WINMARK CORP - Quarter Report: 2013 September (Form 10-Q)

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-Q

 

x               QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended September 28, 2013

 

or

 

o                  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from                  to                

 

Commission File Number: 000-22012

 

 

WINMARK CORPORATION

(Exact name of registrant as specified in its charter)

 

 

 

 

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 has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  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.

 

 

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, 5,135,961 shares outstanding as of October 15, 2013.

 

 

Table of Contents

 

WINMARK CORPORATION AND SUBSIDIARIES

 

INDEX

 

		PAGE
PART I.	FINANCIAL INFORMATION
Item 1.	Financial Statements (Unaudited)
	CONSOLIDATED CONDENSED BALANCE SHEETS: September 28, 2013 and December 29, 2012	3
	CONSOLIDATED CONDENSED STATEMENTS OF OPERATIONS: Three Months Ended September 28, 2013 and September 29, 2012 Nine Months Ended September 28, 2013 and September 29, 2012	4
	CONSOLIDATED CONDENSED STATEMENTS OF COMPREHENSIVE INCOME: Three Months Ended September 28, 2013 and September 29, 2012 Nine Months Ended September 28, 2013 and September 29, 2012	5
	CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS: Nine Months Ended September 28, 2013 and September 29, 2012	6
	NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS	7 — 13
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	14 — 23
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	23
Item 4.	Controls and Procedures	24
PART II.	OTHER INFORMATION
Item 1.	Legal Proceedings	25
Item 1A.	Risk Factors	25
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	25
Item 3.	Defaults Upon Senior Securities	25
Item 4.	Mine Safety Disclosures	25
Item 5.	Other Information	25
Item 6.	Exhibits	26
	SIGNATURES	27

 

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PART I.         FINANCIAL INFORMATION

ITEM 1:   Financial Statements

 

WINMARK CORPORATION AND SUBSIDIARIES

CONSOLIDATED CONDENSED BALANCE SHEETS

(Unaudited)

 

		September 28, 2013			December 29, 2012
ASSETS
Current Assets:
Cash and cash equivalents		$	8,248,000		$	2,233,400
Marketable securities		401,000			85,900
Receivables, less allowance for doubtful accounts of $5,000 and $17,300		1,116,900			1,237,100
Net investment in leases - current		16,398,700			13,461,200
Income tax receivable		366,700			1,400,700
Inventories		69,400			71,200
Prepaid expenses		618,600			445,200
Total current assets		27,219,300			18,934,700
Net investment in leases - long-term		20,274,700			22,697,100
Long-term investments (See Note 4)		—			—
Property and equipment, net		1,073,700			1,229,500
Other assets		677,500			677,500
		$	49,245,200		$	43,538,800
LIABILITIES AND SHAREHOLDERS’ EQUITY
Current Liabilities:
Line of credit		$	—		$	10,800,000
Accounts payable		1,724,300			2,203,700
Accrued liabilities		2,359,100			1,286,300
Discounted lease rentals		834,000			896,800
Rents received in advance		48,700			134,800
Deferred revenue		1,787,900			1,641,700
Deferred income taxes		3,574,200			3,549,900
Total current liabilities		10,328,200			20,513,200
Long-Term Liabilities:
Discounted lease rentals		382,700			177,900
Rents received in advance		111,800			117,700
Deferred revenue		1,128,200			953,000
Other liabilities		1,148,900			1,254,700
Deferred income taxes		2,864,700			2,594,300
Total long-term liabilities		5,636,300			5,097,600
Shareholders’ Equity:
Common stock, no par value, 10,000,000 shares authorized, 5,135,961 and 4,996,459 shares issued and outstanding		2,420,300			—
Accumulated other comprehensive loss		(9,900		)	(4,000		)
Retained earnings		30,870,300			17,932,000
Total shareholders’ equity		33,280,700			17,928,000
		$	49,245,200		$	43,538,800

 

