ITEM 1A: RISK FACTORS
Our business, results of operations, financial condition, cash flows and the market value of our common stock can be adversely affected by pandemics, epidemics or other public health emergencies, such as the recent outbreak of COVID-19.
Our business, results of operations, financial condition, cash flows and the market value of our common stock can be adversely affected by pandemics, epidemics or other public health emergencies, such as the recent outbreak of COVID-19 which has spread from China to many other countries including the United States and Canada. In March 2020, the World Health Organization characterized COVID-19 as a pandemic, and the President of the United States declared the COVID-19 outbreak a national emergency. The outbreak has resulted in federal, state, provincial and local governments throughout the United States and Canada implementing increasingly stringent measures to help control the spread of the virus, including quarantines, “shelter in place” and “stay at home” orders, travel restrictions, business curtailments, school closures, and other measures. In addition, governments and central banks in several parts of the world have enacted fiscal and monetary stimulus measures to counteract the impacts of COVID-19.
The outbreak of COVID-19 and any preventive or protective actions taken by governmental authorities have had and are expected to continue to have a material adverse effect on our operations and those of our franchisees and leasing customers, including forced or voluntary store closures, business shutdowns or disruptions. The extent to which COVID-19 may adversely impact our business depends on future developments, which are highly uncertain and unpredictable, depending upon the severity and duration of the outbreak and the effectiveness of actions taken globally, nationally and locally to contain or mitigate its effects. Any resulting financial impact cannot be estimated reasonably at this time, but may materially adversely affect our business, results of operations, financial condition and cash flows. Even after the COVID-19 pandemic has subsided, we may experience materially adverse effects to our business due to any resulting economic recession or depression. Additionally, concerns over the economic affect of COVID-19 have caused extreme volatility in financial and other capital markets which has and may continue to adversely impact the market value of our common stock and our ability to access capital markets and debt capital. To the extent the COVID-19 pandemic adversely affects our business and financial results, it may also have the effect of heightening many of the other risks described in this Annual Report.
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We are dependent on franchise renewals.
Each of our franchise agreements is 10 years long. At the end of the term of each franchise agreement, each franchisee may, if certain conditions are met, “renew” the franchise relationship by signing a new 10-year franchise agreement. As of December 26, 2020 each of our five franchised retail brands have the following number of franchise agreements that will expire over the next three years:
Play It Again Sports 42 57 38
Music Go Round 1 — 6
Style Encore — — 20
We believe that renewing a significant number of these franchise relationships is important to our continued success. If a significant number of franchise relationships are not renewed, our financial performance would be materially and adversely impacted.
We are dependent on new franchisees.
Our ability to generate increased revenue and achieve higher levels of profitability depends in part on increasing the number of franchises open. Unfavorable macro-economic conditions may affect the ability of potential franchisees to obtain external financing and/or impact their net worth, both of which could lead to a lower level of openings than we have historically experienced. There can be no assurance that we will sustain our current level of franchise openings.
We may make additional investments outside of our core businesses.
From time to time, we have and may continue to make investments both inside and outside of our current businesses. To the extent that we make additional investments that are not successful, such investments could have a material adverse impact on our financial results.
We may sell franchises for a territory, but the franchisee may not open.
We believe that a substantial majority of franchises awarded but not opened will open within the time period permitted by the applicable franchise agreement or we will be able to resell the territories for most of the terminated or expired franchises. However, there can be no assurance that substantially all of the currently sold but unopened franchises will open and commence paying royalties to us.
Our retail franchisees are dependent on supply of used merchandise.
Our retail brands are based on offering customers a mix of used and new merchandise. As a result, the ability of our franchisees to obtain continuing supplies of high quality used merchandise is important to the success of our brands. Supply of used merchandise comes from the general public and is not regular or highly reliable. In addition, adherence to federal and state product safety and other requirements may limit the amount of used merchandise available to our franchisees. In addition to laws and regulations that apply to businesses generally, our franchised retail stores may be subject to state or local statutes or ordinances that govern secondhand dealers. There can be no assurance that our franchisees will avoid supply problems with respect to used merchandise.
We may be unable to collect accounts receivable from franchisees.
In the event that our ability to collect accounts receivable significantly declines from current rates, we may incur additional charges that would affect earnings. If we are unable to collect payments due from our franchisees, it would materially adversely impact our results of operations and financial condition.
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We operate in extremely competitive industries.
Retailing, including the sale of teenage, children’s and women’s apparel, sporting goods and musical instruments, is highly competitive. Many retailers have significantly greater financial and other resources than us and our franchisees. Individual franchisees face competition in their markets from retailers of new merchandise and, in certain instances, resale, thrift and other stores that sell used merchandise. We may face additional competition as our franchise systems expand and if additional competitors enter the used merchandise market.
Our equipment leasing businesses compete with a variety of equipment financing sources that are available to businesses, including: national, regional, and local finance companies that provide leases and loan products; financing through captive finance and leasing companies affiliated with major equipment manufacturers; and commercial banks, savings and loans, credit unions and credit cards. Many of these companies are substantially larger than we are and have considerably greater financial, technical and marketing resources than we do. There can be no assurances that we will be able to successfully compete with these larger competitors.
We are subject to credit risk in our lease portfolio and our allowance for credit losses may be inadequate to absorb losses.
