Rocky Mountain Chocolate Factory, Inc. - Quarter Report: 2017 November (Form 10-Q)

ROCKY MOUNTAIN CHOCOLATE FACTORY, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

(unaudited)

The accompanying notes are an integral part of these consolidated financial statements.

ROCKY MOUNTAIN CHOCOLATE FACTORY, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

The accompanying notes are an integral part of these consolidated financial statements.

ROCKY MOUNTAIN CHOCOLATE FACTORY, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited)

The accompanying notes are an integral part of these consolidated financial statements.

ROCKY MOUNTAIN CHOCOLATE FACTORY, INC. AND SUBSIDIARIES

NOTES TO INTERIM (UNAUDITED) CONSOLIDATED FINANCIAL STATEMENTS

Cautionary Note Regarding Forward-Looking Statements

This Quarterly Report on Form 10-Q (“Quarterly Report”) includes statements of our expectations, intentions, plans and beliefs that constitute “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934 and are intended to come within the safe harbor protection provided by those sections. These forward-looking statements involve various risks and uncertainties. The nature of our operations and the environment in which we operate subject us to changing economic, competitive, regulatory and technological conditions, risks and uncertainties. The statements, other than statements of historical fact, included in this Quarterly Report are forward-looking statements. Many of the forward-looking statements contained in this Quarterly Report may be identified by the use of forward-looking words such as "will," "intend," "believe," "expect," "anticipate," "should," "plan," "estimate," "potential," or similar expressions. Factors which could cause results to differ include, but are not limited to: changes in the confectionery business environment, seasonality, consumer interest in our products, general economic conditions, the ability to attract and retain qualified franchisees, the success of our franchised stores, the success of our frozen yogurt business, receptiveness of our products internationally, consumer and retail trends, costs and availability of raw materials, competition, the success of our co-branding strategy, the success of international expansion efforts and the effect of government regulations. Government regulations which we and our franchisees either are or may be subject to and which could cause results to differ from forward-looking statements include, but are not limited to: local, state and federal laws regarding health, sanitation, safety, building and fire codes, franchising, employment, manufacturing, packaging and distribution of food products and motor carriers. For a detailed discussion of the risks and uncertainties that may cause our actual results to differ from the forward-looking statements contained herein, please see the “Risk Factors” contained in Item 1A. of our Annual Report on Form 10-K for the fiscal year ended February 28, 2017. These forward-looking statements apply only as of the date of this Quarterly Report. As such they should not be unduly relied upon for more current circumstances. Except as required by law, we undertake no obligation to release publicly any revisions to these forward-looking statements that might reflect events or circumstances occurring after the date of this Quarterly Report or those that might reflect the occurrence of unanticipated events.

Unless otherwise specified, the “Company,” “we,” “us” or “our” refers to Rocky Mountain Chocolate Factory, Inc., a Delaware corporation, and its consolidated subsidiaries (including its operating subsidiary with the same name, Rocky Mountain Chocolate Factory, Inc., a Colorado corporation (“RMCF”)).

Overview

We are an international franchisor, confectionery manufacturer and retail operator. Founded in 1981, we are headquartered in Durango, Colorado and manufacture an extensive line of premium chocolate candies and other confectionery products. Our subsidiary, U-Swirl International, Inc. (“U-Swirl”), franchises and operates self-serve frozen yogurt cafés. Our revenues and profitability are derived principally from our franchised/license system of retail stores that feature chocolate, frozen yogurt and other confectionery products. We also sell our candy in selected locations outside of our system of retail stores and license the use of our brand with certain consumer products. As of November 30, 2017, there were 5 Company-owned, 86 Cold Stone Creamery co-branded and 272 franchised Rocky Mountain Chocolate Factory stores operating in 39 states, Canada, South Korea, and the Philippines. As of November 30, 2017, U-Swirl operated 5 Company-owned cafés and 120 franchised cafés located in 29 states and Canada. U-Swirl operates and franchises self-serve frozen yogurt cafés under the names “U-Swirl,” “Yogurtini,” “CherryBerry,” “Yogli Mogli Frozen Yogurt,” “Fuzzy Peach Frozen Yogurt,” “Let’s Yo!,” and “Aspen Leaf Yogurt”.

