WINMARK CORP - Quarter Report: 2014 March (Form 10-Q)

Table of Contents

 

 

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 March 29, 2014

 

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)

 

 

605 Highway 169 North, Suite 400, Minneapolis, MN 55441

(Address of principal executive offices) (Zip Code)

 

(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 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, 5,121,458 shares outstanding as of April 15, 2014.

 

 

 

Table of Contents

 

WINMARK CORPORATION AND SUBSIDIARIES

 

INDEX

 

		PAGE
PART I.	FINANCIAL INFORMATION
Item 1.	Financial Statements (Unaudited)
	CONSOLIDATED CONDENSED BALANCE SHEETS: March 29, 2014 and December 28, 2013	3
	CONSOLIDATED CONDENSED STATEMENTS OF OPERATIONS: Three Months Ended March 29, 2014 and March 30, 2013	4
	CONSOLIDATED CONDENSED STATEMENTS OF COMPREHENSIVE INCOME: Three Months Ended March 29, 2014 and March 30, 2013	5
	CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS: Three Months Ended March 29, 2014 and March 30, 2013	6
	NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS	7 – 12
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	13 – 19
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	20
Item 4.	Controls and Procedures	20
PART II.	OTHER INFORMATION
Item 1.	Legal Proceedings	21
Item 1A.	Risk Factors	21
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	21
Item 3.	Defaults Upon Senior Securities	21
Item 4.	Mine Safety Disclosures	21
Item 5.	Other Information	21
Item 6.	Exhibits	22
	SIGNATURES	23

 

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PART I.                            FINANCIAL INFORMATION

ITEM 1:   Financial Statements

 

WINMARK CORPORATION AND SUBSIDIARIES

CONSOLIDATED CONDENSED BALANCE SHEETS

(Unaudited)

 

		March 29, 2014			December 28, 2013
ASSETS
Current Assets:
Cash and cash equivalents		$	2,411,800		$	10,642,600
Marketable securities		791,600			736,500
Receivables, less allowance for doubtful accounts of $4,500 and $4,300		1,047,800			1,205,500
Net investment in leases - current		17,174,700			17,239,900
Income tax receivable		—			166,500
Inventories		96,700			96,700
Prepaid expenses		581,700			587,300
Total current assets		22,104,300			30,675,000
Net investment in leases - long-term		22,841,900			20,301,400
Property and equipment, net		1,405,200			1,382,200
Other assets		677,500			677,500
		$	47,028,900		$	53,036,100
LIABILITIES AND SHAREHOLDERS’ EQUITY
Current Liabilities:
Line of credit		$	14,000,000		$	—
Accounts payable		1,616,700			2,441,400
Income tax payable		1,829,200			—
Accrued liabilities		2,126,400			1,233,100
Discounted lease rentals		378,900			424,900
Deferred revenue		2,288,800			2,199,900
Deferred income taxes		4,208,200			4,208,200
Total current liabilities		26,448,200			10,507,500
Long-Term Liabilities:
Discounted lease rentals		204,300			277,400
Deferred revenue		1,238,700			1,180,700
Other liabilities		1,480,500			1,489,000
Deferred income taxes		1,436,800			1,436,800
Total long-term liabilities		4,360,300			4,383,900
Shareholders’ Equity:
Common stock, no par, 10,000,000 shares authorized, 5,144,589 and 5,143,530 shares issued and outstanding		2,506,500			2,949,500
Accumulated other comprehensive loss		(13,900		)	(4,100		)
Retained earnings		13,727,800			35,199,300
Total shareholders’ equity		16,220,400			38,144,700
		$	47,028,900		$	53,036,100

 

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
		March 29, 2014			March 30, 2013
REVENUE:
Royalties		$	8,810,000		$	8,474,900
Leasing income		4,375,600			3,407,800
Merchandise sales		788,000			665,700
Franchise fees		349,000			414,600
Other		230,000			185,400
Total revenue		14,552,600			13,148,400
COST OF MERCHANDISE SOLD		754,700			641,100
LEASING EXPENSE		306,600			279,700
PROVISION FOR CREDIT LOSSES		38,900			13,800
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES		6,017,900			5,537,900
Income from operations		7,434,500			6,675,900
INTEREST EXPENSE		(62,100		)	(89,500		)
INTEREST AND OTHER INCOME (EXPENSE)		100			(10,200		)
Income before income taxes		7,372,500			6,576,200
PROVISION FOR INCOME TAXES		(2,820,600		)	(2,518,700		)
NET INCOME		$	4,551,900		$	4,057,500
EARNINGS PER SHARE — BASIC		$	.88		$	.81
EARNINGS PER SHARE — DILUTED		$	.86		$	.78
WEIGHTED AVERAGE SHARES OUTSTANDING — BASIC		5,148,519			4,997,322
WEIGHTED AVERAGE SHARES OUTSTANDING — DILUTED		5,307,946			5,202,696

