WINMARK CORP - Quarter Report: 2016 June (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 June 25, 2016

 

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.

 

Large accelerated filer	o	Accelerated filer x
Non-accelerated filer	o (Do not check if a smaller reporting company)	Smaller reporting company o

 

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, 4,109,760 shares outstanding as of July 15, 2016.

 

 

 

Table of Contents

 

WINMARK CORPORATION AND SUBSIDIARIES

 

INDEX

 

		PAGE
PART I.	FINANCIAL INFORMATION
Item 1.	Financial Statements (Unaudited)
	CONSOLIDATED CONDENSED BALANCE SHEETS: June 25, 2016 and December 26, 2015	3
	CONSOLIDATED CONDENSED STATEMENTS OF OPERATIONS: Three Months Ended June 25, 2016 and June 27, 2015 Six Months Ended June 25, 2016 and June 27, 2015	4
	CONSOLIDATED CONDENSED STATEMENTS OF COMPREHENSIVE INCOME: Three Months Ended June 25, 2016 and June 27, 2015 Six Months Ended June 25, 2016 and June 27, 2015	5
	CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS: Six Months Ended June 25, 2016 and June 27, 2015	6
	NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS	7 – 14
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	15 – 23
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	24
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)

 

		June 25, 2016			December 26, 2015
ASSETS
Current Assets:
Cash and cash equivalents		$	1,058,800		$	1,006,700
Marketable securities		197,300			227,800
Receivables, less allowance for doubtful accounts of $1,900 and $200		1,388,800			1,416,900
Restricted cash		25,000			25,000
Net investment in leases - current		16,486,500			17,741,500
Income tax receivable		768,900			3,290,400
Inventories		81,200			45,200
Prepaid expenses		790,400			677,800
Total current assets		20,796,900			24,431,300
Net investment in leases - long-term		20,477,700			21,246,000
Property and equipment, net		935,700			1,121,500
Goodwill		607,500			607,500
		$	42,817,800		$	47,406,300
LIABILITIES AND SHAREHOLDERS’ EQUITY (DEFICIT)
Current Liabilities:
Notes payable, net of unamortized debt issuance costs of $10,000 and $10,000		$	1,990,000		$	1,990,000
Accounts payable		990,100			1,643,300
Accrued liabilities		2,385,000			1,875,700
Discounted lease rentals		—			38,700
Deferred revenue		1,804,200			1,963,200
Total current liabilities		7,169,300			7,510,900
Long-Term Liabilities:
Line of credit		30,500,000			42,400,000
Notes payable, net of unamortized debt issuance costs of $78,500 and $83,500		20,921,500			21,916,500
Deferred revenue		1,438,000			1,421,600
Other liabilities		1,101,000			1,216,300
Deferred income taxes		3,614,800			3,614,800
Total long-term liabilities		57,575,300			70,569,200
Shareholders’ Equity (Deficit):
Common stock, no par value, 10,000,000 shares authorized, 4,109,760 and 4,124,767 shares issued and outstanding		336,300			406,500
Accumulated other comprehensive loss		(11,500		)	(32,900		)
Retained earnings (accumulated deficit)		(22,251,600		)	(31,047,400		)
Total shareholders’ equity (deficit)		(21,926,800		)	(30,673,800		)
		$	42,817,800		$	47,406,300

 

