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WINA > SEC Filings for WINA > Form 10-K on 14-Mar-2013All Recent SEC Filings

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Form 10-K for WINMARK CORP


14-Mar-2013

Annual Report


ITEM 7: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS

Overview

As of December 29, 2012, we had 968 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 $36.2 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 2012, our royalties increased $3.4 million or 11.2% compared to 2011.

During 2012, we purchased $23.8 million in equipment for lease customers compared to $20.4 million in 2011. Overall, our leasing portfolio (net investment in leases - current and long-term) increased to $36.2 million at December 29, 2012 from $29.8 million at December 31, 2011. Leasing income net of leasing expense in 2012 was $11.4 million compared to $11.2 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.

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 2012, selling, general and administrative expense increased $1.2 million, or 6.5%, compared to the same period last year.

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 29, 2012:

                                                                     AVAILABLE
                              TOTAL                        TOTAL        FOR      COMPLETED
                             12/31/11   OPENED   CLOSED   12/29/12    RENEWAL    RENEWALS    % RENEWED
Plato's Closet
Franchises - US and Canada        324       30       (0 )      354          29          29         100 %
Play It Again Sports
Franchises - US and Canada        325        3      (13 )      315          66          63          95 %
Once Upon A Child
Franchises - US and Canada        247       20       (1 )      266           3           3         100 %
Music Go Round
Franchises - US                    34        1       (2 )       33           -           -         N/A
Total Franchised Stores           930       54      (16 )      968          98          95          97 %


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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 2012, we renewed 97% of franchise agreements up for renewal. This percentage of renewal has ranged between 97% and 100% during the last three years.

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. 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 2012
                                       December 29, 2012    December 31, 2011    over (under) 2011
Revenue:
Royalties                                           65.0 %               59.2 %               11.2 %
Leasing income                                      25.4                 31.9                (19.3 )
Merchandise sales                                    5.3                  4.8                 10.8
Franchise fees                                       2.5                  2.1                 19.4
Other                                                1.8                  2.0                (11.2 )
Total revenue                                      100.0                100.0                  1.2

Cost of merchandise sold                            (5.1 )               (4.6 )               10.8
Lease expense                                       (3.4 )              (10.0 )              (65.0 )
Provision for credit losses                          0.1                  0.1                 (9.7 )
Selling, general and administrative
expenses                                           (39.0 )              (37.1 )                6.5
Income from operations                              52.6                 48.4                  9.9
Loss from equity investments                        (4.8 )               (1.0 )              383.3
Impairment of investment in notes                   (2.5 )               (1.7 )               50.0
Interest expense                                    (0.8 )               (0.2 )              250.3
Interest and other income                            0.1                  0.1                 47.0
Income before income taxes                          44.6                 45.6                 (1.0 )
Provision for income taxes                         (19.7 )              (18.1 )               10.0
Net income                                          24.9 %               27.5 %               (8.2 )%

Revenue

Revenues for the year ended December 29, 2012 totaled $51.9 million compared to $51.3 million for the comparable period in 2011.

Royalties and Franchise Fees

Royalties increased to $33.8 million for 2012 from $30.4 million for the same period in 2011, a 11.2% increase. The increase was due to higher Plato's Closet and Once Upon A Child royalties of $2.6 million and $1.2 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 and 19 additional Once Upon A Child franchise stores in 2012 compared to the same period last year.


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Franchise fees increased to $1.3 million for 2012 from $1.1 million for 2011 primarily as a result of opening 11 more franchises in 2012 compared to 2011. 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 franchise fees is presented in the Franchising subsection of the Business section (Item 1).

Leasing Income

Leasing income decreased to $13.2 million in 2012 compared to $16.4 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 our Computer Support Center or through the Play It Again Sports buying group (together, "Direct Franchisee Sales"). Direct Franchisee Sales increased 10.8% to $2.8 million in 2012 from $2.5 million in 2011. This is a result of increased 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 10.8% to $2.6 million in 2012 from $2.4 million in 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 2012 and 2011 was 95.3% and 95.4%, respectively.