In our leasing business, if we inaccurately assess the creditworthiness of our customers, we may experience a higher number of lease defaults than expected, which would reduce our earnings. For our middle-market customers, we serve a wide range of businesses from smaller companies that may be financed by venture capital investors to larger organizations that may be financed by private equity firms and larger independent public or private companies. In many cases, our credit analysis relies on the customer’s current or projected financials. If we fail to adequately assess the risks of our customer’s business plans, we may experience credit losses.
We may incur concentration of credit risk in our lease portfolio. As of December 26, 2020, leased assets with one customer represented approximately 18% of our total net investment in leases.
If losses from leases exceed our allowance for credit losses, our operating income will be reduced. In connection with our leases, we record an allowance for credit losses to provide for estimated losses. Determining the appropriate level of the allowance is an inherently uncertain process and therefore our determination of this allowance may prove to be inadequate to cover losses in connection with our portfolio of leases. Losses in excess of our allowance for credit losses would cause us to increase our provision for credit losses, reducing or eliminating our operating income. Any such significant increase in losses could have a material adverse impact on our financial results.
Deterioration in economic or business conditions may negatively impact our leasing business.
In an economic slowdown or recession, our equipment leasing businesses may face an increase in delinquent payments, lease defaults and credit losses. The volume of leasing business for our new and existing customers may decline, as well as the credit quality of our customers. Because we extend credit to many emerging and leveraged companies through our subsidiary Winmark Capital Corporation, our customers may be particularly susceptible to economic slowdowns or recessions. Any protracted economic slowdowns or recessions may make it difficult for us to maintain the volume of lease originations for new and existing customers, and may deteriorate the credit quality of new leases. Any of these events may slow the growth of our leasing portfolio and impact the profitability of our leasing operations.
If we are unable to add new leasing customers and grow leased assets, our leasing portfolio will decrease in size and our leasing income will be impacted.
In our leasing business, our ability to grow and maintain our leasing portfolio is dependent upon successfully adding new leasing customers and sustaining leased equipment purchases for existing customers. In the past few years our leasing portfolio has materially declined. If we are unable to effectively accomplish these undertakings, our leasing portfolio will continue to decrease and the operating income of our leasing segment will continue to decline.
We are subject to restrictions in our line of credit and note facilities. Additionally, we are subject to counter party risk in our line of credit facility.
The terms of our line of credit and note facility impose certain operating and financial restrictions on us and require us to meet certain financial tests including tests related to minimum levels of debt service coverage and tangible net worth and maximum levels of leverage. As of December 26, 2020, we were in compliance with all of our financial covenants
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under these facilities; however, failure to comply with these covenants in the future may result in default under one or both of these sources of capital and could result in acceleration of the related indebtedness. Any such acceleration of indebtedness would have an adverse impact on our business activities and financial condition.
Sustained credit market deterioration could jeopardize the counterparty obligations of the bank participating in our line of credit facility, which could have an adverse impact on our business if we are not able to replace such credit facility or find other sources of liquidity on acceptable terms.
We have indebtedness.
We have existing indebtedness in the form of term notes payable (see Note 6 — “Debt”). We expect to generate the cash necessary to pay our expenses, finance our leasing business and to pay the principal and interest on all of our outstanding debt from cash flows provided by operating activities and by opportunistically using other means to repay or refinance our obligations as we determine appropriate. Our ability to pay our expenses, finance our leasing business and meet our debt service obligations depends on our future performance, which may be affected by financial, business, economic, and other factors. If we do not have enough money to pay our debt service obligations, we may be required to refinance all or part of our existing debt, sell assets, borrow more money or raise equity. In such an event, we may not be able to refinance our debt, sell assets, borrow more money or raise equity on terms acceptable to us or at all. Also, our ability to carry out any of these activities on favorable terms, if at all, may be further impacted by any financial or credit crisis which may limit access to the credit markets and increase our cost of capital.
We are subject to government regulation.
As a franchisor, we are subject to various federal and state franchise laws and regulations. Fourteen states, the Federal Trade Commission and six Canadian Provinces impose pre-sale franchise registration and/or disclosure requirements on franchisors. In addition, a number of states have statutes which regulate substantive aspects of the franchisor-franchisee relationship such as termination, nonrenewal, transfer, discrimination among franchisees and competition with franchisees.
Additional legislation, both at the federal and state levels, could expand pre-sale disclosure requirements, further regulate substantive aspects of the franchise relationship and require us to file our franchise offering circulars with additional states. Future franchise legislation could impose costs or other burdens on us that could have a material adverse impact on our operations. In addition, evolving labor and employment laws, rules and regulations could result in potential claims against us as a franchisor for labor and employment related liabilities that have historically been borne by franchisees.
Although most states do not directly regulate the commercial equipment lease financing business, certain states require licensing of lenders and finance companies, impose limitations on interest rates and other charges, constrain collection practices and require disclosure of certain contract terms. Laws or regulations may be adopted with respect to our equipment leases or the equipment leasing industry, and collection processes. Any new legislation or regulation, or changes in the interpretation of existing laws, which affect the equipment leasing industry could increase our costs of compliance.
We may be unable to protect against data security risks.