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 25, 2016			June 27, 2015			June 25, 2016			June 27, 2015
REVENUE:
Royalties		$	10,557,300		$	10,214,400		$	20,829,800		$	19,940,600
Leasing income		4,152,300			3,663,300			8,665,000			13,672,900
Merchandise sales		625,300			686,300			1,362,400			1,420,000
Franchise fees		493,500			475,900			866,000			770,300
Other		471,400			436,800			756,900			697,000
Total revenue		16,299,800			15,476,700			32,480,100			36,500,800
COST OF MERCHANDISE SOLD		588,300			645,800			1,285,700			1,344,000
LEASING EXPENSE		460,100			510,500			1,364,200			4,767,900
PROVISION FOR CREDIT LOSSES		(7,900		)	(93,100		)	(22,300		)	(162,200		)
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES		5,936,200			6,329,300			12,490,800			12,492,800
Income from operations		9,323,100			8,084,200			17,361,700			18,058,300
INTEREST EXPENSE		(593,800		)	(369,500		)	(1,234,500		)	(455,200		)
INTEREST AND OTHER INCOME (EXPENSE)		9,500			9,700			(1,000		)	(49,400		)
Income before income taxes		8,738,800			7,724,400			16,126,200			17,553,700
PROVISION FOR INCOME TAXES		(3,344,500		)	(2,973,000		)	(6,169,000		)	(6,748,000		)
NET INCOME		$	5,394,300		$	4,751,400		$	9,957,200		$	10,805,700
EARNINGS PER SHARE – BASIC		$	1.31		$	1.04		$	2.42		$	2.26
EARNINGS PER SHARE – DILUTED		$	1.25		$	1.00		$	2.31		$	2.18
WEIGHTED AVERAGE SHARES OUTSTANDING – BASIC		4,110,429			4,578,934			4,112,254			4,789,205
WEIGHTED AVERAGE SHARES OUTSTANDING – DILUTED		4,318,763			4,768,777			4,316,346			4,968,122

 

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						Six Months Ended
		June 25, 2016			June 27, 2015			June 25, 2016			June 27, 2015
NET INCOME		$	5,394,300		$	4,751,400		$	9,957,200		$	10,805,700
OTHER COMPREHENSIVE INCOME (LOSS), BEFORE TAX:
Unrealized net gains (losses) on marketable securities:
Unrealized holding net gains (losses) arising during period		18,700			(10,000		)	34,300			38,700
Reclassification adjustment for net gains included in net income		—			—			—			(2,300		)
OTHER COMPREHENSIVE INCOME (LOSS), BEFORE TAX		18,700			(10,000		)	34,300			36,400
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		(7,000		)	3,700			(12,900		)	(14,800		)
Reclassification adjustment for net gains included in net income		—			—			—			900
INCOME TAX (EXPENSE) BENEFIT RELATED TO ITEMS OF OTHER COMPREHENSIVE INCOME		(7,000		)	3,700			(12,900		)	(13,900		)
OTHER COMPREHENSIVE INCOME (LOSS), NET OF TAX		11,700			(6,300		)	21,400			22,500
COMPREHENSIVE INCOME		$	5,406,000		$	4,745,100		$	9,978,600		$	10,828,200

 

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 25, 2016			June 27, 2015
OPERATING ACTIVITIES:
Net income		$	9,957,200		$	10,805,700
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation		217,300			214,200
Provision for credit losses		(22,300		)	(162,200		)
Compensation expense related to stock options		882,200			820,400
Deferred income taxes		—			(2,058,900		)
Loss on sale of marketable securities		12,600			22,800
Deferred initial direct costs		(326,100		)	(279,800		)
Amortization of deferred initial direct costs		234,200			395,800
Tax benefits on exercised stock options		(9,700		)	(16,600		)
Change in operating assets and liabilities:
Receivables		28,100			86,700
Income tax receivable		2,518,300			2,778,400
Inventories		(36,000		)	32,700
Prepaid expenses		(112,600		)	(114,200		)
Accounts payable		(653,200		)	(400,000		)
Accrued and other liabilities		406,000			496,400
Rents received in advance and security deposits		202,800			21,700
Deferred revenue		(142,600		)	156,900
Net cash provided by operating activities		13,156,200			12,800,000
INVESTING ACTIVITIES:
Proceeds from sale of marketable securities		52,200			299,000
Purchase of marketable securities		—			(33,800		)
Purchase of property and equipment		(31,500		)	(87,600		)
Purchase of equipment for lease contracts		(10,585,600		)	(11,417,300		)
Principal collections on lease receivables		12,474,600			16,606,800
Net cash provided by investing activities		1,909,700			5,367,100
FINANCING ACTIVITIES:
Proceeds from borrowings on line of credit		6,500,000			51,600,000
Payments on line of credit		(18,400,000		)	(21,000,000		)
Proceeds from borrowings on notes payable		—			25,000,000
Payments on notes payable		(1,000,000		)	—
Repurchases of common stock		(1,573,900		)	(74,261,500		)
Proceeds from exercises of stock options		150,200			159,000
Dividends paid		(699,800		)	(650,100		)
Tax benefits on exercised stock options		9,700			16,600
Net cash used for financing activities		(15,013,800		)	(19,136,000		)
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS		52,100			(968,900		)
Cash and cash equivalents, beginning of period		1,006,700			2,089,700
Cash and cash equivalents, end of period		$	1,058,800		$	1,120,800
SUPPLEMENTAL DISCLOSURES:
Cash paid for interest		$	939,800		$	157,900
Cash paid for income taxes		$	3,650,700		$	6,028,500

