Winmark Corp: Form 10-Q for the period ended Sep 28, 2024

Overview

Winmark – the Resale Company is focused on sustainability and small business formation. As of September 28, 2024, we had 1,343 franchises operating under the Plato’s Closet, Once Upon A Child, Play It Again Sports, Style Encore and Music Go Round brands. Our business is not capital intensive and is designed to generate consistent, recurring revenue and strong operating margins.

The financial criteria that management closely tracks to evaluate current business operations and future prospects include royalties and selling, general and administrative expenses.

Our most significant source of franchising revenue is royalties received from our franchisees. During the first nine months of 2024, our royalties increased $1.5 million or 2.8% compared to the first nine months of 2023.

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, conferences, travel, occupancy, legal and professional fees. During the first nine months of 2024, selling, general and administrative expenses increased $0.3 million, or 1.5% compared to the first nine months of 2023.

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 net store growth and renewal activity for the first nine months ended September 28, 2024:

Renewal activity is a key focus area for management. Our franchisees sign 10-year agreements with us. The renewal of existing franchise agreements as they approach their expiration is an indicator that management monitors to determine the health of our business and the preservation of future royalties. During the first nine months of 2024, we renewed 106 of the 109 franchise agreements available for renewal.

Our ability to grow our operating income is dependent on our ability to: (i) effectively support our franchise partners so that they produce higher revenues, (ii) open new franchises, and (iii) control our selling, general and administrative expenses.

In May 2021, we made the decision to no longer solicit new leasing customers and pursue an orderly run-off of our middle-market leasing portfolio. Leasing income net of leasing expense for the first nine months of 2024 was $1.6 million compared to $3.6 million in the first nine months of 2023. Given the decision to run-off the portfolio, we anticipate that leasing income net of leasing expense will continue to decrease through the run-off period.

Results of Operations

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

Comparison of Three Months Ended September 28, 2024 to Three Months Ended September 30, 2023

Revenue

Revenues for the quarter ended September 28, 2024 totaled $21.5 million compared to $22.3 million for the comparable period in 2023.

Royalties and Franchise Fees

Royalties increased to $19.5 million for the third quarter of 2024 from $19.2 million for the third quarter of 2023, a 1.6% increase. The increase is primarily from having additional franchise stores in the third quarter of 2024 compared to the same period in 2023.

Franchise fees of $0.5 million for the third quarter of 2024 compared to $0.3 million for the third quarter of 2023.

Leasing Income

Leasing income decreased to $0.3 million for the third quarter of 2024 compared to $1.3 million for the same period in 2023. The decrease is primarily due to a decrease in operating lease income 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 $0.7 million for the third quarter of 2024 compared to $1.0 million in the same period of 2023. The decrease is due to a decrease in buying group and 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 $0.7 million for the third quarter of 2024 compared to $0.9 million in the same period of 2023. The decrease is due to a decrease in Direct Franchise Sales discussed above. Cost of merchandise sold as a percentage of Direct Franchisee Sales for the third quarter of 2024 and 2023 was 94.3% and 93.7%, respectively.

Selling, General and Administrative

Selling, general and administrative expenses decreased 5.3% to $5.9 million in the third quarter of 2024 compared to $6.2 million in the same period of 2023. The decrease was primarily due to a decrease in compensation related expenses.

Interest Expense

Interest expense decreased to $0.7 million for the third quarter of 2024 compared to $0.8 million for the third quarter of 2023. The decrease is primarily due to lower average borrowing when compared to the same period last year.

Income Taxes

The provision for income taxes was calculated at an effective rate of 23.9% and 24.4% for the third quarter of 2024 and 2023, respectively. The decrease is primarily due to a decrease in state income taxes.

Comparison of Nine Months Ended September 28, 2024 to Nine Months Ended September 30, 2023

Revenue

Revenues for the first nine months of 2024 totaled $61.7 million compared to $63.2 million for the comparable period in 2023.

Royalties and Franchise Fees

Royalties increased to $54.6 million for the first nine months of 2024 from $53.1 million for the first nine months of 2023, a 2.8% increase. The increase is primarily from having additional franchise stores in the first nine months of 2024 compared to the same period in 2023.