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						Nine Months Ended
		September 28, 2013			September 29, 2012			September 28, 2013			September 29, 2012
REVENUE:
Royalties		$	9,853,900		$	9,178,400		$	26,937,000		$	25,160,800
Leasing income		3,810,100			4,312,700			11,348,100			9,989,800
Merchandise sales		598,000			716,600			1,821,100			2,083,200
Franchise fees		340,000			411,000			1,144,200			966,000
Other		189,900			180,400			713,400			625,100
Total revenue		14,791,900			14,799,100			41,963,800			38,824,900
COST OF MERCHANDISE SOLD		569,200			684,400			1,734,700			1,982,200
LEASING EXPENSE		399,300			770,700			1,289,500			1,336,200
PROVISION FOR CREDIT LOSSES		(29,800		)	(1,700		)	(67,700		)	(69,600		)
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES		5,311,900			4,882,200			16,728,900			15,239,900
Income from operations		8,541,300			8,463,500			22,278,400			20,336,200
LOSS FROM EQUITY INVESTMENTS		—			(372,300		)	—			(650,400		)
IMPAIRMENT OF INVESTMENT IN NOTES		—			(660,700		)	—			(660,700		)
INTEREST EXPENSE		(35,500		)	(110,200		)	(180,100		)	(302,300		)
INTEREST AND OTHER INCOME (EXPENSE)		5,500			14,300			(4,800		)	50,600
Income before income taxes		8,511,300			7,334,600			22,093,500			18,773,400
PROVISION FOR INCOME TAXES		(3,259,800		)	(3,075,100		)	(8,447,700		)	(7,593,500		)
NET INCOME		$	5,251,500		$	4,259,500		$	13,645,800		$	11,179,900
EARNINGS PER SHARE — BASIC		$	1.03		$	.85		$	2.70		$	2.22
EARNINGS PER SHARE — DILUTED		$	1.00		$	.82		$	2.61		$	2.13
WEIGHTED AVERAGE SHARES OUTSTANDING — BASIC		5,116,872			5,013,822			5,046,156			5,041,023
WEIGHTED AVERAGE SHARES OUTSTANDING — DILUTED		5,263,311			5,222,719			5,222,196			5,257,057

 

The accompanying notes are an integral part of these financial statements.

 

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WINMARK CORPORATION AND SUBSIDIARIES

CONSOLIDATED CONDENSED STATEMENTS OF COMPREHENSIVE INCOME

(Unaudited)

 

		Three Months Ended						Nine Months Ended
		September 28, 2013			September 29, 2012			September 28, 2013			September 29, 2012
NET INCOME		$	5,251,500		$	4,259,500		$	13,645,800		$	11,179,900
OTHER COMPREHENSIVE INCOME (LOSS), BEFORE TAX:
Unrealized net gains (losses) on marketable securities:
Unrealized holding net gains (losses) arising during period		(8,100		)	(5,600		)	(9,500		)	(2,000		)
Reclassification adjustment for net gains included in net income		—			—			—			(28,000		)
OTHER COMPREHENSIVE INCOME (LOSS), BEFORE TAX		(8,100		)	(5,600		)	(9,500		)	(30,000		)
INCOME TAX (EXPENSE) BENEFIT RELATED TO ITEMS OF OTHER COMPREHENSIVE INCOME:
Unrealized net gains/losses on marketable securities:
Unrealized holding net gains (losses) arising during period		3,100			2,200			3,600			800
Reclassification adjustment for net gains included in net income		—			—			—			11,000
INCOME TAX (EXPENSE) BENEFIT RELATED TO ITEMS OF OTHER COMPREHENSIVE INCOME		3,100			2,200			3,600			11,800
OTHER COMPREHENSIVE GAIN (LOSS), NET OF TAX		(5,000		)	(3,400		)	(5,900		)	(18,200		)
COMPREHENSIVE INCOME		$	5,246,500		$	4,256,100		$	13,639,900		$	11,161,700

 

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)

 

