WINMARK CORP - Quarter Report: 2020 September (Form 10-Q)

Nine Months Ended

Nine Months Ended

September 26, 2020

September 28, 2019

Cash paid for amounts included in the measurement of lease liabilities:

Operating cash flow outflow from operating leases

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

☒

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

For the quarterly period ended September 26, 2020

☐

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)


Minnesota		41-1622691
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

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)

Securities registered pursuant to Section 12(b) of the Act:


Title of each class:	Trading Symbol	Name of each exchange on which registered:
Common Stock, no par value per share	WINA	Nasdaq Global Market

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 ☒ No ☐

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted 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 such files).

Yes ☒ No ☐

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

Large accelerated filer ☐

Non-accelerated filer ☒

Accelerated filer ☐

Smaller reporting company ☒

Emerging growth company ☐

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) 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 ☐ No ☒

Common stock, no par value, 3,740,296 shares outstanding as of October 16, 2020.

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WINMARK CORPORATION AND SUBSIDIARIES

INDEX


		PAGE

PART I.	FINANCIAL INFORMATION

Item 1.	Financial Statements (Unaudited)

	CONSOLIDATED CONDENSED BALANCE SHEETS September 26, 2020 and December 28, 2019	3

	CONSOLIDATED CONDENSED STATEMENTS OF OPERATIONS Three Months Ended September 26, 2020 and September 28, 2019 Nine Months Ended September 26, 2020 and September 28, 2019	4

	CONSOLIDATED CONDENSED STATEMENTS OF SHAREHOLDERS’ EQUITY (DEFICIT): Three Months Ended September 26, 2020 and September 28, 2019 Nine Months Ended September 26, 2020 and September 28, 2019	5

	CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS Nine Months Ended September 26, 2020 and September 28, 2019	6

	NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS	7

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	14

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	23

Item 4.	Controls and Procedures	23

PART II.	OTHER INFORMATION	24

Item 1.	Legal Proceedings	24

Item 1A.	Risk Factors	24

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 26, 2020		December 28, 2019
ASSETS
Current Assets:
Cash and cash equivalents	$	8,267,400	$	25,130,300
Restricted cash		50,000		50,000
Receivables, less allowance for doubtful accounts of $800 and $1,900		1,947,600		1,669,500
Net investment in leases - current		10,514,200		12,800,100
Income tax receivable		—		497,900
Inventories		85,100		86,000
Prepaid expenses		1,158,800		968,100
Total current assets		22,023,100		41,201,900
Net investment in leases - long-term		5,090,800		12,505,500
Property and equipment, net		2,439,100		2,772,600
Operating lease right of use assets		3,301,800		3,595,200
Goodwill		607,500		607,500
Other assets		458,300		492,500
Deferred income taxes		1,918,000		667,000
	$	35,838,600	$	61,842,200
LIABILITIES AND SHAREHOLDERS’ EQUITY (DEFICIT)
Current Liabilities:
Notes payable, net of unamortized debt issuance costs of $13,900 and $13,900	$	4,236,100	$	3,736,100
Accounts payable		1,272,700		1,015,000
Income tax payable		472,500		—
Accrued liabilities		2,478,000		2,783,100
Discounted lease rentals		1,522,500		2,680,700
Deferred revenue		1,675,200		1,717,000
Total current liabilities		11,657,000		11,931,900
Long-Term Liabilities:
Notes payable, net of unamortized debt issuance costs of $58,300 and $68,700		18,691,700		21,868,800
Discounted lease rentals		763,000		836,900
Deferred revenue		7,270,000		7,858,500
Operating lease liabilities		5,417,500		5,846,100
Other liabilities		873,100		1,051,700
Total long-term liabilities		33,015,300		37,462,000
Shareholders’ Equity (Deficit):
Common stock, no par value, 10,000,000 shares authorized, 3,735,437 and 3,947,858 shares issued and outstanding		7,717,800		11,929,300
Retained earnings (accumulated deficit)		(16,551,500)		519,000
Total shareholders’ equity (deficit)		(8,833,700)		12,448,300
	$	35,838,600	$	61,842,200

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 26, 2020		September 28, 2019		September 26, 2020		September 28, 2019
Revenue:
Royalties	$	14,210,000	$	13,808,800	$	33,188,300	$	38,223,400
Leasing income		2,695,800		4,375,500		12,040,800		12,733,800
Merchandise sales		631,200		704,500		1,746,800		2,037,300
Franchise fees		335,400		377,400		1,064,900		1,183,100
Other		404,600		414,700		1,225,700		1,238,700
Total revenue		18,277,000		19,680,900		49,266,500		55,416,300
Cost of merchandise sold		598,200		671,700		1,662,000		1,924,400
Leasing expense		510,900		572,400		2,443,700		1,642,000
Provision for credit losses		(339,600)		(55,500)		164,300		23,900
Selling, general and administrative expenses		5,009,700		6,217,600		15,719,100		19,637,900
Income from operations		12,497,800		12,274,700		29,277,400		32,188,100
Interest expense		(345,700)		(406,200)		(1,409,600)		(1,348,700)
Interest and other income (expense)		9,200		500		27,700		(5,900)
Income before income taxes		12,161,300		11,869,000		27,895,500		30,833,500
Provision for income taxes		(2,802,500)		(2,755,200)		(6,164,500)		(7,145,600)
Net income	$	9,358,800	$	9,113,800	$	21,731,000	$	23,687,900
Earnings per share - basic	$	2.51	$	2.39	$	5.86	$	6.19
Earnings per share - diluted	$	2.43	$	2.24	$	5.63	$	5.76
Weighted average shares outstanding - basic		3,730,490		3,808,863		3,710,112		3,829,329
Weighted average shares outstanding - diluted		3,857,702		4,065,301		3,857,754		4,112,318

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

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WINMARK CORPORATION AND SUBSIDIARIES

CONSOLIDATED CONDENSED STATEMENTS OF SHAREHOLDERS’ EQUITY (DEFICIT)

(Unaudited)


					Retained
					Earnings
	Common Stock			(Accumulated
	Shares	Amount		Deficit)		Total
BALANCE, December 28, 2019	3,947,858		11,929,300	$	519,000	$	12,448,300
Repurchase of common stock	(300,000)		(12,215,500)		(36,772,000)		(48,987,500)
Stock options exercised	2,895		145,900		—		145,900
Compensation expense relating to stock options	—		140,300		—		140,300
Cash dividends ($0.25 per share)	—		—		(912,200)		(912,200)
Comprehensive income (Net income)	—		—		7,317,000		7,317,000
BALANCE, March 28, 2020	3,650,753		—		(29,848,200)		(29,848,200)
Stock options exercised	72,434		6,013,600		—		6,013,600
Compensation expense relating to stock options	—		397,700		—		397,700
Cash dividends ($0.05 per share)	—		—		(184,500)		(184,500)
Comprehensive income (Net income)	—		—		5,055,200		5,055,200
BALANCE, June 27, 2020	3,723,187		6,411,300		(24,977,500)		(18,566,200)
Stock options exercised	12,250		914,600		—		914,600
Compensation expense relating to stock options	—		391,900		—		391,900
Cash dividends ($0.25 per share)	—		—		(932,800)		(932,800)
Comprehensive income (Net income)	—		—		9,358,800		9,358,800
BALANCE, September 26, 2020	3,735,437	$	7,717,800	$	(16,551,500)	$	(8,833,700)