Franchise fees of $1.2 million for the first nine months of 2024 compared to $1.1 million for the first nine months of 2023.

Leasing Income

Leasing income decreased to $1.7 million for the first nine months of 2024 compared to $3.9 million for the same period in 2023. The decrease is primarily due to a decrease in operating lease income and a lower level of equipment sales to customers when compared to the same period 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 $2.7 million for the first nine months of 2024 compared to $3.6 million in the same period of 2023. The decrease is primarily due to a decrease in buying group and 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 $2.6 million for the first nine months of 2024 compared to $3.4 million in the same period of 2023. The decrease is due to a decrease in Direct Franchise Sales discussed above. Cost of merchandise sold as a percentage of Direct Franchisee Sales for the first six months of 2024 and 2023 was 93.6% and 93.6%, respectively.

Selling, General and Administrative

Selling, general and administrative expenses increased 1.5% to $19.0 million in the first nine months of 2024 compared to $18.7 million in the same period of 2023. The increase was primarily due to an increase in advertising related expenses and outside services.

Interest Expense

Interest expense was $2.2 million for the first nine months of 2024 compared to $2.3 million for the first nine months of 2023. The decrease is primarily due to lower average borrowings when compared to the same period last year.

Income Taxes

The provision for income taxes was calculated at an effective rate of 21.8% and 22.3% for the first nine months of 2024 and 2023, respectively. The decrease is primarily due to higher tax benefits on the exercise of non-qualified stock options and a decrease in state income taxes.

Segment Comparison of Three Months Ended September 28, 2024 to Three Months Ended September 30, 2023

Franchising Segment Operating Income

The franchising segment’s operating income for the third quarter of 2024 increased to $14.8 million from $14.0 million for the third quarter of 2023. The increase in segment contribution was due to increased royalty revenues and a decrease in selling, general and administrative expenses.

Other Operating Segment Income

The other operating segment income for the third quarter of 2024 decreased to $0.2 million from $1.2 million for the third quarter of 2023. The decrease in segment contribution was due to a decrease in leasing income net of leasing expense.

Segment Comparison of Nine Months Ended September 28, 2024 to Nine Months Ended September 30, 2023

Franchising Segment Income

The franchising segment operating income for the first nine months of 2024 increased to $38.8 million from $37.6 million for the first nine months of 2023. The increase in segment contribution was due to increased royalty revenues, partially offset by an increase in selling, general and administrative expenses.

Other Operating Segment Income

The other operating segment income for the first nine months of 2024 decreased to $1.3 million from $3.2 million for the first nine months of 2023. The decrease in segment contribution was due to a decrease in leasing income net of leasing expenses.

Liquidity and Capital Resources

Our primary sources of liquidity have historically been cash flows from operations and borrowings. The components of the consolidated condensed statements of operations that reduce our net income but do not affect our liquidity include non-cash items for depreciation and amortization and compensation expense related to stock options.

We ended the third quarter of 2024 with $37.3 million in cash, cash equivalents and restricted cash compared to $40.6 million in cash, cash equivalents and restricted cash at the end of the third quarter of 2023.

Operating activities provided $33.7 million of cash during the first nine months of 2024, compared to $35.2 million provided during the same period last year. The decrease in cash provided by operating activities during the first nine months of 2024 compared to 2023 was primarily due to an increase in inventory, cash paid for income taxes and a decrease in principal collections on lease receivables.

Investing activities used $0.2 million of cash during the first nine months of 2024, compared to $0.3 million used during the same period last year. The 2024 activities consisted of the purchase of property and equipment.

Financing activities used $9.6 million of cash during the first nine months of 2024. Our most significant financing activities during the first nine months of 2024 consisted of $9.1 million for the payment of dividends and payments on notes payable of $3.2 million; partially offset by $2.7 million of proceeds from exercise of stock options. (See Note 8 — “Shareholders’ Equity (Deficit),” and Note 9 — “Debt”).

Our debt facilities include a Line of Credit with CIBC Bank USA and a Note Agreement and Shelf Agreement with Prudential. These facilities have been and will continue to be used for general corporate purposes, are secured by a lien against substantially all of our assets, contain customary financial conditions and covenants, and require maintenance of minimum levels of debt service coverage and maximum levels of leverage (all as defined within the agreements governing the facilities). As of September 28, 2024, we were in compliance with all of the financial covenants under the Line of Credit, the Note Agreement and the Shelf Agreement.