 

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
		March 29, 2014			March 30, 2013
NET INCOME		$	4,551,900		$	4,057,500
OTHER COMPREHENSIVE INCOME (LOSS), BEFORE TAX:
Unrealized net gains (losses) on marketable securities:
Unrealized holding net gains (losses) arising during period		(12,000		)	3,400
Reclassification adjustment for net gains included in net income		(3,800		)	—
OTHER COMPREHENSIVE INCOME (LOSS), BEFORE TAX		(15,800		)	3,400
INCOME TAX (EXPENSE) BENEFIT RELATED TO ITEMS OF OTHER COMPREHENSIVE INCOME:
Unrealized net gains/losses on marketable securities:
Unrealized holding net gains arising during period		4,600			(1,300		)
Reclassification adjustment for net gains included in net income		1,400			—
INCOME TAX (EXPENSE) BENEFIT RELATED TO ITEMS OF OTHER COMPREHENSIVE INCOME		6,000			(1,300		)
OTHER COMPREHENSIVE INCOME (LOSS), NET OF TAX		(9,800		)	2,100
COMPREHENSIVE INCOME		$	4,542,100		$	4,059,600

 

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)

 

		Three Months Ended
		March 29, 2014			March 30, 2013
OPERATING ACTIVITIES:
Net income		$	4,551,900		$	4,057,500
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation		105,300			107,000
Provision for credit losses		38,900			13,800
Compensation expense related to stock options		344,500			261,700
Gain on sale of marketable securities		(9,400		)	—
Deferred initial direct costs		(520,300		)	(172,900		)
Amortization of deferred initial direct costs		163,600			140,800
Tax benefits on exercised stock options		(60,000		)	—
Change in operating assets and liabilities:
Receivables		157,700			26,000
Income tax receivable / payable		2,061,700			2,158,800
Inventories		—			(800		)
Prepaid expenses		5,600			22,700
Accounts payable		(824,700		)	(375,200		)
Accrued and other liabilities		876,600			311,400
Rents received in advance and security deposits		(41,100		)	265,100
Deferred revenue		146,900			(92,900		)
Net cash provided by operating activities		6,997,200			6,723,000
INVESTING ACTIVITIES:
Proceeds from sale of marketable securities		463,000			—
Purchase of marketable securities		(524,500		)	—
Purchase of property and equipment		(128,300		)	(53,600		)
Purchase of equipment for lease contracts		(6,499,900		)	(4,673,500		)
Principal collections on lease receivables		4,272,600			4,530,300
Net cash used for investing activities		(2,417,100		)	(196,800		)
FINANCING ACTIVITIES:
Proceeds from borrowings on line of credit		14,000,000			—
Payments on line of credit		—			(6,300,000		)
Repurchases of common stock		(1,075,100		)	(269,600		)
Proceeds from exercises of stock options		227,600			120,600
Dividends paid		(26,023,400		)	(200,000		)
Proceeds from discounted lease rentals		—			80,900
Tax benefits on exercised stock options		60,000			—
Net cash used for financing activities		(12,810,900		)	(6,568,100		)
NET DECREASE IN CASH AND CASH EQUIVALENTS		(8,230,800		)	(41,900		)
Cash and cash equivalents, beginning of period		10,642,600			2,233,400
Cash and cash equivalents, end of period		$	2,411,800		$	2,191,500
SUPPLEMENTAL DISCLOSURES:
Cash paid for interest		$	29,800		$	84,700
Cash paid for income taxes		$	762,300		$	359,800

 

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 three months ended March 29, 2014 are not necessarily indicative of the results to be expected for the full year.

 

Reclassifications

 

Certain reclassifications of previously reported amounts have been made to conform to the current year presentation.  Such reclassifications did not impact net income or shareholders’ equity as previously reported.

 

2.              Organization and Business:

 

The Company offers licenses to operate franchises using the service marks Plato’s Closet®, Once Upon A Child®, Play It Again Sports®, 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.