		Nine Months Ended
		September 28, 2013			September 29, 2012
OPERATING ACTIVITIES:
Net income		$	13,645,800		$	11,179,900
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation		321,400			326,600
Provision for credit losses		(67,700		)	(69,600		)
Compensation expense related to stock options		842,900			683,000
Deferred income taxes		294,700			214,200
Gain on sale of marketable securities		—			(34,600		)
Loss from equity investments		—			650,400
Impairment of investment in notes		—			660,700
Deferred initial direct costs		(374,100		)	(484,100		)
Amortization of deferred initial direct costs		418,700			421,800
Tax benefits on exercised stock options		(310,900		)	(353,300		)
Change in operating assets and liabilities:
Receivables		120,200			151,700
Income tax receivable / payable		1,348,500			53,800
Inventories		1,800			(16,800		)
Prepaid expenses		(173,400		)	(211,300		)
Accounts payable		(479,400		)	51,000
Accrued and other liabilities		967,000			998,400
Rents received in advance and security deposits		160,800			(100		)
Deferred revenue		321,400			450,500
Net cash provided by operating activities		17,037,700			14,672,200
INVESTING ACTIVITIES:
Proceeds from sale of marketable securities		—			1,424,700
Purchase of marketable securities		(324,600		)	(466,700		)
Purchase of property and equipment		(165,600		)	(81,500		)
Purchase of equipment for lease contracts		(14,979,300		)	(17,372,400		)
Principal collections on lease receivables		13,654,700			12,802,200
Net cash used for investing activities		(1,814,800		)	(3,693,700		)
FINANCING ACTIVITIES:
Proceeds from borrowings on line of credit		2,000,000			20,300,000
Payments on line of credit		(12,800,000		)	(9,600,000		)
Repurchases of common stock		(1,854,900		)	(4,893,600		)
Proceeds from exercises of stock options		3,121,400			594,900
Dividends paid		(707,500		)	(25,922,600		)
Proceeds from discounted lease rentals		721,800			1,418,600
Tax benefits on exercised stock options		310,900			353,300
Net cash used for financing activities		(9,208,300		)	(17,749,400		)
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS		6,014,600			(6,770,900		)
Cash and cash equivalents, beginning of period		2,233,400			9,020,100
Cash and cash equivalents, end of period		$	8,248,000		$	2,249,200
SUPPLEMENTAL DISCLOSURES:
Cash paid for interest		$	195,200		$	266,400
Cash paid for income taxes		$	6,787,800		$	7,325,500

 

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 consolidated 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 consolidated 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.  The consolidated condensed financial statements and notes are presented in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions for Form 10-Q, and therefore do not contain certain information included in the Company’s annual consolidated financial statements and notes.  This report should be read in conjunction with the audited consolidated financial statements and the notes thereto included in the Company’s latest Annual Report on Form 10-K.

 

Revenues and operating results for the nine months ended September 28, 2013 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 Plato’s Closet®, Play It Again Sports®, Once Upon A Child®, Music Go Round® and Style Encore™.  The Company also operates both middle market and small-ticket equipment leasing businesses under the Winmark Capital® and Wirth Business Credit® marks.

 

3.     Fair Value Measurements:

 

The Company 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.  The Company uses three levels of inputs 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.

 

The Company’s marketable securities were valued based on Level 1 inputs using quoted prices.

 

The Company determined the fair value of its investment in Tomsten, Inc. to be zero based on Level 3 inputs using a discounted cash flow model which included inputs on future revenues, expenses and other cash flows.  See Note 4.

 

Due to their nature, the carrying value of cash equivalents, receivables, long-term note investments, payables and debt obligations approximates fair value.

 

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4.     Investments:

 

Marketable Securities

 

The following is a summary of marketable securities classified as available-for-sale securities:

 

		September 28, 2013						December 29, 2012
		Cost			Fair Value			Cost			Fair Value
Equity securities		$	417,000		$	401,000		$	92,400		$	85,900

 

The Company’s unrealized gains and losses for marketable securities classified as available-for-sale securities in accumulated other comprehensive loss are as follows:

 

		September 28, 2013			December 29, 2012
Unrealized gains		$	300		$	—
Unrealized losses		(16,300		)	(6,500		)
Net unrealized losses		$	(16,000	)	$	(6,500	)

 

The Company’s realized gains and losses recognized on sales of available-for-sale marketable securities are as follows:

 

		Three Months Ended						Nine Months Ended
		September 28, 2013			September 29, 2012			September 28, 2013			September 29, 2012
Realized gains		$	—		$	4,600		$	—		$	46,900
Realized losses		—			—			—			(12,300		)
Net realized gains/(losses)		$	—		$	4,600		$	—		$	34,600

 

Amounts reclassified out of accumulated other comprehensive loss into earnings is determined by using the average cost of the security when sold.  Gross realized gains (losses) reclassified out of accumulated other comprehensive loss into earnings are included in Interest and Other Income (Expense) and the related tax benefits (expenses) are included in the Provision for Income Taxes lines of the Consolidated Condensed Statements of Operations.

