sophisticated and financially capable multiunit franchisee universe, we can open stores faster and mutually benefit from economies of scale and concentrated targeted markets, everything from administration and shipping to stronger benefits from marketing efforts. I’ll have more to touch on shortly with respect to new store openings in the years ahead.

The next part of our plan is to simplify and focus. For over 10 years, the company migrated away from what made it successful. Not only did it venture into ancillary business lines unrelated to chocolate, but it also went down the path of manufacturing too many low volume and/or time and cost-intensive products. Thus, we have been reevaluating the need for segments outside of chocolate manufacturing, brand marketing, franchising, e-commerce and brick-and-mortar retail. And earlier this month, we took a very important step. I am pleased to report that with the full exit from the frozen yogurt business with our divestiture of U-swirl, we are now after almost 13 years back to being just a chocolate company. The frozen yogurt business was profitable, however, the overall space for frozen yogurt shops have been very challenging.

With multiple brands over 60 stores, we had no critical mass that was easily supportable without a major investment of dollars and human capital to consolidate the business under one banner. And even if we did that, we would not have the scale to compete with larger, more developed players. With the mind share freed up in addition to modest capital from the sale, we can address our urgent need to invest in our factory, our franchisee network and our people. Another area where we can simplify our focus is in our product assortment, which I alluded to earlier, placing emphasis on high-volume SKUs and less product variability will help us simplify factory, store management and consumer choices. Where there are high-volume products with variability in manufacturing complexity, we will utilize third parties to avoid the bottlenecks and added costs that have historically accompanied these types of products.

Beyond our products, we have evaluated our retail footprint. And we will begin a process to right-size the network by eliminating 25 to 35 underperforming stores. By and large, we will be eliminating stores that have struggled to perform well, failed to adhere to our brand and financial standards and do not meet our quality standards. Some of these stores are located in retail formats that are on the wane and to no fault of the operators. While it’s a tough decision to part ways, these exits are a necessary step to improve our growth and margin profile. And last but not least, we are working to implement a new ERP and singular point-of-sale system to enable us and our franchisees to make better data-driven decisions at both the factory and retail level.

Data and reporting systems are critical component that constantly assess our product mix to ensure we’re meeting our customers’ ever-changing consumer preferences. The company has been behind the curve in this regard for a while, and we intend to make up for lost time. So the third and final pillar of our transformation plan relates to amplifying and elevating both areas of the business we currently do well as well as areas that have been underinvested to take our franchising efforts. Although we are rightsizing our store network by shedding 25 to 35 underperforming stores, we will also look to expand in existing and, more importantly, new markets with stronger operators and more desirable locations. Our goal is to add 75 to 100 new stores in highly visible and traffic locations with multiunit developers, as I mentioned earlier, over the next 3 to 5 years.

In addition, we see an opportunity to further elevate our brand by developing a new premium plus concept under a different name, which would be a significantly smaller company-owned store footprint in the top luxury retail locations in the United States. Think the Manhattans, Miami, Dallas and Los Angeles of the country, all targeting the premium plus consumer. Another area to amplify and elevate is the RMCF experience, whether in-store or through our omni-channel. Consumer shopping habits have changed and the company has fallen behind. That being said, we are going to work with our franchisees to make modest improvements to upgrade their store look, flow and functionality while ensuring better use of in-store promotions to upsell and cross-sell.

From an e-commerce standpoint, there is a need to revamp our company website for user-friendly digital shopping, build the social media and influencer presence, roll out a new Rocky Mountain Chocolate app and loyalty program and striking partnerships with online third-party marketplaces such as Amazon Prime. The last area we believe we can amplify and elevate is our product mix. We’ve already hired our first Head of R&D earlier this year. And as much as new product introductions and innovation will be a critical part of our future, in the short-term, time has been spent on optimizing our product portfolio to remove less loved SKUs and making sure that product quality and consistency is the best it can be. So what do we expect these initiatives to deliver to our business?

Over the next 3 to 5 years, we plan to firmly establish Rocky Mountain Chocolate as America’s preferred premium chocolatier with first-class manufacturing and omni-channel retail; more than double revenue and factory pound volume; establish a network of 250-plus revitalized chocolate shops, doing over $800,000 revenue per store; doubling our networks annual system-wide sales; increase e-commerce sales to approximately 10% of the total revenue mix, which is currently less than 2% today; restore factory gross margins to between 25% and 30%; drive operating leverage through better efficiencies and more cost-effective third-party site partners, leading to $1.2 million of annualized cost savings in the next 18 months. And as I mentioned earlier, we expect to launch a subset of premium-plus, company-owned stores, providing an additional value creation channel.