 

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 six months ended June 25, 2016 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 (deficit) 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®, Style Encore® and Music Go Round®.  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:

 

		June 25, 2016						December 26, 2015
		Cost			Fair Value			Cost			Fair Value
Equity securities		$	215,800		$	197,300		$	280,600		$	227,800

 

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

 

		June 25, 2016			December 26, 2015
Unrealized gains		$	—		$	—
Unrealized losses		(18,500		)	(52,800		)
Net unrealized losses		$	(18,500	)	$	(52,800	)

 

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

 

		Three Months Ended						Six Months Ended
		June 25, 2016			June 27, 2015			June 25, 2016			June 27, 2015
Realized gains		$	—		$	—		$	—		$	13,400
Realized losses		(6,400		)	—			(12,600		)	(36,200		)
Net realized losses		$	(6,400	)	$	—		$	(12,600	)	$	(22,800	)

 

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:

 

		June 25, 2016			December 26, 2015
Direct financing and sales-type leases:
Minimum lease payments receivable		$	34,906,500		$	37,181,600
Estimated residual value of equipment		4,417,700			4,511,000
Unearned lease income net of initial direct costs deferred		(5,033,200		)	(4,999,700		)
Security deposits		(3,850,400		)	(3,640,500		)
Equipment installed on leases not yet commenced		7,167,500			6,754,200
Total investment in direct financing and sales-type leases		37,608,100			39,806,600
Allowance for credit losses		(817,100		)	(859,100		)
Net investment in direct financing and sales-type leases		36,791,000			38,947,500
Operating leases:
Operating lease assets		1,147,300			1,083,300
Less accumulated depreciation and amortization		(974,100		)	(1,043,300		)
Net investment in operating leases		173,200			40,000
Total net investment in leasing operations		$	36,964,200		$	38,987,500

 

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As of June 25, 2016, the $37.0 million total net investment in leases consists of $16.5 million classified as current and $20.5 million classified as long-term.  As of December 26, 2015, the $39.0 million total net investment in leases consists of $17.7 million classified as current and $21.3 million classified as long-term.

 

As of June 25, 2016, leased assets with three customers approximated 21%, 13% and 10%, respectively, 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 2016 and the full fiscal years thereafter as of June 25, 2016:

 

		Direct Financing and Sales-Type Leases						Operating Leases
		Minimum Lease Payments Receivable			Income Amortization			Minimum Lease Payments Receivable
2016		$	12,004,400		$	2,240,000		$	41,300
2017		16,095,000			2,304,900			18,000
2018		6,167,600			473,300			—
2019		611,400			12,000			—
2020		8,400			1,500			—
Thereafter		19,700			1,500			—
		$	34,906,500		$	5,033,200		$	59,300

 

The activity in the allowance for credit losses for leasing operations during the first six months of 2016 and 2015, respectively, is as follows:

 

		June 25, 2016			June 27, 2015
Balance at beginning of period		$	859,100		$	386,000
Provisions charged to expense		(22,300		)	(162,200		)
Recoveries		9,600			630,300
Deductions for amounts written-off		(29,300		)	(9,300		)
Balance at end of period		$	817,100		$	844,800

 

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:

 

		June 25, 2016						December 26, 2015
		Investment In Leases			Allowance for Credit Losses			Investment In Leases			Allowance for Credit Losses
Collectively evaluated for loss potential		$	37,608,100		$	817,100		$	39,806,600		$	859,100
Individually evaluated for loss potential		—			—			—			—
Total		$	37,608,100		$	817,100		$	39,806,600		$	859,100

 

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.