 

Long-Term Investments

 

The Company has an investment in Tomsten, Inc. (“Tomsten”), the parent company of “Archiver’s” retail chain.  The Company has invested a total of $8.5 million in the purchase of common stock of Tomsten, with such investment representing 22.0% of Tomsten’s outstanding common stock.  The Company applies the equity method of accounting to this investment, and during the first nine months of 2012, the Company recorded $650,400 for its pro-rata share of Tomsten’s losses in the Consolidated Condensed Statements of Operations on the line item captioned Loss from Equity Investments.  During the fourth quarter of 2012, the Company recorded an impairment charge for the remaining portion of its investment in Tomsten.  On April 29, 2013, Tomsten filed a voluntary petition for reorganization under Chapter 11 of the United States Bankruptcy Code in Minnesota.  The Company’s carrying value of this investment was $0 as of September 28, 2013 and December 29, 2012.

 

The Company has a $2.0 million investment in senior subordinated promissory notes in BridgeFunds Limited (“BridgeFunds”).  The Company has deemed this investment to be impaired, and as of December 29, 2012, the Company had recorded impairment charges and established a corresponding valuation allowance that reduced the net investment balance to $0.  The Company has maintained the net investment balance of $0 as of September 28, 2013, as it does not expect to receive any cash flows from this investment.

 

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5.     Investment in Leasing Operations:

 

Investment in leasing operations consists of the following:

 

		September 28, 2013			December 29, 2012
Direct financing and sales-type leases:
Minimum lease payments receivable		$	37,061,800		$	33,094,100
Estimated residual value of equipment		4,399,100			2,925,900
Unearned lease income net of initial direct costs deferred		(5,544,700		)	(5,155,400		)
Security deposits		(3,135,300		)	(2,882,400		)
Equipment installed on leases not yet commenced		4,496,900			8,443,600
Total investment in direct financing and sales-type leases		37,277,800			36,425,800
Allowance for credit losses		(805,500		)	(775,800		)
Net investment in direct financing and sales-type leases		36,472,300			35,650,000
Operating leases:
Operating lease assets		1,229,800			1,564,300
Less accumulated depreciation and amortization		(1,028,700		)	(1,056,000		)
Net investment in operating leases		201,100			508,300
Total net investment in leasing operations		$	36,673,400		$	36,158,300

 

As of September 28, 2013, the $36.7 million total net investment in leases consists of $16.4 million classified as current and $20.3 million classified as long-term.  As of December 29, 2012, the $36.2 million total net investment in leases consists of $13.5 million classified as current and $22.7 million classified as long-term.

 

As of September 28, 2013, no customer had leased assets totaling more than 10% of the Company’s total assets.

 

Future minimum lease payments receivable under lease contracts and the amortization of unearned lease income, net of initial direct costs deferred, is as follows for the remainder of fiscal 2013 and the full fiscal years thereafter as of September 28, 2013:

 

		Direct Financing and Sales-Type Leases						Operating Leases
		Minimum Lease Payments Receivable			Income Amortization			Minimum Lease Payments Receivable
2013		$	5,862,700		$	1,635,700		$	429,100
2014		19,388,800			3,071,800			332,000
2015		9,836,500			790,500			49,900
2016		1,972,000			46,600			—
2017		1,800			100			—
Thereafter		—			—			—
		$	37,061,800		$	5,544,700		$	811,000

 

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The activity in the allowance for credit losses for leasing operations during the first nine months of 2013 and 2012, respectively, is as follows:

 

		September 28, 2013			September 29, 2012
Balance at beginning of period		$	775,800		$	803,800
Provisions charged to expense		(67,700		)	(69,600		)
Recoveries		114,700			195,900
Deductions for amounts written-off		(17,300		)	(128,100		)
Balance at end of period		$	805,500		$	802,000

 

The Company’s investment in direct financing and sales-type leases (“Investment In Leases”) and allowance for credit losses by loss evaluation methodology are as follows:

 