					Retained
					Earnings
	Common Stock			(Accumulated
	Shares	Amount		Deficit)		Total
BALANCE, December 29, 2018	3,907,686	$	4,425,600	$	(9,234,100)	$	(4,808,500)
Repurchase of common stock	(150,000)		(5,081,000)		(18,947,100)		(24,028,100)
Stock options exercised	1,500		156,600		—		156,600
Compensation expense relating to stock options	—		498,800		—		498,800
Cash dividends ($0.15 per share)	—		—		(586,100)		(586,100)
Comprehensive income (Net income)	—		—		7,272,200		7,272,200
BALANCE, March 30, 2019	3,759,186		—		(21,495,100)		(21,495,100)
Stock options exercised	22,153		788,800		—		788,800
Compensation expense relating to stock options	—		516,800		—		516,800
Cash dividends ($0.25 per share)	—		—		(942,800)		(942,800)
Comprehensive income (Net income)	—		—		7,301,900		7,301,900
BALANCE, June 29, 2019	3,781,339		1,305,600		(15,136,000)		(13,830,400)
Stock options exercised	41,639		2,049,600		—		2,049,600
Compensation expense relating to stock options	—		495,800		—		495,800
Cash dividends ($0.25 per share)	—		—		(954,800)		(954,800)
Comprehensive income (Net income)	—		—		9,113,800		9,113,800
BALANCE, September 28, 2019	3,822,978	$	3,851,000	$	(6,977,000)	$	(3,126,000)

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 26, 2020		September 28, 2019
OPERATING ACTIVITIES:
Net income	$	21,731,000	$	23,687,900
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		366,700		276,700
Provision for credit losses		164,300		23,900
Compensation expense related to stock options		929,900		1,511,400
Deferred income taxes		(1,251,000)		(1,320,800)
Loss from disposal of property and equipment		200		—
Deferred initial direct costs		(18,300)		(87,400)
Amortization of deferred initial direct costs		89,400		492,800
Operating lease right of use asset amortization		293,400		285,000
Tax benefits on exercised stock options		602,400		580,700
Change in operating assets and liabilities:
Receivables		(278,100)		(41,300)
Principal collections on lease receivables		11,418,500		14,407,300
Income tax receivable/payable		368,000		(406,900)
Inventories		900		37,900
Prepaid expenses		(190,700)		(110,900)
Other assets		34,200		(18,600)
Accounts payable		257,700		(166,500)
Accrued and other liabilities		(864,100)		(519,300)
Rents received in advance and security deposits		(1,252,000)		(149,500)
Deferred revenue		(630,300)		(414,500)
Net cash provided by operating activities		31,772,100		38,067,900
INVESTING ACTIVITIES:
Purchase of property and equipment		(33,400)		(135,200)
Purchase of equipment for lease contracts		(3,128,200)		(7,936,600)
Net cash used for investing activities		(3,161,600)		(8,071,800)
FINANCING ACTIVITIES:
Proceeds from borrowings on line of credit		46,600,000		18,800,000
Payments on line of credit		(46,600,000)		(18,800,000)
Payments on notes payable		(2,687,500)		(2,437,500)
Repurchases of common stock		(48,987,500)		(24,028,100)
Proceeds from exercises of stock options		7,074,100		2,995,000
Dividends paid		(2,029,500)		(2,483,700)
Proceeds from discounted lease rentals		1,157,000		944,400
Net cash used for financing activities		(45,473,400)		(25,009,900)
NET INCREASE (DECREASE) IN CASH, CASH EQUIVALENTS AND RESTRICTED CASH		(16,862,900)		4,986,200
Cash, cash equivalents and restricted cash, beginning of period		25,180,300		2,576,000
Cash, cash equivalents and restricted cash, end of period	$	8,317,400	$	7,562,200
SUPPLEMENTAL DISCLOSURES:
Cash paid for interest	$	1,426,100	$	1,322,800
Cash paid for income taxes	$	6,445,200	$	8,292,700
Non-cash landlord leasehold improvements	$	—	$	2,139,000

The following table provides a reconciliation of cash, cash equivalents and restricted cash reported within the Consolidated Condensed Balance Sheets to the total of the same amounts shown above:
	Nine Months Ended
	September 26, 2020		September 28, 2019
Cash and cash equivalents	$	8,267,400	$	7,487,200
Restricted cash		50,000		75,000
Total cash, cash equivalents and restricted cash	$	8,317,400	$	7,562,200

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 26, 2020 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. Recent Accounting Pronouncements:

Recently Issued Accounting Pronouncements

In June 2016, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“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 was to be effective for reporting periods beginning after December 15, 2019, with early adoption permitted. In November 2019, the FASB issued ASU 2019-10, Financial Instruments – Credit Losses (Topic 326), Derivatives and Hedging (Topic 815), and Leases (Topic 842) Effective Dates, which deferred the effective dates for the Company, as a smaller reporting company, until fiscal year 2023. The Company currently plans to adopt the guidance at the beginning of fiscal 2023. The Company is continuing to assess the impact of the standard on its consolidated financial statements.

4. Contract Liabilities:

The Company’s contract liabilities for its franchise revenues consist of deferred revenue associated with franchise fees and software license fees. The table below presents the activity of the current and noncurrent deferred franchise revenue during the first nine months of 2020 and 2019, respectively:


	September 26, 2020		September 28, 2019
Balance at beginning of period	$	9,575,500	$	10,177,300
Franchise and software license fees collected from franchisees, excluding amount earned as revenue during the period		656,700		979,700
Fees earned that were included in the balance at the beginning of the period		(1,287,000)		(1,394,200)
Balance at end of period	$	8,945,200	$	9,762,800

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The following table illustrates future estimated revenue to be recognized for the remainder of 2020 and full fiscal years thereafter related to performance obligations that are unsatisfied (or partially unsatisfied) as of September 26, 2020.


Contract Liabilities expected to be recognized in	Amount
2020	$	425,500
2021		1,642,800
2022		1,497,800
2023		1,326,600
2024		1,128,800
Thereafter		2,923,700
	$	8,945,200

5. 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.

Due to their nature, the carrying value of cash equivalents, receivables, payables and debt obligations approximates fair value.

6. Investment in Leasing Operations:

Investment in leasing operations consists of the following:


	September 26, 2020		December 28, 2019
Direct financing and sales-type leases:
Minimum lease payments receivable	$	16,854,200	$	26,001,200
Estimated unguaranteed residual value of equipment		2,992,600		4,109,800
Unearned lease income, net of initial direct costs deferred		(1,823,600)		(4,039,400)
Security deposits		(2,637,800)		(3,852,000)
Equipment installed on leases not yet commenced		660,300		3,437,800
Total investment in direct financing and sales-type leases		16,045,700		25,657,400
Allowance for credit losses		(583,600)		(580,600)
Net investment in direct financing and sales-type leases		15,462,100		25,076,800
Operating leases:
Operating lease assets		707,100		820,700
Less accumulated depreciation and amortization		(564,200)		(591,900)
Net investment in operating leases		142,900		228,800
Total net investment in leasing operations	$	15,605,000	$	25,305,600

As of September 26, 2020, the $15.6 million total net investment in leases consists of $10.5 million classified as current and $5.1 million classified as long-term. As of December 28, 2019, the $25.3 million total net investment in leases consists of $12.8 million classified as current and $12.5 million classified as long-term.