 

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		June 25, 2016
		0-60 Days Delinquent and Accruing			61-90 Days Delinquent and Accruing			Over 90 Days Delinquent and Accruing			Non-Accrual			Total
Middle-Market		$	36,403,700		$	—		$	—		$	—		$	36,403,700
Small-Ticket		1,204,400			—			—			—			1,204,400
Total Investment in Leases		$	37,608,100		$	—		$	—		$	—		$	37,608,100

 

		December 26, 2015
		0-60 Days Delinquent and Accruing			61-90 Days Delinquent and Accruing			Over 90 Days Delinquent and Accruing			Non-Accrual			Total
Middle-Market		$	38,616,600		$	—		$	—		$	—		$	38,616,600
Small-Ticket		1,185,800			4,200			—			—			1,190,000
Total Investment in Leases		$	39,802,400		$	4,200		$	—		$	—		$	39,806,600

 

6.              Recent Accounting Pronouncements:

 

In May 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2014-09, Revenue from Contracts with Customers, which provides guidance for revenue recognition that supersedes existing revenue recognition guidance (but does not apply to nor supersede accounting guidance for lease contracts).  The ASU’s core principle is that an entity will recognize revenue when it transfers promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.  The ASU also requires more detailed disclosures to enable users of financial statements to understand the nature, amount, timing and uncertainty of revenue and cash flows arising from contracts with customers.  The ASU is effective for reporting periods beginning after December 15, 2016, and should be applied retrospectively to each prior reporting period presented or retrospectively with the cumulative effect of initially applying the ASU recognized at the date of initial application.  In July 2015, the FASB affirmed its proposal to defer the effective date by one year.  The new standard will become effective for the Company beginning with the first quarter of fiscal 2018.  The Company is currently in the process of evaluating the impact of the adoption of this ASU on the Company’s consolidated financial statements.

 

In January 2016, the FASB issued ASU 2016-01, Financial Statements — Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities, which requires equity investments in unconsolidated entities (other than those accounted for using the equity method of accounting) to be measured at fair value with changes in fair value recognized in net income.  There will no longer be an available-for-sale classification for equity securities with readily determinable fair values.  The new guidance is effective for periods beginning after December 15, 2017, with early adoption permitted.  The Company is currently in the process of evaluating the impact of the adoption of this ASU on the Company’s consolidated financial statements.

 

In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842), which provides guidance on accounting for leases that supersedes existing lease accounting guidance.  The ASU’s core principle is that a lessee should recognize lease assets and lease liabilities for those leases classified as operating leases under existing lease accounting guidance.  The new standard also makes targeted changes to lessor accounting.  This guidance is effective for reporting periods beginning after December 15, 2018, with early adoption permitted.  The provisions of this guidance are to be applied using a modified retrospective approach, with elective reliefs, which requires application of the guidance for all periods presented.  The Company is currently in the process of evaluating the impact of the adoption of this ASU on the Company’s consolidated financial statements.

 

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In March 2016, the FASB issued ASU 2016-09, Compensation-Stock Compensation: Improvements to Employee Share-Based Payment Accounting, which simplifies the accounting for the taxes related to stock based compensation, including adjustments to how excess tax benefits should be classified.  This guidance will be effective for reporting periods beginning after December 15, 2016, with early adoption permitted.  The Company is currently in the process of evaluating the impact of the adoption of this ASU on the Company’s consolidated financial statements.

 

In June 2016, the FASB issued ASU 2016-13, Financial Instruments — Credit Losses (Topic 326): Measurement of Credit Losses of Financial Instruments, which changes the methodology for measuring credit losses on financial instruments and the timing of when such losses are recorded.  This guidance will be effective for reporting periods beginning after December 15, 2019 with early adoption permitted.  The Company is currently in the process of evaluating the impact of the adoption of this ASU on the Company’s consolidated financial statements.

 

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				Six Months Ended
		June 25, 2016		June 27, 2015		June 25, 2016		June 27, 2015
Denominator for basic EPS – weighted average common shares		4,110,429		4,578,934		4,112,254		4,789,205
Dilutive shares associated with option plans		208,334		189,843		204,092		178,917
Denominator for diluted EPS – weighted average common shares and dilutive potential common shares		4,318,763		4,768,777		4,316,346		4,968,122
Options excluded from EPS calculation – anti-dilutive		19,172		16,692		21.455		26,372

 

8.     Shareholders’ Equity (Deficit):

 

Dividends

 

On January 27, 2016, the Company’s Board of Directors approved the payment of a $0.07 per share quarterly cash dividend to shareholders of record at the close of business on February 10, 2016, which was paid on March 1, 2016.