		September 28, 2013						December 29, 2012
		Investment In Leases			Allowance for Credit Losses			Investment In Leases			Allowance for Credit Losses
Collectively evaluated for loss potential		$	37,277,800		$	805,500		$	36,425,800		$	775,800
Individually evaluated for loss potential		—			—			—			—
Total		$	37,277,800		$	805,500		$	36,425,800		$	775,800

 

The Company’s key credit quality indicator for its investment in direct financing and sales-type leases is the status of the lease, defined as accruing or non-accrual.  Leases that are accruing income are considered to have a lower risk of loss.  Non-accrual leases are those that the Company believes have a higher risk of loss.  The following table sets forth information regarding the Company’s accruing and non-accrual leases.  Delinquent balances are determined based on the contractual terms of the lease.

 

		September 28, 2013
		0-60 Days Delinquent and Accruing			61-90 Days Delinquent and Accruing			Over 90 Days Delinquent and Accruing			Non-Accrual			Total
Middle-Market		$	36,158,500		$	—		$	—		$	—		$	36,158,500
Small-Ticket		1,097,100			22,200			—			—			1,119,300
Total Investment in Leases		$	37,255,600		$	22,200		$	—		$	—		$	37,277,800

 

		December 29, 2012
		0-60 Days Delinquent and Accruing			61-90 Days Delinquent and Accruing			Over 90 Days Delinquent and Accruing			Non-Accrual			Total
Middle-Market		$	34,901,300		$	—		$	—		$	—		$	34,901,300
Small-Ticket		1,517,700			—			—			6,800			1,524,500
Total Investment in Leases		$	36,419,000		$	—		$	—		$	6,800		$	36,425,800

 

6.              New Accounting Pronouncements:

 

In February 2013, the Financial Accounting Standards Board issued guidance that requires an entity to present, either in a single note or parenthetically on the face of the financial statements, the effect of significant amounts reclassified from each component of accumulated other comprehensive income/loss based on its source and the income statement line items affected by the reclassification.  If a component is not required to be reclassified to net income in its entirety, entities would instead cross reference to the related footnote for additional information.  This guidance is effective prospectively for reporting periods beginning after December 15, 2012.  The Company adopted the new guidance on December 30, 2012 and such adoption has not impacted the consolidated results of the Company.

 

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7.     Earnings Per Share:

 

The following table sets forth the presentation of shares outstanding used in the calculation of basic and diluted earnings per share (“EPS”):

 

		Three Months Ended				Nine Months Ended
		September 28, 2013		September 29, 2012		September 28, 2013		September 29, 2012
Denominator for basic EPS — weighted average common shares		5,116,872		5,013,822		5,046,156		5,041,023
Dilutive shares associated with option plans		146,439		208,897		176,040		216,034
Denominator for diluted EPS — weighted average common shares and dilutive potential common shares		5,263,311		5,222,719		5,222,196		5,257,057
Options excluded from EPS calculation — anti-dilutive		1,267		23,270		9,403		18,863

 

8.     Shareholders’ Equity:

 

Dividends

 

On January 23, 2013, the Company’s Board of Directors approved the payment of a $0.04 per share quarterly cash dividend to shareholders of record at the close of business on February 6, 2013, which was paid on March 1, 2013.

 

On April 24, 2013, the Company’s Board of Directors approved the payment of a $0.05 per share quarterly cash dividend to shareholders of record at the close of business on May 8, 2013, which was paid on June 3, 2013.

 

On July 24, 2013, the Company’s Board of Directors approved the payment of a $0.05 per share quarterly cash dividend to shareholders of record at the close of business on August 7, 2013, which was paid on September 3, 2013.

 

Repurchase of Common Stock

 

In the first nine months of 2013, the Company repurchased 28,422 shares of its common stock for an aggregate purchase price of $1.9 million or $65.26 per share.  Under the Board of Directors’ authorization, as of September 28, 2013, the Company has the ability to repurchase an additional 332,730 shares of its common stock.  Repurchases may be made from time to time at prevailing prices, subject to certain restrictions on volume, pricing and timing.