As of September 26, 2020, there were no customers with leased assets greater than 10% of the Company’s total assets.

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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 2020 and the full fiscal years thereafter as of September 26, 2020:


	Direct Financing and Sales-Type Leases
	Minimum Lease		Income
Fiscal Year	Payments Receivable		Amortization
2020	$	3,382,200	$	564,900
2021		10,571,100		1,099,900
2022		2,726,500		150,200
2023		145,700		6,200
2024		15,200		1,700
Thereafter		13,500		700
	$	16,854,200	$	1,823,600

The activity in the allowance for credit losses for leasing operations during the first nine months of 2020 and 2019, respectively, is as follows:


	September 26, 2020		September 28, 2019
Balance at beginning of period	$	580,600	$	861,200
Provisions charged to expense		164,300		23,900
Recoveries		(12,400)		15,700
Deductions for amounts written-off		(148,900)		(224,000)
Balance at end of period	$	583,600	$	676,800

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:


	September 26, 2020				December 28, 2019
	Investment		Allowance for		Investment		Allowance for
	In Leases		Credit Losses		In Leases		Credit Losses
Collectively evaluated for loss potential	$	16,045,700		583,600	$	25,657,400	$	580,600
Individually evaluated for loss potential		—		—		—		—
Total	$	16,045,700	$	583,600	$	25,657,400	$	580,600

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 26, 2020
	0-60 Days		61-90 Days		Over 90 Days
	Delinquent		Delinquent		Delinquent and
	and Accruing		and Accruing		Accruing		Non-Accrual		Total
Middle-Market	$	15,051,900	$	—	$	—	$	—	$	15,051,900
Small-Ticket		993,800		—		—		—		993,800
Total Investment in Leases	$	16,045,700	$	—	$	—	$	—	$	16,045,700


	December 28, 2019
	0-60 Days		61-90 Days		Over 90 Days
	Delinquent		Delinquent		Delinquent and
	and Accruing		and Accruing		Accruing		Non-Accrual		Total
Middle-Market	$	24,546,300	$	—	$	—	$	—	$	24,546,300
Small-Ticket		1,111,100		—		—		—		1,111,100
Total Investment in Leases	$	25,657,400	$	—	$	—	$	—	$	25,657,400

The Company leases high-technology and other business-essential equipment to its leasing customers. Upon expiration of the initial term or extended lease term, depending on the structure of the lease, the customer may return the

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equipment, renew the lease for an additional term, or purchase the equipment. Due to the uncertainty of such outcome at the end of the lease term, the lease as recorded at commencement represents only the current terms of the agreement. As a lessor, the Company’s leases do not contain non-lease components. The residual values reflect the estimated amounts to be received at lease termination from sales or other dispositions of leased equipment to unrelated parties. The leased equipment residual values are based on the Company’s best estimate. The Company’s risk management strategy for its residual value includes the contractual obligations of customer to maintain, service, and insure the leased equipment, the use of third party remarketers as well as the analytical review of historical asset dispositions.

Leasing income as presented on the Consolidated Condensed Statements of Operations consists of the following:


	Three Months Ended		Three Months Ended		Nine Months Ended		Nine Months Ended
	September 26, 2020		September 28, 2019		September 26, 2020		September 28, 2019
Interest income on direct financing and sales-type leases	$	839,600	$	1,856,000	$	2,947,900	$	6,066,800
Selling profit (loss) at commencement of sales-type leases		267,700		1,098,100		1,453,600		1,971,600
Operating lease income		668,600		702,600		1,758,500		1,908,700
Income on sales of equipment under lease		913,400		496,600		5,078,300		2,268,500
Other		6,500		222,200		802,500		518,200
Leasing income	$	2,695,800	$	4,375,500	$	12,040,800	$	12,733,800

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 26, 2020	September 28, 2019	September 26, 2020	September 28, 2019
Denominator for basic EPS — weighted average common shares	3,730,490	3,808,863	3,710,112	3,829,329
Dilutive shares associated with option plans	127,212	256,438	147,642	282,989
Denominator for diluted EPS — weighted average common shares and dilutive potential common shares	3,857,702	4,065,301	3,857,754	4,112,318
Options excluded from EPS calculation — anti-dilutive	11,979	7,146	11,057	6,782

8. Shareholders’ Equity (Deficit):

Dividends

On January 29, 2020, the Company’s Board of Directors approved the payment of a $0.25 per share quarterly cash dividend to shareholders of record at the close of business on February 12, 2020, which was paid on March 2, 2020.

On April 29, 2020, 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 13, 2020, which was paid on June 1, 2020.

On July 15, 2020, the Company’s Board of Directors approved the payment of a $0.25 per share quarterly cash dividend to shareholders of record at the close of business on August 12, 2020, which was paid on September 1, 2020.

Repurchase of Common Stock

In December 2019, the Company’s Board of Directors authorized the repurchase of up to 300,000 shares of our common stock for a price of $163.00 per share through a tender offer (the “2020 Tender Offer”). The 2020 Tender Offer began on the date of the announcement, December 17, 2019 and expired on January 16, 2020. Upon expiration, the Company purchased 300,000 shares for a total purchase price of approximately $49.0 million, including fees and expenses related

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to the Tender Offer. The 2020 Tender Offer was financed in part by net borrowings of $19.2 million under the Line of Credit. (See Note 9 – “Debt”).

Under a previous Board of Directors’ authorization, as of September 26, 2020, the Company has the ability to repurchase an additional 130,604 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

At the April 29, 2020 Annual Shareholders Meeting, the Company’s shareholders approved a new stock option plan, the 2020 Stock Option Plan (the “2020 Plan”). The 2020 Plan (as described more completely in the Company’s definitive Proxy Statement filed with the United States Securities and Exchange Commission on March 10, 2020) provides for the issuance of up to 100,000 shares of common stock plus (i) the number of common stock authorized and unissued under the 2010 Plan (as of April 29, 2020, 125,465 shares), and (ii) the number of shares of common stock authorized and unissued under the Nonemployee Director Plan (as of April 29, 2020, 24,500 shares) in the form of either nonqualified or incentive stock option grants. Participants in the 2020 Plan may include employees, officers, directors, consultants and advisors of the Company.

Stock option activity under the 2001 Plan, 2010 Plan, 2020 Plan and Nonemployee Directors Plan (collectively, the “Option Plans”) as of September 26, 2020 was as follows:


				Weighted Average
				Remaining
	Number of	Weighted Average		Contractual Life
	Shares	Exercise Price		(years)		Intrinsic Value
Outstanding, December 28, 2019	479,558	$	101.78	5.79	$	45,283,200
Granted	22,550		143.87
Exercised	(87,579)		80.77
Forfeited	(23,000)		148.16
Outstanding, September 26, 2020	391,529	$	106.18	5.41	$	23,296,200
Exercisable, September 26, 2020	279,164	$	87.77	4.22	$	21,578,700

The fair value of options granted under the Option Plans during the first nine months of 2020 and 2019 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 26, 2020			September 28, 2019
Risk free interest rate		0.40	%		1.98	%
Expected life (years)		6			6
Expected volatility		25.03	%		20.30	%
Dividend yield		1.92	%		1.26	%
Option fair value	$	26.55		$	32.65

All unexercised options at September 26, 2020 have an exercise price equal to the fair market value on the date of the grant.

