Winmark Corporation — Q2 2017 Form 10-Q
Business context and period: The unaudited quarter ended July 1, 2017; comparisons are with the quarter ended June 25, 2016. Winmark franchises five value-oriented retail brands and operates middle-market and small-ticket equipment leasing businesses. At quarter-end it had 1,199 franchised stores and a $41.0 million net leasing portfolio.
Financial performance
| Metric | Q2 2017 | Q2 2016 | Six months 2017 | Six months 2016 |
|---|---|---|---|---|
| Revenue | $16.75 million | $16.30 million | $34.37 million | $32.48 million |
| Operating income | $9.13 million | $9.32 million | $18.27 million | $17.36 million |
| Net income | $5.77 million | $5.39 million | $11.19 million | $9.96 million |
| Diluted EPS | $1.29 | $1.25 | $2.50 | $2.31 |
| Operating margin | 54.5% | 57.2% | 53.2% | 53.5% |
| Net margin | 34.5% | 33.1% | 32.5% | 30.7% |
- Q2 revenue rose 2.8%; royalties grew 5.1% to $11.1 million, while leasing income fell to $3.9 million from $4.2 million. Franchise fees increased to $0.7 million from $0.5 million.
- Six-month revenue grew 5.8%. Royalties rose 3.4% to $21.5 million and leasing income increased to $9.8 million from $8.7 million. Leasing income less leasing expense was $7.9 million, versus $7.3 million.
- Q2 operating income decreased 2.0%, as higher SG&A and lower leasing contribution outweighed royalty growth. For six months, operating income rose 5.2%. SG&A increased 8.9% in Q2 and 3.8% year to date.
- Effective tax rates were 33.5% for Q2 and 35.4% for six months, compared with 38.3% in both 2016 periods. Adoption of stock-compensation guidance produced discrete tax benefits of $421,900 in Q2 and $518,000 year to date; this helped net income and EPS growth.
Cash flow, liquidity and debt
- Six-month operating cash flow was $13.4 million, compared with $13.2 million. Investing activities provided $0.4 million: $13.5 million of lease-equipment purchases were offset mainly by $14.0 million of lease principal collections. Financing used $14.0 million, including net debt repayments and $0.9 million of dividends.
- Cash and equivalents were $1.1 million at July 1, 2017. The company reported $39.9 million of unused availability on its $50.0 million line of credit.
- At quarter-end, line-of-credit borrowings were $10.1 million at 3.42%–4.25%; notes had $21.0 million principal outstanding at 5.50%. The company reported compliance with debt covenants. Notes require quarterly principal payments.
- Management said cash, operating cash flow, lease-discounting sources, the credit line and planned term-note proceeds should fund operations through 2018. It cautioned that debt service depends on future performance and access to refinancing or credit markets.
- Total assets were $47.0 million, versus $48.6 million at December 31, 2016. Shareholders’ equity was $4.6 million, compared with a $7.9 million deficit at year-end.
Material developments, outlook and risks
- Franchising segment revenue rose 5.4% in Q2 and 3.2% for six months. Leasing segment contribution fell in Q2 to $1.9 million from $2.5 million, but increased for six months to $4.9 million from $4.6 million.
- The company opened 29 stores and closed 16 during the first six months; 33 of 33 agreements available for renewal were renewed. Management identifies franchise support, openings, lease originations and expense control as key drivers of future operating income. No specific earnings or revenue guidance was provided.
- Subsequent event: On July 19, 2017, Winmark announced a tender offer for up to 400,000 shares at $124.48 per share, approximately $49.8 million plus expenses. It planned to fund the offer with its credit line and new term debt. Amendments extended the credit facility to July 19, 2021 and provided for a new $12.5 million, 10-year term loan at 5.10%, among other provisions. The offer was due to expire August 16, 2017 unless extended or withdrawn. Management warned the transaction would increase leverage and debt-service risk.
- Interest-rate exposure: a one-percentage-point increase in short-term rates was estimated to reduce annual pretax earnings by $101,000; no interest-rate derivatives were in place. Two leasing customers represented approximately 22% and 12% of total assets, respectively. The filing reported no delinquent or non-accrual lease balances at July 1.
- Management reported no material litigation and no material changes to previously disclosed risk factors other than tender-offer-related leverage. Disclosure controls were considered effective, with no material change in internal control over financial reporting.
Important facts for investors to verify
- Whether the tender offer was completed, how many shares were purchased, and the final funding mix and debt balances.
- Whether royalty growth, store openings and franchisee sales continue, and whether all eligible renewals remain strong.
- Lease originations, portfolio size, customer concentration and credit-loss performance, including any subsequent delinquencies or non-accruals.
- The ongoing earnings and cash-flow effects of higher leverage, required principal payments and variable interest rates.
- The effect of stock-option tax benefits on reported tax rates and comparability, and the impact of forthcoming accounting standards, particularly revenue recognition.