 

Stock Option Plans and Stock-Based Compensation

 

The Company had authorized up to 750,000 shares of common stock 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”).  The 2001 Plan expired on February 20, 2011.  The Company has authorized up to 250,000 shares of common stock to be reserved for granting either nonqualified or incentive stock options to officers and key employees under the Company’s 2010 Stock Option Plan (the “2010 Plan”).

 

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.

 

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Stock option activity under the 2001 Plan, 2010 Plan and Nonemployee Directors Plan (collectively, the “Option Plans”) as of September 28, 2013 was as follows:

 

		Number of Shares		Weighted Average Exercise Price			Weighted Average Remaining Contractual Life (years)		Intrinsic Value
Outstanding at December 29, 2012		613,727		$	31.46		7.06		$	16,010,000
Granted		47,500		59.77
Exercised		(168,462	)	18.72
Forfeited		(6,565	)	42.20
Outstanding at September 28, 2013		486,200		$	38.50		7.28		$	17,358,000
Exercisable at September 28, 2013		236,064		$	27.15		6.07		$	11,107,300

 

The fair value of options granted under the Option Plans during the first nine months of 2013 and 2012 were estimated on the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions and results:

 

		Nine Months Ended
		September 28, 2013			September 29, 2012
Risk free interest rate		1.30		%	0.88		%
Expected life (years)		6			6
Expected volatility		32.5		%	31.4		%
Dividend yield		1.90		%	2.06		%
Option fair value		$	15.84		$	12.95

 

During the nine months ended September 28, 2013, option holders surrendered 538 shares of previously owned common stock as payment for option shares exercised as provided for by the Option Plans.  All unexercised options at September 28, 2013 have an exercise price equal to the fair market value on the date of the grant.

 

Compensation expense of $842,900 and $683,000 relating to the vested portion of the fair value of stock options granted was expensed to “Selling, General and Administrative Expenses” in the first nine months of 2013 and 2012, respectively.  As of September 28, 2013, the Company had $2.5 million of total unrecognized compensation expense related to stock options that is expected to be recognized over the remaining weighted average vesting period of approximately 2.4 years.

 

9.  Line of Credit:

 

As of September 28, 2013, there were no borrowings outstanding under the Company’s Line of Credit with The PrivateBank and Trust Company and BMO Harris Bank N.A.

 

The Line of Credit, which provides for an aggregate commitment of $35.0 million subject to certain borrowing base limitations, has been and will continue to be used for general corporate purposes.  The Line of Credit is secured by a lien against substantially all of the Company’s 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 September 28, 2013, the Company was in compliance with all of its financial covenants.

 

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10.  Discounted Lease Rentals:

 

The Company utilized certain lease receivables and underlying equipment as collateral to borrow from financial institutions at a weighted average interest rate of 3.1% at September 28, 2013 on a non-recourse basis.

 

11.  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 financing 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 and includes allocation of shared-service costs.  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, marketable securities, current and long-term investments, current and 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						Nine Months Ended
		September 28, 2013			September 29, 2012			September 28, 2013			September 29, 2012
Revenue:
Franchising		$	10,981,800		$	10,486,400		$	30,615,700		$	28,835,100
Leasing		3,810,100			4,312,700			11,348,100			9,989,800
Total revenue		$	14,791,900		$	14,799,100		$	41,963,800		$	38,824,900
Reconciliation to operating income:
Franchising segment contribution		$	6,306,800		$	6,235,900		$	15,981,700		$	15,335,700
Leasing segment contribution		2,234,500			2,227,600			6,296,700			5,000,500
Total operating income		$	8,541,300		$	8,463,500		$	22,278,400		$	20,336,200
Depreciation:
Franchising		$	86,100		$	83,400		$	252,900		$	253,600
Leasing		23,300			23,800			68,500			73,000
Total depreciation		$	109,400		$	107,200		$	321,400		$	326,600

 

		As of
		September 28, 2013			December 29, 2012
Identifiable assets:
Franchising		$	6,594,700		$	2,957,200
Leasing		40,645,100			37,622,800
Unallocated		2,005,400			2,958,800
Total		$	49,245,200		$	43,538,800

 

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

 

Overview

 

As of September 28, 2013, we had 995 franchises operating under the Plato’s Closet, Play it Again Sports, Once Upon A Child, Music Go Round and Style Encore brands and had a leasing portfolio of $36.7 million.  Management closely tracks the following financial criteria to evaluate current business operations and future prospects: royalties, leasing activity, and selling, general and administrative expenses.

