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 June 26, 2004

 

Commission File Number 000-22012

 

Winmark Corporation

(Exact Name of Registrant as Specified in Its Charter)

 

 

4200 Dahlberg Drive, Suite 100
Golden Valley, MN 55422-4837

(Address of Principal Executive Offices, Zip Code)

 

Registrant’s Telephone Number, Including Area Code 763-520-8500

 

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, and (2) has been subject to such filing requirements for the past 90 days.

 

Yes:     ý      No:     o

 

Indicate by checkmark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

 

Yes:     o      No:     ý

 

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

 

Common stock, no par value, 5,938,906 shares outstanding as of July 30, 2004.

 

 

WINMARK CORPORATION

INDEX

 

PART I.		FINANCIAL INFORMATION
Item 1.		Financial Statements (Unaudited)
		CONDENSED CONSOLIDATED BALANCE SHEETS:
		June 26, 2004 and December 27, 2003
		CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS:
		Three Months Ended June 26, 2004 and June 28, 2003
		Six Months Ended June 26, 2004 and June 28, 2003
		CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS:
		Six Months Ended June 26, 2004 and June 28, 2003
		NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Item 2.		Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3.		Quantitative and Qualitative Disclosures About Market Risk
Item 4.		Disclosure Controls and Procedures
PART II.		OTHER INFORMATION
		Items 1 - 3 and 5 have been omitted since all items are inapplicable or answers negative.
Item 4.		Submission of Matters to a Vote of Security Holders
Item 6.		Exhibits and Reports on Form 8-K

 

2

 

PART I.                       FINANCIAL INFORMATION

 

Item 1:   Financial Statements

 

WINMARK CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS

(unaudited)

 

		June 26, 2004			December 27, 2003
ASSETS
Current Assets:
Cash and cash equivalents		$	7,167,600		$	4,153,300
Marketable securities		1,393,000			2,343,500
Receivables, less allowance for doubtful accounts of  $267,400 and $291,200		2,254,300			2,341,300
Inventories		389,600			528,600
Prepaid expenses and other		162,900			305,800
Deferred income taxes		602,100			602,100
Total current assets		11,969,500			10,274,600
Net investment in leasing operations		95,300			—
Long-term investments and marketable securities		9,042,300			7,783,800
Long-term notes receivables, net		48,600			62,400
Property and equipment, net		243,500			202,200
Other assets, net		624,000			602,600
Deferred income taxes		233,800			233,800
		$	22,257,000		$	19,159,400
LIABILITIES AND SHAREHOLDERS’ EQUITY
Current Liabilities:
Accounts payable		$	1,104,900		$	1,491,400
Accrued liabilities		1,122,400			1,544,500
Current deferred revenue		652,000			604,400
Total current liabilities		2,879,300			3,640,300
Long-term deferred revenue		179,100			113,900
Shareholders’ Equity:
Common stock, no par, 10,000,000 shares authorized,  5,928,906 and 5,671,596 shares issued and outstanding, respectively		4,846,100			2,996,300
Other comprehensive income		1,500			144,500
Retained earnings		14,351,000			12,264,400
Total shareholders’ equity		19,198,600			15,405,200
		$	22,257,000		$	19,159,400

 

The accompanying notes are an integral part of these financial statements

 

3

 

WINMARK CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

 

		Three Months Ended						Six Months Ended
		June 26, 2004			June 28, 2003			June 26, 2004			June 28, 2003
REVENUE:
Royalties		$	4,002,800		$	3,879,100		$	8,632,700		$	8,170,600
Merchandise sales		2,313,500			3,230,800			4,917,500			7,031,300
Franchise fees		200,100			135,000			392,700			270,000
Other		144,100			157,600			281,300			310,800
Total revenue		6,660,500			7,402,500			14,224,200			15,782,700
COST OF MERCHANDISE SOLD		1,956,300			2,527,200			4,108,700			5,648,800
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES		3,446,700			3,895,300			6,765,000			7,353,300
Income from operations		1,257,500			980,000			3,350,500			2,780,600
LOSS FROM EQUITY INVESTMENT		(58,100		)	—			(82,400		)	—
GAIN (LOSS) ON SALE OF MARKETABLE  SECURITIES		(15,400		)	112,400			173,800			115,300
INTEREST AND OTHER INCOME		26,500			80,800			103,000			147,700
Income before income taxes		1,210,500			1,173,200			3,544,900			3,043,600
PROVISION FOR INCOME TAXES		(484,200		)	(416,800		)	(1,458,300		)	(1,165,000		)
NET INCOME		$	726,300		$	756,400		$	2,086,600		$	1,878,600
EARNINGS PER SHARE – BASIC		$	.12		$	.13		$	.36		$	.33
WEIGHTED AVERAGE SHARES OUTSTANDING – BASIC		5,873,719			5,615,919			5,789,463			5,669,063
EARNINGS PER SHARE – DILUTED		$	.11		$	.12		$	.32		$	.30
WEIGHTED AVERAGE SHARES OUTSTANDING – DILUTED		6,548,548			6,244,632			6,444,967			6,230,386

