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WINA > SEC Filings for WINA > Form 10-Q on 25-Oct-2012All Recent SEC Filings

Show all filings for WINMARK CORP

Form 10-Q for WINMARK CORP


25-Oct-2012

Quarterly Report


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

Overview

As of September 29, 2012, we had 958 franchises operating under the Plato's Closet, Play it Again Sports, Once Upon a Child and Music Go Round brands and had a leasing portfolio of $34.1 million. Management closely tracks the following financial criteria to evaluate current business operations and future prospects: royalties, leasing activity, and selling, general and administrative expenses.

Our most profitable source of franchising revenue is royalties received from our franchise partners. During the first nine months of 2012, our royalties increased $3.2 million or 14.8% compared to the first nine months of 2011.

During the first nine months of 2012, we purchased $17.4 million in equipment for lease customers compared to $15.6 million in the first nine months of 2011. Overall, our leasing portfolio (net investment in leases - current and long-term) increased to $34.1 million at September 29, 2012 from $29.8 million at December 31, 2011. Leasing income net of leasing expense during the first nine months of 2012 was $8.7 million compared to $8.4 million in the same period last year. Fluctuations in period-to-period leasing income and leasing expense result primarily from the manner and timing in which leasing income and leasing expense is recognized over the term of each particular lease in accordance with accounting guidance applicable to leasing. For this reason, we believe that more meaningful levels of leasing activity are the purchases of equipment for lease customers and the medium- to long-term trend in the size of the leasing portfolio. Our earnings are also impacted by credit losses. During the first nine months of 2012, our provision for credit losses decreased to $(69,600) from $8,200 in the first nine months of 2011.


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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 the first nine months of 2012, selling, general and administrative expense increased $1.1 million, or 8.1%, compared to the first nine months of 2011.

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 first nine months ended September 29, 2012:

                                                                          NINE MONTHS ENDED 9/29/12
                                                                          AVAILABLE
                              TOTAL                            TOTAL         FOR          COMPLETED
                             12/31/11    OPENED     CLOSED    9/29/12      RENEWAL         RENEWALS
Plato's Closet
Franchises - US and Canada        324         26         (0 )      350             24              24
Play It Again Sports
Franchises - US and Canada        325          2        (10 )      317             51              48
Once Upon A Child
Franchises - US and Canada        247         11         (1 )      257              3               3
Music Go Round
Franchises - US                    34          1         (1 )       34              0               0
Total Franchised Stores           930         40        (12 )      958             78              75

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. During the first nine months of 2012, we renewed 75 of the 78 franchise agreements available for renewal.

Our ability to grow our operating income 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.


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Results of Operations



The following table sets forth selected information from our Consolidated
Condensed Statements of Operations expressed as a percentage of total revenue:



                                          Three Months Ended                Nine Months Ended
                                    September 29,    September 24,    September 29,    September 24,
                                        2012             2011             2012             2011
Revenue:
Royalties                                    62.0 %           68.4 %           64.8 %           57.5 %
Leasing income                               29.1             20.1             25.7             33.0
Merchandise sales                             4.9              5.6              5.4              5.3
Franchise fees                                2.8              4.4              2.5              2.2
Other                                         1.2              1.5              1.6              2.0
Total revenue                               100.0            100.0            100.0            100.0

Cost of merchandise sold                     (4.6 )           (5.4 )           (5.1 )           (5.0 )
Leasing expense                              (5.2 )           (2.5 )           (3.4 )          (10.9 )
Provision for credit losses                     -              0.1              0.2                -
Selling, general and
administrative expenses                     (33.0 )          (35.8 )          (39.3 )          (37.0 )
Income from operations                       57.2             56.4             52.4             47.1
Loss from equity investments                 (2.5 )           (1.9 )           (1.7 )           (1.2 )
Impairment of investment in
notes                                        (4.5 )           (2.5 )           (1.7 )           (1.4 )
Interest expense                             (0.7 )           (0.2 )           (0.8 )           (0.2 )
Interest and other income
(expense)                                     0.1             (0.1 )            0.1                -
Income before income taxes                   49.6             51.7             48.3             44.3
Provision for income taxes                  (20.8 )          (22.1 )          (19.5 )          (18.3 )
Net income                                   28.8 %           29.6 %           28.8 %           26.0 %

Comparison of Three Months Ended September 29, 2012 to Three Months Ended September 24, 2011

Revenue

Revenues for the quarter ended September 29, 2012 totaled $14.8 million compared to $11.8 million for the comparable period in 2011.

