Summary of ROCKY MOUNTAIN CHOCOLATE FACTORY INC

Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

Cautionary Note Regarding Forward-Looking Statements

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the unaudited financial statements and related notes of the Company included elsewhere in this report. The statements included in this report other than statements of historical fact, are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, and within the safe harbor provisions of the Private Securities Litigation Reform Act of 1995, and include statements regarding our cash flow, dividends, operating income and future growth. Many of the forward-looking statements contained in this document may be identified by the use of forward-looking words such as "will," "believe," "expect," "anticipate," "estimate," and "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, consumer and retail trends, costs and availability of raw materials, competition, the success of our co-branding agreement with Cold Stone Creamery Brands, the success of our international expansion efforts, the success of the Aspen Leaf Yogurt concept and the effect of government regulation. 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 our Annual Report on Form 10-K for the fiscal year ended February 29, 2012 which can be viewed at the SEC's website at www.sec.gov or through our website at www.rmcf.com. These forward-looking statements apply only as of the date of this report. Readers are cautioned not to place undue reliance on the forward-looking statements in this report. Except as required by law, we are not obligated to release publicly any revisions to these forward-looking statements that might reflect events or circumstances occurring after the date of this report or those that might reflect the occurrence of unanticipated events.

Overview

We are a product-based international franchisor, confectionery manufacturer and retail operator. Our revenues and profitability are derived principally from our franchised system of retail stores that feature chocolate, frozen yogurt, and other confectionery products. We also sell our candy in selected locations outside our system of retail stores to build brand awareness. We own and operate fifteen retail units as a laboratory to test marketing, design and operational initiatives.

The most important factors in continued growth in our 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.

Our ability to successfully achieve expansion of our Rocky Mountain Chocolate Factory and Aspen Leaf Yogurt franchise systems depends on many factors not within our control, including the availability of suitable sites for new store establishment, the availability of adequate financing options 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, same-store sales, and the receptivity of our franchise system to our product introductions and promotional programs.

In April 2012, we entered into a Master Licensing Agreement for the development and franchising of new Rocky Mountain Chocolate Factory stores in Japan. The agreement requires at least ten new stores to open each year for the next ten years, for a total minimum of 100 stores to be opened in Japan by the expiration of the initial term of the agreement. We believe that international opportunities may create a favorable expansion strategy and reduce dependence on domestic franchise openings to achieve growth. As of September 30, 2012 three stores were operating under the agreement.

Results of Operations

Three Months Ended August 31, 2012 Compared to the Three Months Ended August 31, 2011

Basic earnings per share decreased 6.7% from $.15 in the three months ended August 31, 2011 to $.14 in the same period of the current year. Revenues increased 2.0% from $7.6 million in the three months ended August 31, 2011 to $7.7 million in the same period of the current year. Operating income decreased 9.7% from $1.40 million in the three months ended August 31, 2011 to $1.27 million in the same period of the current year. Net income decreased 9.1% from $912,000 in the three months ended August 31, 2011 to $829,000 in the same period of the current year. The decrease in operating income and net income for the three months ended August 31, 2012 compared to the same period in the prior year was due primarily to an operating loss of approximately $172,000 associated with the retail operations and franchise support of Aspen Leaf Yogurt.

                               Three Months Ended
                                   August 31,                            %
($'s in thousands)             2012          2011         Change      Change
Factory sales                $ 4,673.2     $ 4,539.4     $  133.8         2.9 %
Retail sales                   1,556.9       1,464.2         92.7         6.3 %
Franchise fees                    35.2         143.3       (108.1 )     (75.4 %)
Royalty and Marketing fees     1,464.5       1,428.9         35.6         2.5 %
Total                        $ 7,729.8     $ 7,575.8     $  154.0         2.0 %

Factory Sales

The increase in factory sales for the three months ended August 31, 2012 versus the three months ended August 31, 2011 was primarily due to an increase in shipments of product to international franchisees and Cold Stone Creamery co-branded licensed locations. These increases were partially offset by a 1.3% decrease in same-store pounds purchased by our network of domestic franchised stores.

Retail Sales

The increase in retail sales was primarily due to an increase in the average number of Company-owned stores in operation. The average number of Company owned units in operation increased from 13 during the three months ended August 31, 2011 to 17 units in the same period of the current year. The increase in average Company-owned units in operation and the resulting increase in retail sales was partially offset by a decrease in Company-owned same-store sales. Same-store sales at Company-owned stores decreased by 15.8% in the three months ended August 31, 2012 compared to the three months ended August 31, 2011. We believe the decline in same-store sales was primarily the result of the grand opening effect of Aspen Leaf Yogurt locations and the resulting revenues associated with these openings in the prior year.

