Current Trends and Outlook
The fourth quarter retail environment proved to be the most challenging in the Company's history. Global economic turmoil resulted in a swift and steep decline in consumer spending and a shopping landscape dominated by promotional activity. The Company expects that the difficult environment will persist throughout 2009. Therefore, the Company will continue to focus on managing the business in a seasoned, disciplined and controlled manner.
In managing the business in 2009, the Company is taking a conservative view of market conditions. The Company will continue to focus on its long-term objectives while seeking to maintain flexibility to respond to market conditions.
The Company is a product-based international franchisor. The Company's revenues and profitability are derived principally from its franchised system of retail stores that feature chocolate and other confectionery products. The Company also sells its candy in selected locations outside its system of retail stores to build brand awareness. The Company operates seven retail units as a laboratory to test marketing, design and operational initiatives.
The Company is subject to seasonal fluctuations in sales because of the location of its franchisees, which have traditionally been located in resort or tourist locations. As the Company expands its geographical diversity to include regional centers, it has seen some moderation to its seasonal sales mix. Seasonal fluctuation in sales causes fluctuations in quarterly results of operations. Historically, the strongest sales of the Company's products have occurred during the Christmas holiday and summer vacation seasons. Additionally, 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 the Company's 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.
The most important factors in continued growth in the Company's earnings are ongoing unit growth, increased same store sales and increased same store pounds purchased from the factory. Historically, unit growth has more than offset decreases in same store sales and same store pounds purchased.
The Company's ability to successfully achieve expansion of its Rocky Mountain Chocolate Factory franchise system depends on many factors not within the Company's control including the availability of suitable sites for new store establishment and the availability of qualified franchisees to support such expansion.
Efforts to reverse the decline in same store pounds purchased from the factory by franchised stores and to increase total factory sales depend on many factors, including new store openings, competition, the receptivity of the Company's franchise system to the Company's product introductions and promotional programs. Same store pounds purchased from the factory by franchised stores declined approximately 14% in the first quarter, declined approximately 10% in the second quarter, declined approximately 24% in the third quarter, declined approximately 14% in the fourth quarter and 15% overall in fiscal 2009 as compared to the same periods in fiscal 2008.
Subsequent to February 28, 2009 the Company announced the expansion of the co-branding test relationship with Cold Stone Creamery. The Companies have agreed to expand the co-branding relationship to several hundred potential locations, based upon the performance of four test locations, operating under the test agreement announced in October 2008. The Company believes that if this co-branding strategy proves financially viable it could represent a significant future growth opportunity for the Company. Critical Accounting Policies and Estimates The Company's discussion and analysis of its financial condition and results of operations is based upon the Company's financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires the Company to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and the related disclosures. Estimates and assumptions include, but are not limited to, the carrying value of accounts and notes receivable from franchisees, inventories, the useful lives of fixed assets, goodwill, and other intangible assets, income taxes, contingencies and litigation. The Company bases its estimates on analyses, of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates.
We believe that the following represent our more critical estimates and assumptions used in the preparation of our financial statements, although not all inclusive.