 

Due to their nature, the carrying value of cash equivalents, receivables, 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:

 

		March 29, 2014						December 28, 2013
		Cost			Fair Value			Cost			Fair Value
Equity securities		$	814,000		$	791,600		$	743,100		$	736,500

 

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

 

		March 29, 2014			December 28, 2013
Unrealized gains		$	5,800		$	6,800
Unrealized losses		(28,200		)	(13,400		)
Net unrealized losses		$	(22,400	)	$	(6,600	)

 

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

 

		Three Months Ended
		March 29, 2014			March 30, 2013
Realized gains		$	22,200		$	—
Realized losses		(12,800		)	—
Net realized gains		$	9,400		$	—

 

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.

 

5.                                      Investment in Leasing Operations:

 

Investment in leasing operations consists of the following:

 

		March 29, 2014			December 28, 2013
Direct financing and sales-type leases:
Minimum lease payments receivable		$	38,245,300		$	35,450,900
Estimated residual value of equipment		3,953,400			4,348,800
Unearned lease income net of initial direct costs deferred		(6,700,400		)	(4,963,400		)
Security deposits		(3,276,300		)	(3,325,600		)
Equipment installed on leases not yet commenced		8,570,300			6,718,000
Total investment in direct financing and sales-type leases		40,792,300			38,228,700
Allowance for credit losses		(870,600		)	(822,700		)
Net investment in direct financing and sales-type leases		39,921,700			37,406,000
Operating leases:
Operating lease assets		375,200			1,353,500
Less accumulated depreciation and amortization		(280,300		)	(1,218,200		)
Net investment in operating leases		94,900			135,300
Total net investment in leasing operations		$	40,016,600		$	37,541,300

 

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As of March 29, 2014, the $40.0 million total net investment in leases consists of $17.2 million classified as current and $22.8 million classified as long-term.  As of December 28, 2013, the $37.5 million total net investment in leases consists of $17.2 million classified as current and $20.3 million classified as long-term.

 

As of March 29, 2014, 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 2014 and the full fiscal years thereafter as of March 29, 2014:

 

		Direct Financing and Sales-Type Leases						Operating Leases
		Minimum Lease Payments Receivable			Income  Amortization			Minimum Lease Payments Receivable
2014		$	17,918,600		$	4,101,800		$	204,800
2015		15,189,200			2,200,900			76,800
2016		4,953,500			396,500			—
2017		184,000			1,200			—
2018		—			—			—
Thereafter		—			—			—
		$	38,245,300		$	6,700,400		$	281,600

 

The activity in the allowance for credit losses for leasing operations during the first three months of 2014 and 2013, respectively, is as follows:

 

		March 29, 2014			March 30, 2013
Balance at beginning of period		$	822,700		$	775,800
Provisions charged to expense		38,900			13,800
Recoveries		9,000			21,300
Deductions for amounts written-off		—			(10,900		)
Balance at end of period		$	870,600		$	800,000

 

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:

 

		March 29, 2014						December 28, 2013
		Investment In Leases			Allowance for  Credit Losses			Investment In Leases			Allowance for  Credit Losses
Collectively evaluated for loss potential		$	40,792,300		$	870,600		$	38,228,700		$	822,700
Individually evaluated for loss potential		—			—			—			—
Total		$	40,792,300		$	870,600		$	38,228,700		$	822,700

 

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-accruing.  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.

 

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		March 29, 2014
		0-60 Days  Delinquent and Accruing			61-90 Days  Delinquent and Accruing			Over 90 Days Delinquent and  Accruing			Non-Accrual			Total
Middle-Market		$	39,281,800		$	—		$	—		$	322,300		$	39,604,100
Small-Ticket		1,188,200			—			—			—			1,188,200
Total Investment in Leases		$	40,470,000		$	—		$	—		$	322,300		$	40,792,300

 

		December 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		$	36,716,100		$	—		$	—		$	416,400		$	37,132,500
Small-Ticket		1,096,200			—			—			—			1,096,200
Total Investment in Leases		$	37,812,300		$	—		$	—		$	416,400		$	38,228,700

 

6.              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
		March 29, 2014		March 30, 2013
Denominator for basic EPS — weighted average common shares		5,148,519		4,997,322
Dilutive shares associated with option plans		159,427		205,374
Denominator for diluted EPS — weighted average common shares and dilutive potential common shares		5,307,946		5,202,696
Options excluded from EPS calculation — anti-dilutive		13,938		9,299

 

7.              Shareholders’ Equity:

 

Dividends

 

On January 29, 2014, 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 February 12, 2014, which was paid on March 3, 2014.