We have implemented security systems with the intent of maintaining the physical security of our facilities and protecting our employees, franchisees, lessees, customers’, clients’ and suppliers’ confidential information and information related to identifiable individuals against unauthorized access through our information systems or by other electronic transmission or through the misdirection, theft or loss of physical media. These include, for example, the appropriate encryption of information. Despite such efforts, we are subject to potential breach of security systems which may result in unauthorized access to our facilities or the information we are trying to protect. Because the techniques used to obtain unauthorized access are constantly changing and becoming increasingly more sophisticated and often are not recognized until launched against a target, we may be unable to anticipate these techniques or implement sufficient preventative measures. If unauthorized parties gain physical access to one of our facilities or electronic access to our information systems or such information is misdirected, lost or stolen during transmission or transport, any theft or misuse of such information could result in, among other things, unfavorable publicity, governmental inquiry and oversight, difficulty in marketing our services, allegations by our customers and clients that we have not performed our contractual obligations, litigation by affected parties and possible financial obligations for damages related to the theft or misuse of such information, any of which could have a material adverse effect on our business.
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ITEM 1B: UNRESOLVED STAFF COMMENTS
None.
ITEM 2: PROPERTIES
We lease 41,016 square feet at our headquarters facility in Minneapolis, Minnesota. We are obligated to pay rent monthly under the lease, and will pay an average of $808,000 annually over the remaining term that expires in 2029. We are also obligated to pay estimated taxes and operating expenses as described in the lease, which change annually. The total rentals, taxes and operating expenses paid may increase if we exercise any of our rights to acquire additional space described in the lease. Our facilities are sufficient to meet our current and immediate future needs.
ITEM 3: LEGAL PROCEEDINGS
We are not a party to any material litigation and are not aware of any threatened litigation that would have a material adverse effect on our business.
ITEM 4: MINE SAFETY DISCLOSURES
Not applicable.
PART II
ITEM 5:MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS, AND ISSUER PURCHASES OF EQUITY SECURITIES
Market Information, Holders, Dividends
Winmark Corporation’s common stock trades on the NASDAQ Global Market under the symbol “WINA”. For dividend information see Note 5 – “Shareholders’ Equity (Deficit).”
At March 8, 2021, there were approximately 55 shareholders of record of our common stock.
Purchases of Equity Securities by the Issuer and Affiliated Purchasers
Total Number of Maximum Number
Shares Purchased as of Shares that may
Total Number of Average Price Part of a Publicly yet be Purchased
Period Shares Purchased Paid Per Share Announced Plan(1) Under the Plan
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ITEM 6: SELECTED FINANCIAL DATA
The following table sets forth selected financial information for the periods indicated. The information should be read in conjunction with the consolidated financial statements and related notes discussed in Items 8 and 15, and Management’s Discussion and Analysis of Financial Condition and Results of Operations discussed in Item 7.
Fiscal Year Ended
(in thousands except per share data)
December 26, December 28, December 29, December 30, December 31,
Revenue:
Provision for credit losses (79) (78) 39 9 18
Interest and other income (expense) 43 67 (33) 13 (12)
Cash dividends per common share $ 3.80 $ 0.90 $ 0.56 $ 0.43 $ 0.37
Balance Sheet Data:
Selected Financial Ratios:
Return on average equity N/A % N/A % N/A % N/A % N/A %
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ITEM 7:MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following is management’s discussion and analysis of certain significant factors which have affected our financial position and operating results during the periods included in the accompanying consolidated financial statements and should be read in conjunction with those consolidated financial statements. This section of this 10-K generally discusses 2020 and 2019 items and year-to-year comparisons between 2020 and 2019. Discussions of 2018 items and year-to-date comparisons between 2019 and 2018 that are not included in this Form 10-K, can be found in ‘Management’s Discussion and Analysis of Financial Condition and Results of Operations’ in Part II, Item 7 of our Annual Report on Form 10-K for the fiscal year ended December 28, 2019.
COVID-19 Pandemic
The emergence of the coronavirus (COVID-19) around the world, and particularly in the United States and Canada, presents significant risks to the Company, not all of which the Company is able to fully evaluate or even foresee at the current time. The COVID-19 pandemic adversely affected the Company’s financial results and business operations in the Company’s fiscal year ended December 26, 2020, as noted below, and economic and health conditions in the United States and across most of the globe have continued to change throughout the year. Notably, a substantial number of the Company’s franchised store locations were temporarily closed to in-store consumer activities for a portion of 2020. Such temporary store closings may reoccur and customer traffic at those locations operational may continue to be reduced and may not return to historical levels in the near term depending on the duration and severity of the COVID-19 pandemic, the length of time it takes for normal economic and operating conditions to resume, additional governmental actions that may be taken and/or the re-imposition of restrictions that have been imposed to date, and numerous other uncertainties. The resulting economic disruption could also affect our ability to generate leasing revenue from new and existing leasing customers through reduced equipment leases and possible increases in defaults by existing leasing customers.
The COVID-19 pandemic has affected the Company’s operations in 2020, and may continue to do so indefinitely thereafter. All of these factors may have far reaching impacts on the Company’s business, operations, and financial results and conditions, directly and indirectly, including without limitation impacts on the health of the Company’s management and employees, its franchisees and leasing customers, customer and consumer behaviors, and on the overall economy. The scope and nature of these impacts, most of which are beyond the Company’s control, continue to evolve and the outcomes are uncertain.