Accounts and Notes Receivable - In the normal course of business, the Company extends credit to customers, primarily franchisees, that satisfy pre-defined credit criteria. The Company believes that it has limited concentration of credit risk primarily because its receivables are secured by the assets of the franchisees to which the Company ordinarily extends credit, including, but not limited to, their franchise rights and inventories. An allowance for doubtful accounts is determined through analysis of the aging of accounts receivable, assessments of collectability based on historical trends, and an evaluation of the impact of current and projected economic conditions. The process by which the Company performs its analysis is conducted on a customer by customer, or franchisee by franchisee, basis and takes into account, among other relevant factors, sales history, outstanding receivables, customer financial strength, as well as customer specific and geographic market factors relevant to projected performance. The Company monitors the collectability of its accounts receivable on an ongoing basis by assessing the credit worthiness of its customers and evaluating the impact of reasonably likely changes in economic conditions that may impact credit risks. Estimates with regard to the collectability of accounts receivable are reasonably likely to change in the future.
The Company recorded average expense of approximately $121,000 per year for potential uncollectible accounts over the three-year period ended February 28, 2009. Write-offs of uncollectible accounts net of recoveries averaged approximately $43,000 over the same period. The provision for uncollectible accounts is recognized as general and administrative expense in the Statements of Income. Over the past three years, the allowances for doubtful notes and accounts have ranged from 2.8% to 7.1% of gross receivables.
Revenue Recognition - The Company recognizes revenue on sales of products to franchisees and other customers at the time of delivery. Franchise fee revenue is recognized upon the opening of the store. The Company also recognizes a marketing and promotion fee of one percent (1%) of the Rocky Mountain Chocolate Factory franchised stores' gross retail sales and a royalty fee based on gross retail sales. Beginning with franchise store openings in the third quarter of fiscal year 2004, the Company modified its royalty structure. Under the current structure, the Company recognizes no royalty on franchised stores' retail sales of products purchased from the Company and recognizes a ten percent (10%) royalty on all other sales of product sold at franchise locations. For franchise stores opened prior to the third quarter of fiscal 2004 the Company recognizes a royalty fee of five percent (5%) of franchised stores' gross retail sales. Inventories - The Company's inventories are stated at the lower of cost or market value and are reduced by an allowance for slow-moving, excess, discontinued and shelf-life expired inventories. Our estimate for such allowance is based on our review of inventories on hand compared to estimated future usage and demand for our products. Such review encompasses not only potentially perishable inventories but also specialty packaging, much of it specific to certain holiday seasons. If actual future usage and demand for our products are less favorable than those projected by our review, inventory reserve adjustments may be required. We closely monitor our inventory, both perishable and non-perishable, and related shelf and product lives. Historically we have experienced low levels of obsolete inventory or returns of products that have exceeded their shelf life. Over the three-year period ended February 28, 2009, the Company recorded expense averaging approximately $80,000 per year for potential inventory losses, or approximately 0.5% of total cost of sales for that period.
Goodwill - Goodwill consists of the excess of purchase price over the fair market value of acquired assets and liabilities. Effective March 1, 2002, under SFAS 142 all goodwill with indefinite lives is no longer subject to amortization. SFAS 142 requires that an impairment test be conducted annually or in the event of an impairment indicator. Our test conducted in fiscal 2009 showed no impairment of our goodwill.
Other accounting estimates inherent in the preparation of the Company's financial statements include estimates associated with its evaluation of the recoverability of deferred tax assets, as well as those used in the determination of liabilities related to litigation and taxation. Various assumptions and other factors underlie the determination of these significant estimates. The process of determining significant estimates is fact specific and takes into account factors such as historical experience, current and expected economic conditions, and product mix. The Company constantly re-evaluates these significant factors and makes adjustments where facts and circumstances dictate. Historically, actual results have not significantly deviated from those determined using the estimates described above.
As discussed in Note 5 to the financial statements, the Company is involved in litigation incidental to its business, the disposition of which is expected to have no material effect on the Company's financial position or results of operations. It is possible, however, that future results of operations for any particular quarterly or annual period could be materially affected by changes in the Company's assumptions related to these proceedings.

Results of Operations

Fiscal 2009 Compared To Fiscal 2008
Results Summary
Basic earnings per share decreased 20.5% from $.78 in fiscal 2008 to $.62 in
fiscal 2009. Revenues decreased 10.5% from fiscal 2008 to fiscal 2009. Operating
income decreased 26.5% from $7.9 million in fiscal 2008 to $5.8 million in
fiscal 2009. Net income decreased 25.0% from $5.0 million in fiscal 2008 to
$3.7 million in fiscal 2009. The decrease in revenue, earnings per share,
operating income, and net income in fiscal 2009 compared to fiscal 2008 was due
primarily to decreased sales to specialty markets and decreased same store
pounds purchased by domestic franchise locations.
Revenues

      ($'s in thousands)               2009           2008          Change       % Change
      Factory sales                $ 20,572.5     $ 23,758.2     $ (3,185.7 )     (13.4 %)
      Retail sales                    1,880.7        1,800.0           80.7         4.5 %
      Royalty and marketing fees      5,627.0        5,696.9          (69.9 )      (1.2 %)
      Franchise fees                    458.5          623.1         (164.6 )     (26.4 %)
      Total                        $ 28,538.7     $ 31,878.2     $ (3,339.5 )     (10.5 %)

Factory Sales
Factory sales decreased in fiscal 2009 compared to fiscal 2008 due to a decrease of 29.0% in product shipments to specialty markets and a decline in same store pounds purchased by domestic franchise stores. Same store pounds purchased in fiscal 2009 were down approximately 15% from fiscal 2008. The Company believes the decrease in same store pounds purchased is due primarily to a product mix shift from factory products to products made in the stores and is primarily a result of the United States recession and the resulting financial pressure the recession has created for our system of franchised stores. Retail Sales
The increase in total retail sales was due to a change in the Company-owned stores in operation during fiscal year 2009 compared to fiscal year 2008 resulting from the closure of one Company-owned store in the first quarter of fiscal year 2009 and the acquisition of one Company-owned store in the second quarter and two Company-owned stores in the fourth quarter of fiscal year 2009. Same store retail sales at Company-owned store declined 4.9% in fiscal year 2009 compared to fiscal year 2008.
Royalties, Marketing Fees and Franchise Fees The decrease in royalties and marketing fees resulted from a decrease in same store sales of (5.4%), which more than offset the growth in the average number of domestic units in operation from 281 in fiscal 2008 to 284 in fiscal 2009. Franchise fee revenues decreased due to a decrease in the number of domestic franchises opened during the year when compared to the same period in the prior year.