 

On April 27, 2016, the Company’s Board of Directors approved the payment of a $0.10 per share quarterly cash dividend to shareholders of record at the close of business on May 11, 2016, which was paid on June 1, 2016.

 

Repurchase of Common Stock

 

In the first six months of 2016 the Company repurchased 17,194 shares of its common stock.  Under the Board of Directors’ authorization, as of June 25, 2016, the Company has the ability to repurchase additional 142,988 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.  The Company has authorized up to 500,000 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 350,000 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 June 25, 2016 was as follows:

 

		Number of Shares		Weighted Average Exercise Price			Weighted Average Remaining Contractual Life (years)		Intrinsic Value
Outstanding at December 26, 2015		668,740		$	53.73		6.41		$	25,582,300
Granted		34,300		98.25
Exercised		(2,187	)	68.69
Forfeited		(3,501	)	80.31
Outstanding at June 25, 2016		697,352		$	55.74		6.09		$	29,349,500
Exercisable at June 25, 2016		489,067		$	44.07		5.03		$	26,275,800

 

The fair value of options granted under the Option Plans during the first six months of 2016 and 2015 were estimated on the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions and results:

 

		Six Months Ended
		June 25, 2016			June 27, 2015
Risk free interest rate		1.52		%	1.68		%
Expected life (years)		6			6
Expected volatility		27.1		%	30.8		%
Dividend yield		1.38		%	1.34		%
Option fair value		$	23.78		$	25.48

 

All unexercised options at June 25, 2016 have an exercise price equal to the fair market value on the date of the grant.

 

Compensation expense of $882,200 and $820,400 relating to the vested portion of the fair value of stock options granted was expensed to “Selling, General and Administrative Expenses” in the first six months of 2016 and 2015, respectively.  As of June 25, 2016, the Company had $3.9 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 2.6 years.

 

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9.  Debt:

 

Line of Credit

 

As of June 25, 2016, there were $30.5 million in borrowings outstanding under the Company’s Line of Credit with the PrivateBank and Trust Company and BMO Harris Bank N.A., bearing interest ranging from 2.70% to 3.50%, leaving $24.5 million available for additional borrowings.

 

The Line of Credit 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 June 25, 2016, the Company was in compliance with all of its financial covenants.

 

Notes Payable

 

As of June 25, 2016, the Company had $23.0 million in principal outstanding from the $25.0 million Note Agreement (the “Note Agreement”) entered into in May 2015 with Prudential Investment Management, Inc., its affiliates and managed accounts (“Prudential”).

 

The final maturity of the notes is 10 years.  Interest at a rate of 5.50% per annum on the outstanding principal balance is payable quarterly, along with required prepayments of the principal of $500,000 quarterly for the first five years, and $750,000 quarterly thereafter until the principal is paid in full.  The notes may be prepaid, at the option of the Company, in whole or in part (in a minimum amount of $1.0 million), but prepayments require payment of a Yield Maintenance Amount, as defined in the Note Agreement.

 

The Company’s obligations under the Note Agreement are secured by a lien against substantially all of the Company’s assets (as the notes rank pari passu with the Line of Credit), and the Note Agreement contains customary financial conditions and covenants, and requires maintenance of minimum levels of fixed charge coverage and tangible net worth and maximum levels of leverage (all as defined within the Note Agreement).  As of June 25, 2016, the Company was in compliance with all of its financial covenants.

 

In connection with the Note Agreement, the Company incurred debt issuance costs, of which unamortized amounts are presented as a direct deduction from the carrying amount of the related liability.