We revitalized in a piecemeal fashion. Operational improvements will come first, and we will be reporting out on our progress in greater detail in future calls. Omni-channel sales bottomed out last year, and we expect strong growth in doing more with great existing partners. Dollar factory sales of franchisees have set new records, but we are focused on increasing throughput and velocity to the existing store network before we bring on stronger, both financially and operationally multiunit operators to open clusters of stores in key markets. And most importantly, we will be updating our brand look, trade dress and store design and the latter can frankly take a while. And of course, we fully expect to hold ourselves accountable for measuring our results.

This will be accomplished through a key set of KPIs, some of which will be reported on a quarterly basis, while others on an annual basis. As mentioned earlier, more details around these KPIs can be found in the investor presentation published on the Investor Relations website. To briefly summarize, we will report on AUVs of full chocolate stores, what we call chocolate equivalent stores. And every 10 co-owned or co-brand stores considered the equivalent of one full chocolate store. And we’re seeking to reach $800,000 average annual revenue per store by the end of fiscal 2028. We will track average factory stores per chocolate store equivalent on an annual basis. We will track factory gross margin on a quarterly basis, which is equal to total factory sales minus cost of sales.

We’re targeting a return to 25% to 30% factory gross margin levels. We also expect to realize $1.2 million of annualized OpEx savings in the next 18 months, which we will report on periodically. These additional savings will come from SKU optimization, less waste and scrap, better labor utilization and more machine uptime or OEE. To track our e-commerce initiatives, we will provide updates on customer lifetime value beginning at the end of fiscal ‘24 and then turning the quarterly updates going forward in fiscal 2025. We will also report periodically on average customer transaction size, frequency of purchasing and level of social media engagement. And last, we expect to report on e-commerce sales as a percentage of total factory sales on a quarterly basis.

I will now hand it over to our CFO, Allen Arroyo, to discuss our fiscal fourth quarter and full year financial highlights before returning for close remarks. Allen?

Allen Arroyo: Thank you, Rob. Please note that all financial results discussed today are for continuing operations, while all variants commentary is on a year-over-year basis, unless otherwise stated. Jumping right into our fourth quarter results. For the fourth quarter, total revenue increased 5% to $8.1 million. Breaking down our revenue further, total factory sales increased 6% to $6.1 million. The increase was driven primarily by higher shipments of products from our franchise and licensed retail stores. Royalty and marketing revenue increased 5% to $1.7 million. Retail sales were $270,000 compared to $331,000. Same-store sales at all domestic Rocky Mountain Chocolate Factory locations increased 1.5%. Franchise fee revenue increased to $57,000 compared to $43,000.

Total factory and retail gross profit was $79,000 compared to $899,000 with gross profit margin of 1.2% compared to 14.7%. The decrease was primarily due to $577,000 of the write-off of obsolete inventory as a result of our aggressive effort to rationalize the products we offer and to reduce overall inventory levels. We drove a significant drawdown of our inventory in the fourth quarter to not only manage working capital more efficiently, but to position inventory more closely to our go-forward sales and marketing efforts. Inventory levels relative to our factory sales at fiscal year-end were at the lowest point in 10 years. Total operating expenses increased to $10.1 million compared to $7.2 million. The increase was primarily driven by one-time items, including costs associated with solicitation of proxies, severance payments – and severance payments.

Excluding these non-recurring items, fiscal Q4 operating expenses were $8.5 million. Net loss from continuing operations was $1.9 million or $0.29 per share compared to net income from continuing operations of $0.4 million or $0.06 per share. Adjusted EBITDA, a non-GAAP measure defined below, was $56,000 compared to $1 million with a decrease again, primarily driven by inventory write-downs. Our operating cash flow was $1.5 million in the fourth quarter compared to $2 million. Now quickly reviewing our full year ‘23 results. Total revenue increased 3% to $30.4 million. Total factory gross profit was $4 million compared to $4.9 million with gross margin of 16.4% compared to 20.9%. The gross margin decline was primarily due to lower production volumes, expenses with the aforementioned efforts to right-size our inventory levels.