Compensation expense of $929,900 and $1,511,400 relating to the vested portion of the fair value of stock options granted was expensed to “Selling, General and Administrative Expenses” in the first nine months of 2020 and 2019, respectively. As of September 26, 2020, the Company had $2.7 million of total unrecognized compensation expense related to stock options that is expected to be recognized over the remaining weighted average vesting period of approximately 2.4 years.

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9. Debt:

Line of Credit

In September 2020, the Company’s Line of Credit with CIBC Bank USA and BMO Harris Bank N.A. was amended to, among other things:

●

Decrease the aggregate commitments from $40.0 million to $25.0 million;

●

Remove BMO Harris Bank N.A. as a lender under the Credit Agreement;

●

Extend the termination date from July 19, 2021 to August 31, 2024;

●

Amend the tangible net worth covenant requirement to be reset as of September 26, 2020;

●

Permit the Company to issue up to $25.0 million in additional term notes to one or more affiliates or managed accounts of Prudential.

As of September 26, 2020, there were no borrowings outstanding under the Company’s Line of Credit, leaving $25.0 million available for additional borrowings.

The Line of Credit has been and will continue to be used for general corporate purposes. During the first quarter of 2020, the Line of Credit was used to finance in part the 2020 Tender Offer (as indicated above). 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 26, 2020, the Company was in compliance with all of its financial covenants.

Notes Payable

In September 2020, the Note Agreement with Prudential Investment Management, Inc., its affiliates and managed accounts (“Prudential”) was amended to, among other things, amend the tangible net worth covenant requirement to be reset as of September 26, 2020.

As of September 26, 2020, the Company had $14.3 million in principal outstanding from the $25.0 million Series A notes issued in May 2015 and $8.7 million in principal outstanding from the $12.5 million Series B notes issued in August 2017 under the Note Agreement.

The final maturity of the Series A and Series B notes is 10 years from the issuance date (May 2025 and August 2027, respectively). For the Series A notes, 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. For the Series B notes, interest at a rate of 5.10% per annum on the outstanding principal balance is payable quarterly, along with required prepayments of the principal of $312,500 quarterly until the principal is paid in full. The Series A and Series B 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 September 26, 2020, 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. Discounted Lease Rentals:

The Company utilized certain lease receivables and underlying equipment as collateral to borrow from financial institutions at a weighted average rate of 6.10% at September 26, 2020 on a non-recourse basis. As of September 26, 2020, $1.5 million of the $2.3 million liability balance is current.

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11. Operating Leases:

As of September 26, 2020, the Company leases its Minnesota corporate headquarters in a facility with an operating lease that expires in December 2029. The remaining lease term for this lease is 9.3 years and the discount rate is 5.5%. The Company recognized $896,400 and $1,047,600 of rent expense for the periods ended September 26, 2020 and September 28, 2019, respectively.

Maturities of operating lease liabilities is as follows for the remainder of fiscal 2020 and full fiscal years thereafter as of September 26, 2020:


Operating Lease Liabilities expected to be recognized in	Amount
2020	$	179,100
2021		723,100
2022		742,900
2023		763,300
2024		784,400
Thereafter		4,258,600
Total lease payments		7,451,400
Less imputed interest		(1,603,500)
Present value of lease liabilities	$	5,847,900

Of the $5.8 million operating lease liability outstanding at September 26, 2020, $0.4 million is included in Accrued liabilities in the Current liabilities section of the Consolidated Condensed Balance Sheets.

Supplemental cash flow information related to our operating leases is as follows for the period ended September 26, 2020:

12. Income Taxes:

During the second quarter of 2020, we deferred $4.4 million in federal and state income tax payments as allowed under the Coronavirus Aid, Relief and Economic Security Act (the “CARES’ Act), which was signed into law in March 2020 to help businesses navigate COVID-19 related challenges. The deferred federal and state income tax payments were made in the third quarter of 2020.

13. Segment Reporting:

The Company currently has two reportable business segments, franchising and leasing. The franchising segment franchises value-oriented retail store concepts that buy, sell, trade and consign merchandise. The leasing segment includes (i) Winmark Capital Corporation, a middle-market equipment leasing business and (ii) Wirth Business Credit, Inc., a small ticket 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, restricted cash, accounts receivable, prepaid expenses, inventory, property and equipment, investment in leasing operations and goodwill. Unallocated assets include corporate cash and cash equivalents, current and deferred tax amounts, operating lease right of use assets and other corporate assets. Inter-segment balances and transactions have been eliminated. The following

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tables summarize financial information by segment and provide a reconciliation of segment contribution to operating income:


	Three Months Ended				Nine Months Ended
	September 26, 2020		September 28, 2019		September 26, 2020		September 28, 2019
Revenue:
Franchising	$	15,581,200	$	15,305,400	$	37,225,700	$	42,682,500
Leasing		2,695,800		4,375,500		12,040,800		12,733,800
Total revenue	$	18,277,000	$	19,680,900	$	49,266,500	$	55,416,300

Reconciliation to operating income:
Franchising segment contribution	$	10,789,900	$	9,895,700	$	22,601,000	$	25,844,500
Leasing segment contribution		1,707,900		2,379,000		6,676,400		6,343,600
Total operating income	$	12,497,800	$	12,274,700	$	29,277,400	$	32,188,100

Depreciation and amortization:
Franchising	$	70,800	$	79,000	$	216,100	$	208,900
Leasing		49,900		31,700		150,600		67,800
Total depreciation and amortization	$	120,700	$	110,700	$	366,700	$	276,700


	As of
	September 26, 2020		December 28, 2019
Identifiable assets:
Franchising	$	4,285,500	$	3,736,000
Leasing		16,772,300		26,596,700
Unallocated		14,780,800		31,509,500
Total	$	35,838,600	$	61,842,200

14. Subsequent Events:

On October 14, 2020, the Company’s Board of Directors approved the payment of a $3.00 per share special cash dividend (the “2020 Special Dividend”) to shareholders of record at the close of business November 11, 2020, which will be paid on December 15, 2020. The 2020 Special Dividend will be approximately $11.2 million based on the current number of shares outstanding and is expected to be financed by cash on hand.

On October 14, 2020, the Line of Credit and Note Agreement were amended to, among other things, provide the consent of the lenders under these facilities for the declaration and payment of the 2020 Special Dividend and to amend the fixed charge covenant ratio definition to remove the effect of the 2020 Special Dividend.

The Company continues to closely monitoring the impact of the coronavirus (COVID-19) pandemic on all aspects of its business, including that of its franchisees and leasing customers. The COVID-19 pandemic adversely affected the Company’s financial results and business operations in the Company’s first nine months ended September 26, 2020, and uncertainties regarding the pandemic continue to result in economic disruptions including reduced operating levels at many of our franchisee’s stores. Governmental authorities in the United States and Canada have taken and may continue to take measures in order to combat the spread of disease including forced closures of retail stores and other business establishments from time to time. The full impact of the COVID-19 outbreak is unknown, resulting in a high degree of uncertainty for potentially extended periods of time. At this time, neither the duration nor scope of the disruption can be predicted, therefore, the negative impact on our financial position and operating results cannot be reasonably estimated.