 

Our most profitable source of franchising revenue is royalties received from our franchise partners.  During the first nine months of 2013, our royalties increased $1.8 million or 7.1% compared to the first nine months of 2012.

 

During the first nine months of 2013, we purchased $15.0 million in equipment for lease customers compared to $17.4 million in the first nine months of 2012.  Overall, our leasing portfolio (net investment in leases — current and long-term) increased to $36.7 million at September 28, 2013 from $36.2 million at December 29, 2012.  Leasing income net of leasing expense during the first nine months of 2013 was $10.1 million compared to $8.7 million in the same period last year.  Fluctuations in period-to-period leasing income and leasing expense result primarily from the manner and timing in which leasing income and leasing expense is recognized over the term of each particular lease in accordance with accounting guidance applicable to leasing.  For this reason, we believe that more meaningful levels of leasing activity are the purchases of equipment for lease customers and the medium- to long-term trend in the size of the leasing portfolio.

 

Management continually monitors the level and timing of selling, general and administrative expenses.  The major components of selling, general and administrative expenses include salaries, wages and benefits, advertising, travel, occupancy, legal and professional fees.  During the first nine months of 2013, selling, general and administrative expense increased $1.5 million, or 9.8%, compared to the first nine months of 2012.

 

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 first nine months ended September 28, 2013:

 

										NINE MONTHS ENDED 9/28/13
		TOTAL 12/29/12		OPENED		CLOSED		TOTAL 9/28/13		AVAILABLE FOR RENEWAL		COMPLETED RENEWALS
Plato’s Closet Franchises - US and Canada		354		31		(2	)	383		20		20
Play It Again Sports Franchises - US and Canada		315		5		(16	)	304		29		27
Once Upon A Child Franchises - US and Canada		266		15		(4	)	277		23		21
Music Go Round Franchises - US		33		1		(4	)	30		1		1
Style Encore Franchises - US		0		1		0		1		0		0
Total Franchised Stores		968		53		(26	)	995		73		69

 

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Renewal activity is a key focus area for management.  Our franchisees sign 10-year agreements with us.  The renewal of existing franchise agreements as they approach their expiration is an indicator that management monitors to determine the health of our business and the preservation of future royalties.  During the first nine months of 2013, we renewed 69 of the 73 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, (iii) increase lease originations and minimize write-offs in our leasing portfolios, and (iv) control our selling, general and administrative expenses.

 

Results of Operations

 

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

 

		Three Months Ended				Nine Months Ended
		September 28, 2013		September 29, 2012		September 28, 2013		September 29, 2012
Revenue:
Royalties		66.6	%	62.0	%	64.2	%	64.8	%
Leasing income		25.8		29.1		27.1		25.7
Merchandise sales		4.0		4.9		4.3		5.4
Franchise fees		2.3		2.8		2.7		2.5
Other		1.3		1.2		1.7		1.6
Total revenue		100.0		100.0		100.0		100.0
Cost of merchandise sold		(3.9	)	(4.6	)	(4.1	)	(5.1	)
Leasing expense		(2.7	)	(5.2	)	(3.1	)	(3.4	)
Provision for credit losses		0.2		—		0.1		0.2
Selling, general and administrative expenses		(35.9	)	(33.0	)	(39.9	)	(39.3	)
Income from operations		57.7		57.2		53.0		52.4
Loss from equity investments		—		(2.5	)	—		(1.7	)
Impairment of investment in notes		—		(4.5	)	—		(1.7	)
Interest expense		(0.2	)	(0.7	)	(0.4	)	(0.8	)
Interest and other income (expense)		—		0.1		—		0.1
Income before income taxes		57.5		49.6		52.6		48.3
Provision for income taxes		(22.0	)	(20.8	)	(20.1	)	(19.5	)
Net income		35.5	%	28.8	%	32.5	%	28.8	%

 

Comparison of Three Months Ended September 28, 2013 to Three Months Ended September 29, 2012

 

Revenue

 

Revenues for the quarter ended September 28, 2013 totaled $14.8 million compared to $14.8 million for the comparable period in 2012.

 

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