Royalties, Marketing Fees and Franchise Fees

Royalties and marketing fees increased 2.5% in the three months ended August 31, 2012 compared with the same period of the prior year as a result of an increase in royalties based on the Company's purchase-based royalty structure, an increase in royalties from co-branded locations and an increase in same-store sales, partially offset by a decrease in domestic franchise units. Same store sales at franchise locations increased 1.1% during the three months ended August 31, 2012 compared to the same period in the prior year. Average licensed locations in operation increased from 44 units in the three months ended August 31, 2011 to 53 units in the same period of the current year. The average number of domestic units in operation decreased from 247 in the three months ended August 31, 2011 to 238 in the same period of the current year. The decrease in franchise fee revenue during the three months ended August 31, 2012, compared with the prior year period was the result of a decrease in domestic franchise openings from 5 during the three months ended August 31, 2011 to 2 openings during the three months ended August 31, 2012.

Costs and Expenses
                                     Three months ended
                                         August 31,                           %
($'s in thousands)                   2012          2011        Change      Change
Cost of sales - factory adjusted   $ 3,068.6     $ 3,017.0     $  51.6         1.7 %
Cost of sales - retail                 601.0         560.6        40.4         7.2 %
Franchise costs                        558.1         514.8        43.3         8.4 %
Sales and marketing                    408.8         384.9        23.9         6.2 %
General and administrative             701.7         717.0       (15.3 )      (2.1 %)
Retail operating                       893.3         787.4       105.9        13.4 %
Total                              $ 6,231.5     $ 5,981.7     $ 249.8         4.2 %



Adjusted gross margin
                                  Three months ended
                                      August 31,                            %
($'s in thousands)                2012          2011        Change       Change
Factory adjusted gross margin   $ 1,604.6     $ 1,522.4     $  82.2          5.4 %
Retail                              955.9         903.6        52.3          5.8 %
Total                           $ 2,560.5     $ 2,426.0     $ 134.5          5.5 %

(Percent)
Factory adjusted gross margin        34.3 %        33.5 %       0.8 %        2.4 %
Retail                               61.4 %        61.7 %      (0.3 %)      (0.5 %)
Total                                41.1 %        40.4 %       0.7 %        1.7 %

Adjusted gross margin, a non-GAAP measure, 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 is helpful in understanding our past performance as a supplement to gross margin and other performance measures calculated in conformity with 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 factory adjusted gross margin to factory gross margin, the most comparable performance measure under GAAP:

                                        Three Months Ended
                                            August 31,
($'s in thousands)                      2012          2011
Factory adjusted gross margin         $ 1,604.6     $ 1,522.4
Less: Depreciation and Amortization        71.9          69.0
Factory GAAP gross margin             $ 1,532.7     $ 1,453.4

Costs and Expenses

Cost of Sales

Factory margins increased 80 basis points in the three months ended August 31, 2012 compared to the three months ended August 31, 2011 due primarily to an increase in the average selling price of products to domestic franchise units. The slight decrease in Company-owned store margin is due primarily to a change in product mix.

Franchise Costs

The increase in franchise costs in the three months ended August 31, 2012 versus the three months ended August 31, 2011 is due primarily to an increase in costs associated with support and development of the Company's international development initiative. As a percentage of total royalty and marketing fees and franchise fee revenue, franchise costs increased to 37.2% in the three months ended August 31, 2012 from 32.7% in the three months ended August 31, 2011. This increase as a percentage of royalty, marketing and franchise fees is primarily a result of a 75.4% decrease in franchise fee revenue as a result of fewer franchise store openings in the three months ended August 31, 2012.

Sales and Marketing

The increase in sales and marketing expense for the three months ended August 31, 2012 compared to the same period in the prior year is due primarily to an increase in marketing-related compensation and benefit costs.

General and Administrative

The decrease in general and administrative costs for the three months ended August 31, 2012 compared to the same period in the prior year is due primarily to lower costs associated with Aspen Leaf Yogurt site selection. As a percentage of total revenues, general and administrative expense decreased to 9.1% in the three months ended August 31, 2012 compared to 9.5% in the same period of the prior year.

Retail Operating Expenses

The increase in retail operating expense was primarily due to an increase in the average number of Company-owned stores in operation. The average number of Company owned units in operation increased from 13 during the three months ended August 31, 2011 to 17 units in the same period of the current year. Retail operating expenses, as a percentage of retail sales, increased from 53.8% in the three months ended August 31, 2011 to 57.4% in the same period of the current year.