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

Overview

COVID-19 Pandemic

The emergence of the coronavirus (COVID-19) around the world, and particularly in the United States and Canada, presents significant risks to the Company, not all of which the Company is able to fully evaluate or even to foresee at the current time. The COVID-19 pandemic adversely affected the Company’s financial results and business operations in

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the Company’s nine months ended September 26, 2020, as noted below, and economic and health conditions in the United States and across most of the globe have continued to change throughout the year. Notably, a substantial number of the Company’s franchised store locations were temporarily closed to in-store consumer activities for a portion of the first nine months of 2020. Such temporary store closings may reoccur and customer traffic at those locations operational may continue to be reduced and may not return to historical levels in the near term depending on the duration and severity of the COVID-19 pandemic, the length of time it takes for normal economic and operating conditions to resume, additional governmental actions that may be taken and/or the re-imposition of restrictions that have been imposed to date, and numerous other uncertainties. The resulting economic disruption could also affect our ability to generate leasing revenue from new and existing leasing customers through reduced equipment leases and possible increases in defaults by existing leasing customers.

The COVID-19 pandemic has affected the Company’s operations in the first nine months of 2020, and may continue to do so indefinitely thereafter. All of these factors may have far reaching impacts on the Company’s business, operations, and financial results and conditions, directly and indirectly, including without limitation impacts on the health of the Company’s management and employees, its franchisees and leasing customers, customer and consumer behaviors, and on the overall economy. The scope and nature of these impacts, most of which are beyond the Company’s control, continue to evolve and the outcomes are uncertain.

Due to the above circumstances and as described generally in this Form 10-Q, the Company’s results of operations for the nine-month period ended September 26, 2020 are not necessarily indicative of the results to be expected for the full fiscal year. Management cannot predict the full impact of the COVID-19 pandemic on the Company’s franchisees or leasing customers nor to economic conditions generally, including the effects on consumer spending. The ultimate extent of the effects of the COVID-19 pandemic on the Company is highly uncertain and will depend on future developments, and such effects could exist for an extended period of time even after the pandemic might end.

Overview

As of September 26, 2020, we had 1,262 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 $15.6 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 franchisees. During the first nine months of 2020, our royalties decreased $5.0 million or 13.2% compared to the first nine months of 2019.

Leasing income net of leasing expense during the first nine months of 2020 was $9.6 million compared to $11.1 million in the same period last year. Fluctuations in period-to-period leasing income and leasing expense can result 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 medium- to long-term trend in the purchases of equipment for lease customers and the size of the leasing portfolio. During the first nine months of 2020, we purchased $3.1 million in equipment for lease customers compared to $7.9 million in the first nine months of 2019 and $20.2 million in the first nine months of 2018. Our leasing portfolio (net investment in leases — current and long-term) was $15.6 million at September 26, 2020 compared to $25.3 million at December 28, 2019 and $30.0 million at September 28, 2019. The lower equipment purchases and the decrease in the size of the portfolio across these periods were a direct result of a decrease in the number of customers installing equipment. We continue to explore ways to grow leased assets and add new customers to our leasing portfolio; however, continued low levels of equipment purchases for lease customers and decreases in the size of our portfolio will impact the long-term operating income of our leasing segment.

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 2020, selling, general and administrative expenses decreased $3.9 million, or 20.0% compared to the first nine months of 2019.

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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 26, 2020:


					AVAILABLE
	TOTAL			TOTAL	FOR	COMPLETED
	12/28/2019	OPENED	CLOSED	9/26/2020	RENEWAL	RENEWALS
Plato’s Closet
Franchises - US and Canada	483	3	(3)	483	31	31
Once Upon A Child
Franchises - US and Canada	388	11	(4)	395	21	21
Play It Again Sports
Franchises - US and Canada	280	1	(3)	278	14	13
Style Encore
Franchises - US and Canada	68	3	(2)	69	—	—
Music Go Round
Franchises - US	37	—	—	37	1	1
Total Franchised Stores	1,256	18	(12)	1,262	67	66

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 2020, we renewed 66 of the 67 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				Nine Months Ended
	September 26, 2020		September 28, 2019		September 26, 2020		September 28, 2019

Revenue:
Royalties	77.7	%	70.2	%	67.4	%	69.0	%
Leasing income	14.8		22.2		24.4		23.0
Merchandise sales	3.5		3.6		3.5		3.7
Franchise fees	1.8		1.9		2.2		2.1
Other	2.2		2.1		2.5		2.2
Total revenue	100.0		100.0		100.0		100.0

Cost of merchandise sold	(3.3)		(3.4)		(3.4)		(3.5)
Leasing expense	(2.8)		(2.9)		(5.0)		(3.0)
Provision for credit losses	1.9		0.3		(0.3)		—
Selling, general and administrative expenses	(27.4)		(31.6)		(31.9)		(35.4)
Income from operations	68.4		62.4		59.4		58.1
Interest expense	(1.9)		(2.1)		(2.9)		(2.4)
Interest and other income (expense)	—		—		0.1		—
Income before income taxes	66.5		60.3		56.6		55.7
Provision for income taxes	(15.3)		(14.0)		(12.5)		(12.9)
Net income	51.2	%	46.3	%	44.1	%	42.8	%

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Comparison of Three Months Ended September 26, 2020 to Three Months Ended September 28, 2019

Revenue

Revenues for the quarter ended September 26, 2020 totaled $18.3 million compared to $19.7 million for the comparable period in 2019.

Royalties and Franchise Fees

Royalties increased to $14.2 million for the third quarter of 2020 from $13.8 million for the third quarter of 2019, a 2.9% increase. The increase is primarily from higher franchisee retail sales and from having additional franchise stores in the third quarter of 2020 compared to the same period last year

Franchise fees of $0.3 million for the third quarter of 2020 were comparable to $0.4 million for the third quarter of 2019.

Leasing Income

Leasing income decreased to $2.7 million for the third quarter of 2020 compared to $4.4 million for the same period in 2019. The decrease is primarily due to lower levels of interest income from the smaller lease portfolio and a decrease in selling profit at the commencement of sales-type leases, when compared to the same period last year.

Merchandise Sales

Merchandise sales include the sale of product to franchisees either through our Computer Support Center or through the Play It Again Sports buying group (together, “Direct Franchisee Sales”). Direct Franchisee Sales of $0.6 million for the third quarter of 2020 was comparable to $0.7 million in the same period of 2019.

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 of $0.6 million for the third quarter of 2020 was comparable to $0.7 million in the same period of 2019. Cost of merchandise sold as a percentage of Direct Franchisee Sales for the third quarter of 2020 and 2019 was 94.8% and 95.3%, respectively.

Leasing Expense

Leasing expense of $0.5 million for the third quarter of 2020 was comparable to $0.6 million for the third quarter of 2019.

Provision for Credit Losses

Provision for credit losses was $(0.3) million for the third quarter of 2020 compared to $(0.1) million for the third quarter of 2019. The provision levels in the third quarter of 2020 reflected the reduction in lease payments receivable from lease customers and the estimated impact of the COVID-19 pandemic on the credit quality of customers in our lease portfolio.