The Line of Credit provides for up to $20.0 million in revolving loans and $30.0 million in delayed draw term loans. As of September 28, 2024, we had no revolving loans outstanding, and had delayed draw term loan borrowings totaling $30.0 million that mature in 2029.

The Shelf Agreement allows us to offer privately negotiated senior notes to Prudential in an aggregate principal amount up to (i) $100.0 million, less (ii) the aggregate principal amount of notes outstanding at such point (including notes outstanding under the Note Agreement, which at September 28, 2024 was $36.0 million). As of September 28, 2024, we had not issued any notes under the Shelf Agreement. Of the $36.0 million of principal outstanding under the Note Agreement, $6.0 million amortizes over the remainder of 2024 through 2027, and $30.0 million matures in 2028.

See Part I, Item 1, Note 9 – “Debt” for more information regarding the Line of Credit, Note Agreement and Shelf Agreement.

We expect to generate the cash necessary to pay our expenses and to pay the principal and interest on 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 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 our Form 10-K for the fiscal year ended December 30, 2023 and under Item 1A below. 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.

As of the date of this report we believe that the combination of our cash on hand, the cash generated from our business, our Line of Credit and our Shelf Agreement will be adequate to fund our planned operations through 2025.

Critical Accounting Policies

A discussion of our critical accounting policies is contained in our annual report on Form 10-K for the year ended December 30, 2023. There have been no changes to our critical accounting policies from those disclosed on our Form 10-K for the year ended December 30, 2023.

Forward Looking Statements

The statements contained in this Item 2 “Management’s Discussion and Analysis of Financial Condition and Results of Operations” that are not strictly historical fact, including without limitation, the Company’s 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 that 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 may result in material variations between results contemplated by such forward looking statements and actual results and conditions. See the section appearing in our Annual Report on Form 10-K for the fiscal year ended December 30, 2023 entitled “Risk Factors” and Part II, Item 1A in this Report for a more complete discussion of certain factors that may cause the Company’s actual results to differ from those in its forward looking statements. You should not place undue reliance on these forward-looking statements, which speak only as of the date they were made. The Company undertakes no obligation to revise or update publicly any forward looking statements for any reason.

The Company incurs financial market 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 September 28, 2024, the Company’s Line of Credit with CIBC Bank USA included a commitment for revolving loans of $20.0 million. The interest rates applicable to revolving loans are based on either the bank’s base rate or SOFR for short-term borrowings (twelve months or less). The Company had no revolving loans outstanding at September 28, 2024 under this Line of Credit. The Company had no interest rate derivatives in place at September 28, 2024. The Company’s fixed rate debt exposes the company to changes in the market interest rate only to the extent that the Company may need to refinance maturing debt with new debt at a higher rate.

None of the Company’s cash and cash equivalents at September 28, 2024 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 nine months ended September 28, 2024. During fiscal 2023, less than 8% 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 $670,000. 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.

As of the end of the period covered by this report, the Company conducted an evaluation, under the supervision and with the participation of the principal executive officer and principal financial officer, of its disclosure controls and procedures as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”). Based upon, and as of the date of that evaluation, the principal executive officer and principal financial officer concluded that the Company’s disclosure controls and procedures are effective to ensure that information required to be disclosed by the Company in reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms, and that such information is accumulated and communicated to the Company’s management, including its principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure. There was no change in the Company’s internal control over financial reporting during its most recently completed fiscal quarter that has materially affected, or is reasonably likely to materially affect, its internal control over financial reporting.

In addition to the other information set forth in this report, including the important information in “Forward-Looking Statements,” you should carefully consider the “Risk Factors” discussed in our Annual Report on Form 10-K for the year ended December 30, 2023. If any of those factors were to occur, they could materially adversely affect our financial condition or future results, and could cause our actual results to differ materially from those expressed in its forward-looking statements in this report. We are aware of no material changes to the Risk Factors discussed in our Annual Report on Form 10-K for the year ended December 30, 2023.