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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-Q

 

 

Commission File Number: 000-22012

 

 

WINMARK CORPORATION

(Exact name of registrant as specified in its charter)

 

 

(763) 520-8500

(Registrant’s telephone number, including area code)

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days:

 

Yes  x

No  o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See the definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act:

 

Large accelerated filer o	Accelerated filer o
Non-accelerated filer o	Smaller reporting company x

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act:

 

Yes  o

No  x

 

Common stock, no par value, 5,523,383 shares outstanding as of July 25, 2008.

 

 

Table of Contents

 

WINMARK CORPORATION AND SUBSIDIARIES

 

INDEX

 

		PAGE
PART I.	FINANCIAL INFORMATION
Item 1.	Financial Statements (Unaudited)
	CONSOLIDATED CONDENSED BALANCE SHEETS: June 28, 2008 and December 29, 2007	3
	CONSOLIDATED CONDENSED STATEMENTS OF OPERATIONS: Three Months Ended June 28, 2008 and June 30, 2007 Six Months Ended June 28, 2008 and June 30, 2007	4
	CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS: Six Months Ended June 28, 2008 and June 30, 2007	5
	NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS	6 – 15
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	15 – 25
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	25 – 26
Item 4T.	Controls and Procedures	26
PART II.	OTHER INFORMATION	26
Item 1.	Item 1 has been omitted since the item is inapplicable or the answer is negative.	26
Item 1A.	Risk Factors	26
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	27
Item 3.	Item 3 has been omitted since the item is inapplicable or the answer is negative.	27
Item 4.	Submission of Matters to a Vote of Security Holders	27 – 28
Item 5.	Other Information	28
Item 6.	Exhibits	29

 

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PART I. FINANCIAL INFORMATION

 

ITEM 1:   Financial Statements

 

WINMARK CORPORATION AND SUBSIDIARIES

CONSOLIDATED CONDENSED BALANCE SHEETS

(unaudited)

 

		June 28, 2008			December 29, 2007
ASSETS
Current Assets:
Cash and cash equivalents		$	2,585,200		$	1,253,000
Receivables, less allowance for doubtful accounts of $53,500 and $52,200		2,136,400			2,312,300
Net investment in leases - current		16,356,400			10,554,900
Income tax receivable		831,800			166,300
Inventories		70,700			145,000
Prepaid expenses		977,200			1,104,900
Deferred income taxes		208,200			208,200
Total current assets		23,165,900			15,744,600
Net investment in leases – long-term		29,186,600			31,331,600
Long-term investments		7,360,000			7,496,500
Long-term notes receivables, net		49,400			59,700
Property and equipment, net		612,700			667,400
Other assets		625,800			625,800
Deferred income taxes		1,021,200			1,021,200
		$	62,021,600		$	56,946,800
LIABILITIES AND SHAREHOLDERS’ EQUITY
Current Liabilities:
Current line of credit		$	3,741,600		$	7,553,600
Current renewable subordinated notes		4,217,800			3,535,900
Accounts payable		1,149,400			1,414,100
Accrued liabilities		2,843,000			2,501,900
Current discounted lease rentals		948,700			27,400
Rents received in advance		1,729,100			1,385,900
Current deferred revenue		1,104,000			1,132,300
Total current liabilities		15,733,600			17,551,100
Long-term line of credit		11,198,300			8,685,000
Long-term renewable subordinated notes		17,081,300			17,486,000
Long-term discounted lease rentals		1,720,200			—
Long-term deferred revenue		619,000			556,000
Shareholders’ Equity:
Common stock, no par, 10,000,000 shares authorized, 5,526,459 and 5,417,775 shares issued and outstanding		1,438,600			305,900
Retained earnings		14,230,600			12,362,800
Total shareholders’ equity		15,669,200			12,668,700
		$	62,021,600		$	56,946,800

 

The accompanying notes are an integral part of these financial statements

 

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WINMARK CORPORATION AND SUBSIDIARIES

CONSOLIDATED CONDENSED STATEMENTS OF OPERATIONS

(Unaudited)

 