Royalties and Franchise Fees

Royalties increased to $9.2 million for the third quarter of 2012 from $8.0 million for the third quarter of 2011, a 14.1% increase. The increase was primarily due to higher Plato's Closet and Once Upon A Child royalties of $0.7 million and $0.3 million, respectively. The increase in royalties for these brands is primarily due to higher franchisee retail sales in these brands as well as having 30 additional Plato's Closet franchise stores in the third quarter of 2012 compared to the same period last year.

Franchise fees decreased to $411,000 for the third quarter of 2012 compared to $516,200 for the third quarter of 2011, primarily as a result of opening five fewer franchises in the 2012 period compared to the same period in 2011.


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Leasing Income

Leasing income increased to $4.3 million for the third quarter of 2012 compared to $2.4 million for the same period in 2011. The increase is primarily due to a higher level of equipment sales to customers.

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 increased to $716,600 for the third quarter of 2012 compared to $664,300 in the same period of 2011. The increase is due an increase in technology purchases by our franchisees, partially offset by decreased buying group sales.

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 increased to $684,400 for the third quarter of 2012 compared to $631,500 in the same period of 2011. The increase was due to an increase in Direct Franchisee Sales discussed above. Cost of merchandise sold as a percentage of Direct Franchisee Sales for the third quarter of 2012 and 2011 was 95.5% and 95.1%, respectively.

Leasing Expense

Leasing expense increased to $0.8 million for the third quarter of 2012 compared to $0.3 million for the third quarter of 2011. The increase is primarily due to an increase in the associated cost of equipment sales to customers discussed above.

Provision for Credit Losses

Provision for credit losses was $(1,700) for the third quarter of 2012 compared to $(13,100) for the third quarter of 2011. Provision levels for the periods presented were impacted by net recoveries as well as a lower level of delinquencies, primarily in the small-ticket financing business portion of our leasing segment. During the third quarter of 2012, we had total net recoveries of $17,900 compared to total net recoveries of $44,100 in the third quarter of 2011.

Selling, General and Administrative

Selling, general and administrative expenses increased 15.7% to $4.9 million in the third quarter of 2012 from $4.2 million in the same period of 2011. The increase was primarily due to an increase in compensation, benefits and sales commission expense.

Loss from Equity Investments

During the third quarter of 2012 and 2011, we recorded losses of $372,300 and $224,700, respectively, from our investment in Tomsten (representing our pro-rata share of losses for the periods).

Impairment of Investment in Notes

During the third quarter of 2012 and 2011, we recorded impairment charges of $660,700 and $293,200, respectively, for our investment in BridgeFunds notes as a result of our estimate of expected future cash flows from the investment. (See Note 4 - "Investments").


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Interest Expense

Interest expense increased to $110,200 for the third quarter of 2012 compared to $26,200 for the third quarter of 2011. The increase is due to higher corporate borrowings.

Interest and Other Income (Expense)

During the third quarter of 2012, we had interest and other income of $14,300 compared to $(9,000) of interest and other income (expense) in the third quarter of 2011.

Income Taxes

The provision for income taxes was calculated at an effective rate of 41.9% and 42.8% for the third quarter of 2012 and 2011, respectively. The lower effective rate in 2012 compared to 2011 is primarily due to a decrease in state taxes.

Comparison of Nine Months Ended September 29, 2012 to Nine Months Ended September 24, 2011

Revenue

Revenues for the first nine months of 2012 totaled $38.8 million compared to $38.1 million for the comparable period in 2011.

Royalties and Franchise Fees

Royalties increased to $25.2 million for the first nine months of 2012 from $21.9 million for the first nine months of 2011, a 14.8% increase. The increase was due to higher Plato's Closet and Once Upon A Child royalties of $2.3 million and $1.1 million, respectively. The increase in royalties for these brands is primarily due to higher franchisee retail sales in these brands as well as having 30 additional Plato's Closet franchise stores in the first nine months of 2012 compared to the same period last year.

