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WINA > SEC Filings for WINA > Form 10-K on 12-Mar-2014All Recent SEC Filings

Show all filings for WINMARK CORP

Form 10-K for WINMARK CORP


12-Mar-2014

Annual Report


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

Overview

As of December 28, 1013, we had 1,005 franchises operating under the Plato's Closet, Once Upon A Child, Play It Again Sports, Music Go Round and Style Encore brands and had a leasing portfolio of $37.5 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 2013, our royalties increased $2.6 million or 7.7% compared to 2012.

During 2013, we purchased $20.7 million in equipment for lease customers compared to $23.8 million in 2012. Overall, our leasing portfolio (net investment in leases - current and long-term) increased to $37.5 million at December 28, 2013 from $36.2 million at December 29, 2012. Leasing income net of leasing expense in 2013 was $12.9 million compared to $11.4 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.

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 2013, selling, general and administrative expense increased $1.9 million, or 9.5%, 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 28, 2013:

                                                           AVAILABLE
                    TOTAL                        TOTAL        FOR      COMPLETED
                   12/29/12   OPENED   CLOSED   12/28/13    RENEWAL    RENEWALS    % RENEWED
Plato's Closet
Franchises - US
and Canada              354       39       (2 )      391          25          25         100 %
Once Upon A
Child
Franchises - US
and Canada              266       20       (4 )      282          37          35          95 %
Play It Again
Sports
Franchises - US
and Canada              315        6      (21 )      300          38          36          95 %
Music Go Round
Franchises - US          33        1       (5 )       29           2           2         100 %
Style Encore
Franchises - US           -        3        -          3           -           -         N/A
Total Franchised
Stores                  968       69      (32 )    1,005         102          98          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 2013, we renewed 96% of franchise agreements up for renewal. This percentage of renewal has ranged between 96% and 100% during the last three years.


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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 2013     Fiscal 2012
                                December 28,    December 29,    December 31,    over (under)    over (under)
                                    2013            2012            2011            2012            2011
Revenue:
Royalties                               65.2 %          65.0 %          59.2 %           7.7 %          11.2 %
Leasing income                          26.1            25.4            31.9             9.9           (19.3 )
Merchandise sales                        4.2             5.3             4.8           (15.4 )          10.8
Franchise fees                           2.6             2.5             2.1            13.0            19.4
Other                                    1.9             1.8             2.0            15.8           (11.2 )
Total revenue                          100.0           100.0           100.0             7.3             1.2

Cost of merchandise sold                (4.0 )          (5.1 )          (4.6 )         (15.9 )          10.8
Lease expense                           (2.8 )          (3.4 )         (10.0 )         (11.1 )         (65.0 )
Provision for credit losses              0.1             0.1             0.1             6.1            (9.7 )
Selling, general and
administrative expenses                (39.8 )         (39.0 )         (37.1 )           9.5             6.5
Income from operations                  53.5            52.6            48.4             9.1             9.9
Loss from equity investments               -            (4.8 )          (1.0 )        (100.0 )         383.3
Impairment of investment in
notes                                      -            (2.5 )          (1.7 )        (100.0 )          50.0
Interest expense                        (0.4 )          (0.8 )          (0.2 )         (45.6 )         250.3
Interest and other income                  -             0.1             0.1           (64.5 )          47.0
Income before income taxes              53.1            44.6            45.6            27.8            (1.0 )
Provision for income taxes             (20.4 )         (19.7 )         (18.1 )          10.8            10.0
Net income                              32.7 %          24.9 %          27.5 %          41.2 %          (8.2 )%

Revenue

Revenues for the year ended December 28, 2013 totaled $55.7 million compared to $51.9 million and $51.3 million for the comparable periods in 2012 and 2011, respectively.

Royalties and Franchise Fees

Royalties increased to $36.3 million for 2013 from $33.8 million for the same period in 2012, a 7.7% increase. The increase was due to higher Plato's Closet and Once Upon A Child royalties of $1.6 million and $1.2 million, respectively. The increase in royalties for these brands is primarily from having 37 additional Plato's Closet and 16 additional Once Upon A Child franchise stores in 2013 compared to 2012 as well as higher franchisee retail sales in these brands. In 2012, royalties increased $3.4 million compared to 2011. This increase was primarily due to higher franchisee retail sales as well as having 38 additional franchise stores in 2012 compared to 2011.