Selling, General and Administrative

Selling, general and administrative expenses decreased 19.4% to $5.0 million in the third quarter of 2020 compared to $6.2 million in the same period of 2019. The decrease was primarily due to a decrease in compensation related expenses, inclusive of those related to organizational changes made in 2019, as well as a decrease in travel expenses due to the COVID-19 pandemic.

Interest Expense

Interest expense of $0.3 million for the third quarter of 2020 was comparable to $0.4 million for the third quarter of 2019.

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Income Taxes

The provision for income taxes was calculated at an effective rate of 23.0% and 23.2% for the third quarter of 2020 and 2019, respectively.

Comparison of Nine Months Ended September 26, 2020 to Nine Months Ended September 28, 2019

Revenue

Revenues for the first nine months of 2020 totaled $49.3 million compared to $55.4 million for the comparable period in 2019.

Royalties and Franchise Fees

Royalties decreased to $33.2 million for the first nine months of 2020 from $38.2 million for the first nine months of 2019, a 13.2% decrease. The decrease in royalties is primarily from lower franchisee retail sales in the first nine months of 2020 compared to the same period last year. Lower franchisee retail sales in the first nine months of 2020 were directly attributable to the temporary store closings and reduced customer traffic resulting from the COVID-19 pandemic.

Franchise fees of $1.1 million for the first nine months of 2020 were comparable to $1.2 million for the first nine months of 2019.

Leasing Income

Leasing income decreased to $12.0 million for the first nine months of 2020 compared to $12.7 million for the same period in 2019. The decrease is primarily due to lower levels of interest income from the smaller lease portfolio, partially offset by higher level of equipment sales to customers, when compared to the same period last year.

Merchandise Sales

Merchandise sales include the sale of product to franchisees either through our Computer Support Center or through the Play It Again Sports buying group (together, “Direct Franchisee Sales”). Direct Franchisee Sales were $1.7 million for the first nine months of 2020 compared to $2.0 million in the same period of 2019. The decrease is due to decreases in buying group and technology purchases by our franchisees.

Cost of Merchandise Sold

Cost of merchandise sold includes in-bound freight and the cost of merchandise associated with Direct Franchisee Sales. Cost of merchandise sold was $1.7 million for the first nine months of 2020 compared to $1.9 million in the same period of 2019. The decrease is due to the decrease in Direct Franchisee Sales discussed above. Cost of merchandise sold as a percentage of Direct Franchisee Sales for the first nine months of 2020 and 2019 was 95.1% and 94.5%, respectively.

Leasing Expense

Leasing expense increased to $2.4 million for the first nine months of 2020 compared to $1.6 million for the first nine months of 2019. The increase was due to an increase in the associated cost of equipment sales to customers discussed above.

Provision for Credit Losses

Provision for credit losses was $164,300 for the first nine months of 2020 compared to $23,000 for the first nine months of 2019. The increase was due to the estimated impact of the COVID-19 pandemic on the credit quality of customers in our lease portfolio.

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Selling, General and Administrative

Selling, general and administrative expenses decreased 20.0% to $15.7 million in the first nine months of 2020 compared to $19.6 million in the same period of 2019. The decrease was primarily due to a decrease in compensation related expenses, inclusive of those related to organizational changes made in 2019, as well as decreases in conference and travel expenses due to the COVID-19 pandemic.

Interest Expense

Interest expense of $1.4 million for the first nine months of 2020 was comparable to $1.3 million for the first nine months of 2019.

Income Taxes

The provision for income taxes was calculated at an effective rate of 22.1% and 23.2% for the first nine months of 2020 and 2019, respectively. The decrease is primarily due to tax benefits on the exercise of non-qualified stock options.

Segment Comparison of Three Months Ended September 26, 2020 to Three Months Ended September 28, 2019

Franchising Segment Operating Income

The franchising segment’s operating income for the third quarter of 2020 increased to $10.8 million from $9.9 million for the third quarter of 2019. The increase in segment contribution was primarily due to a decreased selling, general and administrative expenses, partially offset by increased royalty revenues.

Leasing Segment Operating Income

The leasing segment’s operating income for the third quarter of 2020 decreased to $1.7 million from $2.4 million for the third quarter of 2019. The decrease in segment contribution was primarily due to a decrease in leasing income net of leasing expenses, partially offset by a decrease in selling, general and administrative expenses.

Segment Comparison of Nine Months Ended September 26, 2020 to Nine Months Ended September 28, 2019

Franchising Segment Operating Income

The franchising segment’s operating income for the first nine months of 2020 decreased to $22.6 million from $25.8 million for the first nine months of 2019. The decrease in segment contribution was primarily due to decreased royalty revenues, partially offset by a decrease in selling, general and administrative expenses.

Leasing Segment Operating Income

The leasing segment’s operating income for the first nine months of 2020 increased to $6.7 million from $6.3 million for the first nine months of 2019. The increase in segment contribution was primarily due to a decrease in selling, general and administrative expenses.

Liquidity and Capital Resources

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

We ended the third quarter of 2020 with $8.3 million in cash, cash equivalents and restricted cash compared to $7.6 million in cash, cash equivalents and restricted cash at the end of the third quarter of 2019.

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Operating activities provided $31.8 million of cash during the first nine months of 2020, compared to $38.1 million provided during the same period last year. The decrease in cash provided by operating activities in the first nine months of 2020 compared to 2019 was primarily due to decreases in principal collections on lease receivables and net income.

Investing activities used $3.2 million of cash during the first nine months of 2020. The 2020 activities consisted primarily of the purchase of equipment for lease customers of $3.1 million.

Financing activities used $45.5 million of cash during the first nine months of 2020. Our most significant financing activities during the first nine months of 2020 consisted of $49.0 million to repurchase 300,000 shares of our common stock in the 2020 Tender Offer (including fees and expenses), payments on notes payable of $2.7 million and $2.0 million for the payment of dividends; partially offset by $7.1 million of proceeds from exercise of stock options and $1.2 million in proceeds received from discounted lease rentals. (See Note 8 — “Shareholders’ Equity (Deficit),” Note 9 — “Debt” and Note 10 — “Discounted Lease Rentals”).

As of September 26, 2020, we had no off balance sheet arrangements.

In September 2020, our Line of Credit with CIBC Bank USA and BMO Harris Bank N.A. was amended to, among other things:

●

Decrease the aggregate commitments from $40.0 million to $25.0 million;

●

Remove BMO Harris Bank N.A. as a lender under the Credit Agreement;

●

Extend the termination date from July 19, 2021 to August 31, 2024;

●

Amend the tangible net worth covenant requirement to be reset as of September 26, 2020;

●

Permit the Company to issue up to $25.0 million in additional term notes to one or more affiliates or managed accounts of Prudential.

As of September 26, 2020, our borrowing availability under our Line of Credit was $25.0 million (the lesser of the borrowing base or the aggregate line of credit). There were no borrowings outstanding at September 26, 2020 under the Line of Credit leaving $25.0 million available for additional borrowings.