Costs and Expenses

  ($'s in thousands)                     2009           2008          Change        % Change
  Cost of sales - factory adjusted   $ 14,360.3     $ 15,948.7     $ (1,588.4 )      (10.0 %)
  Cost of sales - retail                  716.8          729.8          (13.0 )       (1.8 %)
  Franchise costs                       1,718.6        1,498.7          219.9         14.7 %
  Sales and marketing                   1,495.4        1,503.2           (7.8 )       (0.5 %)
  General and administrative            2,562.3        2,505.7           56.6          2.3 %
  Retail operating                      1,107.9          994.8          113.1         11.4 %
  Total                              $ 21,961.3     $ 23,180.9     $ (1,219.6 )       (5.3 %)

  Adjusted Gross margin
  ($'s in thousands)
  Factory adjusted gross margin      $  6,212.2     $  7,809.5     $ (1,597.3 )      (20.5 %)
  Retail                                1,163.9        1,070.2           93.7          8.8 %
  Total                              $  7,376.1     $  8,879.7     $ (1,503.6 )      (16.9 %)

  (Percent)
  Factory adjusted gross margin            30.2 %         32.9 %         (2.7 %)      (8.2 %)
  Retail                                   61.9 %         59.5 %          2.4 %        4.0 %
  Total                                    32.9 %         34.7 %         (1.8 %)      (5.2 %)

Fiscal 2009 Compared To Fiscal 2008 - CONTINUED Adjusted gross margin is equal to gross margin minus depreciation and amortization expense. We believe adjusted gross margin is helpful in understanding our past performance as a supplement to gross margin and other performance measures calculated in conformity with accounting principles generally accepted in the United States ("GAAP"). We believe that adjusted gross margin is useful to investors because it provides 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 rather than gross margin to make incremental pricing decisions. Adjusted gross margin has limitations as an analytical tool because it excludes 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 as a measure of performance only in conjunction with GAAP measures of performance such as gross margin. The following table provides a reconciliation of adjusted gross margin to gross margin, the most comparable performance measure under GAAP:

             ($'s in thousands)                      2009          2008
             Factory adjusted gross margin        $ 6,212.2     $ 7,809.5
             Less: Depreciated and Amortization       370.5         389.3
             Factory GAAP gross margin            $ 5,841.7     $ 7,420.2

Cost of Sales
Factory margins decreased 270 basis points from the fiscal 2008 compared to fiscal 2009 due to lower manufacturing efficiencies associated with lower production volume and higher commodity prices during fiscal 2009 versus fiscal 2008.
Franchise Costs
The increase in franchise costs is due to higher professional fees and higher compensation costs in fiscal 2009 compared with fiscal 2008. As a percentage of total royalty and marketing fees and franchise fee revenue, franchise costs increased to 28.2% in fiscal 2009 from 23.7% in fiscal 2008. Sales and Marketing
Sales and marketing costs were approximately the same in fiscal 2009 as in fiscal 2008.
General and Administrative
The increase in general and administrative costs is due primarily to an increase in the allowance for doubtful accounts. As a percentage of total revenues, general and administrative expenses increased to 9.0% in fiscal 2009 compared to 7.9% in fiscal 2008.
Retail Operating Expenses
The increase in retail operating expenses during fiscal 2009 compared to fiscal 2008 was due primarily to costs associated with the acquisition of three Company-owned stores during fiscal 2009. Retail operating expenses, as a percentage of retail sales, increased from 55.3% in fiscal 2008 to 58.9% in fiscal 2009 due to a higher increase in costs relative to the increase in revenues.
Depreciation and Amortization
Depreciation and amortization of $758,000 in fiscal 2009 decreased 3.1% from $783,000 incurred in fiscal 2008 due to certain assets becoming fully depreciated.
Other, Net
Other, net of $5,500 realized in fiscal 2009 represents a decrease of $95,500 from the $101,000 realized in fiscal 2008 due to lower average outstanding cash balances and an increase in interest expense incurred related to use of the operating line of credit.
Income Tax Expense
The Company's effective income tax rate in fiscal 2009 was 36.2% which is a decrease of 1.9% compared to fiscal 2008. The decrease in the effective tax rate is primarily due to an increase in allowable deductions.