Management cannot predict the full impact of the COVID-19 pandemic on the Company’s franchisees or leasing customers nor to economic conditions generally, including the effects on consumer spending. The ultimate extent of the effects of the COVID-19 pandemic on the Company is highly uncertain and will depend on future developments, and such effects could exist for an extended period of time even after the pandemic might end.
Overview
As of December 26, 2020, we had 1,264 franchises operating under the Plato’s Closet, Once Upon A Child, Play It Again Sports, Style Encore and Music Go Round brands and had a leasing portfolio of $13.3 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 significant source of franchising revenue is royalties received from our franchisees. During 2020, our royalties decreased $5.1 million or 10.0% compared to 2019, due to reduced franchisee retail sales resulting from the COVID-19 pandemic.
Leasing income net of leasing expense in 2020 was $11.9 million compared to $14.0 million in 2019. Fluctuations in period-to-period leasing income and leasing expense can result 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 medium- to long-term trend in the purchases of equipment for lease customers and the size of the leasing portfolio. During 2020, we purchased $4.1 million in equipment for lease customers compared to $9.0 million in 2019 and $23.1 million in 2018. Our leasing portfolio (net investment in leases — current and long-term) was $13.3 million at December 26, 2020 compared to $25.3 million at December 28, 2019 and $39.0 million at December 29, 2018. The lower equipment purchases and the
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decrease in the size of the leasing portfolio were a direct result of a decrease in the number of our customers installing leased equipment. We continue to explore ways to grow leased assets and add new customers to our leasing portfolio; however, continued low levels of equipment purchases for lease customers and decreases in the size of our portfolio will impact the long-term operating income of our leasing segment.
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 2020, selling, general and administrative expense decreased $4.5 million, or 17.6%, 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 26, 2020:
AVAILABLE
TOTAL TOTAL FOR COMPLETED
Plato’s Closet
Once Upon A Child
Play It Again Sports
Style Encore
Franchises - US and Canada 68 4 (3) 69 — — N/A
Music Go Round
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 2020, we renewed 99% of franchise agreements up for renewal. This percentage of renewal has ranged between 98% 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”.
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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 2020
December 26, December 28, over (under)
Revenue:
Merchandise sales 3.4 3.6 (15.4)
Franchise fees 2.2 2.1 (6.3)
Cost of merchandise sold (3.2) (3.4) (14.8)
Leasing expense (4.0) (2.8) 29.1
Provision for credit losses 0.1 0.1 (1.3)
Selling, general and administrative expenses (32.1) (35.1) (17.6)
Income from operations 60.8 58.8 (6.8)
Interest expense (2.6) (2.4) 0.4
Interest and other income (expense) 0.1 0.1 (35.6)
Income before income taxes 58.3 56.5 (7.1)
Provision for income taxes (13.2) (12.7) (6.7)
Revenue
Revenues for the year ended December 26, 2020 totaled $66.1 million compared to $73.3 million in 2019.
Royalties and Franchise Fees
Royalties decreased to $46.3 million for 2020 from $51.4 million for the same period in 2019, a 10.0% decrease. The decrease is due to lower franchisee retail sales in 2020 compared to 2019. Lower franchisee retail sales were directly attributable to the temporary store closings and reduced customer traffic resulting from the COVID-19 pandemic.
Franchise fees of $1.4 million for 2020 were comparable to $1.5 million for 2019. 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 over the estimated life of the franchise, beginning when the franchise opens. 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 $14.5 million in 2020 compared to $16.1 million for the same period in 2019. The decrease is primarily due to lower levels of interest income from the smaller lease portfolio, partially offset by a higher level of equipment sales to customers, when compared to last year.
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 $2.2 million in 2020 from $2.6 million in 2019. The decrease is primarily due to a decrease in technology purchases by our franchisees.
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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 decreased to $2.1 million in 2020 from $2.5 million in 2019. The decrease was due to a decrease in Direct Franchisee Sales in 2020 discussed above. Cost of merchandise sold as a percentage of Direct Franchisee Sales for 2020 and 2019 was 95.0% and 94.3%, respectively.
Leasing Expense
Leasing expense increased to $2.6 million in 2020 compared to $2.0 million in 2019. The increase was due to an increase in the associated cost of equipment sales to customers discussed above.
Provision for Credit Losses
Provision for credit losses was ($79,300) in 2020 compared to ($78,300) in 2019.
Selling, General and Administrative Expenses
Selling, general and administrative expenses decreased 17.6% to $21.2 million in 2020 from $25.7 million in 2019. The decrease was primarily due to a decrease in compensation related expenses inclusive of those related to organizational changes made in 2019, as well as decreases in conference and travel expenses due to the COVID-19 pandemic.
Interest Expense
Interest expense of $1.7 million in 2020 was comparable to $1.7 million in 2019.
Income Taxes
The provision for income taxes was calculated at an effective rate of 22.6% and 22.5% for 2020 and 2019, respectively.
Segment Comparison of Fiscal Years 2020 and 2019
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
Revenue:
Reconciliation to income from operations:
Revenues are all generated from United States operations other than franchising revenue from Canadian operations of $4.0 million and $4.7 million in each of fiscal 2020 and 2019, respectively.