Franchise fees increased to $1.5 million for 2013 from $1.3 million for 2012 primarily as a result of opening 15 more franchises in 2013 compared to 2012. Franchise fees in 2012 increased $0.2 million compared to 2011 primarily due to 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).


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Leasing Income

Leasing income increased to $14.5 million in 2013 compared to $13.2 million for the same period in 2012. The increase is primarily due to the classification of certain leases as sales-type leases in accordance with accounting guidance applicable to lessors as well as a larger lease portfolio in 2013 compared to 2012. Leasing income in 2012 decreased $3.2 million compared to 2011 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 decreased to $2.3 million in 2013 from $2.8 million in 2012. The decrease is primarily due to a decrease in technology purchases by our franchisees. Direct Franchisee Sales in 2012 increased $0.3 million compared to 2011 as a result of increased technology purchases by our franchisees.

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 to $2.2 million in 2013 from $2.6 million in 2012. The decrease was due to a decrease in Direct Franchisee Sales in 2013 discussed above. Cost of merchandise sold in 2012 increased $0.3 million compared to 2011 due to an increase in Direct Franchisee Sales in 2012 discussed above. Cost of merchandise sold as a percentage of Direct Franchisee Sales for 2013, 2012 and 2011 was 94.8%, 95.3% and 95.4%, respectively.

Leasing Expense

Leasing expense decreased to $1.6 million in 2013 compared to $1.8 million in 2012. The decrease is primarily due to a decrease in the associated cost of equipment sales to customers. Leasing expense in 2012 decreased $3.3 million compared to 2011 due to a decrease in the associated cost of equipment sales to customers discussed above.

Provision for Credit Losses

Provision for credit losses was ($44,700) in 2013 compared to ($47,600) in 2012 and ($43,400) in 2011. The provision levels for the periods presented were impacted by net recoveries in the leasing portfolio.

Selling, General and Administrative Expenses

Selling, general and administrative expenses increased 9.5% to $22.2 million in 2013 from $20.3 million in 2012. The increase was primarily due to an increase in compensation, benefits and advertising production expenses, inclusive of amounts related to the launch of our new Style Encore resale concept. The $1.2 million, or 6.5%, increase in selling, general and administrative expenses in 2012 compared to 2011 was 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 during 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 in 2012 of $1.8 million to reduce our carrying value of this investment to $0 as of December 29, 2012. As this investment was fully impaired, we did not record additional losses during 2013. (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 reduced the net carrying value of this investment to $0. We maintained the net investment balance of $0 as of December 28, 2013, as we do not expect to receive any cash flows from this investment, and therefore did not record any additional impairment during 2013. (See Note 3 - "Investments").

Interest Expense

Interest expense decreased to $213,500 in 2013 compared to $392,300 in 2012. The decrease is primarily due to lower average corporate borrowings during 2013 when compared to 2012. Interest expense in 2012 increased $280,300 compared to 2011 due to higher average corporate borrowings during 2012 when compared to 2011.

Interest and Other Income

During 2013, we had interest and other income of $23,400 compared to $66,000 and $44,900 of interest and other income in 2012 and 2011, respectively.

Income Taxes

The provision for income taxes was calculated at an effective rate of 38.4%, 44.1% and 39.7% for 2013, 2012 and 2011, respectively. The lower effective rate in 2013 compared to 2012 is primarily due to a decrease in state taxes and our recording of deferred tax asset valuation allowance for the losses from and impairments of our investments in Tomsten and BridgeFunds in 2012. The higher effective rate in 2012 compared to 2011 primarily reflected our recording of deferred tax asset valuation allowance for losses from and impairments of our investments in Tomsten and BridgeFunds in 2012 that exceeded such amounts recorded in 2011.

Segment Comparison of Fiscal Years 2013, 2012 and 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 28, 2013      December 29, 2012      December 31, 2011
Revenue:
Franchising                                  $        41,207,100    $        38,731,300    $        34,923,300
Leasing                                               14,524,100             13,211,800             16,411,700
Total revenue                                $        55,731,200    $        51,943,100    $        51,335,000

Reconciliation to income from operations:
Franchising segment contribution             $        21,867,700    $        20,705,100    $        18,389,300
Leasing segment contribution                           7,912,300              6,594,000              6,458,300
Total income from operations                 $        29,780,000    $        27,299,100    $        24,847,600


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Franchising Segment Operating Income

The franchising segment's 2013 operating income increased by $1.2 million, or 5.6%, to $21.9 million from $20.7 million for 2012. The increase in segment contribution was primarily due to increased royalty revenues, partially offset by an increase in selling, general and administrative expenses (inclusive of amounts related to the launch of our new Style Encore resale concept). The $2.3 million increase in the franchising segment's 2012 operating income from 2011 was primarily due to increased royalty revenues.