Total operating expenses increased to $35.3 million compared to $30.2 million. The increase was driven by the previously mentioned non-recurring items in Q4. Excluding those for the full year – excluding all those for the full year, 2023 operating expenses would have been $29.2 million. Net loss from continuing operations was $5.5 million or $0.88 per share compared to net loss from continuing operations of $501,000 or $0.08 per share. Our adjusted EBITDA, which is a non-GAAP measure, was $2.6 million compared to $4.1 million. Operating cash flow was a negative $2.1 million compared to a positive $2.9 million. The previously mentioned drivers of our lower gross margin and higher operating expenses were the key drivers of the year-over-year decline in cash flow.

Now turning to the balance sheet. We ended the fourth quarter with a cash balance of $4.7 million compared to $7.6 million at the end of the last fiscal year. As of February 28, 2023, the company remained debt free. With that, I’d like to turn the call back over to Rob for closing remarks.

Rob Sarlls: Thanks, Allen. This leadership team is fully committed and excited to affect this Strategic Transformation Plan. I look forward to sharing more details in the coming quarters and reporting on our continued progress to all Rocky Mountain Chocolate Factory stakeholders as we work to build the business to its potential of consistently and sustainably generating growth and profitability. With the plan in place, we can now entirely focus our attention on improving execution in the factory in retail stores and online. This concludes our prepared remarks, and we will now open it up for questions for those participating in the call. Operator, back to you.

Q&A Session

Operator: [Operator Instructions] And our first question will come from Roger Lipton of Lipton Financial Services. Your line is open.

Roger Lipton: Yes. Good morning gentlemen. Thank you. Thanks for taking my questions. The $1.2 million of savings, is much of that in place at the moment, or is that going to be kind of put in place in the course of the next 12 months?

Rob Sarlls: Roger, good morning and thanks for your question. It’s a good question. We are going to be reporting our fourth – first quarter earnings not too long from now. And at that point, we will report the sum total of what’s been already gathered. And yes, there has already been a decent chunk of that $1.2 million already put into place. Some of it relates to some of my earlier comments about closing third-party warehousing that’s not needed, SKU rationalization and other process improvements that have already taken place in the factory.

Roger Lipton: Alright. And the 25% to 30% and the $1.2 million is, no doubt, part of that 25% to 30% gross margin objective, correct?

Rob Sarlls: Absolutely. Of course, we would love it to be more and more top line by getting the OpEx right sets the stage in the table for more profitable business being added going forward.

Roger Lipton: And can you put a little more precise timeframe on that – on your hope for the 25% to 30% gross margin, 3 years to 5 years is a long time, I mean what…?

Rob Sarlls: No, it absolutely is. But realize, this is a 10-year resurrection that we are underway. And we are only in basically the beginning to middle of year one. So, the $1.2 million, if you were to put it against our current volumes is a pretty meaningful bump to factory gross margins as a start. We intend for more of that to happen. And as we basically achieve levels, we will be re-updating.

Roger Lipton: Right. And I should know the answer to this, but you know better than I, what’s the price of chocolate doing these days?

Rob Sarlls: Price of chocolate, price of cocoa, prices of sugar, all those things are rather hefty right now. I believe sugar is at an 11-year high. Cocoa has been not as unstable as sugar prices, but it’s been highish. And one thing that we are very excited about is this is a year for which, the Farm Bill in the United States has come up. And you should know that this company and this leadership team has been working actively with [Technical Difficulty] officials in Colorado to really apply efficient and directed pressure to Congress to make amendments in the Farm Bill so that the whole industry that utilizes sugar can get more relief.

Roger Lipton: Right. And lastly, along the same line, I would imagine that your prices – your sale-price of product and your franchisee sale-price of product are up materially versus a year ago. Roughly what kind of a price impact is there year-to-year?

Rob Sarlls: We took a high-single digit increase last fiscal year. What we should share with everybody is given our confidence and the progress we have been making in our OpEx improvements, we have promised our franchisees at sort of a force majeure event, there will be no price increase in fiscal 2024.

Roger Lipton: Alright. That’s all I have got for now. A good presentation, and talk to you soon.

Rob Sarlls: Thank you, Roger. I appreciate the questions.

Operator: Thank you. And now we will address questions that have been received via e-mail. One moment for our first question. And the first question received was, help us understand the investment, both capitalized and expensed items necessary to fully execute your Strategic Transformation Plan.