In January 2013, through our wholly-owned subsidiaries, including Aspen Leaf Yogurt, LLC (“ALY”), we entered into two agreements to sell all of the assets of our ALY frozen yogurt stores, along with our interest in the self-serve frozen yogurt franchises and retail units branded as “Yogurtini” which we also acquired in January 2013, to U-Swirl, Inc., a publicly traded company (OTCQB: SWRL) (“SWRL”), in exchange for a 60% controlling equity interest in SWRL (46% interest as of November 30, 2017). At that time, U-Swirl was a wholly-owned subsidiary of SWRL, and was the operating subsidiary for all of SWRL’s operations. Upon completion of these transactions, we ceased to directly operate any Company-owned ALY locations or sell and support frozen yogurt franchise locations, which was being supported by SWRL.

In fiscal year (“FY”) 2014, SWRL acquired the franchise rights and certain other assets of self-serve frozen yogurt concepts under the names “CherryBerry,” “Yogli Mogli Frozen Yogurt” and “Fuzzy Peach Frozen Yogurt.” In connection with these acquisitions, the Company entered into a credit facility with Wells Fargo, N.A. used to finance the acquisitions of SWRL, and in turn, the Company entered into a loan and security agreement with SWRL to cover the purchase price and other costs associated with the acquisitions (the “SWRL Loan Agreement”). Borrowings under the SWRL Loan Agreement were secured by all of the assets of SWRL, including all of the outstanding stock of its wholly-owned subsidiary, U-Swirl. As a result of certain defaults, we issued a demand for payment of all obligations under the SWRL Loan Agreement. SWRL was unable to repay the obligations under the SWRL Loan Agreement, and as a result, we foreclosed on all of the outstanding stock of U-Swirl on February 29, 2016 in full satisfaction of the amounts owed under the SWRL Loan Agreement. This resulted in U-Swirl becoming a wholly-owned subsidiary of the Company as of February 29, 2016.

Results of Operations

Three Months Ended November 30, 2017 Compared to the Three Months Ended November 30, 2016

Basic earnings per share decreased 23.5% from $.17 in the three months ended November 30, 2016 to $.13 in the three months ended November 30, 2017. Revenues were unchanged at approximately $10.0 million in the three months ended November 30, 2016 and 2017. Operating income decreased 25.7% from $1.6 million in the three months ended November 30, 2016 to $1.2 million in the three months ended November 30, 2017. Net income decreased 25.8% from $1.0 million in the three months ended November 30, 2016 to $751,000 in the three months ended November 30, 2017. The decrease in operating income and net income was primarily the result of higher cost of sales partially offset by lower operating costs.

Factory Sales

The increase in factory sales for the three months ended November 30, 2017 versus the three months ended November 30, 2016 was primarily due to a 15.5% increase in shipments of product to customers outside our network of franchise retail locations. This increase was mostly offset by a 5.3% decrease in purchases by our network of franchised and licensed retail locations. Same store pounds purchased by domestic Rocky Mountain Chocolate Factory franchise and license locations decreased 8.7% in the three months ended November 30, 2017, compared with the three months ended November 30, 2016.

Retail Sales

The increase in retail sales was primarily due to changes in retail units in operation resulting from the acquisition of a franchise location from a franchisee partially offset by the closure of an underperforming location. Same store sales at all Company-owned stores and cafés decreased 0.8% in the three months ended November 30, 2017 compared to the three months ended November 30, 2016.

Royalties, Marketing Fees and Franchise Fees

The decrease in royalties and marketing fees from the three months ended November 30, 2016 to the three months ended November 30, 2017 resulted from a 14.5% decrease in domestic franchise units in operation and lower same store sales. The average number of total domestic franchise stores in operation decreased from 365 in the three months ended November 30, 2016 to 312 during the three months ended November 30, 2017. This decrease is the result of domestic store closures exceeding domestic store openings. Same store sales at total franchise stores and cafés in operation decreased 4.3% during the three months ended November 30, 2017 compared to the three months ended November 30 2016. Franchise fees increased primarily as a result of an increase in domestic franchise openings during the three months ended November 30, 2017 compared to the three months ended November 30, 2016.