Leasing Segment Operating Income

The leasing segment's operating income for 2013 increased to $7.9 million from $6.6 million for 2012. The increase in segment contribution was due to an increase in leasing income net of leasing expense. The $0.1 million increase in the leasing segment's 2012 operating income from 2011 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 Statements 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 2013 with $10.6 million in cash and cash equivalents and a current ratio (current assets divided by current liabilities) of 2.9 to 1.0 compared to $2.2 million in cash and cash equivalents and a current ratio of 0.9 to 1.0 at the end of 2012.

Operating activities provided $21.6 million of cash during 2013 compared to $18.2 million provided during 2012 and $20.6 million provided during 2011. A contributing factor to the increase in cash provided by operating activities in 2013 compared to 2012 was a decrease in income tax receivable of $1.2 million. 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 $4.0 million of cash during 2013 compared to $6.1 million used during 2012 and $2.3 million used during 2011. Our most significant investing activities consist of the purchase of equipment for lease contracts and principal collections on lease receivables, as our franchising business is not capital intensive. Purchase of equipment for lease customers in 2013 was $20.7 million compared to $23.8 million in 2012 and $20.4 million in 2011. During 2013, principal collections on lease receivables were $17.8 million compared to $16.9 million during 2012 and $20.1 million during 2011.

Financing activities used $9.2 million of cash during 2013 compared to $18.8 million used during 2012 and $11.6 used during 2011. Our most significant financing activities over the past three years have consisted of net borrowings/payments on our line of credit, the payment of dividends, repurchase of common stock, and net proceeds and tax benefits received from the exercise of stock options. During 2012, we paid $26.1 million in cash dividends (including a $5.00 per share special cash dividend) and used $7.2 million to purchase 134,720 shares of our common stock. Net borrowings on our line of credit of $10.8 million during 2012 were associated with these activities. During 2013, we paid off the $10.8 million remaining on the line of credit from the 2012 activities, paid dividends of $1.0 million, repurchased 28,422 shares of our common stock for $1.9 million and received net proceeds and tax benefits from the exercise of stock options of $3.7 million. (See Note 6 - "Shareholders' Equity").


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We have future operating lease commitments for our corporate headquarters. As of December 28, 2013, we had no other material outstanding commitments. (See Note 11 - "Commitments and Contingencies"). The following table summarizes our significant future contractual obligations at December 28, 2013 (in millions):

                                                    Payments due by period
                                           Less than 1                                    More than
Contractual Obligations       Total           year          1-3 years      3-5 years       5 years
Operating Lease
Obligations                $ 3,841,800    $     603,200    $ 1,368,700    $ 1,423,800    $   446,100
Total Contractual
Obligations                $ 3,841,800    $     603,200    $ 1,368,700    $ 1,423,800    $   446,100

As of December 28, 2013, 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 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 28, 2013, we were in compliance with all of our financial covenants, there were no borrowings outstanding 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).

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. 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.

On February 4, 2014, we announced that our Board of Directors approved the payment of a special dividend to shareholders. The special dividend of $5.00 per share paid on March 3, 2014, totaled $25.8 million and was financed by a combination of cash on hand as well as net borrowings under the Line of Credit of $13.0 million. On February 21, 2014, the Line of Credit was amended to
(i) amend the debt service coverage and tangible net worth calculations to remove the effect of the special dividend, (ii) reduce the applicable margin on the interest rate options for Base Rate, LIBOR and Fixed Rate borrowings from 0.50% to 0.00%, 2.75% to 2.25%, and 2.75% to 2.25%, respectively, and
(iii) extend the termination date from February 29, 2016 to February 28, 2018.

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 2014.


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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 2013, the Company collected $17,700 less than it estimated at December 29, 2012. As of December 28, 2013, the Company's royalty receivable was $1,150,200.

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 28, 2013, deferred franchise fees were $2,034,100.

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.


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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.

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