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Franchising Segment Operating Income
The franchising segment’s 2020 operating income decreased by $3.3 million, or 9.4%, to $31.9 million from $35.2 million for 2019. The decrease in segment contribution was primarily due to decreased royalty revenues, partially offset by a decrease in selling, general and administrative expenses.
Leasing Segment Operating Income
The leasing segment’s operating income for 2020 increased by $0.3 million, or 4.6%, to $8.3 million from $8.0 million for 2019. The increase in segment contribution was primarily due to a decrease in selling, general and administrative expenses.
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 and compensation expense related to stock options.
We ended 2020 with $6.7 million in cash, cash equivalents and restricted cash compared to $25.2 million in cash, cash equivalents and restricted cash at the end of 2019.
Operating activities provided $43.2 million of cash during 2020 compared to $50.6 million provided during 2019. The decrease in cash provided by operating activities in 2020 compared to 2019 was primarily due to decreases in principal collections on lease receivables and net income.
Investing activities used $4.2 million of cash during 2020 compared to $9.2 million used during 2019. Our most significant investing activities consist of the purchase of equipment for lease contracts as our franchising business is not capital intensive. Purchase of equipment for lease customers in 2020 was $4.1 million compared to $9.0 million in 2019.
Financing activities used $57.6 million of cash during 2020 compared to $18.9 million used during 2019. Our most significant financing activities over the past two years have consisted of net borrowings/payments on our debt facilities, the payment of dividends, repurchase of common stock, and net proceeds received from the exercise of stock options and discounted lease rentals. During 2019, we paid $3.4 million in cash dividends, used $24.0 million to purchase 150,000 shares of our common stock in a tender offer (the “2019 Tender Offer”) and made net payments on our Line of Credit and notes payable of $3.3 million; partially offset by $10.9 million of proceeds from the exercise of stock options and $0.9 million in proceeds received from discounted lease rentals. During 2020, we used $49.0 million to purchase 300,000 shares of our common stock in a tender offer (the “2020 Tender Offer”), paid $14.2 million in cash dividends (including a $3.00 per share special cash dividend; the “2020 Special Dividend”) and made net payments on our line of credit and notes payable of $3.8 million; partially offset by $8.3 million of proceeds from exercise of stock options and $1.2 million in proceeds received from discounted lease rentals. (See Note 5 — “Shareholders’ Equity (Deficit)” and Note 6 — “Debt”).
We have debt obligations and future operating lease commitments for our corporate headquarters and satellite office space. As of December 26, 2020, we had no other material outstanding commitments. (See Note 12 — “Commitments and Contingencies”). The following table summarizes our significant future contractual obligations at December 26, 2020:
Payments due by period
Less than 1 More than 5
Total year 1-3 years 3-5 years years
Contractual Obligations
Line of Credit(2) $ — $ — $ — $ — $ —
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During 2020, our Line of Credit with CIBC Bank USA (formerly known as the PrivateBank and Trust Company) and BMO Harris Bank N.A. was amended to, among other things:
● Decrease the aggregate commitments from $40.0 million to $25.0 million;
● Remove BMO Harris Bank N.A. as a lender under the Credit Agreement;
● Extend the termination date from July 19, 2021 to August 31, 2024;
● Provide the consent of CIBC Bank USA for the 2020 Special Dividend;
The Line of Credit has been and will continue to be used for general corporate purposes. During 2020 and 2019, the Line of Credit was used to finance in part the 2020 and 2019 Tender Offer. During 2020, in response to uncertainty resulting from the COVID-19 outbreak, we drew additional amount on the Line of Credit to increase our cash balances. All amounts drawn on the Line of Credit during 2020 were repaid by December 26, 2020.
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 26, 2020, our borrowing availability under our Line of Credit was $25.0 million (the lesser of the borrowing base or the aggregate Line of Credit). There were no borrowings outstanding under the line of credit leaving $25.0 million available for additional borrowings.
The Line of Credit allows us to choose between two interest rate options in connection with our borrowings. The interest rate options are the Base Rate (as defined) and the LIBOR Rate (as defined) plus an applicable margin of 0% and 2.0% respectively. Interest periods for LIBOR borrowings can be one, two, three, six or twelve months, 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 have a Note Agreement (the “Note Agreement”) with Prudential Investment Management, Inc., its affiliates and managed accounts (“Prudential”) that was entered into in May 2015. As of December 26, 2020, the aggregate principal outstanding under the Note Agreement was $21.9 million, consisting of $13.5 million from the $25.0 million Series A notes issued in May 2015 and $8.4 million from the $12.5 million Series B notes issued in August 2017.
The final maturity of the Series A and Series B notes is 10 years from the issuance date. For the Series A notes, interest at a rate of 5.50% per annum on the outstanding principal balance is payable quarterly, along with required prepayments of the principal of $500,000 quarterly for the first five years, and $750,000 quarterly thereafter until the principal is paid in full. For the Series B notes, interest at a rate of 5.10% per annum on the outstanding principal balance is payable quarterly, along with required prepayments of the principal of $312,500 quarterly until the principal is paid in full. The Series A and Series B notes may be prepaid, at our option, in whole or in part (in a minimum amount of $1.0 million), but prepayments require payment of a Yield Maintenance Amount, as defined in the Note Agreement.