 

On February 4, 2014, the Company’s Board of Directors approved the payment of a $5.00 per share special cash dividend (the “2014 Special Dividend”) to shareholders of record at the close of business February 17, 2014, which was paid on March 3, 2014.  The 2014 Special Dividend totaled $25.8 million and was financed by a combination of cash on hand as well as net borrowings under the Line of Credit of $13.0 million (see Note 8 — “Line of Credit”).

 

Repurchase of Common Stock

 

In the first three months of 2014 the Company repurchased 14,066 shares of its common stock for an aggregate price of $1,075,100 or $76.43 per share.  Under the Board of Directors’ authorization, as of March 29, 2014, the Company has the ability to repurchase an additional 318,664 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.

 

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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.  As of March 29, 2014, 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, as of March 29, 2014, has reserved a total of 300,000 shares for issuance to directors of the Company who are not employees.

 

Stock option activity under the 2001 Plan, 2010 Plan and Nonemployee Directors Plan (collectively, the “Option Plans”) as of March 29, 2014 was as follows:

 

		Number of  Shares		Weighted  Average  Exercise Price			Weighted Average  Remaining Contractual  Life (years)		Intrinsic Value
Outstanding at December 28, 2013		526,712		$	42.87		7.33		$	26,446,700
Exercised		(15,125	)	15.05
Outstanding at March 29, 2014		511,587		$	43.69		7.14		$	16,222,100
Exercisable at March 29, 2014		258,762		$	30.50		5.92		$	11,418,400

 

No options were granted during the three months ended March 29, 2014 or the three months ended March 30, 2013.  All unexercised options at March 29, 2014 have an exercise price equal to the fair market value on the date of the grant.

 

Compensation expense of $344,500 and $261,700 relating to the vested portion of the fair value of stock options granted was expensed to “Selling, General and Administrative Expenses” in the first three months of 2014 and 2013, respectively.  As of March 29, 2014, the Company had $3.0 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.

 

8.  Line of Credit

 

On February 21, 2014, the Company’s Line of Credit with The PrivateBank and Trust Company and BMO Harris Bank N.A. was amended to, among other things, amend certain financial covenant calculations to remove the effect of the 2014 Special Dividend in such calculations, to reduce the applicable margin on the interest rate options, and to extend the termination date from February 29, 2016 to February 28, 2018.

 

The Line of Credit provides for an aggregate commitment of $35.0 million, subject to certain borrowing base limitations.  During the first three months of 2014, the Line of Credit was used to finance in part the 2014 Special Dividend (as indicated above) and 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 March 29, 2014, the Company was in compliance with all of its financial covenants.  There were $14.0 million in borrowings outstanding under the Line of Credit bearing interest ranging from 2.40% to 3.25%, leaving $21.0 million available for additional borrowings.

 

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9.              Discounted Lease Rentals:

 

The Company utilized certain lease receivables and underlying expenses as collateral to borrow from financial institutions at a weighted average rate of 3.27% at March 29, 2014 on a non-recourse basis.

 

10.       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 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
		March 29, 2014			March 30, 2013
Revenue:
Franchising		$	10,177,000		$	9,740,600
Leasing		4,375,600			3,407,800
Total revenue		$	14,552,600		$	13,148,400
Reconciliation to operating income:
Franchising segment contribution		$	4,701,200		$	4,834,100
Leasing segment contribution		2,733,300			1,841,800
Total operating income		$	7,434,500		$	6,675,900
Depreciation:
Franchising		$	83,100		$	84,200
Leasing		22,200			22,800
Total depreciation		$	105,300		$	107,000

 

		As of
		March 29, 2014			December 28, 2013
Identifiable assets:
Franchising		$	2,534,100		$	7,407,400
Leasing		41,499,000			42,490,800
Unallocated		2,995,800			3,137,900
Total		$	47,028,900		$	53,036,100

 

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

 

Overview

 

As of March 29, 2014, we had 1,021 franchises operating under the Plato’s Closet, Once Upon A Child, Play it Again Sports, Music Go Round and Style Encore brands and had a leasing portfolio of $40.0 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 three months of 2014, our royalties increased $0.3 million or 4.0% compared to the first three months of 2013.

 

During the first three months of 2014, we purchased $6.5 million in equipment for lease customers compared to $4.7 million in the first three months of 2013.  Overall, our leasing portfolio (net investment in leases — current and long-term) increased to $40.0 million at March 29, 2014 from $37.5 million at December 28, 2013.  Leasing income net of leasing expense during the first three months of 2014 was $4.1 million compared to $3.1 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 three months of 2014, selling, general and administrative expense increased $0.5 million, or 8.7%, compared to the first three months of 2013.