 

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, prepaid expenses, 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:

 

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		Three Months Ended						Six Months Ended
		June 25, 2016			June 27, 2015			June 25, 2016			June 27, 2015
Revenue:
Franchising		$	12,147,500		$	11,813,400		$	23,815,100		$	22,827,900
Leasing		4,152,300			3,663,300			8,665,000			13,672,900
Total revenue		$	16,299,800		$	15,476,700		$	32,480,100		$	36,500,800
Reconciliation to operating income:
Franchising segment contribution		$	6,865,100		$	6,214,700		$	12,774,800		$	11,851,500
Leasing segment contribution		2,458,000			1,869,500			4,586,900			6,206,800
Total operating income		$	9,323,100		$	8,084,200		$	17,361,700		$	18,058,300
Depreciation:
Franchising		$	83,700		$	84,600		$	168,500		$	169,900
Leasing		24,400			22,000			48,800			44,300
Total depreciation		$	108,100		$	106,600		$	217,300		$	214,200

 

		As of
		June 25, 2016			December 26, 2015
Identifiable assets:
Franchising		$	2,920,000		$	3,100,900
Leasing		37,956,200			39,687,400
Unallocated		1,941,600			4,618,000
Total		$	42,817,800		$	47,406,300

 

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

 

Overview

 

As of June 25, 2016, we had 1,169 franchises operating under the Plato’s Closet, Once Upon A Child, Play It Again Sports, Style Encore and Music Go Round brands and had a leasing portfolio of $37.0 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 significant source of franchising revenue is royalties received from our franchise partners.  During the first six months of 2016, our royalties increased $0.9 million or 4.5% compared to the first six months of 2015.

 

Leasing income net of leasing expense during the first six months of 2016 was $7.3 million compared to $8.9 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.  During the first six months of 2016, we purchased $10.6 million in equipment for lease customers compared to $11.4 million in the first six months of 2015.  Our leasing portfolio (net investment in leases — current and long-term) decreased to $37.0 million at June 25, 2016 from $39.0 million at December 26, 2015.

 

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 six months of 2016, selling, general and administrative expenses were comparable to the first six months of 2015.

 

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 six months ended June 25, 2016:

 

										SIX MONTHS ENDED 6/25/16
		TOTAL 12/26/15		OPENED		CLOSED		TOTAL 6/25/16		AVAILABLE FOR RENEWAL		COMPLETED RENEWALS
Plato’s Closet
Franchises - US and Canada		456		10		(2	)	464		14		13
Once Upon A Child
Franchises - US and Canada		326		15		(2	)	339		14		14
Play It Again Sports
Franchises - US and Canada		297		0		(12	)	285		10		9
Style Encore
Franchises - US		38		11		(1	)	48		—		—
Music Go Round
Franchises - US		33		0		(0	)	33		3		3
Total Franchised Stores		1,150		36		(17	)	1,169		41		39

 

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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 six months of 2016, we renewed 39 of the 41 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 portfolio, 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				Six Months Ended
		June 25, 2016		June 27, 2015		June 25, 2016		June 27, 2015
Revenue:
Royalties		64.8	%	66.0	%	64.1	%	54.6	%
Leasing income		25.5		23.7		26.7		37.5
Merchandise sales		3.8		4.4		4.2		3.9
Franchise fees		3.0		3.1		2.7		2.1
Other		2.9		2.8		2.3		1.9
Total revenue		100.0		100.0		100.0		100.0
Cost of merchandise sold		(3.6	)	(4.2	)	(4.0	)	(3.7	)
Leasing expense		(2.8	)	(3.3	)	(4.2	)	(13.1	)
Provision for credit losses		—		0.6		0.1		0.4
Selling, general and administrative expenses		(36.4	)	(40.9	)	(38.4	)	(34.2	)
Income from operations		57.2		52.2		53.5		49.4
Interest expense		(3.6	)	(2.4	)	(3.8	)	(1.3	)
Interest and other income (expense)		—		0.1		—		—
Income before income taxes		53.6		49.9		49.7		48.1
Provision for income taxes		(20.5	)	(19.2	)	(19.0	)	(18.5	)
Net income		33.1	%	30.7	%	30.7	%	29.6	%

 

Comparison of Three Months Ended June 25, 2016 to Three Months Ended June 27, 2015

 

Revenue

 

Revenues for the quarter ended June 25, 2016 totaled $16.3 million compared to $15.5 million for the comparable period in 2015.

 

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