Adjusted gross margin and factory adjusted gross margin are non-GAAP measures. Adjusted gross margin is equal to the sum of our factory adjusted gross margin plus our retail gross margin calculated in accordance with GAAP. Factory adjusted gross margin is equal to factory gross margin minus depreciation and amortization expense. We believe adjusted gross margin and factory adjusted gross margin are helpful in understanding our past performance as a supplement to gross margin, factory gross margin and other performance measures calculated in conformity with GAAP. We believe that adjusted gross margin and factory adjusted gross margin are useful to investors because they provide a measure of operating performance and our ability to generate cash that is unaffected by non-cash accounting measures. Additionally, we use adjusted gross margin and factory adjusted gross margin rather than gross margin and factory gross margin to make incremental pricing decisions. Adjusted gross margin and factory adjusted gross margin have limitations as analytical tools because they exclude the impact of depreciation and amortization expense and you should not consider it in isolation or as a substitute for any measure reported under GAAP. Our use of capital assets makes depreciation and amortization expense a necessary element of our costs and our ability to generate income. Due to these limitations, we use adjusted gross margin and factory adjusted gross margin as measures of performance only in conjunction with GAAP measures of performance such as gross margin and factory gross margin.

Cost of Sales

Factory margins decreased 560 basis points in the three months ended November 30, 2017 compared to the three months ended November 30, 2016. This decrease was due primarily to increased production costs and product mix shift during the three months ended November 30, 2017 compared to the three months ended November 30, 2016. The decrease in Company-owned store margin is due primarily to a decrease in Company-owned café revenue resulting from the sale of yogurt and the associated higher margins. This change is the result of a decrease in units in operation during the three months ended November 30, 2017 compared to the prior year.

Franchise Costs

The decrease in franchise costs in the three months ended November 30, 2017 versus the three months ended November 30, 2016 is due primarily to lower franchise support costs, primarily the result of fewer units in operation. This decrease was mostly offset by increased professional fees incurred during the three months ended November 30, 2017 compared with the three months ended November 30, 2016. As a percentage of total royalty and marketing fees and franchise fee revenue, franchise costs increased to 32.0% in the three months ended November 30, 2017 from 30.5% in the three months ended November 30, 2016.

Sales and Marketing

The decrease in sales and marketing costs for the three months ended November 30, 2017 compared to the three months ended November 30, 2016 is primarily due to lower marketing-related compensation and lower marketing-related costs associated with U-Swirl franchise locations, the result of fewer units in operation.     

General and Administrative

The decrease in general and administrative costs for the three months ended November 30, 2017 compared to the three months ended November 30, 2016 is due primarily to lower professional fees, the result of resolving legal proceedings, and lower compensation costs. For the three months ended November 30, 2017, approximately $66,000 of U-Swirl general and administrative costs were consolidated within our results, compared with $86,000 in the three months ended November 30, 2016. As a percentage of total revenues, general and administrative expenses decreased to 8.3% in the three months ended November 30, 2017 compared to 8.8% in the three months ended November 30, 2016.

Retail Operating Expenses

The increase in retail operating expenses for the three months ended November 30, 2017 compared to the three months ended November 30, 2016 was due to changes in retail units in operation resulting from the acquisition of a franchise location partially offset by the closure of an underperforming location. Retail operating expenses, as a percentage of retail sales, increased from 66.7% in the three months ended November 30, 2016 to 69.6% in the three months ended November 30, 2017. This increase is primarily the result of a change in units in operation from the prior year.

Depreciation and Amortization

Depreciation and amortization, exclusive of depreciation and amortization included in cost of sales, was $202,000 in the three months ended November 30, 2017, unchanged from $202,000 incurred in the three months ended November 30, 2016. Depreciation and amortization included in cost of sales increased 13.7% from $118,000 in the three months ended November 30, 2016 to $134,000 in the three months ended November 30, 2017. This increase was the result of an increase in production assets in service.

Other Income (Expense)

Net interest expense was $22,300 in the three months ended November 30, 2017 compared to net interest expense of $31,300 incurred in the three months ended November 30, 2016. This change was the result of less interest expense incurred on lower average outstanding promissory note balances.

Income Tax Expense

Our effective income tax rate for the three months ended November 30, 2017 was 36.2%, compared to 36.1% for the three months ended November 30, 2016. Beginning March 1, 2017 the Company adopted ASU No. 2019-09, which requires recognition of excess tax benefits and tax deficiencies in the income statement.