Franchise fees increased to $966,000 for the first nine months of 2012 compared to $836,200 for the first nine months of 2011, primarily as a result of opening six more franchises in the 2012 period compared to the same period in 2011.

Leasing Income

Leasing income decreased to $10.0 million for the first nine months of 2012 compared to $12.6 million million for the same period in 2011. The decrease is due to a lower level of equipment sales to customers.

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 increased to $2.1 million for the first nine months of 2012 compared to $2.0 million in the same period of 2011. The increase is due to an increase in technology purchases by our franchisees, partially offset by decreased buying group sales.


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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 increased to $2.0 million for the first nine months of 2012 compared to $1.9 million in the same period of 2011. The increase was due to an increase in direct Franchisee Sales discussed above. Cost of merchandise sold as a percentage of Direct Franchisee Sales for the first nine months of 2012 and 2011 was 95.2% and 95.5%, respectively.

Leasing Expense

Leasing expense decreased to $1.3 million for the first nine months of 2012 compared to $4.1 million for the first nine months of 2011. The decrease is due to a decrease in the associated cost of equipment sales to customers discussed above.

Provision for Credit Losses

Provision for credit losses was $(69,600) for the first nine months of 2012 compared to $8,200 for the first nine months of 2011. Provision levels for the periods presented were impacted by net recoveries/write-offs as well as a lower level of delinquencies, primarily in the small-ticket financing business portion of our leasing segment. During the first nine months of 2012, we had total net recoveries of $67,800 compared to total net write-offs of $39,600 in the first nine months of 2011.

Selling, General and Administrative

Selling, general and administrative expenses increased 8.1% to $15.2 million in the first nine months of 2012 from $14.1 million in the same period of 2011. The increase was primarily due to an increase in compensation, benefits and sales commission expense.

Loss from Equity Investments

During the first nine months of 2012 and 2011, we recorded losses of $650,400 and $444,600 respectively, from our investment in Tomsten (representing our pro-rata share of losses for the periods).

Impairment of Investment in Notes

During the first nine months of 2012 and 2011, we recorded impairment charges of $660,700 and $546,100, respectively, for our investment in BridgeFunds notes as a result of our estimate of expected future cash flows from the investment. (See Note 4 - "Investments").

Interest Expense

Interest expense increased to $302,300 for the first nine months of 2012 compared to $84,200 for the first nine months of 2011. The increase is due to higher corporate borrowings.

Interest and Other Income (Expense)

During the first nine months of 2012, we had interest and other income of $50,600 compared to $22,100 of interest and other income in the first nine months of 2011.

Income Taxes

The provision for income taxes was calculated at an effective rate of 40.4% and 41.3% for the first nine months of 2012 and 2011, respectively. The lower effective rate in 2012 compared to 2011 is primarily due to a decrease in state taxes.


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Segment Comparison of Three Months Ended September 29, 2012 to Three Months Ended September 24, 2011

Franchising Segment Operating Income

The franchising segment's operating income for the third quarter of 2012 increased by $0.6 million, or 10.6%, to $6.2 million from $5.6 million for the third quarter of 2011. The increase in segment contribution was due to increased royalty revenue.

Leasing Segment Operating Income

The leasing segment's operating income for the third quarter of 2012 increased by $1.2 million to $2.2 million from $1.0 million for the third quarter of 2011. The increase in segment contribution was due to an increase in leasing income net of leasing expense.

Segment Comparison of Nine Months Ended September 29, 2012 to Nine Months Ended September 24, 2011

Franchising Segment Operating Income

The franchising segment's operating income for the first nine months of 2012 increased by $2.2 million, or 17.2%, to $15.3 million from $13.1 million for the first nine months of 2011. The increase in segment contribution was primarily due to increased royalty revenue.

Leasing Segment Operating Income

The leasing segment's operating income for the first nine months of 2012 increased by $0.1 million to $5.0 million from $4.9 million for the first nine months of 2011. The increase in segment contribution was due to an increase in leasing income net of leasing expense.