		Three Months Ended						Six Months Ended
		June 28, 2008			June 30, 2007			June 28, 2008			June 30, 2007
REVENUE:
Royalties		$	5,303,800		$	4,846,500		$	10,635,400		$	9,999,400
Leasing income		1,907,000			995,800			3,859,600			1,771,500
Merchandise sales		975,000			1,193,600			1,907,800			2,452,700
Franchise fees		386,100			417,400			913,600			717,400
Other		145,400			109,300			278,300			248,500
Total revenue		8,717,300			7,562,600			17,594,700			15,189,500
COST OF MERCHANDISE SOLD		940,700			1,148,000			1,834,600			2,355,200
LEASING EXPENSE		463,100			197,400			949,000			333,200
PROVISION FOR CREDIT LOSSES		269,200			165,300			654,300			279,700
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES		5,138,500			4,923,600			10,324,300			9,802,900
Income from operations		1,905,800			1,128,300			3,832,500			2,418,500
LOSS FROM EQUITY INVESTMENTS		(60,700		)	(197,400		)	(136,500		)	(252,200		)
INTEREST EXPENSE		(340,200		)	(387,600		)	(688,600		)	(720,600		)
INTEREST AND OTHER INCOME		59,000			171,400			131,800			300,800
Income before income taxes		1,563,900			714,700			3,139,200			1,746,500
PROVISION FOR INCOME TAXES		(633,400		)	(284,200		)	(1,271,400		)	(686,200		)
NET INCOME		$	930,500		$	430,500		$	1,867,800		$	1,060,300
EARNINGS PER SHARE – BASIC		$	.17		$	.08		$	.34		$	.19
EARNINGS PER SHARE – DILUTED		$	.17		$	.08		$	.34		$	.19
WEIGHTED AVERAGE SHARES OUTSTANDING – BASIC		5,534,781			5,447,697			5,517,807			5,516,214
WEIGHTED AVERAGE SHARES OUTSTANDING – DILUTED		5,562,319			5,560,564			5,548,482			5,638,543

 

The accompanying notes are an integral part of these financial statements

 

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WINMARK CORPORATION AND SUBSIDIARIES

CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS

(Unaudited)

 

		Six Months Ended
		June 28, 2008			June 30, 2007
OPERATING ACTIVITIES:
Net income		$	1,867,800		$	1,060,300
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation		171,300			143,700
Allowance for doubtful accounts		300			1,700
Provision for credit losses		536,100			253,600
Compensation expense related to stock options		415,200			291,100
Loss from equity investment		136,500			252,200
Deferred initial direct costs, net of amortization		(286,500		)	(427,000		)
Change in operating assets and liabilities:
Receivables		185,900			(22,300		)
Income tax receivable		(665,500		)	(243,600		)
Inventories		74,300			(38,900		)
Prepaid expenses		127,700			409,700
Deferred income taxes		—			134,700
Accounts payable		(264,700		)	(475,400		)
Accrued liabilities		341,100			75,700
Additions to advance and security deposits		644,900			629,600
Deferred revenue		34,700			172,400
Net cash provided by operating activities		3,319,100			2,217,500
INVESTING ACTIVITIES:
Purchases of property and equipment		(116,600		)	(255,300		)
Purchase of equipment for lease contracts		(12,276,000		)	(12,145,200		)
Principal collections on lease receivables		7,797,100			4,053,400
Net cash used for investing activities		(4,595,500		)	(8,347,100		)
FINANCING ACTIVITIES:
Proceeds from borrowings on line of credit		3,000,000			11,900,000
Payments on line of credit		(4,298,700		)	—
Proceeds from issuance of subordinated notes		889,300			1,383,100
Payments on subordinated notes		(612,100		)	(2,021,200		)
Repurchase of common stock		(308,000		)	(4,765,100		)
Proceeds from exercises of options and warrants		—			104,600
Proceeds from discounted lease rentals		2,912,600			—
Tax benefit on exercised options and warrants		1,025,500			40,700
Net cash provided by financing activities		2,608,600			6,642,100
INCREASE IN CASH AND CASH EQUIVALENTS		1,332,200			512,500
Cash and cash equivalents, beginning of period		1,253,000			1,037,800
Cash and cash equivalents, end of period		$	2,585,200		$	1,550,300
SUPPLEMENTAL DISCLOSURES:
Cash paid for interest		$	1,254,600		$	843,100
Cash paid for income taxes		$	863,400		$	672,900

 

The accompanying notes are an integral part of these financial statements

 

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WINMARK CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

 

1.     Management’s Interim Financial Statement Representation:

 

The accompanying condensed financial statements have been prepared by Winmark Corporation and subsidiaries (the “Company”), without audit, pursuant to the rules and regulations of the Securities and Exchange Commission.  The Company has a 52/53 week year which ends on the last Saturday in December.  The information in the condensed financial statements includes normal recurring adjustments and reflects all adjustments which are, in the opinion of management, necessary for a fair presentation of such financial statements.  This report should be read in conjunction with the audited financial statements and the notes thereto included in the Company’s latest Annual Report on Form 10-K.

 

Revenues and operating results for the six months ended June 28, 2008 are not necessarily indicative of the results to be expected for the full year.

 

2.     Organization and Business:

 

The Company offers licenses to operate franchises using the service marks Play it Again SportsÒ, Once Upon A ChildÒ, Music Go RoundÒ, Plato’s ClosetÒ and Wirth Business Credit®.  In addition, the Company sells inventory to its Play It Again SportsÒ franchisees through its buying group.  The Company also operates both small-ticket and middle-market equipment leasing businesses.