Beginning on March 1, 2016, the results of U-Swirl were included in our consolidated income tax return, and on the same date, were removed from SWRL’s consolidated tax return. This is a result of the foreclosure on the outstanding stock of U-Swirl in satisfaction of debt with SWRL as discussed previously. The consolidated tax return for future periods will include all operating results of U-Swirl. SWRL will file separate income tax returns in future periods. However, there are no remaining operating assets held by SWRL.   U-Swirl has significant net operating loss carryovers. In accordance with Section 382 of the Internal Revenue Code, deductibility of U-Swirl’s U.S. net operating loss carryovers may be subject to annual limitation in the event of a change in control. We have performed a preliminary evaluation as to whether a change in control has taken place, and have concluded that there were changes of control with respect to the net operating losses of U-Swirl when we acquired a 60% ownership interest of SWRL in January 2013 and when we foreclosed upon the stock of U-Swirl International, Inc. in February 2016.

Nine Months Ended November 30, 2017 Compared to the Nine Months Ended November 30, 2016

Basic earnings per share decreased 10.6% from $.47 in the nine months ended November 30, 2016 compared to $.42 in the nine months ended November 30, 2017. Revenues decreased 1.3% to $27.6 million for the nine months ended November 30, 2017 compared to $27.9 million in the nine months ended November 30, 2016. Operating income decreased 8.2% from $4.4 million in the nine months ended November 30, 2016 to $4.0 million in the nine months ended November 30, 2017. Net income decreased 8.3% from $2.7 million in the nine months ended November 30, 2016 to $2.5 million in the nine months ended November 30, 2017. The decrease in operating income and net income was due primarily to a decrease in revenue and an increase in operating expenses.

Factory Sales

The increase in factory sales for the nine months ended November 30, 2017 versus the nine months ended November 30, 2016 was primarily due to an 18.8% increase in shipments of product to customers outside our network of franchised retail stores, partially offset by a 3.4% decrease in shipments to our network of franchised and licensed stores. Same store pounds purchased by domestic Rocky Mountain Chocolate Factory franchise and license locations decreased 4.0% in the nine months ended November 30, 2017, compared with the nine months ended November 30, 2016.

Retail Sales

The decrease in retail sales was primarily due to changes in retail units in operation resulting from the sale of certain Company-owned locations and the closure of a certain underperforming Company-owned location, partially offset by the acquisition of a franchised location. Same store sales at all Company-owned stores and cafés decreased 3.9% in the nine months ended November 30, 2017 compared to the nine months ended November 30, 2016.

Royalties, Marketing Fees and Franchise Fees

The decrease in royalties and marketing fees for the nine months ended November 30, 2017 compared to the nine months ended November 30, 2016 resulted from a 15.3% decrease in franchise units in operation and lower same store sales. The average number of total franchise stores in operation decreased from 380 in the nine months ended November 30, 2016 to 322 during the nine months ended November 30, 2017. This decrease is the result of domestic store closures exceeding domestic store openings, primarily the result of franchise and license closures of U-Swirl franchise locations. Same store sales at total franchise stores and cafés in operation decreased 3.2% during the nine months ended November 30, 2017 compared to the nine months ended November 30, 2016. Franchise fee revenues increased as a result of an increase in international license fees recognized during the nine months ended November 30, 2017 compared to the nine months ended November 30, 2016.

Adjusted gross margin and factory adjusted gross margin are non-GAAP measures. Adjusted gross margin is equal to the sum of our factory adjusted gross margin plus our retail gross margin calculated in accordance with GAAP. Factory adjusted gross margin is equal to factory gross margin minus depreciation and amortization expense. We believe adjusted gross margin and factory adjusted gross margin are helpful in understanding our past performance as a supplement to gross margin, factory gross margin and other performance measures calculated in conformity with GAAP. We believe that adjusted gross margin and factory adjusted gross margin are useful to investors because they provide a measure of operating performance and our ability to generate cash that is unaffected by non-cash accounting measures. Additionally, we use adjusted gross margin and factory adjusted gross margin rather than gross margin and factory gross margin to make incremental pricing decisions. Adjusted gross margin and factory adjusted gross margin have limitations as analytical tools because they exclude the impact of depreciation and amortization expense and you should not consider it in isolation or as a substitute for any measure reported under GAAP. Our use of capital assets makes depreciation and amortization expense a necessary element of our costs and our ability to generate income. Due to these limitations, we use adjusted gross margin and factory adjusted gross margin as measures of performance only in conjunction with GAAP measures of performance such as gross margin and factory gross margin.