Rob Sarlls: Well, that’s a good question, and I am going to trade off some of that to Allen to finish. To start, and I said this as recently as yesterday some of our industry peers at the Sweets & Snacks Show, which used to be called the Candy Show once upon a time. The company was not thinking of itself as a manufacturer of candy first. And so less than full attention was given to the optimization of what equipment is in the factory, doing what and with whom. All of those things have been given an incredible amount of scrutiny by Scott Ouellet, Tyson Snider and new other members of our team. And so a fair bit of investment will come in capital investment with new equipment in the factory not only to streamline and get efficiency, but also to give us capabilities to meet new product demand for consumers and also thinking about the labor situation, which is going to remain challenging, we see for the foreseeable future as it is anywhere in the United States.

So, we are more mindful to make capital investments so that we can do more pounds per factory employee than we have in the past. And so if we can get some good increases in volume, we are not having the sale on tons of increase in people. And then there is investment in things that aren’t capital intensive for the factories that are more systems and data that have the same benefit. I am going to turn it over to Allen to answer that.

Allen Arroyo: Yes. I would say that we have made investments that we have talked about on this call and previous calls to bolster our team, mainly in manufacturing. So, we have made that forward investment. But from a capital basis, we believe we are going to spend the lion’s share of our budget on capital equipment in the manufacturing facility. We also have money earmarked for ERP systems to upgrade that for our financial information that’s going to lead to better decisions and our deployment of capital. So, we – it’s a sizable amount that we have allocated for that in the next 12 months. And then based on our projections of the business, that will continue, but there is definitely a sizable investment in CapEx in the next 12 months to 18 months.

Operator: And our next question, one moment, would be, how should we think about the timing and impact of an acceleration or e-commerce sales and b, the rationalization of your retail footprint and pace of new store openings?

Rob Sarlls: Sure. I will answer the second part of that question first. So, all franchisors like us in the normal course are closing stores on a regular basis. We have – and actually, ironically, there have been fewer closings during the COVID period than one might have expected. So, those will be slightly more accelerated than the pace of the past and a lot of the data gathered from my 50 visits from – the highest number of field visits we have had by our team in many, many years and gaining also some analytical additional information from third-party sources, we are going to be trying to get the bulk of those done in the next 2 years. New store openings, I think will continue to pace normal course. We have a whole bunch that are coming in the next two quarters.

But realize, we will be pivoting to a new brand, a new store look sometime in fiscal ‘24, with all of that rollout with other sorts of enhancements to the attractiveness of investing in the Rocky Mountain Chocolate franchise, we expect the new store volume to be more meaningfully taking off in fiscal ‘25 and beyond. And then back to the omnichannel and other spending related to e-com, that is more a function of return on ad spend and there has been a more concerted effort to put more dollars and focus on that. That can be more immediate. It’s coming from a much smaller base because as I indicated earlier, our omnichannel sales hit a multiyear low in fiscal ‘23. So frankly, for fiscal ‘24, omnichannel sales should look very robust compared to the prior 2 years.

Operator: And we have an additional question. Will new stores be opened under the current or revised format? And what will be the financial impact of closing 25 stores to 35 stores?

Rob Sarlls: Okay. I will answer the second part of that first. So, with the analysis we have done of our store universe and a good example of which is the stores that were closed in the latter part of fiscal year ‘23, virtually all of them fell far below our average unit volume, which was $574,000. So realize, many of our less successful stores not only have lower annual sales volumes, they also ironically make more product in-store and buy less factory product. So, the financial impact of the stores, leaving our network, will not be significant as one might think. When you put all those facts in play, it is closer to de minimis than not. And what was the first part of the question again, I am sorry?

Operator: One moment. The first part was will new stores be opened under their current or revised format?

Rob Sarlls: Yes. So, new stores are opening right now. And if you think of any franchisor doing a brand and store image upgrade, the safest answer to the question is the stores that are opening right now are going to be the last stores if they want to, to wait to do some of the adjustments and accepting the new branding and the new store look. And we are being mindful of that and being very open with new franchisees about what’s coming down the pike.

Operator: Thank you. One moment, I am showing no further questions at this time. We do appreciate your attendance and participation. You may now disconnect. Have a wonderful day.

Rob Sarlls: Thanks everyone.

Allen Arroyo: Thank you.

Rob Sarlls: Thank you.