 

3.     Long-Term Investments:

 

The Company has an investment in Tomsten, the parent company of “Archiver’s” retail chain.  Archiver’s is a retail concept created to help people preserve and enjoy their photographs.  The Company has invested a total of $7.5 million in the purchase of common stock of Tomsten.  The Company’s investment currently represents 18.3% of the outstanding common stock of Tomsten.  The Company’s investment was originally accounted for using the cost method based upon an analysis that included the fact that no officers or directors of the Company served as officers or directors of Tomsten, and the existence of a voting agreement between the Company and Tomsten, appointing officers of Tomsten as the Company’s proxy with the right to vote the Tomsten shares held by the Company.

 

On October 2, 2007, the Company changed its relationship with Tomsten, primarily by (i) John Morgan, our Chairman and Chief Executive Officer, joining Tomsten’s board of directors and (ii) Tomsten and Winmark eliminating the voting agreement between the parties.  Due to these factors, the Company determined that it was necessary to change the accounting treatment for its investment in Tomsten from the cost method (which had been in place since the date of the Company’s first investment in August 2002) to the equity method of accounting.  At the date of the change in accounting treatment, the Company’s historical financial statements were adjusted retroactively to reflect the portion of Tomsten’s operating losses attributable to the Company’s ownership from the date of the original investment. (See Note 7.) As of June 28, 2008, $3.1 million of the Company’s investment, with a current carrying cost of $5.4 million, is attributable to goodwill.  The amount of goodwill was determined by calculating the difference between the Company’s net investment in Tomsten less its pro rata share of Tomsten’s net worth.

 

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On October 13, 2004, the Company made a commitment to lend $2.0 million to BridgeFunds Limited at an annual rate of 12% pursuant to several senior subordinated promissory notes.  BridgeFunds Limited advances funds to claimants involved in civil litigation to cover litigation expenses.  At December 29, 2007 and June 28, 2008, the Company had previously funded the $2.0 million commitment.  In addition, the Company has received a warrant to purchase approximately 257,000 shares of BridgeFunds which currently represents approximately 7.0% of the equity of BridgeFunds on a fully diluted basis.  On August 23, 2007, in connection with raising capital, BridgeFunds Limited completed a restructuring where all assets and liabilities, including the warrant, were assigned to and assumed by BridgeFunds, LLC.

 

4.  Investment in Leasing Operations:

 

Investment in leasing operations consists of the following:

 

		June 28, 2008			December 29, 2007
Minimum lease payments receivable		$	53,145,100		$	38,948,800
Estimated residual value of equipment		2,075,900			1,472,800
Unearned lease income net of initial direct costs deferred		(9,693,300		)	(7,583,800		)
Security deposits		(1,601,100		)	(1,299,300		)
Allowance for credit losses		(788,100		)	(613,800		)
Equipment installed on leases not yet commenced		2,404,500			10,961,800
Total net investment in leases		45,543,000			41,886,500
Less: net investment in leases – current		(16,356,400		)	(10,554,900		)
Net investment in leases – long-term		$	29,186,600		$	31,331,600

 

The Company had $480,000 and $26,600 of net charge-offs during the first six months of 2008 and 2007, respectively.

 

As of June 28, 2008, leased assets with one customer approximated 14% of the Company’s total assets, of which $2.3 million of the customer commitment is secured by a letter of credit.

 

Minimum lease payments receivable under lease contracts and the amortization of unearned lease income, net of initial direct costs and fees deferred is as follows for the remainder of fiscal 2008 and the full fiscal years thereafter as of June 28, 2008:

 

Fiscal Year		Minimum Lease Payments Receivable			Income Amortization
2008		$	10,442,700		$	3,079,400
2009		20,608,100			4,015,000
2010		13,709,100			1,856,200
2011		5,695,300			599,000
2012		2,491,000			140,600
Thereafter		198,900			3,100
		$	53,145,100		$	9,693,300

 

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5.  Accounting for Stock-Based Compensation:

 

Financial Accounting Standards Board (FASB) Statement No. 123, Share-Based Payment (revised 2004) requires the cost of all share-based payments to employees, including grants of employee stock options, to be recognized in the consolidated financial statements based on the grant date fair value of those awards.  In accordance with Statement No. 123R, this cost is recognized over the period for which an employee is required to provide service in exchange for the award.  Statement No. 123R requires that the benefits associated with tax deductions in excess of recognized compensation expense be reported as a financing cash flow rather than as an operating cash flow.  The Company uses the straight-line method of expensing graded vesting awards.  Compensation expense of $415,200 and $291,100 relating to the vested portion of the fair value of stock options granted was expensed to “Selling, General and Administration Expenses” in the first six months of 2008 and 2007, respectively.

 

The Company estimates the fair value of options granted using the Black-Scholes option valuation model.  We estimate the volatility of our common stock at the date of grant based on our historical volatility rate, consistent with SFAS No. 123(R) and Securities and Exchange Commission Staff Accounting Bulletin No. 107 (SAB 107).  Our decision to use historical volatility was based upon the lack of actively traded options on our common stock.  We estimate the expected term based upon historical option exercises.  The risk-free interest rate assumption is based on observed interest rates for the volatility period.  We use 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, we amortize the fair value on a straight-line basis.  All options are amortized over the vesting periods.