Costs and Expenses

Cost of Sales

Factory margins decreased 170 basis points. This decrease was due primarily to increased production costs and product mix shift during the nine months ended November 30, 2017 compared to the nine months ended November 30, 2016. The decrease in Company-owned store margin is due primarily to a decrease in Company-owned café revenue resulting from the sale of yogurt and the associated higher margins. This change is the result of a change in units in operation during the nine months ended November 30, 2017 compared to the prior year.

Franchise Costs

The increase in franchise costs in the nine months ended November 30, 2017 versus the nine months ended November 30, 2016 is due primarily to an increase in legal and professional expenses. As a percentage of total royalty and marketing fees and franchise fee revenue, franchise costs increased to 26.7% in the nine months ended November 30, 2017 from 24.8% in the nine months ended November 30, 2016. This increase as a percentage of royalty, marketing and franchise fees is primarily a result of lower royalty and marketing revenues.

Sales and Marketing

The decrease in sales and marketing costs for the nine months ended November 30, 2017 compared to the Nine months ended November 30, 2016 is due primarily due to lower marketing related compensation and lower marketing-related costs associated with U-Swirl franchise locations.

General and Administrative

The decrease in general and administrative costs for the nine months ended November 30, 2017 compared to the nine months ended November 30, 2016 is due primarily to lower professional fees, the result of resolving legal proceedings, and lower compensation costs. For the nine months ended November 30, 2017, approximately $259,000 of U-Swirl general and administrative costs were consolidated within our results, compared with $347,000 in the nine months ended November 30, 2016. As a percentage of total revenues, general and administrative expenses decreased to 10.6% in the nine months ended November 30, 2017 compared to 11.1% in the nine months ended November 30, 2016.

Retail Operating Expenses

The decrease in retail operating expenses for the nine months ended November 30, 2017 compared to the nine months ended November 30, 2016 was due primarily to changes in units in operation, resulting from the sale of certain Company-owned units and the closure of certain underperforming Company-owned units. Retail operating expenses, as a percentage of retail sales, increased from 54.7% in the nine months ended November 30, 2016 to 58.3% in the nine months ended November 30, 2017. This increase is primarily the result of a change in units in operation from the prior year.

Depreciation and Amortization

Depreciation and amortization, exclusive of depreciation and amortization included in cost of sales, was $592,000 in the nine months ended November 30, 2017, a decrease of 7.3% from $638,000 incurred in the nine months ended November 30, 2016. This decrease was the result of fewer Company-owned store assets in service. Depreciation and amortization included in cost of sales increased 19.6% from $324,000 in the nine months ended November 30, 2016 to $388,000 in the nine months ended November 30, 2017. This increase was the result of an increase in production assets in service.

Restructuring and acquisition related charges

There were no restructuring and acquisition related charges during the nine months ended November 30, 2017 a decrease from $60,000 during the nine months ended November 30, 2016. The decrease is primarily the result of lease settlement costs related to the closure of an ALY company-owned location incurred during the nine months ended November 30, 2016 with no comparable expense incurred during the nine months ended November 30, 2017.

Other Income (Expense)

Net interest expense was $76,100 in the nine months ended November 30, 2017, a decrease of 24.1% compared to net interest expense of $100,300 in the nine months ended November 30, 2016. This change was the result of less interest expense incurred on lower average outstanding promissory note balances.

Income Tax Expense

Our effective income tax rate for the nine months ended November 30, 2017 was 36.4%, compared to 36.1% for the nine months ended November 30, 2016. The increase of 0.3% was primarily due to an increase in income tax expense associated with the vesting of restricted stock units. Beginning March 1, 2017 the Company adopted ASU No. 2019-09, which requires recognition of excess tax benefits and tax deficiencies in the income statement.