During 2020, the Note Agreement was amended to, among other things, amend the tangible net worth coverage requirement to be reset as of September 26, 2020, to provide the consent of Prudential for the declaration and payment of the 2020 Special Dividend and to amend the fixed charge covenant ratio definition to remove the effect of the 2020 Special Dividend.
Our obligations under the Note Agreement are secured by a lien against substantially all of our assets, and the Note Agreement contains customary financial conditions and covenants, and requires maintenance of minimum levels of fixed charge coverage and tangible net worth and maximum levels of leverage (all as defined within the Note Agreement).
As of December 26, 2020, we were in compliance with all of the financial covenants under the Line of Credit and Note Agreement.
We expect to generate the cash necessary to pay our expenses, finance our leasing business and to pay the principal and interest on all of our outstanding debt from cash flows provided by operating activities and by opportunistically using other means to repay or refinance our obligations as we determine appropriate. Our ability to pay our expenses, finance
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our leasing business and meet our debt service obligations depends on our future performance, which may be affected by financial, business, economic, and other factors including the risk factors described under Item 1A of this report. If we do not have enough money to pay our debt service obligations, we may be required to refinance all or part of our existing debt, sell assets, borrow more money or raise equity. In such an event, we may not be able to refinance our debt, sell assets, borrow more money or raise equity on terms acceptable to us or at all. Also, our ability to carry out any of these activities on favorable terms, if at all, may be further impacted by any financial or credit crisis which may limit access to the credit markets and increase our cost of capital.
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 2021.
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 the most recent franchisee sales information available. If there are significant changes in the actual performance of franchisees versus the Company’s estimates, its royalty revenue would be impacted. During 2020, the Company collected $10,200 more than it estimated at December 28, 2019. As of December 26, 2020, the Company’s royalty receivable was $1,518,000.
The Company collects initial franchise fees when franchise agreements are signed and recognizes the initial franchise fees as revenue over the estimated life of the franchise, beginning when the franchise is opened. 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 26, 2020, deferred franchise fee revenue was $6,823,100.
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.
For sales-type leases in which the equipment has a fair value greater or less than its carrying amount, selling profit/loss is recognized at commencement. For subsequent periods or for leases in which the equipment’s fair value is equal to its carrying amount, 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.
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.
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Recent Accounting Pronouncements
See Note 2, “Significant Accounting Policies — Recently Issued Accounting Pronouncements.
ITEM 7A:QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company incurs financial markets risk in the form of interest rate risk. Risk can be quantified by measuring the financial impact of a near-term adverse increase in short-term interest rates. At December 26, 2020, the Company had available a $25.0 million line of credit with CIBC Bank USA. The interest rates applicable to this agreement are based on either the bank’s base rate or LIBOR for short-term borrowings (twelve months or less). The Company had no debt outstanding at December 26, 2020 under this line of credit. The Company’s earnings would be affected by changes in short-term interest rates only in the event that it were to borrow amounts under this facility. With the Company’s borrowings at December 26, 2020, a one percent increase in short-term rates would have no impact on annual pretax earnings. The Company had no interest rate derivatives in place at December 26, 2020.
None of the Company’s cash and cash equivalents at December 26, 2020 was invested in money market mutual funds, which are subject to the effects of market fluctuations in interest rates.
Foreign currency transaction gains and losses were not material to the Company’s results of operations for the year ended December 26, 2020, as less than 7% of the Company’s total revenues and 1% of expenses were denominated in a foreign currency. Based upon these revenues and expenses, a 10% increase or decrease in the foreign currency exchange rates would impact annual pretax earnings by approximately $388,000. To date, the Company has not entered into any foreign currency forward exchange contracts or other derivative financial instruments to hedge the effects of adverse fluctuations in foreign currency exchange rates.
ITEM 8:FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Winmark Corporation and Subsidiaries
Index to Consolidated Financial Statements
Consolidated Balance Sheets Page 23
Consolidated Statements of Operations Page 24
Consolidated Statements of Shareholders’ Equity (Deficit) Page 25
Consolidated Statements of Cash Flows Page 26
Notes to the Consolidated Financial Statements Page 27
Report of Independent Registered Public Accounting Firm Page 43
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WINMARK CORPORATION AND SUBSIDIARIES
Consolidated Balance Sheets
ASSETS
Current Assets:
Property and equipment:
Less - accumulated depreciation and amortization (4,195,100) (4,093,400)
LIABILITIES AND SHAREHOLDERS' EQUITY (DEFICIT)
Current Liabilities:
Long-term Liabilities:
Commitments and Contingencies — —
Shareholders’ Equity (Deficit):
The accompanying notes are an integral part of these consolidated financial statements.
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WINMARK CORPORATION AND SUBSIDIARIES
Consolidated Statements of Operations
Fiscal Year Ended
Revenue:
Earnings per share - basic $ 8.02 $ 8.37 $ 7.77
Earnings per share - diluted $ 7.72 $ 7.84 $ 7.26
The accompanying notes are an integral part of these consolidated financial statements.
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WINMARK CORPORATION AND SUBSIDIARIES
Consolidated Statements of Shareholders’ Equity (Deficit)
Fiscal years ended December 26, 2020, December 28, 2019 and December 29, 2018
Retained
Earnings
Common Stock (Accumulated
Shares Amount Deficit) Total
The accompanying notes are an integral part of these consolidated financial statements.