The Line of Credit has been and will continue to be used for general corporate purposes. During the first nine months of 2020, the Line of Credit was used to finance in part the 2020 Tender Offer and in March 2020, in response to uncertainty resulting from the COVID-19 outbreak, we drew additional amounts on the Line of Credit to increase our cash balances. All amounts drawn on the Line of Credit during the first nine months of 2020 were repaid by September 26, 2020. The Line of Credit is secured by a lien against substantially all of our 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 26, 2020, we had $14.3 million in principal outstanding from the $25.0 million Series A notes issued in May 2015 and $8.7 million in principal outstanding from the $12.5 million Series B notes issued in August 2017 under our Note Agreement.

The final maturity of the Series A and Series B notes is 10 years from the issuance date. For the Series A notes, 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. For the Series B notes, interest at a rate of 5.10% per annum on the outstanding principal balance is payable quarterly, along with required prepayments of the principal of $312,500 quarterly until the principal is paid in full. The Series A and Series B notes may be prepaid, at our option, 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.

Our obligations under the Note Agreement are secured by a lien against substantially all of our assets, 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).

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As of September 26, 2020, we were in compliance with all of the financial covenants under the Line of Credit and Note Agreement.

On October 14, 2020, we approved the payment of a $3.00 per share special cash dividend (the “2020 Special Dividend”) to shareholders of record at the close of business November 11, 2020, which will be paid on December 15, 2020. The 2020 Special Dividend will be approximately $11.2 million based on the current number of shares outstanding and is expected to be financed by cash on hand.

We expect to generate the cash necessary to pay our expenses, finance our leasing business and to pay the principal and interest on our outstanding debt from cash flows provided by operating activities and by opportunistically using other means to repay or refinance our obligations as we determine appropriate. Our ability to pay our expenses, finance our leasing business and meet our debt service obligations depends on our future performance, which may be affected by financial, business, economic, and other factors including the risk factors described under Item 1A of our Form 10-K for the fiscal year ended December 28, 2019 and under Item 1A below. If we do not have enough money to pay our debt service obligations, we may be required to refinance all or part of our existing debt, sell assets, borrow more money or raise equity. In such an event, we may not be able to refinance our debt, sell assets, borrow more money or raise equity on terms acceptable to us or at all. Also, our ability to carry out any of these activities on favorable terms, if at all, may be further impacted by any financial or credit crisis which may limit access to the credit markets and increase our cost of capital.

We may utilize discounted lease financing to provide funds for a portion of our leasing activities. Rates for discounted lease financing reflect prevailing market interest rates and the credit standing of the lessees for which the payment stream of the leases are discounted. We believe that discounted lease financing will continue to be available to us at competitive rates of interest through the relationships we have established with financial institutions.

While significant uncertainty exists as to the full impact of the COVID-19 pandemic on our liquidity and capital resources, as of the date of this report we believe that the combination of our cash on hand, the cash generated from our franchising and leasing businesses, cash generated from discounting sources and our Line of Credit will be adequate to fund our planned operations through 2021.

Critical Accounting Policies

The Company prepares the consolidated condensed financial statements of Winmark Corporation and Subsidiaries in conformity with accounting principles generally accepted in the United States of America. As such, the Company is required to make certain estimates, judgments and assumptions that it believes are reasonable based on information available. These estimates and assumptions affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the periods presented. There can be no assurance that actual results will not differ from these estimates. The critical accounting policies that the Company believes are most important to aid in fully understanding and evaluating the reported financial results include the following:

Revenue Recognition — Royalty Revenue and Franchise Fees

The Company collects royalties from each retail franchise based on a percentage of retail store gross sales. The Company recognizes royalties as revenue when earned. At the end of each accounting period, estimates of royalty amounts due are made based on the most recent franchisee sales information available. If there are significant changes in the actual performance of franchisees versus the Company’s estimates, its royalty revenue would be impacted. During the first nine months of 2020, the Company collected $10,200 more than it estimated at December 28, 2019. As of September 26, 2020, the Company’s royalty receivable was $1,737,900.

The Company collects initial franchise fees when franchise agreements are signed and recognizes the initial franchise fees as revenue over the estimated life of the franchise, beginning when the franchise is opened. Franchise fees collected

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from franchisees but not yet recognized as income are recorded as deferred revenue in the liability section of the consolidated condensed balance sheet. As of September 26, 2020, deferred franchise fee revenue was $7,063,300.

Leasing Income Recognition

Leasing income for direct financing leases is recognized under the effective interest method. The effective interest method of income recognition applies a constant rate of interest equal to the internal rate of return on the lease.

For sales-type leases in which the equipment has a fair value greater or less than its carrying amount, selling profit/loss is recognized at commencement. For subsequent periods or for leases in which the equipment’s fair value is equal to its carrying amount, the recording of income is consistent with the accounting for a direct financing lease.

For leases that are accounted for as operating leases, income is recognized on a straight-line basis when payments under the lease contract are due.

Generally, when a lease is more than 90 days delinquent (where more than three monthly payments are owed), the lease is classified as being on non-accrual and the Company stops recognizing leasing income on that date. Payments received on leases in non-accrual status generally reduce the lease receivable. Leases on non-accrual status remain classified as such until there is sustained payment performance that, in the Company’s judgment, would indicate that all contractual amounts will be collected in full.

Allowance for Credit Losses

The Company maintains an allowance for credit losses at an amount that it believes to be sufficient to absorb losses inherent in its existing lease portfolio as of the reporting dates. Leases are collectively evaluated for potential loss. The Company’s methodology for determining the allowance for credit losses includes consideration of the level of delinquencies and non-accrual leases, historical net charge-off amounts and review of any significant concentrations.

A provision is charged against earnings to maintain the allowance for credit losses at the appropriate level. If the actual results are different from the Company’s estimates, results could be different. The Company’s policy is to charge-off against the allowance the estimated unrecoverable portion of accounts once they reach 121 days delinquent. (See Note 6 — “Investment in Leasing Operations”).

Stock-Based Compensation

The Company currently uses the Black-Scholes option pricing model to determine the fair value of stock options. The determination of the fair value of the awards on the date of grant using an option-pricing model is affected by stock price as well as assumptions regarding a number of complex and subjective variables. These variables include implied volatility over the term of the awards, actual and projected employee stock option exercise behaviors, risk-free interest rate and expected dividends.

The Company evaluates the assumptions used to value awards on an annual basis. If factors change and the Company employs different assumptions for estimating stock-based compensation expense in future periods or if the Company decides to use a different valuation model, the future periods may differ significantly from what it has recorded in the current period and could materially affect operating income, net income and earnings per share.

Forward Looking Statements

The statements contained in this Item 2 “Management’s Discussion and Analysis of Financial Condition and Results of Operations” that are not strictly historical fact, including without limitation, specific and overall impacts of the COVID-19 pandemic on the Company’s financial condition or results of operations, the Company’s belief that it will have adequate capital and reserves to meet its current and contingent obligations and operating needs, as well as its disclosures regarding market rate risk are forward looking statements made under the safe harbor provision of the Private Securities Litigation Reform Act. Such statements are based on management’s current expectations as of the date of this Report, but involve risks, uncertainties and other factors that may cause actual results to differ materially from those contemplated by such forward looking statements. Additionally, many of these risks and uncertainties are currently elevated by and may or will continue to be elevated by the COVID-19 pandemic. Investors are cautioned to consider these forward looking statements in light of important factors which may result in material variations between results

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contemplated by such forward looking statements and actual results and conditions. See the section appearing in our Annual Report on Form 10-K for the fiscal year ended December 28, 2019 entitled “Risk Factors” and Part II, Item 1A in this Report for a more complete discussion of certain factors that may cause the Company’s actual results to differ from results or events described in any forward looking statements. You should not place undue reliance on these forward-looking statements, which speak only as of the date they were made. The Company undertakes no obligation to revise or update publicly any forward-looking statements for any reason.

