Overview

As of December 27, 2008, we had 924 franchises operating under the Play it Again Sports®, Once Upon a Child®, Plato's Closet®, Music Go Round® and Wirth Business Credit® brands and had a leasing portfolio of $45.4 million. Management closely tracks the following criteria to evaluate current business operations and future prospects: franchising revenue, leasing activity, and selling, general and administrative expenses.

Our most profitable sources of franchising revenue are royalties earned from our franchise partners and franchise fees for new openings and transfers. During 2008, our royalties increased $1,357,400 or 6.6% compared to 2007. Franchise fees decreased $19,600 or 1.1% compared to last year.

During 2008, we purchased $21.9 million in equipment for lease contracts compared to $33.6 million in 2007. The level of equipment purchases for lease contracts during 2008 was impacted by the unfavorable general economic environment as well as our decision to tighten credit standards in response to these conditions. Overall, our leasing portfolio (net investment in leases - current and long-term) grew 8.4% to $45.4 million at December 27, 2008 from $41.9 million at December 29, 2007. Revenue generated from our leasing activities in 2008 was $8,092,800 compared to $4,416,200 in the same period last year. (See Note 12 - "Segment Reporting"). Our earnings are also significantly impacted by credit losses. During 2008, our provision for credit losses increased to $2,569,800 from $603,700 in 2007, primarily due to a higher level of net charge-offs in the small-ticket financing business portion of our leasing segment, as well as an increase in our allowance for credit losses due to the worsening general economic trends that have increased the level of delinquencies in this business.

Management continually monitors the level and timing of selling, general and administrative expenses. The major components of selling, general and administrative expenses include salaries, wages and benefits, advertising, travel, occupancy, legal and professional fees. During 2008, selling, general and administrative expense increased $492,800, or 2.6%, compared to the same period last year primarily due to increases in amortization of initial direct costs, stock option expenses and bank fees, partially offset by a decrease in development advertising.

Management also monitors several nonfinancial factors in evaluating the current business operations and future prospects including franchise openings and closings and franchise renewals. The following is a summary of our franchising activity for the fiscal year ended December 27, 2008:

                                                                 AVAILABLE
                          TOTAL                        TOTAL        FOR      COMPLETED      %
                         12/29/07   OPENED   CLOSED   12/27/08    RENEWAL    RENEWALS    RENEWED
Play It Again Sports®
Franchises - US and
Canada                        374       14      (24 )      364           9           9        100 %

Once Upon A Child®
Franchises - US and
Canada                        228       10       (9 )      229           8           7         88 %

Plato's Closet®
Franchises - US and
Canada                        211       33       (3 )      241           -           -        N/A

Music Go Round®
Franchises - US                38        0       (2 )       36           6           6        100 %

Total Franchised
Stores                        851       57      (38 )      870          23          22         96 %

Wirth Business Credit®
Territories - US               41       23      (10 )       54           -           -        N/A
Total
Franchises/Territories        892       80      (48 )      924          23          22         96 %

Renewal activity is a key focus area for management. Our franchisees sign 10-year agreements with us. The renewal of existing franchise agreements as they approach their expiration is an indicator that management monitors to determine the health of our business and the preservation of future royalties. In 2008, we renewed 96% of franchise agreements up for renewal. This percentage of renewal has ranged between 96% and 100% during the last three years.

Our ability to grow our profits is dependent on our ability to: (i) effectively support our franchise partners so that they produce higher revenues, (ii) open new franchises, (iii) increase lease originations and minimize write-offs in our leasing portfolios, and (iv) control our selling, general and administrative expenses. A detailed description of the risks to our business along with other risk factors can be found in Item 1A "Risk Factors".