 

In accordance with SFAS 123R, the fair value of each option granted in 2008 and 2007 was estimated on the date of the grant using the Black-Scholes option pricing model with the following assumptions:

 

Year Granted		Option Fair Value		Risk Free Interest Rate		Expected Life (Years)		Expected Volatility		Dividend Yield
2008		—		—		—		—		—
2007		$ 5.76 / $6.16 / $6.93		4.55% / 3.54% / 3.67%		5 / 5 / 6		27.2% / 25.3% / 25.4%		none

 

6.  New Accounting Pronouncements

 

Effective December 30, 2007, the Company adopted SFAS No. 157, “Fair Value Measurements” (“SFAS No.157”).  SFAS No. 157 defines fair value, establishes a framework for measuring fair value in accordance with generally accepted accounting principles and expands disclosures about fair value measurements.  The adoption of SFAS No. 157 did not have a material impact on the Company’s financial condition or results of operations.

 

SFAS No. 157 defines fair value as the price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date.  SFAS No. 157 also describes three levels of inputs that may be used to measure fair value:

 

·                  Level 1 – quoted prices in active markets for identical assets and liabilities.

 

·                  Level 2 – observable inputs other than quoted prices in active markets for identical assets and liabilities.

 

·                  Level 3 – unobservable inputs in which there is little or no market data available, which require the reporting entity to develop its own assumptions.

 

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The Company’s cash and cash equivalents are valued using quoted prices.  The fair value of the Company’s long-term investments (described in Note 3) was determined based on Level 3 inputs using a discounted cash flow model.

 

In February 2008, the FASB issued FSP FAS 157-2, Effective Date of FASB Statement No. 157 (“FSP FAS 157-2”).  FSP 157-2 delays the effective date of SFAS 157 for non-financial assets and non-financial liabilities, except those that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually).  The Company will adopt FAS 157 for non-financial assets and non-financial liabilities on December 28, 2008, and do not anticipate this adoption will have a material impact on the financial statements.

 

In February 2007, FASB issued FAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities Including an Amendment of FASB Statement No. 115 (“FAS 159”).  FAS 159 permits entities to choose to measure many financial instruments and certain other items at fair value.  The Company adopted FAS 159 on December 30, 2007.  The Company did not elect the fair value of accounting option for any of its eligible assets; therefore, the adoption of FAS 159 had no impact on the financial statements.

 

7.  Reclassifications:

 

Certain amounts in the June 30, 2007 financial statements have been reclassified to conform with the June 28, 2008 presentation.

 

Change in Accounting

 

As a result of the change in accounting treatment for our investment in Tomsten from the cost basis to the equity method of accounting in 2007 (See Note 3.), the Company retroactively adjusted the accompanying 2007 historical financial statements to reflect the portion of Tomsten’s operating losses attributable to the Company’s ownership from the date of its original investment until the change in accounting treatment.  The table below reflects the effect of the change in accounting method on the June 30, 2007 financial statements.

 

Statement of Earnings		Three months ended June 30, 2007 as previously reported			Adjustments			Three months ended June 30, 2007 as adjusted
Loss on Investments		$	—		$	(197,400	)	$	(197,400	)
Net Income		547,200			(116,700		)	430,500
Earnings per share - Basic		.10			(.02		)	.08
Earnings per share - Diluted		.10			(.02		)	.08

 

Statement of Earnings		Six months ended June 30, 2007 as previously reported			Adjustments			Six months ended June 30, 2007 as adjusted
Loss on Investments		$	—		$	(252,200	)	$	(252,200	)
Net Income		1,209,400			(149,100		)	1,060,300
Earnings per share - Basic		.22			(.03		)	.19
Earnings per share - Diluted		.21			(.02		)	.19

 

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8.     Earnings Per Share:

 

The Company calculates earnings per share in accordance with SFAS No. 128 by dividing net income by the weighted average number of shares of common stock outstanding to arrive at the Earnings Per Share - Basic.  The Company calculates Earnings Per Share - Diluted by dividing net income by the weighted average number of shares of common stock and dilutive stock equivalents from the exercise of stock options and warrants using the treasury stock method.  The weighted average diluted outstanding shares is computed by adding the weighted average basic shares outstanding with the dilutive effect of 27,538 and 112,867 stock options and warrants for the three months and 30,675 and 123,329 for the six months ended June 28, 2008 and June 30, 2007, respectively.

 

Stock options for 167,335 and 148,705 shares for the three months and 143,886 and 157,167 shares for the six months ended June 28, 2008 and June 30, 2007, respectively, were outstanding but were not included in the calculation of Earnings Per Share – Diluted because their exercise prices were greater than the average market price of the common shares and, therefore, including the options in the denominator would be anti-dilutive.