 

The accompanying notes are an integral part of these financial statements

 

4

 

WINMARK CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

 

		Six Months Ended
		June 26, 2004			June 28, 2003
OPERATING ACTIVITIES:
Net income		$	2,086,600		$	1,878,600
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		58,200			116,800
Compensation expense related to granting of stock options		172,200			102,900
Gain on sale of marketable securities		(173,800		)	(115,300		)
Deferred gain on building sale		(90,100		)	(91,600		)
Tax benefit on exercised options		336,600			88,800
Change in operating assets and liabilities:
Receivables		100,800			402,400
Inventories		139,000			(60,500		)
Prepaid expenses and other		142,900			337,900
Deferred income taxes		—			34,900
Accounts payable		(386,500		)	(541,900		)
Accrued liabilities		(336,700		)	(304,000		)
Deferred revenue		202,900			335,800
Net cash provided by operating activities		2,252,100			2,184,800
INVESTING ACTIVITIES:
Purchase of marketable securities and investments, net of proceeds from sales		(362,600		)	(1,215,200		)
Purchase of property and equipment		(112,100		)	(42,500		)
Additions to other assets		(23,200		)	(36,200		)
Proceeds from sale of property and equipment		14,400			—
Net investment in leasing operations		(95,300		)	—
Net cash used for investing activities		(578,800		)	(1,293,900		)
FINANCING ACTIVITIES:
Repurchase of common stock		—			(1,875,000		)
Proceeds from stock option exercises		1,341,000			325,200
Net cash provided by (used for) financing activities		1,341,000			(1,549,800		)
INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS		3,014,300			(658,900		)
Cash and cash equivalents, beginning of period		4,153,300			4,730,000
Cash and cash equivalents, end of period		$	7,167,600		$	4,071,100
SUPPLEMENTAL DISCLOSURES:
Cash paid for interest		$	—		$	—
Cash paid for income taxes		$	1,363,000		$	603,000

 

The accompanying notes are an integral part of these financial statements

 

5

 

WINMARK CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

1.     Management’s Interim Financial Statement Representation:

 

The accompanying condensed financial statements have been prepared by Winmark Corporation and subsidiary (the “Company”), without audit, pursuant to the rules and regulations of the Securities and Exchange Commission.  The information in the 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.  Although the Company believes that the disclosures are adequate to make the information presented not misleading, it is suggested that these condensed financial statements be read in conjunction with the audited financial statements and the notes thereto included in the Company’s latest Annual Report on Form 10-K.

 

Revenues and operating results for the six months ended June 26, 2004 are not necessarily indicative of the results to be expected for the full year.

 

Long-Term Investments

 

The Company has an investment in Tomsten, Inc. (“Tomsten”), the parent company of “Archiver’s” retail chain.  Archiver’s is a retail concept created to help people preserve and enjoy their photographs.  Archiver’s stores feature a wide variety of photo-safe products, including photo albums, scrapbooks and scrapbook supplies, frames, rubber stamps and photo storage and organization products.  The Company has invested a total of $7.5 million in the purchase of common stock of Tomsten.  Such amount was paid in three equal installments of $2 million on July 30, 2002, February 1, 2003 and August 1, 2003, and an additional $1.5 million on March 8, 2004.  The Company’s investment currently represents 19% of the outstanding common stock of Tomsten and is accounted for by the cost method.  The Company has entered into a voting agreement with Tomsten appointing officers of Tomsten as the Company’s proxy with the right to vote the Tomsten shares held by the Company consistent with the two largest shareholders of Tomsten (or in case of their disagreement, consistent with a majority of the remaining shareholders) as long as the Company owns such shares.  No officers or directors of the Company serve as officers or directors of Tomsten.