Beginning on March 1, 2016, the results of U-Swirl were included in our consolidated income tax return, and on the same date, were removed from SWRL’s consolidated tax return. This is a result of the foreclosure on the outstanding stock of U-Swirl in satisfaction of debt with SWRL as discussed previously. The consolidated tax return for future periods will include all operating results of U-Swirl. SWRL will file separate income tax returns in future periods. However, there are no remaining operating assets held by SWRL.   U-Swirl has significant net operating loss carryovers. In accordance with Section 382 of the Internal Revenue Code, deductibility of U-Swirl’s U.S. net operating loss carryovers may be subject to annual limitation in the event of a change in control. We have performed a preliminary evaluation as to whether a change in control has taken place, and have concluded that there were changes of control with respect to the net operating losses of U-Swirl when we acquired a 60% ownership interest of SWRL in January 2013 and when we foreclosed upon the stock of U-Swirl International, Inc. in February 2016.

Liquidity and Capital Resources

As of November 30, 2017, working capital was $7.0 million, compared with $7.1 million as of February 28, 2017, a decrease of $100,000. The decrease in working capital was primarily due to the payment of dividends and payments on long-term debt partially offset by positive operating results.

Cash and cash equivalent balances decreased $1.7 million from $5.8 million as of February 28, 2017 to $4.1 million as of November 30, 2017 as a result of cash flow used by financing activities, including repayment of indebtedness and payment of dividends. Our current ratio was 1.9 to 1 at November 30, 2017 and February 28, 2017. We monitor current and anticipated future levels of cash and cash equivalents in relation to anticipated operating, financing and investing requirements.

For the nine months ended November 30, 2017, we had net income of $2,493,012. Operating activities provided cash of $1,647,658, with the principal adjustment to reconcile the net income to net cash provided by operating activities being depreciation and amortization of $979,712, stock-based compensation expense of $458,275 and an increase in accrued liabilities of $362,718 more than offset by an increase to inventory of $990,398, an increase in deferred income taxes of $444,747 and an increase in accounts receivable of $1,307,149. During the comparable 2016 period, we had net income of $2,718,446, and operating activities provided cash of $2,997,051. The principal adjustment to reconcile the net income to net cash provided by operating activities was depreciation and amortization of $962,632, stock-based compensation expense of $447,581, and an increase in accounts payable of $156,150 mostly offset by an increase to inventory of $771,281 and an increase in accounts receivable of $650,708.

For the nine months ended November 30, 2017, investing activities used cash of $274,052, primarily due to the purchases of property and equipment of $446,935 partially offset by proceeds on notes receivable of $194,646. In comparison, investing activities used cash of $1,171,779 during the nine months ended November 30, 2016 primarily due to the purchases of property and equipment of $1,048,667.

Financing activities used cash of $3,085,883 for the nine months ended November 30, 2017 and used cash of $3,423,767 during the prior year period. This change was primarily due to a decrease in cash used to repurchase common stock during the nine months ended November 30, 2017 compared to the nine months ended November 30, 2016.

We have a $5.0 million ($5.0 million available as of November 30, 2017) working capital line of credit collateralized by substantially all of our assets with the exception of our retail store assets. Additionally, the line of credit is subject to various financial ratio and leverage covenants. As of November 30, 2017, we were in compliance with all such covenants. The line is subject to renewal in September 2019. As of November 30, 2017, no amount was outstanding under this line of credit.

The Company’s long-term debt is comprised of a promissory note, the proceeds of which were loaned to SWRL and used to finance business acquisitions by SWRL (unpaid balance as of November 30, 2017, $2.9 million). The promissory note allowed the Company to borrow up to a maximum of $7.0 million to finance business acquisitions and bears interest at a fixed annual rate of 3.75%. The promissory note matures on January 15, 2020, with amortized principal and accrued interest due monthly on the promissory note. Additionally, the promissory note is subject to various financial ratio and leverage covenants. As of November 30, 2017, we were in compliance with all such covenants.