 

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 three months ended March 29, 2014:

 

										THREE MONTHS ENDED 3/29/14
		TOTAL 12/28/13		OPENED		CLOSED		TOTAL 3/29/14		AVAILABLE FOR RENEWAL		COMPLETED  RENEWALS
Plato’s Closet
Franchises - US and Canada		391		6		0		397		6		6
Once Upon A Child
Franchises - US and Canada		282		6		0		288		12		12
Play It Again Sports
Franchises - US and Canada		300		0		0		300		11		10
Music Go Round
Franchises - US		29		0		0		29		1		1
Style Encore
Franchises - US		3		4		0		7		—		—
Total Franchised Stores		1,005		16		0		1,021		30		29

 

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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 three months of 2014, we renewed 29 of the 30 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
		March 29, 2014		March 30, 2013
Revenue:
Royalties		60.5	%	64.5	%
Leasing income		30.1		25.9
Merchandise sales		5.4		5.1
Franchise fees		2.4		3.1
Other		1.6		1.4
Total revenue		100.0	%	100.0	%
Cost of merchandise sold		(5.2	)	(4.9	)
Leasing expense		(2.1	)	(2.1	)
Provision for credit losses		(0.3	)	(0.1	)
Selling, general and administrative expenses		(41.3	)	(42.1	)
Income from operations		51.1		50.8
Interest expense		(0.4	)	(0.7	)
Interest and other income (expense)		—		(0.1	)
Income before income taxes		50.7		50.0
Provision for income taxes		(19.4	)	(19.2	)
Net income		31.3	%	30.8	%

 

Comparison of Three Months Ended March 29, 2014 to Three Months Ended March 30, 2013

 

Revenue

 

Revenues for the first three months of 2014 totaled $14.6 million compared to $13.1 million for the comparable period in 2013.

 

Royalties and Franchise Fees

 

Royalties increased to $8.8 million for the first three months of 2014 from $8.5 million for the first three months of 2013, a 4.0% increase.  The increase was due to higher Once Upon A Child and Plato’s Closet royalties of $0.2 million and $0.1 million, respectively.  The increase in royalties for these brands is primarily from having 18 additional Once Upon A Child  and 30 additional Plato’s Closet franchise stores in the first three months of 2014 compared to the same period last year.

 

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Franchise fees decreased to $349,000 for the first three months of 2014 compared to $414,600 for the first three months of 2013, primarily as a result of opening five fewer franchises in the 2014 period compared to the same period in 2013.

 

Leasing Income

 

Leasing income increased to $4.4 million for the first three months of 2014 compared to $3.4 million for the same period in 2013.  The increase is primarily due to a higher level of equipment sales to customers as well as the classification of certain leases as sales-type leases in accordance with accounting guidance applicable to lessors.

 

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 increased to $788,000 for the first three months of 2014 compared to $665,700 in the same period of 2013.  The increase is due to an increase in 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 increased to $754,700 for the first three months of 2014 compared to $641,100 in the same period of 2013.  The increase was due to an increase in Direct Franchisee Sales discussed above.  Cost of merchandise sold as a percentage of Direct Franchisee Sales for the first three months of 2014 and 2013 was 95.8% and 96.3%, respectively.

 

Leasing Expense

 

Leasing expense increased to $306,600 for the first three months of 2014 compared to $279,700 for the first three months of 2013.  The increase is primarily due to an increase in the associated cost of equipment sales to customers discussed above.

 

Provision for Credit Losses

 

Provision for credit losses was $38,900 for the first three months of 2014 compared to $13,800 for the first three months of 2013.  The increase in provision for credit losses is primarily due to the increase in lease payments receivable associated with the larger lease portfolio.

 

Selling, General and Administrative

 

Selling, general and administrative expenses increased 8.7% to $6.0 million in the first three months of 2013 from $5.5 million in the same period of 2013.  The increase was primarily due to an increase in compensation and benefits expenses.

 

Interest Expense

 

Interest expense decreased to $62,100 for the first three months of 2014 compared to $89,500 for the first three months of 2013.  The decrease is primarily due to lower average corporate borrowings when compared to last year.

 

Interest and Other Income (Expense)

 

During the first three months of 2013, we had interest and other income of $100 compared to $(10,200) of interest and other income (expense) in the first three months of 2013.  Interest and other income during the first quarter of 2014 included gains on sales of marketable securities that did not occur during the first quarter of 2013.  (See Note 4 — “Investments”).

 

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