Depreciation and Amortization

Depreciation and amortization of $230,000 in the three months ended August 31, 2012 increased 21.1% from $190,000 incurred in the three months ended August 31, 2011, due to additional depreciable assets acquired by us as a result of an increase in the number of Company-owned stores in operation and the associated depreciation of those assets.

Interest Income

Interest income of $11,500 realized in the three months ended August 31, 2012 represents a decrease of $2,500 from the $14,000 realized in the three months ended August 31, 2011.

Income Tax Expense

Our effective income tax rate for the three months ended August 31, 2012 was 35.2%, compared to 35.7% for the three months ended August 31, 2011.

Six Months Ended August 31, 2012 Compared to the Six Months Ended August 31, 2011

Basic earnings per share increased 3.3% from $.30 for the six months ended August 31, 2011 to $��.31 for the same period of the current year. Revenues increased 7.2% to $17.4 million for the six months ended August 31, 2012 compared to $16.2 million in the same period of the prior year. Operating income increased 3.2% from $2.8 million in the six months ended August 31, 2011 to $2.9 million in the same period of the current year. Net income increased 3.3% from $1.8 million in the six months ended August 31, 2011 to $1.9 million in the same period of the current year. The increase in operating income and net income for the six months ended August 31, 2012 compared to the same period in the prior year was due primarily to an increase in revenues, partially offset by an increase in operating expenses and an operating loss of approximately $272,000 associated with the retail operations and franchise support of Aspen Leaf Yogurt.

Revenues

                                 Six Months Ended
                                    August 31,                              %
($'s in thousands)              2012           2011         Change       Change
Factory sales                $ 11,161.8     $ 10,372.0     $   789.8         7.6 %
Retail sales                    3,158.9        2,842.1         316.8        11.1 %
Franchise fees                    159.1          249.8         (90.7 )     (36.3 %)
Royalty and marketing fees      2,908.2        2,749.8         158.4         5.8 %
Total                        $ 17,388.0     $ 16,213.7       1,174.3         7.2 %

Factory Sales

The increase in factory sales for the six months ended August 31, 2012 versus the six months ended August 31, 2011 was primarily due to an 11.4% increase in shipments of product to customers outside our network of franchised retail stores and a 6.6% increase in sales to domestic and international franchised and licensed stores. These increases were partially offset by a 3.6% decrease in the average number of domestic Rocky Mountain Chocolate Factory franchised stores in operation and a 2.7% decline in same-store pounds purchased by our network of franchised stores.

Retail Sales

The increase in retail sales resulted primarily from an increase in the average number of Company-owned stores in operation from 14 in the six months ended August 31, 2011 to 18 in the same period of the current year. The increase in average Company-owned units in operation and the resulting increase in retail sales was partially offset by a decrease in Company-owned same-store sales. Same-store retail sales at Company-owned locations decreased 0.4% in the six months ended August 31, 2012 compared to the same period in the prior year.

Royalties, Marketing Fees and Franchise Fees

Royalties and marketing fees increased 5.8% in the six months ended August 31, 2012 compared with the same period of the prior year as a result of an increase in royalties based on the Company's purchase based royalty structure, an increase in same store sales and an increase in royalties from co-branded locations, partially offset by a decrease in domestic franchise units. Same store sales at franchise locations increased 1.1% during the six months ended August 31, 2012 compared to the same period in the prior year. Average licensed locations in operation increased from 43 units in six months ended August 31, 2011 to 52 units in the same period of the current year. The average number of domestic units in operation decreased from 247 in the six months ended August 31, 2011 to 238 in the same period of the current year. The decrease in franchise fee revenue during the six months ended August 31, 2012, compared with the prior year period was the result of a decrease in domestic franchise opening from 9 during the six months ended August 31, 2011 to 4 openings during the six months ended August 31, 2012, partially offset by an increase in international license fees.

Costs and Expenses
                                       Six months ended
                                          August 31,                            %
($'s in thousands)                    2012           2011        Change      Change

Cost of sales - factory adjusted   $  7,500.8     $  7,087.8     $ 413.0         5.8 %
Cost of sales - retail                1,191.0        1,123.1        67.9         6.0 %
Franchise costs                       1,102.5          921.7       180.8        19.6 %
Sales and marketing                     870.0          825.1        44.9         5.4 %
General and administrative            1,541.8        1,456.6        85.2         5.8 %
Retail operating                      1,824.3        1,638.6       185.7        11.3 %
Total                              $ 14,030.4     $ 13,052.9     $ 977.5         7.5 %