 

On July 1, 2003, the Company made a $1 million equity investment in eFrame, LLC (“eFrame”).  On November 21, 2003, the Company made an additional $500,000 investment in eFrame.  Based in Omaha, Nebraska, eFrame provides out-sourced information technology services to customers that lower their costs and increase their operating efficiencies.  The investment represents 27.2% of the outstanding units of membership interests in eFrame.  The investment is recorded using the equity method of accounting, whereby the Company’s share of income or loss is included in the statement of operations and increase or decrease the carrying value of the investment.  During the second quarter and first six months of 2004, the Company recorded a $58,100 and $82,400 loss, respectively, on the investment.

 

Net Investment in Leasing

 

The Company has direct financing lease receivables which become due over the next three years.

 

Comprehensive Income (Loss)

 

The Company reports comprehensive income/(loss) in accordance with Statement of Financial Accounting Standards No. 130, “Reporting Comprehensive Income” (“SFAS No. 130”).  SFAS No. 130 establishes standards for reporting in the financial statements all changes in equity during a period.  For the Company, comprehensive income/(loss) consists of unrealized holding gains and losses from investments classified as “available-for-sale.”

 

6

 

Comprehensive income and the components of other comprehensive income were as follows:

 

		Three Months Ended						Six Months Ended
		June 26, 2004			June 28, 2003			June 26, 2004			June 28, 2003
Net income		$	726,300		$	756,400		$	2,086,600		$	1,878,600
Other comprehensive income (loss)		(22,800		)	26,400			(143,000		)	84,900
Total comprehensive income		$	703,500		$	782,800		$	1,943,600		$	1,963,500

 

Accounting for Stock-Based Compensation

 

The Company adopted in 2002 the fair value method recognition provisions of Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (Statement No. 123) using the prospective method as provided by Statement of Financial Accounting Standards No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure.”  Historically, the Company had applied the intrinsic value method permitted under Statement 123, as defined in Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” and related interpretations, in accounting for our stock-based compensation plans.  Accordingly, no compensation cost has been recognized for our stock option plans prior to 2002.  Compensation expense of $86,100 and $172,200 relating to the vested portion of the fair value of stock options granted subsequent to adoption of the fair value method has been expensed to “Selling, General and Administration Expenses” in the three months and six months ended June 26, 2004, respectively.

 

For the options granted prior to fiscal 2002, the Company accounts for the stock option plans under Accounting Principles Board (APB) Opinion No. 25, and accordingly, no compensation expense relating to the granting of these options has been recognized in the Statement of Operations.  Had compensation cost for these plans been determined consistent with SFAS No. 123 “Accounting for Stock-Based Compensations” (SFAS 123), the Company’s pro forma net income and net income per common share would have changed to the following pro forma amounts:

 

		Three Months Ended						Six Months Ended
		June 26, 2004			June 28, 2003			June 26, 2004			June 28, 2003
Net Income as reported		$	726,300		$	756,400		$	2,086,600		$	1,878,600
Add: stock-based employee compensation expense included in reported net income, net of related tax effects.		53,900			40,300			107,800			64,600
Deduct: total stock-based employee compensation expense determined under fair value based method of all awards, net of related tax effects.		(101,500		)	(233,100		)	(203,000		)	(450,200		)
Pro forma net income		$	678,700		$	563,600		$	1,991,400		$	1,493,000
Net income per common share:
Basic – as reported		$	.12		$	.13		$	.36		$	.33
Basic – pro forma		$	.12		$	.10		$	.34		$	.26
Diluted – as reported		$	.11		$	.12		$	.32		$	.30
Diluted – pro forma		$	.10		$	.09		$	.31		$	.24

 

7

 

In accordance with SFAS 123, the fair value of each option granted was estimated on the date of the grant using the Black-Scholes option pricing model with the following weighted average assumptions:

 

Year Granted		Option Fair Value		Risk Free Interest Rate		Expected Life (Years)		Expected Volatility		Dividend Yield
2003		$10.12		3.76%		7		49.7%		none
2002		5.86 / 5.91		3.59 / 3.63		7		55.2 / 55.0		none

 

As of June 26, 2004, the Company had a total of 957,890 stock options and warrants outstanding with an average price of $7.48, of which 554,140 were exercisable as of June 26, 2004.

