Winmark Corporation — Q2 2018 Form 10-Q
Business context and period. Unaudited results cover the three and six months ended June 30, 2018, compared with the periods ended July 1, 2017. Winmark franchises five retail brands and operates middle-market and small-ticket equipment leasing businesses. It reported 1,224 franchised stores and a $43.4 million net leasing portfolio at quarter-end.
Financial performance
| Metric | Q2 2018 | Q2 2017 | First half 2018 | First half 2017 |
|---|---|---|---|---|
| Revenue | $18.16 million | $16.43 million | $36.32 million | $34.24 million |
| Operating income | $10.07 million | $8.81 million | $20.15 million | $18.13 million |
| Net income | $7.14 million | $5.53 million | $14.10 million | $11.08 million |
| Diluted EPS | $1.73 | $1.23 | $3.42 | $2.48 |
| Operating margin | 55.5% | 53.6% | 55.5% | 52.9% |
| Net margin | 39.3% | 33.6% | 38.8% | 32.3% |
- Q2 revenue rose about 10.5% and net income about 29%; first-half revenue rose about 6.1% and net income about 27%. Growth reflected higher royalties and leasing income, alongside lower effective tax rates.
- First-half royalties increased 6.1% to $22.87 million, primarily from higher franchisee sales and additional stores. Leasing income rose to $10.39 million; leasing expense fell to $1.05 million from $1.93 million. First-half segment contribution was $14.20 million for franchising and $5.95 million for leasing.
- SG&A increased 4.0% in the first half to $13.49 million, mainly from compensation, benefits and development advertising. Interest expense rose to $1.40 million from $0.95 million, attributed mainly to higher average corporate borrowings.
- Effective tax rate was 24.1% for Q2 and 24.7% for the first half, versus 33.9% and 35.5%. The filing attributes the decrease primarily to the Tax Cuts and Jobs Act’s reduction of the federal corporate rate to 21%.
- Operating cash flow was $18.39 million for the first half, versus $13.39 million. Investing used $2.36 million; financing used $15.86 million. Operating cash flow benefited from higher net income and lower cash taxes; the cash-flow statement also reflects a $2.27 million favorable change in income taxes receivable/payable.
Financial position and liquidity
- At June 30, cash and cash equivalents were $1.23 million and restricted cash was $0.11 million. Current assets were $20.80 million versus current liabilities of $12.87 million; current assets include $17.05 million of current lease investment.
- Line-of-credit borrowings were $18.4 million, with $31.6 million available under the $50 million facility. Notes had $30.6 million of principal outstanding: $19.0 million Series A and $11.6 million Series B. Discounted lease-rental liabilities were $3.9 million, including $1.6 million current.
- The line of credit carried rates of 3.73%–5.00%; notes carry fixed rates of 5.50% and 5.10%. Both the credit facility and note agreement are secured by substantially all company assets. Winmark reported covenant compliance. A 1% increase in short-term rates was estimated to reduce annual pretax earnings by $184,000; no interest-rate derivatives were in place.
- Shareholders’ deficit narrowed to $20.76 million from $35.71 million at year-end. The company paid $1.00 million in dividends during the first half and repurchased no shares.
Material changes, outlook and risks
- Franchise activity in the first half included 24 openings and 11 closures. All 29 agreements available for renewal were renewed.
- Management expects cash on hand, franchising cash flow, discounted lease financing and the line of credit to fund planned operations through 2019. It expects to meet expenses, fund leasing activity and service debt from operating cash flow and other financing options, while noting that future performance and access to refinancing or capital markets are uncertain.
- In May 2018, Winmark extended its headquarters lease for ten years and four months beginning September 1, 2019, with estimated rent of $8.0 million over the extension, plus taxes and operating expenses.
- A single leasing customer’s leased assets represented approximately 28% of total assets. The lease portfolio allowance for credit losses was $755,900; first-half provision was $204,000 and net charge-offs were approximately $0.2 million.
- Adoption of revenue-recognition guidance was applied retrospectively. Initial franchise fees are now recognized over the estimated franchise life, and marketing fees over the franchise duration; prior-period results were restated. The filing says this adoption changed the timing of recognition for certain franchise revenue and costs.
- Management reported no material litigation, no material changes to the risk factors from the latest Form 10-K, and no material change in internal control over financial reporting. It also stated there were no off-balance-sheet arrangements at quarter-end.
Important facts for investors to verify
- Whether franchisee sales, store growth and renewals continue to support royalty growth.
- Leasing portfolio growth, customer concentration, credit performance, charge-offs and residual-value assumptions.
- Debt repayment needs, borrowing availability, covenant headroom and exposure to variable interest rates.
- Whether first-half operating cash flow is sustainable, given the income-tax working-capital contribution and lower cash taxes.
- The ongoing effects of revenue-recognition changes and the future cash commitments under the extended headquarters lease.