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WINMARK CORPORATION AND SUBSIDIARIES
Consolidated Statements of Cash Flows
Fiscal Year Ended
OPERATING ACTIVITIES:
Loss from disposal of property and equipment 200 1,900 —
Operating lease right of use asset amortization 368,900 345,400 —
Change in operating assets and liabilities:
INVESTING ACTIVITIES:
Principal collections on lease receivables — — 24,252,200
FINANCING ACTIVITIES:
SUPPLEMENTAL DISCLOSURES:
Non-cash landlord leasehold improvements $ — $ 2,139,000 $ —
Fiscal Year Ended
The accompanying notes are an integral part of these consolidated financial statements.
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WINMARK CORPORATION AND SUBSIDIARIES
Notes to the Consolidated Financial Statements
December 26, 2020, December 28, 2019 and December 29, 2018
1. Organization and Business:
Winmark Corporation and subsidiaries (the Company) offers licenses to operate franchises using the service marks Plato’s Closet®, Once Upon A Child®, Play It Again Sports®, Style Encore® and Music Go Round®. In addition, the Company sells point-of-sale system hardware to its franchisees and certain merchandise to its Play It Again Sports franchisees. The Company also operates a middle market equipment leasing businesses under the Winmark Capital® mark and operated a small-ticket financing business under the Wirth Business Credit® mark until November 2020. The Company has a 52/53-week fiscal year that ends on the last Saturday in December. Fiscal years 2020, 2019 and 2018 were 52-week fiscal years.
2. Significant Accounting Policies:
Principles of Consolidation
The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries, Winmark Capital Corporation, Wirth Business Credit, Inc. and Grow Biz Games, Inc. All material inter-company transactions have been eliminated in consolidation.
Cash Equivalents
Cash equivalents consist of highly liquid investments with an original maturity of three months or less when purchased. Cash equivalents are stated at cost, which approximates fair value. As of December 26, 2020 and December 28, 2019, the Company had $77,100 and $56,500 of cash located in Canadian banks. The Company holds its cash and cash equivalents with financial institutions and at times, such balances may be in excess of insurance limits.
Receivables
The Company provides an allowance for doubtful accounts on trade receivables. The allowance for doubtful accounts was $800 and $1,900 at December 26, 2020 and December 28, 2019, respectively. If receivables in excess of the provided allowance are determined uncollectible, they are charged to expense in the year the determination is made. Trade receivables are written off when they become uncollectible (which generally occurs when the franchise terminates and there is no reasonable expectation of collection), and payments subsequently received on such receivable are credited to the allowance for doubtful accounts. Historically, receivables balances written off have not exceeded allowances provided.
Restricted Cash
The Company is required by certain states to maintain initial franchise fees in a restricted bank account until the franchise opens. The use of these funds by the Company is restricted until the franchise opens. Cash held in escrow totaled $25,000 and $50,000 at December 26, 2020 and December 28, 2019, respectively.
Investment in Leasing Operations
The Company uses the direct finance method of accounting to record income from direct financing leases. At the inception of a lease, the Company records the minimum future lease payments receivable, the estimated residual value of the leased equipment and the unearned lease income. Initial direct costs related to lease originations are deferred as part of the investment and amortized over the lease term. Unearned lease income is the amount by which the total lease receivable plus the estimated residual value exceeds the cost of the equipment.
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.
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Notes to the Consolidated Financial Statements
December 26, 2020, December 28, 2019 and December 29, 2018
For sales-type leases in which the equipment has a fair value greater or less than its carrying amount, selling profit/loss is recognized at commencement. For subsequent periods or for leases in which the equipment’s fair value is equal to its carrying amount, 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.
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.
Leasing Expense
Leasing expense includes the cost of financing equipment purchases, the cost of equipment sales as well as depreciation expense for operating lease assets.
Initial Direct Costs
The Company defers initial direct costs incurred to originate its leases in accordance with applicable accounting guidance. The initial direct costs deferred are part of the investment in leasing operations and are amortized using the effective interest method. Initial direct costs include commissions and other incremental costs related to originating a lease.
Lease Residual Values
Residual values reflect the estimated amounts to be received at lease termination from sales or other dispositions of leased equipment to unrelated parties. The leased equipment residual values are based on the Company’s best estimate.
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.
Inventories
The Company values its inventories at the lower of cost, as determined by the weighted average cost method, and net realizable values. Inventory consists of computer hardware and related accessories.
Impairment of Long-lived Assets
The Company reviews its long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. If the carrying amount of the asset exceeds expected undiscounted future cash flows, the Company measures the amount of impairment by comparing the carrying amount of the asset to its fair value.
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Notes to the Consolidated Financial Statements
December 26, 2020, December 28, 2019 and December 29, 2018
Property and Equipment
Property and equipment is stated at cost. Depreciation and amortization for financial reporting purposes is provided on the straight-line method. Estimated useful lives used in calculating depreciation and amortization are: three to five years for computer and peripheral equipment, five to seven years for furniture and equipment and the shorter of the lease term or useful life for leasehold improvements. Major repairs, refurbishments and improvements which significantly extend the useful lives of the related assets are capitalized. Maintenance and repairs, supplies and accessories are charged to expense as incurred.