 

Reclassification

 

Certain amounts in the June 28, 2003 financial statements have been reclassified to conform with the June 26, 2004 presentation.  These reclassifications have no effect on net income or shareholders’ equity as previously reported.

 

2.     Organization and Business:

 

The Company offers licenses to operate retail stores using the service marks Play it Again Sports^Ò, Once Upon A Child^Ò, Plato’s Closet^Ò and Music Go Round^Ò.  In addition, the Company sells inventory to its Play It Again Sports^Ò franchisees through its buying group and operates retail stores.  The Company has a 52/53-week year which ends on the last Saturday in December.

 

3.     Earnings Per Share:

 

The Company calculates earnings per share in accordance with SFAS No. 128 by dividing net income by the weighted average number of shares of common stock outstanding to arrive at the Earnings Per Share - Basic.  The Company calculates Earnings Per Share - Dilutive by dividing net income by the weighted average number of shares of common stock and dilutive stock equivalents from the exercise of stock options and warrants using the treasury stock method.  The weighted average diluted outstanding shares is computed by adding the weighted average basic shares outstanding with the dilutive effect of 674,829 and 628,713 stock options and warrants for the three months ended and 655,504 and 561,323 for the six months ended June 26, 2004 and June 28, 2003, respectively.

 

4.     Other Contingencies:

 

In addition to the operating lease obligations disclosed in footnote 10 of the Company’s Form 10-K for the year ended December 27, 2003, the Company has remained a guarantor on Company-owned retail stores that have been either sold or closed.  These leases have various expiration dates through 2006.  The Company believes it has adequate reserves for any future liability.

 

5.              Subsequent Events:

 

On June 28, 2004, the Company granted options to purchase 2,000 shares of stock to each of the five non-employee directors at an exercise price of $24 per share.  These options vest and become exercisable in five equal increments of 400 shares, beginning one year after the date of grant.

 

On July 30, 2004, Stephen M. Briggs resigned from the board of managers of eFrame, LLC.  The Company continues to own 27.2% of the outstanding membership interests of eFrame.

 

8

 

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

 

Overview

 

As of June 26, 2004, we had 784 franchised retail stores operating under the following brands:  Play it Again Sports^®, Once Upon a Child^®, Plato’s Closet^® and Music Go Round^®.  Management tracks closely the following criteria to evaluate current business operations and future prospects: royalties, franchise fees, leasing activity, selling, general and administrative expenses, franchise store openings and closings and franchise renewals.

 

Our most profitable sources of revenue are royalties earned from our franchise partners and franchise fees for new store openings and transfers.

 

 

During the first six months of 2004, our royalties increased $462,100 or 5.7% compared to the first six months of 2003.  This was partly due to a strengthening economic environment.  Franchise fees grew 45.4% compared to the same period last year and primarily reflect new store openings in all brands.

 

Management monitors several nonfinancial factors in evaluating the current business operations and future prospects including franchise store openings and closings and franchise renewals.  The following is a summary of our franchising store activity for the six months ended June 26, 2004:

 

										SIX MONTHS ENDING 6/26/04
		TOTAL 12/27/03		OPENED/ PURCHASED		CLOSED/ SOLD		TOTAL 6/26/04		AVAILABLE FOR RENEWAL		COMPLETED RENEWALS
Play It Again Sports®
Franchised Stores - US and Canada		427		4		(13	)	418		20		15
Once Upon A Child®
Franchised Stores - US and Canada		211		3		(4	)	210		24		20
Plato’s Closet®
Franchised Stores		106		8		0		114		0		0
Music Go Round®
Franchised Stores		40		4		(2	)	42		0		0
Total		784		19		(19	)	784		44		35

 

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 six months ended June 26, 2004, the Company renewed 35 franchise agreements of the 44 franchise agreements that were available for renewal.

 

9

 

The profitability of our business is dependent in part on management’s ability to control selling, general and administrative expenses.  The major components of selling, general and administrative expenses include salaries, wages and benefits, advertising, travel, rent and administrative costs.  Selling, general and administrative expenses decreased during the first six months of 2004 primarily due to selling a total of five Company-owned stores in the fourth quarter of 2003 and the first quarter of 2004 and the elimination of related salary and rent expenses, partially offset by start-up costs associated with leasing activity.