Results of Operations

The following table sets forth selected information from our Consolidated Statements of Operations expressed as a percentage of total revenue and the percentage change in the dollar amounts from the prior period:

                                                 Fiscal Year Ended                Fiscal 2008
                                       December 27, 2008   December 29, 2007   over (under) 2007
Revenue:
Royalties                                           61.6 %              65.6 %               6.6 %
Leasing income                                      22.8                14.2                83.3
Merchandise sales                                    9.2                12.8               (18.3 )
Franchise fees                                       4.8                 5.5                (1.1 )
Other                                                1.6                 1.9                (4.3 )
Total revenue                                      100.0               100.0                13.7

Cost of merchandise sold                            (8.8 )             (12.3 )             (18.7 )
Lease expense                                       (5.3 )              (3.3 )              82.5
Provision for credit losses                         (7.3 )              (2.0 )             325.7
Selling, general and administrative
expenses                                           (55.8 )             (61.8 )               2.6
Income from operations                              22.8                20.6                25.9
Loss from equity investments                        (8.9 )              (1.1 )            (779.6 )
Interest expense                                    (3.7 )              (4.7 )             (10.4 )
Interest and other income                            0.7                 1.7               (58.3 )
Income before income taxes                          10.9                16.5               (25.3 )
Provision for income taxes                          (7.7 )              (6.7 )              28.7
Net income                                           3.2 %               9.8 %             (62.6 )%

Revenue

Revenues for the year ended December 27, 2008 totaled $35.4 million compared to $31.2 million for the comparable period in 2007.

Royalties and Franchise Fees

Royalties increased to $21.8 million for 2008 from $20.4 million for the same period in 2007, a 6.6% increase. The increase was due to higher Plato's Closet® and Once Upon A Child® royalties of $1,479,300 and $425,900, respectively. The increase in Plato's Closet® and Once Upon A Child® royalties is primarily due to having 30 additional Plato's Closet® and 1 additional Once Upon A Child® franchise stores in 2008 compared to the same period last year and higher franchisee retail sales in both brands.

Franchise fees include initial franchise fees from the sale of new franchises and transfer fees related to the transfer of existing franchises. Franchise fee revenue is recognized when the franchise opens or when the franchise agreement is assigned to a buyer of a franchise. An overview of retail brand and Wirth Business Credit® franchise fees is presented in the Franchising subsection of the Business section. Franchise fees decreased to $1,704,500 for 2008 from $1,724,100 for 2007, primarily as a result of opening three fewer franchise territories in 2008 compared to 2007.

Leasing Income

Leasing income increased to $8,092,800 in 2008 compared to $4,416,200 for the same period in 2007. The increase is due to a larger lease portfolio in 2008 compared to 2007. Our monthly average lease portfolio during 2008 was $45.3 million compared to $29.2 million during 2007.

Merchandise Sales

Merchandise sales include the sale of product to franchisees either through the Play It Again Sports® buying group or through our Computer Support Center (together, "Direct Franchisee Sales"). Direct Franchisee Sales decreased 18.3% to $3,268,100 in 2008 from $3,999,500 in 2007. This is a result of management's strategic decision to have more franchisees purchase merchandise directly from vendors and having 10 fewer Play It Again Sports® stores open than one year ago.

Cost of Merchandise Sold

Cost of merchandise sold includes in-bound freight and the cost of merchandise associated with Direct Franchisee Sales. Cost of merchandise sold decreased 18.7% to $3,120,700 in 2008 from $3,837,200 in 2007. The decrease was primarily due to a decrease in Direct Franchisee Sales discussed above. Cost of merchandise sold as a percentage of Direct Franchisee Sales for 2008 and 2007 was 95.5% and 95.9%, respectively.

Leasing Expense

Leasing expense increased to $1,881,800 in 2008 compared to $1,031,000 in 2007. The increase is due to interest on increased borrowing in connection with the growth of our lease portfolio.

Provision for Credit Losses

Provision for credit losses increased to $2,569,800 in 2008 compared to $603,700 in 2007. The increase is primarily due to a higher level of net charge-offs in the small-ticket financing business portion of our leasing segment. During 2008, we had total net charge-offs of $1,644,700 compared to $424,100 in 2007. In addition, we increased our allowance for credit losses during 2008 due to worsening general economic trends that have increased the level of delinquencies in our small-ticket financing business.

Selling, General and Administrative Expenses

The $492,800, or 2.6%, increase in selling, general and administrative expenses in 2008 compared to the same period in 2007 is primarily due to increases in amortization of initial direct costs resulting from the larger lease portfolio, compensation expense related to stock options and bank fees of $479,000, $142,000 and $141,000, respectively, partially offset by a $365,000 decrease in development advertising.