Adjusted gross margin
Six months ended

                           August 31,                           %
                       2012          2011        Change      Change
($'s in thousands)
Factory              $ 3,661.0     $ 3,284.2     $ 376.8        11.5 %
Retail                 1,967.9       1,719.0       248.9        14.5 %
Total                $ 5,628.9     $ 5,003.2     $ 625.7        12.5 %



(Percent)
Factory       32.8 %     31.7 %     1.1 %     3.5 %
Retail        62.3 %     60.5 %     1.8 %     3.0 %
Total         39.3 %     37.9 %     1.4 %     3.7 %

                                         Six Months Ended
                                            August 31,
($'s in thousands)                      2012          2011
Factory adjusted gross margin         $ 3,661.0     $ 3,284.2
Less: Depreciation and Amortization       142.3         138.5
Factory GAAP gross margin             $ 3,518.7     $ 3,145.7

Costs and Expenses

Cost of Sales

Factory margins increased 110 basis points for the six months ended August 31, 2012 compared to the six months ended August 31, 2011 due primarily to an increase in the average selling price of products to domestic franchise units. The increase in Company-owned store margin is due primarily to lower costs associated with Aspen Leaf Yogurt grand openings, a change in the number of Company-owned stores in operation, and the associated change in product mix.

Franchise Costs

The increase in franchise costs for the six months ended August 31, 2012 compared to the six months ended August 31, 2011 is due primarily to an increase in travel and support costs associated with our international development initiative and an increase in franchise opportunity advertising costs. As a percentage of total royalty and marketing fees and franchise fee revenue, franchise costs increased to 35.9% in the six months ended August 31, 2012 from 30.7% in the six months ended August 31, 2011. This increase as a percentage of royalty, marketing and franchise fees is primarily a result of higher franchise costs relative to revenues as discussed above.

Sales and Marketing

The increase in sales and marketing expense for the six months ended August 31, 2012 compared to the same period in the prior year is due primarily to an increase in marketing-related compensation and benefit costs.

General and Administrative

The increase in general and administrative costs for the six months ended August 31, 2012 compared to the six months ended August 31, 2011 is due primarily to an increase in travel costs associated with our international development initiative and an increase in expense associated with our analysis of doubtful accounts and notes receivable. As a percentage of total revenues, general and administrative expenses was approximately unchanged at 8.9% in the six months ended August 31, 2012 compared to 9.0% in the same period of the prior year.

Retail Operating Expenses

The increase in retail operating expense was primarily due to an increase in the average number of Company-owned stores in operation during the six months ended August 31, 2012 compared with the same period of the prior year. The average number of Company owned units in operation increased from 14 during the six months ended August 31, 2011 to 18 units in the same period of the current year. Retail operating expenses, as a percentage of retail sales, was approximately unchanged from 57.7% in the six months ended August 31, 2011 to 57.8% in the same period of the current year.

Depreciation and Amortization

Depreciation and amortization of $468,000 in the six months ended August 31, 2012 increased 30.2% from $359,000 incurred in the six months ended August 31, 2011 due to an increase in the number of Company-owned stores in operation and the associated depreciation of those assets.

Interest Income

Interest income of $23,000 realized in the six months ended August 31, 2012 represents a decrease of $8,000 from the $31,000 realized in the same period of the prior year due to lower balances of notes receivable.

Income Tax Expense

Our effective income tax rate in the six months ended August 31, 2012 was 35.1% and was approximately unchanged from 35.4% in the same period in the prior year.

Liquidity and Capital Resources

As of August 31, 2012, working capital was $10.2 million, compared with $10.6 million as of February 29, 2012, a decrease of $400,000. The change in working capital was due primarily to operating results being offset by the repurchase of stock and payment of cash dividends.

Cash and cash equivalent balances decreased from $4.1 million as of February 29, 2012 to $3.8 million as of August 31, 2012 as a result of repurchase and share retirement of $1.7 million partially offset by cash flows provided by operating activities. Our current ratio was 4.53 to 1 at August 31, 2012 in comparison with 3.98 to 1 at February 29, 2012. We monitor current and anticipated future levels of cash and cash equivalents in relation to anticipated operating, financing and investing requirements.

We have a $5.0 million (no amount was outstanding as of August 31, 2012) 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 August 31, 2012, we were in compliance with all such covenants. The line was subject to renewal on July 31, 2012. The line was renewed on September 24, 2012.

In November 2011, we executed a promissory note for $2.5 million in order to establish a line of credit for the funding of the potential expansion of Company-owned Aspen Leaf Yogurt locations. The line of credit is guaranteed by us and is collateralized by our land, building and improvements. We may draw from the line of credit until November 1, 2013 to fund new Aspen Leaf Yogurt . . .