Goodwill
The Company reviews its goodwill for impairment at its fiscal year end or whenever events or changes in circumstances indicate that there has been impairment in the value of its goodwill. No impairment was noted during fiscal years ended 2020, 2019 and 2018. Goodwill of $607,500 in the consolidated balance sheets at December 26, 2020 and December 28, 2019 is all attributable to the Franchising segment.
Use of Estimates
The preparation of financial statements in conformity with generally accepted U.S. accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. The ultimate results could differ from those estimates.
Advertising
Advertising costs are charged to operating expenses as incurred. Advertising costs were $273,900, $402,700 and $423,400 for fiscal years 2020, 2019 and 2018, respectively.
Accounting for Stock-Based Compensation
The Company recognizes the cost of all share-based payments to employees, including grants of employee stock options, in the consolidated financial statements based on the grant date fair value of those awards. This cost is recognized over the period for which an employee is required to provide service in exchange for the award.
The Company estimates the fair value of options granted using the Black-Scholes option valuation model. The Company estimates the volatility of its common stock at the date of grant based on its historical volatility rate. The Company’s decision to use historical volatility was based upon the lack of actively traded options on its common stock. The Company estimates the expected term based upon historical option exercises. The risk-free interest rate assumption is based on observed interest rates for the expected term. The Company uses historical data to estimate pre-vesting option forfeitures and record share-based compensation expense only for those awards that are expected to vest. For options granted, the Company amortizes the fair value on a straight-line basis. All options are amortized over the vesting periods, which are generally four years beginning from the date of grant.
Revenue Recognition – Franchising
The following is a description of the principal sources of revenue for the company’s franchising segment. The Company’s performance obligations under franchise agreements consist of (a) a franchise license, including a license to use one of our brands, (b) a point-of-sale software license, (c) initial services, such as pre-opening training and marketing support, and (d) ongoing services, such as marketing services and operational support. These performance obligations are highly interrelated so we do not consider them to be individually distinct and therefore account for them under ASC 606 as a single performance obligation, which is satisfied by providing a right to use our intellectual property over the estimated life of the franchise. The disaggregation of the Company’s franchise revenue is presented within the Revenue lines of the Consolidated Statements of Operations with the amounts included in Revenue: Other delineated below. For more detailed information about reportable segments, see Note 13 – “Segment Reporting”.
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Notes to the Consolidated Financial Statements
December 26, 2020, December 28, 2019 and December 29, 2018
Royalties
The Company collects royalties from each retail franchise based upon a percentage of retail store gross sales. The Company recognizes royalties as revenue when earned.
Merchandise Sales
Merchandise sales include the sale of point-of-sale technology equipment to franchisees and the sale of a limited amount of sporting goods to certain Play It Again Sports franchisees. Merchandise sales, which includes shipping and handling charges, are recognized at a point in time when the product has been shipped to the franchisee. Shipping and handling costs associated with outbound freight are accounted for as a fulfillment cost and included in cost of merchandise sold.
Franchise Fees
The Company collects initial franchise fees when franchise agreements are signed. The Company recognizes franchise fee revenue over the estimated life of the franchise, beginning with the opening of the franchise, which is when the Company has performed substantially all initial services required by the franchise agreement and the franchisee benefits from the rights afforded by the franchise agreement. The Company had deferred franchise fee revenue of $6,823,100 and $7,623,800 at December 26, 2020 and December 28, 2019, respectively.
Marketing Fees
Marketing fee revenue is included in the Revenue: Other line of the Consolidated Statements of Operations. The Company bills and collects annual marketing fees from its franchisees at various times throughout the year. The Company recognizes marketing fee revenue on a straight line basis over the franchise duration. The Company recognized $1.3 million in marketing fee revenue for each of the fiscal years ended December 26, 2020, December 28, 2019 and December 29, 2018.
Software License Fees
Software license fee revenue is included in the Revenue: Other line of the Consolidated Statements of Operations. The Company bills and collects software license fees from its franchisees when the point-of-sale system is provided to the franchisee. The Company recognizes software license fee revenue on a straight line basis over the franchise duration. The Company recognized $0.3 million in software license fee revenue for each of the fiscal years ended December 26, 2020, December 28, 2019 and December 29, 2018. The Company had deferred software license fees of $1,655,100 and $1,741,800 at December 26, 2020 and December 28, 2019, respectively.
Contract Liabilities
The Company’s contract liabilities for its franchise revenues consist of deferred revenue associated with franchise fees and software license fees described above.
Commission Fees
The Company capitalizes incremental commission fees paid as a result of obtaining franchise agreement contracts. Capitalized commission fees of $0.5 million and $0.6 million are outstanding at December 26, 2020 and December 28, 2019, respectively and are included in Prepaid expenses and Other assets of the Consolidated Balance Sheets.
Capitalized commission fees are amortized over the life of the franchise and are included in selling, general and administrative expenses. During the fiscal years ended December 26, 2020, December 28, 2019 and December 29, 2018, the Company recognized $102,600, $107,200 and $99,500 of commission fee expense, respectively.
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WINMARK CORPORATION AND SUBSIDIARIES
Notes to the Consolidated Financial Statements
December 26, 2020, December 28, 2019 and December 29, 2018
Income Taxes