As discussed above, in FY 2014, SWRL acquired the franchise rights and certain other assets of self-serve frozen yogurt concepts under the names “CherryBerry,” “Yogli Mogli Frozen Yogurt” and “Fuzzy Peach Frozen Yogurt.” In connection with these acquisitions, the Company entered into a credit facility with Wells Fargo Bank, N.A. used to finance the acquisitions of SWRL, and in turn, the Company entered into the SWRL Loan Agreement with SWRL. Borrowings under the SWRL Loan Agreement were secured by all of the assets of SWRL, including all of the outstanding stock of its wholly-owned subsidiary, U-Swirl. As a result of certain defaults under the SWRL Loan Agreement, we issued a demand for payment of all obligations under the SWRL Loan Agreement. SWRL was unable to repay the obligations under the SWRL Loan Agreement, and as a result, we foreclosed on all of the outstanding stock of U-Swirl as of February 29, 2016 in full satisfaction of the amounts owed under the SWRL Loan Agreement. This resulted in U-Swirl becoming a wholly-owned subsidiary of the Company as of February 29, 2016, and concurrently the Company ceased to have financial control of SWRL as of February 29, 2016. As of February 29, 2016 and November 30, 2017, SWRL had no operating assets.

On July 15, 2014, the Company publicly announced a plan to repurchase up to $3.0 million of its common stock in the open market or in private transactions, whenever deemed appropriate by management. On January 13, 2015, the Company announced a plan to purchase up to an additional $2,058,000 of its common stock under the repurchase plan, and on May 21, 2015, the Company announced a further increase to the repurchase plan by authorizing the purchase of up to an additional $2,090,000 of its common stock under the repurchase plan. The Company did not repurchase any shares during the three and nine months ended November 30, 2017. As of November 30, 2017, approximately $638,000 remains available under the repurchase plan for further stock repurchases.

We believe cash flows generated by operating activities and available financing will be sufficient to fund our operations for at least the next twelve months. If necessary, the Company has an available bank line of credit to help meet these requirements.

Off-Balance Sheet Arrangements

As of November 30, 2017, we had no off-balance sheet arrangements or obligations.

Impact of Inflation

Inflationary factors such as increases in the costs of ingredients and labor directly affect our operations. Most of our leases provide for cost-of-living adjustments and require us to pay taxes, insurance and maintenance expenses, all of which are subject to inflation. Additionally, our future lease costs for new facilities may include potentially escalating costs of real estate and construction. There is no assurance that we will be able to pass on increased costs to our customers.

Depreciation expense is based on the historical cost to us of our fixed assets, and is therefore potentially less than it would be if it were based on current replacement cost. While property and equipment acquired in prior years will ultimately have to be replaced at higher prices, it is expected that replacement will be a gradual process over many years.

Seasonality

We are subject to seasonal fluctuations in sales, which cause fluctuations in quarterly results of operations. Historically, the strongest sales of our confectionary products have occurred during the Christmas holiday through Mother’s Day. We believe the strongest sales of frozen yogurt products will occur during the summer months. In addition, quarterly results have been, and in the future are likely to be, affected by the timing of new store openings and sales of franchises. Because of the seasonality of our business and the impact of new store openings and sales of franchises, results for any quarter are not necessarily indicative of results that may be achieved in other quarters or for a full fiscal year.

Item 3.     Quantitative and Qualitative Disclosures About Market Risk

We do not engage in commodity futures trading or hedging activities and do not enter into derivative financial instrument transactions for trading or other speculative purposes. We also do not engage in transactions in foreign currencies or in interest rate swap transactions that could expose us to market risk. However, we are exposed to some commodity price and interest rate risks.

We frequently enter into purchase contracts of between six to eighteen months for chocolate and certain nuts. These contracts permit us to purchase the specified commodity at a fixed price on an as-needed basis during the term of the contract. Because prices for these products may fluctuate, we may benefit if prices rise during the terms of these contracts, but we may be required to pay above-market prices if prices fall and we are unable to renegotiate the terms of the contract. As of November 30, 2017, based on future contractual obligations for ingredients, we estimate that a 10.0% change in the prices of contracted ingredients would result in a $100,000 favorable or unfavorable price benefit or cost, respectively, resulting from our contracts.

We have a $5.0 million bank line of credit that bears interest at a variable rate. As of November 30, 2017, no amount was outstanding under the line of credit. We do not believe that we are exposed to any material interest rate risk related to this credit facility.

The Company also entered into a $7.0 million promissory note with interest at a fixed rate of 3.75% annually to finance the previous acquisitions by SWRL. As of November 30, 2017, $2.9 million was outstanding under this promissory note. We do not believe that we are exposed to any material interest rate risk related to this promissory note.