Fiscal 2009 Compared To Fiscal 2008 - CONTINUED In July 2006, the Financial Accounting Standards Board ("FASB") issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes ("FIN 48"). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise's financial statements in accordance with FASB Statement No. 109, Accounting for Income Taxes. FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. The Company adopted FIN 48 effective March 1, 2007 with no impact on the Company's financial statements.
Fiscal 2008 Compared To Fiscal 2007
Results Summary
Basic earnings per share increased 5.4% from $.74 in fiscal 2007 to $.78 in fiscal 2008. Revenues increased 1.0% from fiscal 2007 to fiscal 2008. Operating income increased 4.7% from $7.6 million in fiscal 2007 to $7.9 million in fiscal 2008. Net income increased 4.6% from $4.7 million in fiscal 2007 to $5.0 million in fiscal 2008. The increase in revenue, earnings per share, operating income, and net income in fiscal 2008 compared to fiscal 2007 was due primarily to increased number of franchised stores in operation, increased sales to speciality markets and the corresponding increases in revenue.

Revenues

       ($'s in thousands)               2008           2007         Change      % Change
       Factory sales                $ 23,758.2     $ 22,709.0     $ 1049.2         4.6 %
       Retail sales                    1,800.0        2,626.7       (826.7 )     (31.5 %)
       Royalty and marketing fees      5,696.9        5,603.8         93.1         1.7 %
       Franchise fees                    623.1          633.8        (10.7 )      (1.7 %)
       Total                        $ 31,878.2     $ 31,573.3     $  304.9         1.0

Factory Sales
Factory sales increased in fiscal 2008 compared to fiscal 2007 due to an increase of 28.8% in product shipments to specialty markets and growth in the average number of stores in operation to 324 in fiscal 2008 from 310 in fiscal 2007. Same store pounds purchased in fiscal 2008 were down approximately 9% from fiscal 2007, more than offsetting the increase in the average number of franchised stores in operation and mostly offsetting the increase in specialty market sales. The Company believes the decrease in same store pounds purchased is due primarily to a product mix shift from factory products to products made in the stores and softening in the retail sector of the economy. Retail Sales
The decrease in retail sales resulted primarily from a decrease in the average number of Company-owned stores in operation from 8 in fiscal 2007 to 5 in fiscal 2008. Same store sales at Company-owned stores increased 1.1% from fiscal 2007 to fiscal 2008.
Royalties, Marketing Fees and Franchise Fees The increase in royalties and marketing fees resulted from growth in the average number of domestic units in operation from 266 in fiscal 2007 to 281 in fiscal 2008 plus an increase in same store sales of 0.9%. Franchise fee revenues decreased due to a decrease in the number of franchises sold during the same period last year.

Costs and Expenses

                                                                                      %
   ($'s in thousands)                     2008           2007         Change        Change
   Cost of sales - factory adjusted   $ 15,948.7     $ 14,942.9     $ 1,005.8         6.7 %
   Cost of sales - retail                  729.8        1,045.7        (315.9 )     (30.2 %)
   Franchise costs                       1,498.7        1,570.0         (71.3 )      (4.5 %)
   Sales and marketing                   1,503.2        1,538.5         (35.3 )      (2.3 %)
   General and administrative            2,505.7        2,538.7         (33.0 )      (1.3 %)
   Retail operating                        994.8        1,502.1        (507.3 )     (33.8 %)
   Total                              $ 23,180.9     $ 23,137.9     $    43.0         0.2 %


Adjusted Gross margin

                                                                                   %
      ($'s in thousands)                 2008          2007         Change       Change
      Factory adjusted gross margin   $ 7,809.5     $ 7,766.1     $   43.4         0.6 %
      Retail                            1,070.2       1,581.0       (510.8 )     (32.3 %)
      Total                           $ 8,879.7     $ 9,347.1     $ (467.4 )      (5.0 %)

Fiscal 2008 Compared To Fiscal 2007 - CONTINUED

Adjusted Gross Margin - CONTINUED

          (Percent)
          Factory adjusted gross margin     32.9 %     34.2 %     (1.3 %)     (3.8 %)
          Retail                            59.5 %     60.2 %     (0.7 %)     (1.2 %)
          Total                             34.7 %     36.9 %     (2.2 %      (6.0 %)

Adjusted gross margin is equal to gross margin minus depreciation and amortization expense. We believe adjusted gross margin is helpful in understanding our past performance as a supplement to gross margin and other performance measures calculated in conformity with accounting principles generally accepted in the United States ("GAAP"). We believe that adjusted gross margin is useful to investors because it provides 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 rather than gross margin to make incremental pricing decisions. Adjusted gross margin has limitations as an analytical tool because it excludes 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 as a measure of performance only in conjunction with GAAP measures of performance such as gross margin. The following table provides a reconciliation of adjusted gross margin to gross margin, the most comparable performance measure under GAAP:

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