Leasing Expense

Leasing expense decreased to $1.8 million in 2012 compared to $5.1 million in 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 ($47,600) in 2012 compared to ($43,400) in 2011. Provision levels for the periods presented were impacted by net recoveries/write-offs as well as a lower level of delinquencies. During 2012, we had total net recoveries of $19,600 compared to total net write-offs of $60,700 in 2011.

Selling, General and Administrative Expenses

The $1.2 million, 6.5%, increase in selling, general and administrative expenses in 2012 compared to the same period in 2011 is primarily due to an increase in compensation, benefits and sales commission expense.

Loss from Equity Investments

During 2012 and 2011, we recorded losses of $0.7 million and $0.5 million, respectively, from our investment in Tomsten (representing our pro-rata share of losses for the periods). In addition, as part of an impairment analysis at December 29, 2012 we determined that the carrying value of our investment was not expected to be recoverable from the future cash flows of the Tomsten business or the sale of our ownership stake. We therefore recorded an impairment charge of $1.8 million to reduce our carrying value of this investment to $0. (See Note 3 - "Investments").


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Impairment of Investment in Notes

During 2012 and 2011, we recorded impairment charges of $1.3 million and $0.9 million, respectively, for our investment in BridgeFunds notes as a result of our estimate of expected future cash flows from this investment. As of December 29, 2012, our aggregate valuation allowance reduces the net carrying value of this investment to $0. (See Note 3 - "Investments").

Interest Expense

Interest expense increased to $392,300 in 2012 compared to $112,000 in 2011. The increase is due to higher corporate borrowings.

Interest and Other Income

During 2012, we had interest and other income of $66,000 compared to $44,900 of interest and other income in 2011.

Income Taxes

The provision for income taxes was calculated at an effective rate of 44.1% and 39.7% for 2012 and 2011, respectively. The higher effective rate in 2012 compared to 2011 primarily reflects our recording of deferred tax asset valuation allowance for losses from and impairment of our investments in Tomsten and BridgeFunds in 2012 that exceeded such amounts recorded in 2011.

Segment Comparison of the Year Ended December 29, 2012 to

Year Ended December 31, 2011

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. The leasing segment 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 income from operations:

                                                                  Year Ended
                                                   December 29, 2012      December 31, 2011
Revenue:
Franchising                                       $        38,731,300    $        34,923,300
Leasing                                                    13,211,800             16,411,700
Total revenue                                     $        51,943,100    $        51,335,000

Reconciliation to income from operations:
Franchising segment contribution                  $        20,705,100    $        18,389,300
Leasing segment contribution                                6,594,000              6,458,300
Total income from operations                      $        27,299,100    $        24,847,600


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Franchising Segment Operating Income

The franchising segment's 2012 operating income increased by $2.3 million, or 12.6%, to $20.7 million from $18.4 million for 2011. The increase in segment contribution was primarily due to increased royalty revenues.

Leasing Segment Operating Income

The leasing segment's operating income for 2012 increased to $6.6 million from $6.5 million for 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 and impairment of equity investments and impairment of investment in notes.

We ended 2012 with $2.2 million in cash and cash equivalents and a current ratio (current assets divided by current liabilities) of 0.9 to 1.0 compared to $9.0 million in cash and cash equivalents and a current ratio of 3.0 to 1.0 at the end of 2011.

Operating activities provided $18.2 million of cash during 2012 compared to $20.6 million during 2011. A contributing factor to the decrease in cash provided by operating activities in 2012 compared to 2011 was an increase in cash paid for income taxes of $5.1 million.

Investing activities used $6.1 million of cash during 2012 compared to $2.3 million during 2011. The 2012 activities consisted primarily of the purchase of equipment for lease customers of $23.8 million, collections on lease receivables of $16.9 million and proceeds from sale of marketable securities of $1.5 million.