Loss from Equity Investments

During 2008 and 2007, we recorded losses of $324,100 and $359,600, respectively, from our investment in Tomsten (representing our pro-rata share of losses for the periods). In addition, as part of an impairment analysis during 2008 we determined that the carrying value of our investment was not expected to be fully recoverable from the future cash flows of the Tomsten business and we recorded an impairment charge of $2,839,100. (See Item 1A "Risk Factors" as well as Note 3 - "Investments").

Interest Expense

Interest expense decreased to $1,305,000 in 2008 compared to $1,456,800 in 2007. The decrease is due to lower interest rates and lower corporate borrowings.

Interest and Other Income

During 2008, we had interest and other income of $224,600 compared to $539,100 of interest and other income in 2007. The decrease is primarily due to the sale of the Commercial Credit Group senior subordinated notes in August 2007 and foreign currency transaction losses incurred in 2008. (See Item 7A "Quantitative and Qualitative Disclosures About Market Risk").

Income Taxes

The provision for income taxes was calculated at an effective rate of 70.4% and 40.9% for 2008 and 2007, respectively. The higher effective rate in 2008 compared to 2007 reflects our recording of a $1.2 million deferred tax asset valuation allowance for losses from and impairment of our investment in Tomsten in 2008, partially offset by an adjustment to uncertain tax positions of $127,300 in 2008.

We currently have two reportable business segments, franchising and leasing. The franchising segment franchises value-oriented retail store concepts that buy, sell, trade and consign merchandise and Wirth Business Credit, Inc., our small-ticket leasing franchise. The leasing segment, which commenced operations in 2004, includes (i) Winmark Capital Corporation, our middle-market equipment leasing business and (ii) Wirth Business Credit, Inc., our small-ticket financing business. Segment reporting is intended to give financial statement users a better view of how we manage and evaluate our businesses. Our internal management reporting is the basis for the information disclosed for our business segments and includes allocation of shared-service costs. The following tables summarize financial information by segment and provide a reconciliation of segment contribution to operating income:

                                                        Year Ended
                                          December 27, 2008     December 29, 2007
  Revenue:
  Franchising                            $        27,330,800   $        26,749,000
  Leasing                                          8,092,800             4,416,200
  Total revenue                          $        35,423,600   $        31,165,200

  Reconciliation to operating income:
  Franchising segment operating income   $        10,019,500   $         9,137,700
  Leasing segment operating loss                  (1,928,400 )          (2,711,800 )
  Total operating income                 $         8,091,100   $         6,425,900

Franchising segment operating income

The franchising segment's 2008 operating income increased by $881,800, or 9.7%, to $10.0 million from $9.1 million for 2007. The increase in segment contribution was primarily due to higher royalty income of $1,357,400 and a decrease in development advertising of $365,000, partially offset by increases in selling, general and administrative expenses and corporate shared-service cost allocations. The increase in royalties was primarily due to higher Plato's Closet® and Once Upon A Child® royalties of $1,479,300 and $425,900, respectively. The increase in Plato's Closet® and Once Upon A Child® royalties is primarily due to having 30 additional Plato's Closet® and 1 additional Once Upon A Child® franchise stores open in 2008 compared to the same period last year and higher franchisee retail sales in both brands.

Leasing segment operating loss

The leasing segment's 2008 operating loss decreased $783,400 or 28.9% to ($1.9 million) compared to a loss of ($2.7 million) during 2007. This improvement was primarily due to a $3,676,600 increase in leasing income partially offset by an $850,800 increase in leasing expense, a $1,966,100 increase in provision for credit losses and a $479,000 increase in amortization of initial direct costs.

Liquidity and Capital Resources

Our primary sources of liquidity have historically been cash flow from operations and borrowings. The components of the income statement that affect our liquidity include non-cash items for depreciation, compensation expense related to stock options and loss from and impairment of equity investments. The most significant component of the balance sheet that affects liquidity is long-term investments. Long-term investments include $4.3 million of illiquid investments in two private companies: Tomsten, Inc. and BridgeFunds LLC.

We ended 2008 with $2.1 million in cash and cash equivalents and a current ratio (current assets divided by current liabilities) of 1.3 to 1.0 compared to $1.3 million in cash and cash equivalents and a current ratio of 1.0 to 1.0 at the end of 2007.