 

9.     Shareholders’ Equity:

 

Repurchase of Common Stock

 

Under the Board of Directors’ authorization, the Company has the ability to repurchase up to 4,000,000 shares of its common stock, of which all but 167,390 shares have been repurchased through June 28, 2008.  Repurchases may be made from time to time at prevailing prices, subject to certain restrictions on volume, pricing and timing.  Since the inception of stock repurchase activities in November 1995 through June 28, 2008, the Company has repurchased 3,832,610 shares of its stock at an average price of $14.09 per share.  In the first six months of 2008, the Company repurchased 17,364 shares for an aggregate purchase price of $307,994 or $17.74 per share.

 

Stock Option Plans

 

The Company has authorized up to 750,000 shares of common stock to be reserved for granting either nonqualified or incentive stock options to officers and key employees under the Company’s 2001 Stock Option Plan (“the 2001 Plan”).

 

Grants under the 2001 Plan are made by the Board of Directors or a Board-designated committee at a price of not less than 100% of the fair market value on the date of grant.  If an incentive stock option is granted to an individual who owns more than 10% of the voting rights of the Company’s common stock, the option exercise price may not be less than 110% of the fair market value on the date of grant.  The term of the options may not exceed 10 years, except in the case of nonqualified stock options, whereby the terms are established by the Board of Directors or a Board-designated committee.  Options may be exercisable in whole or in installments, as determined by the Board of Directors or a Board-designated committee.

 

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The Company also sponsors a Stock Option Plan for Nonemployee Directors (the “Nonemployee Directors Plan”) and has reserved a total of 300,000 shares for issuance to directors of the Company who are not employees.  At the April 30^th Annual Shareholders Meeting, the Company’s shareholders approved a resolution (as described more completely in the Company’s definitive Proxy Statement filed with the United States Securities and Exchange Commission on March 19, 2008) to amend the Nonemployee Directors Plan by extending the term of future options granted under the Plan from a six (6) year term to a ten (10) year term, and by modifying the vesting schedule from 20% to 25% per year, beginning one year from the grant date.

 

Stock options granted and exercised under the 2001 Plan and Nonemployee Directors Plan as of June 28, 2008 were as follows:

 

		Number of Shares		Weighted Average Exercise Price			Weighted Average Remaining Contractual Life (years)		Remaining Intrinsic Value
Outstanding at December 29, 2007		443,300		$	19.35		7.67		$	731,800
Granted		—		—
Exercised		—		—
Forfeited		—		—
Outstanding at June 28, 2008		443,300		19.35			7.17		$	—
Exercisable at June 28, 2008		197,622		$	17.67		5.80		$	183,800

 

All unexercised options at June 28, 2008 have an exercise price equal to the fair market value on the date of the grant.

 

As of June 28, 2008, the Company had $1.7 million of total unrecognized compensation expense related to stock options that is expected to be recognized over the remaining weighted average vesting period of 2.9 years.

 

Other Options

 

On March 22, 2000, Sheldon Fleck, a former consultant to the Company, was granted a warrant to purchase 200,000 shares of common stock at an exercise price of $6 per share.  This warrant would have expired on March 22, 2008 if unexercised.  On October 4, 2007 and January 17, 2008, Mr. Fleck exercised 25,000 and 175,000 of the warrant shares, respectively.  The exercise of the warrant shares resulted in a $1,025,500 tax benefit in the first six months of 2008 which was recorded as an increase to common stock.

 

10.  Long-term Debt:

 

As of June 28, 2008, the Company had $14.9 million outstanding on its line of credit bearing interest between 4.58% and 5.76%.

 

On June 10, 2008, the Company amended and restated its 364-Day Revolving Credit Agreement with LaSalle, to among other things, join The PrivateBank and Trust Company as a lender and Documentation Agent, and appoint LaSalle Administrative Agent.  The Amended Credit Agreement permits the Company to draw up to a $55,000,000 line of credit.  The Amended Credit Agreement also increased the minimum tangible net worth requirement to $19.1 million while maintaining the existing calculation for subsequent monthly periods.  As of June 28, 2008, the Company’s tangible net worth was $26.8 million.

 

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The Credit Facility has a borrowing base that is equal to two times the Earnings Before Interest, Taxes, Depreciation and Amortization (“EBITDA”) of the Company’s franchising and corporate overhead plus 90% of the amount of eligible leased assets.  The line of credit has been and will continue to be used for growing the Company’s leasing business, stock repurchases and general corporate purposes.  The Credit Facility is secured by a lien against substantially all of the Company’s assets.

