Many value investors are extolling the virtues of Rocky Mountain Chocolate Factory (RMCF), and with good reason. The stock has a P/E of 8, while the company has almost no debt and has managed to stay profitable throughout this downturn. As noted at Wide Moat Investing, the company has also not been shy to return money to shareholders, with a dividend yield above 7%. But there is one risk that investors would be wise to note: we just don't know that much about this company's financials.

It's not that the company isn't disclosing required information, but the inherent structure of the firm makes it very difficult for investors to determine how well (or how badly!) things are actually going. Ninety-five percent of the company's revenue comes from sales to its franchisees, and the results of these independent entrepreneurs are not consolidated in RMCF's financial statements - but the health of these franchisees does have a direct bearing on the value of RMCF. If franchisees are hemorraging money, the sales (and profits) currently enjoyed by RMCF will come to an abrupt halt.

While we don't have any direct data as to the health of the franchisees, we can take get some clues based on what RMCF has disclosed. Franchisee purchases from RMCF declined by 24% in the last quarter (y/y), meaning franchisee sales have probably declined by a similar amount. If their cost structures are fairly rigid, chances are many of them are losing money. Indeed, since this time last year, 11 domestic stores or kiosks have closed down. However, even though the number of franchisees is down, and the existing franchisees are purchasing significantly less product, RMCF is actually carrying more inventory now than it did at this point last year.

These facts don't necessarily mean that RMCF is not a buy, however, it is very difficult to tell how independent franchisees are faring in this environment. Their sales are clearly down, but do they have the financial strength to stick it out and keep buying product from RMCF, or will more of them start to drop off, propogating their difficulties to RMCF? The answer is too difficult for this investor to determine.

Saj Karsan
www.barelkarsan.com

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