Winmark Corporation — Q3 2018 Form 10-Q
Reporting period: Quarter ended September 29, 2018; comparisons are with the quarter ended September 30, 2017. Year-to-date figures cover the first nine months of each year. The filing is unaudited.
Business context
Winmark franchises five value-oriented retail brands and operates equipment-leasing businesses. At quarter-end it had 1,236 franchised stores and a $44.5 million net leasing portfolio. The company reported franchising and leasing as its two business segments.
Financial performance
| Metric | Q3 2018 | Q3 2017 | First nine months 2018 | First nine months 2017 |
|---|---|---|---|---|
| Revenue | $19.1 million | $17.7 million | $55.4 million | $52.0 million |
| Operating income | $11.4 million | $10.0 million | $31.6 million | $28.2 million |
| Operating margin | 59.8% | 56.6% | 57.0% | 54.2% |
| Net income | $8.4 million | $5.9 million | $22.5 million | $16.9 million |
| Diluted EPS | $2.01 | $1.36 | $5.43 | $3.84 |
| Effective tax rate | 23.0% | 38.0% | 24.1% | 36.4% |
- Quarterly revenue rose 7.8%; year-to-date revenue rose 6.7%. Royalties grew 4.5% in the quarter and 5.5% year to date, which management attributed primarily to higher franchisee sales and additional stores. Leasing income also increased, primarily due to a higher level of equipment sales to customers.
- Quarterly net income increased about 43%; year-to-date net income increased about 33%. Lower tax rates, following the federal corporate tax rate reduction, contributed to the earnings increase.
- Year-to-date operating cash flow was $27.6 million, versus $19.2 million. Investing activities used $4.4 million, including $20.2 million of lease-equipment purchases and $16.3 million of lease-receivable collections. Financing activities used $23.2 million.
- Cash and restricted cash totaled $1.24 million at September 29, 2018. The $50.0 million revolving facility had $10.1 million drawn and $39.9 million available. Notes payable had $29.8 million principal outstanding; discounted lease rentals were approximately $4.9 million. The company reported compliance with debt covenants.
- Net investment in leases increased to $44.5 million from $41.3 million at December 30, 2017. The allowance for lease credit losses was $969,200, up from $711,200. No leases were delinquent or on non-accrual at quarter-end, according to the filing.
- Shareholders’ equity remained negative at $11.7 million. The company paid $1.6 million in dividends during the first nine months and repurchased 3,770 shares.
Material changes and management commentary
- Franchising revenue was $14.5 million in the quarter and $40.4 million year to date. The company opened 41 stores and closed 16 in the first nine months; all 38 agreements available for renewal were renewed.
- Leasing segment contribution rose to $2.4 million for the quarter and $8.3 million year to date. Franchising segment contribution rose to $9.1 million and $23.3 million, respectively.
- SG&A was essentially flat year over year in Q3 and increased 2.8% year to date, primarily reflecting compensation, benefits and development advertising. Year-to-date interest expense increased to $2.0 million from $1.6 million, primarily due to higher average corporate borrowings.
- Winmark adopted the new revenue-recognition standard retrospectively. Initial franchise fees are now recognized over the estimated franchise life, marketing fees over the franchise duration, and contract-acquisition commissions are capitalized and amortized. Prior-period figures were restated; the adoption changed some reported line items and prior-period net income but did not change the current-period figures shown here.
Outlook, risks and contingencies
- Management said available cash, franchising cash flows, discounted lease financing and the credit line should fund planned operations through 2019. It expects to fund expenses, leasing activity and debt service from operating cash flow and, as appropriate, other financing sources. No specific earnings or revenue guidance was provided.
- The company cited dependence on franchisee performance and openings, leasing originations and credit quality, and control of SG&A. It warned that refinancing or other funding may not be available on acceptable terms if cash flow is insufficient.
- Lease exposure is concentrated: two customers represented approximately 24% and 11% of total assets, respectively. A portion of their lease payments was assigned as collateral in non-recourse financing.
- A 1% increase in short-term interest rates was estimated to reduce annual pretax earnings by $101,000. The company had no interest-rate derivatives. It also disclosed foreign-currency exposure, though foreign-currency gains and losses were not material in the period.
- A headquarters lease extension beginning September 1, 2019 entails estimated rent payments of $8.0 million over the extended term, plus taxes and operating expenses. The company reported no material litigation, no off-balance-sheet arrangements, and no material changes to the risk factors in its latest 10-K.
Important facts for investors to verify
- Whether royalty growth and store openings continue, and whether franchisee sales support further royalty increases.
- Lease-portfolio credit quality, customer concentration, allowance adequacy and the economics of new lease originations.
- Cash generation and liquidity relative to debt amortization, line-of-credit availability, floating-rate exposure and covenant requirements.
- Whether the lower effective tax rate and earnings growth are sustainable, and how retrospective revenue-recognition changes affect comparisons.
- Future store closures and renewal performance, along with the company’s capital allocation through dividends and share repurchases.