 

Renewable Unsecured Subordinated Notes

 

In May 2006, the Company filed a public offering of up to $50 million of Renewable Unsecured Subordinated Notes that was declared effective in June 2006.  In March 2007, the Company filed Post-Effective Amendment No. 2 to the public offering that was declared effective March 30, 2007.  In November 2007, the Company filed a Post-Effective Amendment Number 3 to the public offering that was declared effective November 29, 2007.  In March 2008, the Company filed a Post-Effective Amendment Number 4 to the public offering that was declared effective March 27, 2008.  As of June 28, 2008, the Company has $21,299,100 outstanding in renewable unsecured subordinated notes.  The table below presents the Company’s outstanding notes payable as of June 28, 2008:

 

		Original Term		Principal Amount			Weighted Average Interest Rate
Renewable unsecured subordinated notes		3 months		$	32,800		6.27	%
		6 months		506,500			6.78	%
		1 year		1,399,400			7.90	%
		2 years		4,187,900			8.77	%
		3 years		7,463,500			9.67	%
		4 years		1,818,500			9.83	%
		5 years		5,703,000			10.10	%
		10 years		187,500			10.22	%
Total				$	21,299,100		9.43	%

 

The Company made interest payments of $997,000 and $581,900 on the renewable unsecured subordinated notes during the first six months of 2008 and 2007, respectively.  The weighted average term of the outstanding renewable unsecured subordinated notes at June 28, 2008 is 40 months.

 

The Company incurred $231,800 in costs related to the issuance of the Renewable Unsecured Subordinated Notes in 2006.  The costs can be broken into three distinct categories (i) offering costs (ii) on going costs, and (iii) annual costs.  These costs have been capitalized and will be amortized as a component of interest expense.  The offering and on going costs associated with the debt offering are being amortized over the weighted-average term of the debt.  In connection with the debt offering, the Company will incur certain additional annual costs that are being amortized over a 12-month period.

 

11.          Discounted Lease Rentals

 

The Company utilized certain lease rentals receivable and underlying equipment as collateral to borrow from financial institutions at a weighted average rate of 5.69% at June 28, 2008 on a non-recourse basis.  In the event of a default by a customer in non-recourse financing, the financial institution has a first lien on the underlying leased equipment, with no further recourse against the Company.  As of June 28, 2008, $948,700 of the $2.7 million balance is current.

 

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12.          Other Contingencies:

 

In addition to the operating lease obligations disclosed in Note 12 of the Company’s Form 10-K for the year ended December 29, 2007, the Company has remained a guarantor on Company-owned retail stores that have been either sold or closed.  At June 28, 2008 and June 30, 2007, $74,000 and $93,000, respectively, are included in accrued liabilities relating to these obligations.  These leases have various expiration dates through 2008.  The Company believes it has adequate accruals for any future liability.

 

13.          Segment Reporting:

 

The Company currently has 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, a middle-market equipment leasing business and (ii) Wirth Business Credit, Inc., a small ticket equipment leasing business.  Segment reporting is intended to give financial statement users a better view of how the Company manages and evaluates its businesses. The Company’s internal management reporting is the basis for the information disclosed for its business segments.  Segment assets are those that are directly used in or identified with segment operations, including cash, accounts receivable, prepaids, inventory, property and equipment and investment in leasing operations. Unallocated assets include corporate cash and cash equivalents, long-term investments, deferred tax amounts and other corporate assets.  Inter-segment balances and transactions have been eliminated.  The following tables summarize financial information by segment and provide a reconciliation of segment contribution to operating income:

 

		Three Months Ended						Six Months Ended
		June 28, 2008			June 30, 2007			June 28, 2008			June 30, 2007
Revenue:
Franchising		$	6,810,300		$	6,566,800		$	13,735,100		$	13,418,000
Leasing		1,907,000			995,800			3,859,600			1,771,500
Total revenue		$	8,717,300		$	7,562,600		$	17,594,700		$	15,189,500
Reconciliation to operating income:
Franchising segment contribution		$	2,153,400		$	1,823,500		$	4,352,300		$	4,048,200
Leasing segment contribution		(247,600		)	(695,200		)	(519,800		)	(1,629,700		)
Total operating income		$	1,905,800		$	1,128,300		$	3,832,500		$	2,418,500
Depreciation and amortization:
Leasing		$	16,500		$	17,900		$	35,100		$	35,800
Unallocated		69,800			54,100			136,200			107,900
Total depreciation and amortization		$	86,300		$	72,000		$	171,300		$	143,700

 

		As of
		June 28, 2008			December 29, 2007
Identifiable assets:
Franchising		$	3,730,400		$	3,690,700
Leasing		48,140,100			43,565,300
Unallocated		10,151,100			9,690,800
Total		$	62,021,600		$	56,946,800

 

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14. Related Party Transactions:

 

On February 12, 2007, in connection with Winmark Corporation’s (“Winmark”) existing stock repurchase plan, Winmark agreed to repurchase 50,000 shares of common stock from K. Jeffrey Dahlberg for aggregate consideration of $900,000, or $18.00 per share.

 

On February 27, 2007, John L. Morgan, chief executive officer and chairman of Winmark, subscribed for and purchased $500,000 of two year maturity unsecured subordinated notes on a monthly interest payment schedule as described in the Interest Rate Supplement filed on Form 424B2 with the Securities and Exchange Commission on June 16, 2006 offered by Winmark pursuant to the Prospectus and related documents declared effective June 14, 2006.  In connection with their investment, Mr. Morgan agreed that his notes would be voted consistent with the majority of the remaining note holders in an event of default.