ITEM 3: Quantitative and Qualitative Disclosures About Market Risk

The Company incurs financial market risk in the form of interest rate risk. Risk can be quantified by measuring the financial impact of a near-term adverse increase in short-term interest rates. At September 26, 2020, the Company had available a $25.0 million line of credit with CIBC Bank USA. The interest rates applicable to this agreement are based on either the bank’s base rate or LIBOR for short-term borrowings (twelve months or less). The Company had no debt outstanding at September 26, 2020 under this line of credit. The Company’s earnings would be affected by changes in these short-term interest rates only in the event that it were to borrow amounts under this facility. With the Company’s borrowings at September 26, 2020, a one percent increase in short-term rates would have no impact on annual pretax earnings. The Company had no interest rate derivatives in place at September 26, 2020.

None of the Company’s cash and cash equivalents at September 26, 2020 was invested in money market mutual funds, which are subject to the effects of market fluctuations in interest rates.

Foreign currency transaction gains and losses were not material to the Company’s results of operations for the nine months ended September 26, 2020. During fiscal 2019, less than 7% of the Company’s total revenues and 1% of expenses were denominated in a foreign currency. Based upon these revenues and expenses, a 10% increase or decrease in the foreign currency exchange rates would impact annual pretax earnings by approximately $458,000. To date, the Company has not entered into any foreign currency forward exchange contracts or other derivative financial instruments to hedge the effects of adverse fluctuations in foreign currency exchange rates.

ITEM 4: Controls and Procedures

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

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PART II. OTHER INFORMATION

ITEM 1: Legal Proceedings

We are not a party to any material litigation and are not aware of any threatened litigation that would have a material adverse effect on our business.

ITEM 1A: Risk Factors

In addition to the other information set forth in this report, including the important information in “Forward-Looking Statements,” you should carefully consider the “Risk Factors” discussed in our Annual Report on Form 10-K for the year ended December 28, 2019. If any of those factors were to occur, they could materially adversely affect our financial condition or future results, and could cause our actual results to differ materially from those expressed in its forward-looking statements in this report. Except as noted below, we are aware of no material changes to the Risk Factors discussed in our Annual Report on Form 10-K for the year ended December 28, 2019.

Our business, results of operations, financial condition, cash flows and the market value of our common stock can be adversely affected by pandemics, epidemics or other public health emergencies, such as the recent outbreak of COVID-19 which has spread from China to many other countries including the United States and Canada. In March 2020, the World Health Organization characterized COVID-19 as a pandemic, and the President of the United States declared the COVID-19 outbreak a national emergency. The outbreak has resulted in federal, state, provincial and local governments throughout the United States and Canada implementing increasingly stringent measures to help control the spread of the virus, including quarantines, “shelter in place” and “stay at home” orders, travel restrictions, business curtailments, school closures, and other measures. In addition, governments and central banks in several parts of the world have enacted fiscal and monetary stimulus measures to counteract the impacts of COVID-19.

The outbreak of COVID-19 and any preventive or protective actions taken by governmental authorities have had and are expected to continue to have a material adverse effect on our operations and those of our franchisees and leasing customers, including forced or voluntary store closures, business shutdowns or disruptions. The extent to which COVID-19 may adversely impact our business depends on future developments, which are highly uncertain and unpredictable, depending upon the severity and duration of the outbreak and the effectiveness of actions taken globally, nationally and locally to contain or mitigate its effects. Any resulting financial impact cannot be estimated reasonably at this time, but may materially adversely affect our business, results of operations, financial condition and cash flows. Even after the COVID-19 pandemic has subsided, we may experience materially adverse effects to our business due to any resulting economic recession or depression. Additionally, concerns over the economic affect of COVID-19 have caused extreme volatility in financial and other capital markets which has and may continue to adversely impact the market value of our common stock and our ability to access capital markets and debt capital. To the extent the COVID-19 pandemic adversely affects our business and financial results, it may also have the effect of heightening many of the other risks described in our Annual Report on Form 10-K for the year ended December 28, 2019.

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ITEM 2: Unregistered Sales of Equity Securities and Use of Proceeds

Purchase of Equity Securities by the Issuer and Affiliated Purchasers

The following table summarized the Company’s common stock repurchase during the third quarter of 2020. No shares were purchased during the quarter.


				Total Number of	Maximum Number
				Shares Purchased as	of Shares that may
	Total Number of	Average Price		Part of a Publicly	yet be Purchased
Period	Shares Purchased	Paid Per Share		Announced Plan(1)	Under the Plan

June 28, 2020 to August 1, 2020	—	$	—	—	130,604
August 2, 2020 to August 29, 2020	—	$	—	—	130,604
August 30, 2020 to September 26, 2020	—	$	—	—	130,604

(1)

The Board of Directors’ authorization for the repurchase of shares of the Company’s common stock was originally approved in 1995 with no expiration date. The total shares approved for repurchase has been increased by additional Board of Directors’ approvals and is currently limited to 5,000,000 shares, of which 130,604 may still be repurchased.

ITEM 3: Defaults Upon Senior Securities

None.

ITEM 4: Mine Safety Disclosures

Not applicable.

ITEM 5: Other Information

All information required to be reported in a report on Form 8-K during the period covered by this Form 10-Q has been reported.

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ITEM 6: Exhibits

3.1		Articles of Incorporation, as amended (Exhibit 3.1)(1)

3.2		By-laws, as amended and restated to date (Exhibit 3.2)(2)

31.1		Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002*

31.2		Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002*

32.1		Certification of Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002*

32.2		Certification of Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002*

101		Interactive Data Files Pursuant to Rule 405 of Regulation S-T: Financial statements from the Quarterly Report on Form 10-Q of Winmark Corporation and Subsidiaries for the quarter ended September 26, 2020, formatted in Inline XBRL: (i) Consolidated Condensed Balance Sheets, (ii) Consolidated Condensed Statements of Operations, (iii) Consolidated Condensed Statements of Shareholders’ Equity (Deficit), (iv) Consolidated Condensed Statements of Cash Flows, and (v) Notes to Consolidated Condensed Financial Statements.
104		The cover page from the Quarterly Report on Form 10-Q of Winmark Corporation and Subsidiaries for the quarter ended September 26, 2020, formatted in Inline XBRL (contained in Exhibit 101).

*Filed Herewith

(1)	Incorporated by reference to the specified exhibit to the Registration Statement on Form S-1, effective August 24, 1993 (Reg. No. 333-65108).

(2)	Incorporated by reference to the specified exhibit to the Annual Report on Form 10-K for the fiscal year ended December 30, 2006.

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

		WINMARK CORPORATION


Date: October 20, 2020	By:	/s/ Brett D. Heffes
		Brett D. Heffes Chairman of the Board and Chief Executive Officer (principal executive officer)


Date: October 20, 2020	By:	/s/ Anthony D. Ishaug
		Anthony D. Ishaug Executive Vice President Chief Financial Officer and Treasurer (principal financial and accounting officer)