Operating activities provided $9.0 million of cash during 2008 compared to $6.7 million during 2007. Cash provided by operating assets and liabilities include an increase in advance and security deposits of $860,500 due to increased lease originations. Accrued liabilities provided cash of $403,500 primarily due to increased accrued compensation and interest accrued on borrowings. Accounts receivable provided cash of $269,900 primarily due to lease chargeback collections. Cash utilized by operating assets and liabilities include a $305,900 decrease in accounts payable due to a decrease in amounts owed for lease equipment purchases.

Investing activities used $7.6 million of cash during 2008 compared to $22.5 million during 2007. The 2008 activities consisted primarily of the purchase of equipment for lease contracts of $21.9 million and collections on lease receivables of $14.9 million.

Financing activities used $0.5 million of cash during 2008 compared to $16.1 million provided during 2007. The 2008 activities were proceeds from discounted leases of $3.0 million and a $1.0 million tax benefit on exercised warrants, net payments of $2.8 million on the line of credit and subordinated notes and $1.7 million used to purchase 110,213 shares of our common stock.

We have future operating lease commitments for our corporate headquarters and have remained a guarantor on Company-owned retail stores that have been previously sold or closed at December 27, 2008. As of December 27, 2008, we had no other material outstanding commitments. See Note 11 to the consolidated financial statements.

As of December 27, 2008, we had no off balance sheet arrangements.

On June 10, 2008, we amended and restated our 364-Day Revolving Credit Agreement with Bank of America, N.A. to, among other things, join the PrivateBank and Trust Company as lender and Documentation Agent, appoint Bank of America as Administrative Agent, increase the aggregate commitment to $55.0 million and extend the term to June 15, 2013. The Amended and Restated Revolving Credit Agreement (the "Credit Facility") permits us to borrow up to the aggregate commitment subject to certain borrowing base limitations.

The Credit Facility allows us to choose between three interest rate options in connection with our borrowings. The interest rate options are the Base Rate, LIBOR and Fixed Rate (all as defined within the Credit Facility) plus an applicable margin of 0%, 2.00% and 2.00%, respectively. Interest periods for LIBOR borrowings can be one, two, three or six months, and interest periods for Fixed Rate borrowings can be one, two, three, four or five years as selected by us. The Credit Facility also provides for non-utilization fees of 0.25% per annum on the daily average of the unused commitment.

As of December 27, 2008, our borrowing availability under the Credit Facility was $55.0 million (the lesser of the borrowing base or the aggregate line of credit). There were $13.1 million in borrowings outstanding bearing Fixed Rate interest ranging from 4.58% to 5.76% and having initial terms ranging from three years to five years, and $0.5 million in borrowings bearing Base Rate interest of 3.25%, leaving $41.4 million available for additional borrowings.

The Credit Facility will be used for growing our leasing business, stock repurchases and general corporate purposes. The Credit Facility is secured by a lien against substantially all of our assets, contains customary financials conditions and covenants, and requires maintenance of minimum levels of debt service coverage and tangible net worth and maximum levels of leverage (all as defined within the Credit Facility). As of December 27, 2008, we were in compliance with all of our financial covenants.

On April 19, 2006, we announced the filing of a "shelf registration" on Form S-1 registration statement with the Securities and Exchange Commission for the sale of up to $50 million of renewable subordinated unsecured notes with maturities from three months to ten years. In June 2006, the Form S-1 registration became effective. In March 2007, we filed Post-Effective Amendment Number 2 to the public offering that was declared effective March 30, 2007. In November 2007, we filed Post-Effective Amendment Number 3 to the public offering that was declared effective November 29, 2007. In March 2008, we filed Post-Effective amendment Number 4 to the public offering that was declared effective March 27, 2008. We have in the past and continue to intend to use the net proceeds from the offering to pay down our credit facility, expand our leasing portfolio, to make acquisitions, to repurchase common stock and for other general corporate purposes. As of December 27, 2008, $26.6 million of the renewable subordinated notes have been sold.