 

On April 5, 2007, John L. Morgan, subscribed for and purchased $400,000 of four year maturity unsecured subordinated notes on a monthly interest payment schedule at the rates described in the Interest Rate Supplement filed on Form 424B2 with the Securities and Exchange Commission on April 3, 2007 (“April Interest Rate Supplement”) offered by Winmark pursuant to a prospectus and related documents declared effective on March 30, 2007 (“March Prospectus”).  In connection with his investment, Mr. Morgan agreed that his notes would be voted consistent with the majority of the remaining note holders in an event of default.

 

On May 15, 2007, in connection with Winmark’s existing stock repurchase plan, Winmark agreed to repurchase 50,000 shares of common stock from K. Jeffrey Dahlberg for aggregate consideration of $850,000, or $17.00 per share.

 

On June 28, 2007, John L. Morgan subscribed for and purchased $1 million of three year maturity unsecured subordinated notes on a monthly interest payment schedule as described in the April Interest Rate Supplement offered by Winmark pursuant to the March Prospectus.  In connection with this investment, Mr. Morgan agreed that his notes would be voted consistent with the majority of the remaining note holders in an event of default.

 

On September 18, 2007, in connection with the Winmark’s existing stock repurchase plan, Winmark agreed to purchase 41,138 shares of common stock from Mark T. Hooley, a former executive officer and son-in-law of John L. Morgan, for aggregate consideration of $771,700 or $18.76 per share.

 

On October 4, 2007, John L. Morgan subscribed for and purchased $800,000 of unsecured subordinated notes of various maturities ($200,000 of six month maturity, $200,000 of one year maturity, $200,000 of two year maturity and $200,000 of three year maturity) all on a monthly interest payment schedule at the rates described in the Interest Rate Supplement filed on Form 424B2 with the Securities and Exchange Commission on August 23, 2007 offered by Winmark pursuant to the March Prospectus.  In connection with his investment, Mr. Morgan agreed that his notes would be voted consistent with the majority of the remaining note holders in an event of default.

 

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On November 6, 2007, Sheila Morgan, spouse of John L. Morgan, subscribed for and purchased $2,000,000 of unsecured subordinated notes of various maturities ($500,000 of one year maturity, $500,000 of two year maturity and $1,000,000 of three year maturity) all on a monthly interest payment schedule at the rates described in the Interest Rate Supplement filed on Form 424B2 with the Securities and Exchange Commission on October 12, 2007 offered by Winmark pursuant to the March Prospectus. In connection with her investment, Mrs. Morgan agreed that her notes would be voted consistent with the majority of the remaining note holders in an event of default.

 

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

 

Overview

 

As of June 28, 2008, we had franchises operating under the following brands:  Play it Again Sports®, Once Upon a Child®, Plato’s Closet®, Music Go Round® and Wirth Business Credit®.  Management closely tracks the following criteria to evaluate current business operations and future prospects: royalties, franchise fees, leasing activity, selling, general and administrative expenses, franchise openings and closings and franchise renewals.

 

Our most profitable sources of franchising revenue are royalties earned from our franchisees and franchise fees for new openings and transfers.

 

During the first six months of 2008, our royalties increased $636,000 or 6.4% compared to the first six months of 2007.  Franchise fees increased $196,200 or 27.3% compared to the same period last year and primarily reflect consistent new openings in established brands and the addition of the new Wirth Business Credit® franchise system.  During the first six months of 2008, revenue generated from the Company’s leasing activities was $3,859,600 compared to $1,771,500 in the same period last year.  (See Note 13 – “Segment Reporting.”)  The Company’s leasing portfolio was $45.5 million at June 28, 2008.

 

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Management monitors several nonfinancial factors in evaluating the current business operations and future prospects, including franchise openings and closings and franchise renewals.  The following is a summary of our franchising activity for the first six months ended June 28, 2008:

 

										SIX MONTHS ENDING 6/28/08
		TOTAL 12/29/07		OPENED		CLOSED		TOTAL 6/28/08		AVAILABLE FOR RENEWAL		COMPLETED RENEWALS
Play It Again Sports® Franchised Stores - US and Canada		374		6		(16	)	364		3		3
Once Upon A Child® Franchised Stores - US and Canada		228		6		(2	)	232		4		3
Plato’s Closet® Franchised Stores - US and Canada		211		15		(2	)	224		0		0
Music Go Round® Franchised Stores		38		0		(1	)	37		4		4
Total Franchised Stores		851		27		(21	)	857		11		10
Wirth Business Credit® Territories		41		17		(2	)	56		0		0
Total Franchises/Territories		892		44		(23	)	913		11		10

 

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 six months ended June 28, 2008, the Company renewed 10 franchise agreements of the 11 franchise agreements that were available for renewal.