Liquidity and Capital Resources

Our primary sources of liquidity have historically been cash flow from operations and borrowings. The components of the consolidated statement of operations that reduce our net income but do not affect our liquidity include non-cash items for depreciation, compensation expense related to stock options, loss from equity investments and impairment of investment in notes. A significant component of the consolidated balance sheet that affects liquidity is our long-term investments. Long-term investments include $2.5 million of illiquid investments in two private companies: Tomsten, Inc. and BridgeFunds,
LLC. (See Note 4 - "Investments").

We ended the third quarter of 2012 with $2.2 million in cash and cash equivalents and a current ratio (current assets divided by current liabilities) of 0.8 to 1.0 compared to $3.9 million in cash and cash equivalents and a current ratio of 2.1 to 1.0 at the end of the third quarter of 2011.

Operating activities provided $14.7 million of cash during the first nine months of 2012 compared to $15.4 million provided during the same period last year. A contributing factor to the decrease in cash provided by operating activities in 2012 compared to 2011 was an increase in the cash paid for income taxes of $3.2 million.

Investing activities used $3.7 million of cash during the first nine months of 2012 compared to $1.9 million used during the same period of 2011. The 2012 activities consisted primarily of the purchase of equipment for lease customers of $17.4 million, collections on lease receivables of $12.8 million and proceeds from sale of marketable securities of $1.4 million.


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Financing activities used $17.7 million of cash during the first nine months of 2012 compared to $11.8 million used during the same period of 2011. The 2012 activities consisted primarily of net proceeds and tax benefits from exercises of stock options of $0.9 million, net borrowings on our line of credit of $10.7 million, proceeds from discounted lease rentals of $1.4 million, $25.9 million used for the payment of dividends and $4.9 million used to purchase 92,652 shares of our common stock. (See Note 8 - "Shareholders' Equity").

As of September 29, 2012, we had no off balance sheet arrangements.

As of September 29, 2012, our borrowing availability under our credit agreement with The PrivateBank and Trust Company and BMO Harris Bank, N.A. (the "Line of Credit") was $35.0 million (the lesser of the borrowing base or the aggregate line of credit). There were $10.7 million in borrowings outstanding at September 29, 2012 under the Line of Credit bearing interest ranging from 2.97% to 3.75%, leaving $24.3 million available for additional borrowings.

The Line of Credit, which has a termination date of February 29, 2016, has been and will continue to be used for general corporate purposes. The Line of Credit is secured by a lien against substantially all of our assets, contains customary financial 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 Line of Credit). As of September 29, 2012, we were in compliance with all of our financial covenants.

We may 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 and our Line of Credit will be adequate to fund our planned operations through 2013.

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 it believes 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 the 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 performance of franchisees versus the Company's estimates, its royalty revenue would be impacted. During the first nine months of 2012, the Company collected $91,300 more than it estimated at December 31, 2011. As of September 29, 2012, the Company's royalty receivable was $961,100.


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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 September 29, 2012, deferred franchise fees were $1,224,200.

Leasing Income Recognition

Leasing income for direct financing leases 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 more than 90 days delinquent (where more than three monthly payments are owed), the lease is classified as being on non-accrual and the Company stops recognizing leasing income on that date. Payments received on leases in non-accrual status generally reduce the lease receivable. Leases on non-accrual status remain classified as such until there is sustained payment performance that, in the Company's judgment, would indicate that all contractual amounts will be collected in full.

In certain circumstances, the Company may re-lease equipment in its existing portfolio. As this equipment may have a fair value greater than its carrying amount when re-leased, the Company may be required to account for the lease as a sales-type lease. At inception of a sales-type lease, revenue is recorded that consists of the present value of the future minimum lease payments discounted at the rate implicit in the lease. In subsequent periods, the recording of income is consistent with the accounting for a direct financing lease.

For leases that are accounted for as operating leases, income is recognized on a straight-line basis when payments under the lease contract are due.

Allowances 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. Leases are collectively evaluated for potential loss. The Company's methodology for determining the allowance for credit losses includes consideration of the level of delinquencies and non-accrual leases, historical net charge-off amounts and review of any significant concentrations.

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. (See Note 5 - "Investment in Leasing Operations").

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.


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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 . . .

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