We utilize discounted lease financing to provide funds for a portion of our leasing activities. Rates for discounted lease financing reflect prevailing market interest rates and the credit standing of the lessees for which the payment stream of the leases are discounted. We believe that discounted lease financing will continue to be available to us at competitive rates of interest through the relationships we have established with financial institutions.

We believe that the combination of our cash on hand, the cash generated from our franchising business, cash generated from discounting sources, our bank line of credit as well as our renewable subordinated unsecured notes, will be adequate to fund our planned operations, including leasing activity, for 2009.

Critical Accounting Policies

The Company prepares the consolidated financial statements of Winmark Corporation and Subsidiaries in conformity with accounting principles generally accepted in the United States of America. As such, the Company is required to make certain estimates, judgments and assumptions that we believe are reasonable based on information available. These estimates and assumptions affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the periods presented. There can be no assurance that actual results will not differ from these estimates. The critical accounting policies that the Company believes are most important to aid in fully understanding and evaluating our reported financial results include the following:

Revenue Recognition - Royalty Revenue and Franchise Fees

The Company collects royalties from each retail franchise based on a percentage of retail store gross sales. The Company recognizes royalties as revenue when earned. At the end of each accounting period, estimates of royalty amounts due are made based on applying historical weekly sales information to the number of weeks of unreported franchisee sales. If there are significant changes in the actual performances of franchisees versus the Company's estimates, its royalty revenue would be impacted. During 2008, the Company collected $36,800 more than it estimated at December 29, 2007. As of December 27, 2008, the Company's royalty receivable was $1,288,900.

The Company collects initial franchise fees when franchise agreements are signed and recognizes the initial franchise fees as revenue when the franchise is opened, which is when the Company has performed substantially all initial services required by the franchise agreement. Franchise fees collected from franchisees but not yet recognized as income are recorded as deferred revenue in the liability section of the consolidated balance sheet. As of December 27, 2008, deferred franchise fees were $855,800.

Stock-Based Compensation

The Company currently uses the Black-Scholes option pricing model to determine the fair value of stock options. The determination of the fair value of the awards on the date of grant using an option-pricing model is affected by stock price as well as assumptions regarding a number of complex and subjective variables. These variables include implied volatility over the term of the awards, actual and projected employee stock option exercise behaviors, risk-free interest rate and expected dividends.

The Company evaluates the assumptions used to value awards on an annual basis. If factors change and the Company employs different assumptions for estimating stock-based compensation expense in future periods or if the Company decides to use a different valuation model, the future periods may differ significantly from what it has recorded in the current period and could materially affect operating income, net income and earnings per share.

Impairment of Long-term Investments

The Company evaluates its long-term investments for impairment on an annual basis or whenever events or changes in circumstances indicate the carrying amount may not be recoverable. The impairment, if any, is measured by the difference between the assets' carrying amount and their fair value, based on the best information available, including market prices, discounted cash flow analysis or other financial metrics that management utilizes to help determine fair value. Judgments made by management related to the fair value of its long-term investments are affected by factors such as the ongoing financial performance of the investees, additional capital raised by the investees as well as general changes in the economy.

Leasing Income Recognition

Leasing income is recognized under the effective interest method. The effective interest method of income recognition applies a constant rate of interest equal to the internal rate of return on the lease. Generally, when a lease is 90 days or more delinquent, the lease is classified as being on non-accrual and the Company stops recognizing leasing income on that date.

Allowance for Credit Losses

The Company maintains an allowance for credit losses at an amount that it believes to be sufficient to absorb losses inherent in its existing lease portfolio as of the reporting dates. A provision is charged against earnings to maintain the allowance for credit losses at the appropriate level. If the actual results are different from the Company's estimates, results could be different. The Company's policy is to charge-off against the allowance the estimated unrecoverable portion of accounts once they reach 121 days delinquent.

New Accounting Pronouncements

Effective December 30, 2007, the Company adopted Financial Accounting Standards Board (FASB) Statement No. 157, Fair Value Measurements. Statement No. 157 defines fair value, establishes a framework for measuring fair value in accordance with generally accepted accounting principles and expands disclosures about fair value measurements. The adoption of Statement No. 157 did not have a material impact on the Company's financial condition or results of operations.

Statement No. 157 defines fair value as the price that would be received for an . . .