 

Management continually monitors the level and timing of selling, general and administrative expenses.  The major components of selling, general and administrative expenses include salaries, wages and benefits, advertising, travel, occupancy, legal and professional fees.  During the six months ended June 28, 2008, selling, general and administrative expense increased mainly due to amortization of initial direct costs, bank charges, stock option expenses and sales commissions.

 

		Six Months Ended
		June 28, 2008			June 30, 2007
Selling, general and administrative expenses		$	10,324,200		$	9,802,900

 

Our ability to grow our profits is dependent on our ability to: (i) effectively support our franchise partners so that they produce higher revenues, (ii) open new franchises, (iii) increase lease originations and minimize write-offs in our leasing portfolios and (iv) control our selling, general and administrative expenses.

 

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Results of Operations

 

The following table sets forth for the periods indicated, certain income statement items as a percentage of total revenue:

 

		Three Months Ended				Six Months Ended
		June 28, 2008		June 30, 2007		June 28, 2008		June 30, 2007
Revenue:
Royalties		60.8	%	64.1	%	60.5	%	65.8	%
Leasing income		21.9		13.2		21.9		11.7
Merchandise sales		11.2		15.8		10.8		16.2
Franchise fees		4.4		5.5		5.2		4.7
Other		1.7		1.4		1.6		1.6
Total revenues		100.0	%	100.0	%	100.0	%	100.0	%
Cost of merchandise sold		(10.8	)	(15.2	)	(10.4	)	(15.5	)
Leasing expense		(5.3	)	(2.6	)	(5.4	)	(2.2	)
Provision for credit losses		(3.1	)	(2.2	)	(3.7	)	(1.9	)
Selling, general and administrative expenses		(58.9	)	(65.1	)	(58.7	)	(64.5	)
Income from operations		21.9		14.9		21.8		15.9
Loss from equity investments		(0.7	)	(2.6	)	(0.8	)	(1.7	)
Interest expense		(3.9	)	(5.1	)	(3.9	)	(4.7	)
Interest and other income		0.7		2.2		0.7		2.0
Income before income taxes		18.0		9.4		17.8		11.5
Provision for income taxes		(7.3	)	(3.7	)	(7.2	)	(4.5	)
Net income		10.7	%	5.7	%	10.6	%	7.0	%

 

Comparison of Three Months Ended June 28, 2008 to Three Months Ended June 30, 2007

 

Revenue

 

Revenue for the quarter ended June 28, 2008 totaled $8.7 million compared to $7.6 million for the comparable period in 2007.

 

Royalties increased to $5.3 million for the second quarter of 2008 from $4.8 million for the same period in 2007, a 9.4% increase.  The increase was due to higher Plato’s Closet® and Once Upon A Child® royalties of $301,000 and $120,000, respectively.  The increase in Plato’s Closet® and Once Upon A Child® royalties is primarily due to having 27 additional Plato’s Closet® and 11 additional Once Upon A Child® franchise stores in the second quarter of 2008 compared to the same period last year and higher franchisee retail sales in both brands.

 

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Merchandise sales include the sale of product to franchisees either through the Play It Again Sports® buying group, or through our Computer Support Center (“Direct Franchisee Sales”).  For the second quarter of 2008 and 2007, they were as follows:

 

 

Direct Franchisee Sales revenues decreased $218,600, or 18.3%, for the six months ended June 28, 2008 compared to the same period last year.  This is a result of management’s strategic decision to have more franchisees purchase merchandise directly from vendors and having 21 fewer Play It Again Sports® stores open than one year ago.

 

Franchise fees decreased to $386,100 for the second quarter of 2008 compared to $417,400 for the second quarter of 2007.  The decrease is due to opening 16 franchises in the second quarter of 2008, compared to 21 in the same period of 2007.

 

Leasing income increased to $1,907,000 for the second quarter of 2008 compared to $995,800 for the same period in 2007.  The increase is due to a larger lease portfolio in 2008 compared to 2007.

 

Cost of Merchandise Sold

 

Cost of merchandise sold decreased $207,300 or 18.1% for the second quarter of 2008 compared to the same period last year.  The decrease was primarily due to a decrease in Direct Franchisee Sales discussed in the revenue section.

 

Cost of merchandise sold includes in-bound freight and the cost of merchandise sold to franchisees either through the Play It Again Sports® buying group, or through our Computer Support Center (“Direct Franchisee Sales”).  The cost of merchandise sold as a percentage of Direct Franchisee Sales for the second quarter of 2008 and 2007 were as follows:

 

 

Leasing Expense

 

Leasing expense increased to $463,100 in the second quarter of 2008 compared to $197,400 in the second quarter of 2007.  The increase is due to interest on increased borrowings in connection with the growth of our lease portfolio.

 

Provision for Credit Losses

 

Provision for credit losses increased to $269,200 in the second quarter of 2008 compared to $165,300 in the second quarter of 2007.  The increase is due to a higher level of net charge-offs and originations in the leasing segment.

 

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