Item 4.     Controls and Procedures

Evaluation of Disclosure Controls and Procedures

We maintain disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”)) that are designed to ensure that material information relating to us is made known to the officers who certify as to our financial reports and to other members of senior management and the Board of Directors. These disclosure controls and procedures are designed to ensure that information required to be disclosed in our reports that are filed or submitted under the Exchange Act, are recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by an issuer in the reports that it files or submits under the Exchange Act is accumulated and communicated to our management, including our principal executive and principal financial officers, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure.

Company management, with the participation of our Chief Executive Officer and Chief Financial Officer, conducted an evaluation of the effectiveness of our disclosure controls and procedures. Based upon this evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective as of November 30, 2017.

Changes in Internal Control over Financial Reporting

There were no changes in our internal control over financial reporting that occurred during the quarter ended November 30, 2017 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

PART II.    OTHER INFORMATION

Item 1.     Legal Proceedings

In January 2014, SWRL entered into an Asset Purchase Agreement (the “CherryBerry Purchase Agreement”) with CherryBerry Enterprises LLC, CherryBerry Corporate LLC, CherryBerry LLC (collectively, the “CherryBerry Entities”), and their respective owners, pursuant to which SWRL acquired the franchise rights of frozen yogurt stores branded as “CherryBerry”. As previously disclosed, among other actions, on January 13, 2016, the CherryBerry Entities filed a lawsuit in the United States District Court for the Northern District of Oklahoma (the “Oklahoma Court”) asserting certain claims for alleged wrongful actions against SWRL and RMCF under the CherryBerry Purchase Agreement. On July 11, 2017, the Oklahoma Court granted summary judgement in favor of SWRL and RMCF on all of the claims made by the CherryBerry Entities, and in connection therewith, on September 26, 2017, the Oklahoma Court dismissed all counterclaims made by SWRL. The Company does not expect any further proceedings with respect to this matter. See Item 3. “Legal Proceedings” of our Annual Report on Form 10-K for the fiscal year ended February 28, 2017 and Item 1. “Legal Proceedings” of our Quarterly Report on Form 10-Q for the quarter ended August 31, 2017 for additional information concerning this matter.

The Company is party to various other legal proceedings arising in the ordinary course of business from time to time. Management believes that the resolution of these matters will not have a material adverse effect on the Company’s financial position, results of operations or cash flows.

Item 1A.   Risk Factors

In addition to the other information set forth in this Quarterly Report on Form 10-Q, you should carefully consider the factors discussed in Part 1, Item 1A. “Risk Factors” in our Annual Report on Form 10-K for the fiscal year ended February 28, 2017. There have been no material changes in our risk factors from those disclosed in our Annual Report on Form 10-K for the fiscal year ended February 28, 2017.

Item 2.     Unregistered Sales of Equity Securities and Use of Proceeds

Issuer Purchases of Equity Securities

On July 15, 2014, the Company publicly announced a plan to repurchase up to $3.0 million of its common stock in the open market or in private transactions, whenever deemed appropriate by management. On January 13, 2015, the Company announced a plan to purchase up to an additional $2,058,000 of its common stock under the repurchase plan, and on May 21, 2015, the Company announced a further increase to the repurchase plan by authorizing the purchase of up to an additional $2,090,000 of its common stock under the repurchase plan. The Company did not repurchase any shares during the three and nine months ended November 30, 2017. As of November 30, 2017, approximately $638,000 remains available under the repurchase plan for further stock repurchases.

The Company plans to continue the repurchase plan until it has been completed. The number, price, structure and timing of the repurchases, if any, will be at the Company’s sole discretion and future repurchases will be evaluated by the Company depending on market conditions, liquidity needs and other factors. The repurchase authorization does not have an expiration date and does not oblige the Company to acquire any particular amount of its common stock. The Board of Directors may suspend, modify or terminate the repurchase program at any time without prior notice.

Item 3.     Defaults Upon Senior Securities

None.

Item 4.     Mine Safety Disclosures

Not Applicable.

Item 5.     Other Information

None.

Item 6.     Exhibits

Signatures

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

ROCKY MOUNTAIN CHOCOLATE FACTORY, INC.

(Registrant)

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