Financing activities used $18.8 million of cash during 2012 compared to $11.6 million used during 2011. The 2012 activities consisted primarily of net proceeds and tax benefits from exercises of stock options of $2.3 million, net borrowings on our line of credit of $10.8 million, proceeds from discounted lease rentals of $1.4 million, $26.1 million for the payment of dividends (including a $5.00 per share special cash dividend) and $7.2 million used to purchase 134,720 shares of our common stock. (See Note 6 - "Shareholders' Equity").

We have future operating lease commitments for our corporate headquarters. As of December 29, 2012, we had no other material outstanding commitments. (See Note 11 - "Commitments and Contingencies").

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

We have a revolving credit facility with The PrivateBank and Trust Company and BMO Harris Bank N.A. (the "Line of Credit"). 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. Borrowings under the Line of Credit are subject to certain borrowing base limitations, and 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 December 29, 2012, we were in compliance with all of our financial covenants and our borrowing availability under the Line of Credit was $35.0 million (the lesser of the borrowing base or the aggregate line of credit). There were $10.8 million in borrowings outstanding under the Line of Credit bearing interest ranging from 2.96% to 3.75%, leaving $24.2 million available for additional borrowings.


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The Line of Credit 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 Line of Credit) plus an applicable margin of 0.50%, 2.75% and 2.75%, respectively. Interest periods for LIBOR borrowings can be one, two or three months, and interest periods for Fixed Rate borrowings can be one, two, three or four years as selected by us. The Line of Credit also provides for non-utilization fees of 0.25% per annum on the daily average of the unused commitment.

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, including leasing activity, 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 2012, the Company collected $91,200 more than it estimated at December 31, 2011. As of December 29, 2012, the Company's royalty receivable was $1,074,600.

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 29, 2012, deferred franchise fees were $1,339,200.


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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 (when 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.

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. 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 4 - "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.

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.


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Impairment of Long-term Investments

The Company evaluates its long-term equity 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 (as prescribed by applicable accounting guidance), 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 equity 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. If there are significant changes in the actual performance of the long-term equity investments versus the Company's estimates, the carrying values of these investments could be significantly impacted.

The Company evaluates its long-term note investments for impairment on an annual basis or whenever events or changes in circumstances indicate that it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the notes. The impairment, if any, is measured by the difference between the recorded investment in the notes, including accrued interest, and the present value of expected future cash flows discounted at the effective interest rate of the notes (as prescribed by applicable accounting guidance), based on the best information available to management. Once a note investment is deemed impaired, any significant change in the amount or timing of the expected or actual cash flows requires recalculation of the impairment applying the procedures described above. See Note 3 - "Long-Term Investments" for the Company's discussion of its impaired note investment. Estimates and assumptions made by management related to the expected future cash flows from the notes could be different than the actual cash flows, which could significantly impact the carrying value of these investments.

Outlook

Forward Looking Statements

The statements contained in the letter from the CEO, Item 1 "Business", Item 1A "Risk Factors", in this Item 7 "Management's Discussion and Analysis of Financial Condition and Results of Operations", and in Item 8 "Financial Statements and Supplemental Data" that are not strictly historical fact, including without limitation, the Company's statements relating to growth opportunities, prospects for Winmark Capital Corporation and Wirth Business Credit, contribution of the leasing business to financial results, anticipated operations of the leasing businesses, its ability to open new franchises, its ability to manage costs in the future, the number of franchises it believes will open, its future cash requirements, allowance for credit losses, possible losses related to its investments and its belief that it will have adequate capital and reserves to meet its current and contingent obligations and operating needs, as well as its disclosures regarding market rate risk, are forward looking statements made under the safe harbor provision of the Private Securities Litigation Reform Act. Such statements are based on management's current expectations as of the date of this report but involve risks, uncertainties and other factors which may cause actual results to differ materially from those contemplated by such forward looking statements. Investors are cautioned to consider these forward looking statements in light of important factors which . . .

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