 

 

Our ability to grow our profits is dependent on our ability to effectively support our franchise partners to produce higher revenues, open new stores, realize opportunities relating to leasing activities of Winmark Business Solutions while controlling our selling, general and administrative expenses.

 

Results of Operations

 

The following table sets forth for the periods indicated, certain income statement items as a percentage of total revenue:

 

		Three Months Ended				Six Months Ended
		June 26, 2004		June 28, 2003		June 26, 2004		June 28, 2003
Revenue:
Royalties		60.1	%	52.4	%	60.7	%	51.8	%
Merchandise sales		34.7		43.7		34.6		44.6
Franchise fees		3.0		1.8		2.7		1.7
Other		2.2		2.1		2.0		1.9
Total revenues		100.0	%	100.0	%	100.0	%	100.0	%
Cost of merchandise sold		(29.4	)	(34.2	)	(28.9	)	(35.8	)
Selling, general and administrative expenses		(51.7	)	(52.6	)	(47.5	)	(46.6	)
Income from operations		18.9		13.2		23.6		17.6
Loss from equity investment		(0.9	)	—		(0.6	)	—
Gain (loss) on sale of investments		(0.2	)	1.5		1.2		0.7
Interest and other income		0.4		1.1		0.7		1.0
Income before income taxes		18.2		15.8		24.9		19.3
Provision for income taxes		(7.3	)	(5.6	)	(10.2	)	(7.4	)
Net income		10.9	%	10.2	%	14.7	%	11.9	%

 

Comparison of Three Months Ended June 26, 2004 to Three Months Ended June 28, 2003

 

Revenues

 

Revenues for the quarter ended June 26, 2004 totaled $6.7 million compared to $7.4 million for the comparable period in 2003, a decrease of 10.0%.

 

Royalties increased to $4 million for the second quarter of 2004 from $3.9 million for the same period in 2003, an approximate 3.2% increase.  The increase is primarily due to higher franchisee retail sales.

 

10

 

Merchandise sales include the sale of product to franchisees either through the Play It Again Sports^® buying group, or through our Computer Support Center (“Direct Franchisee Sales”) and retail sales at the Company-owned stores.  For the second quarter of 2004 and 2003, they were as follows:

 

 

Direct Franchisee Sales revenues decreased $192,500, or 9.9%, for the quarter ended June 26, 2004 compared to the second quarter last year.  This is a result of management’s strategic decision to have more Play It Again Sports^Ò franchisees purchase merchandise directly from vendors and having 23 fewer Play It Again Sports^Ò stores open than one year ago.  The Play It Again Sports^® buying group has not historically contributed to the Company’s net income.  Retail store sales decreased $724,800, or 56.5%, for the quarter ended June 26, 2004 compared to the second quarter last year.  The revenue decline was primarily due to selling two Company-owned Music Go Round^® Stores in the fourth quarter of 2003 and selling three additional Company-owned Music Go Round^® Stores in the first quarter of 2004.

 

Franchise fees increased to $200,100 for the second quarter of 2004 compared to $135,000 for the second quarter of 2003, due to nine franchised stores opening in 2004 compared to six in 2003.

 

Cost of Merchandise Sold

 

Cost of merchandise sold includes the cost of merchandise sold through the Play It Again Sports^Ò buying group, or through our Computer Support Center (“Direct Franchisee Sales”) and at Company-owned retail stores.  Direct Franchisee Sales cost of merchandise sold as a percentage of the Direct Franchisee Sales revenue and cost of merchandise sold at Company-owned stores as a percentage of Company-owned store retail revenue, respectively, for the second quarter of 2004 and 2003 were as follows:

 

 

The 2.1 percentage point decrease in retail cost of goods sold is primarily due to selling five Company-owned Music Go Round^® stores within the last nine months.  Since Music Go Round^® stores have a higher cost of goods sold than the other brands of Company-owned stores, the mix of sales by brand and related cost of goods sold has improved.

 

Selling, General and Administrative

 

The $448,600, or 11.5%, decrease in selling, general and administrative expenses in the quarter ended June 26, 2004 compared to the second quarter of 2003 is primarily due to selling a total of five Company-owned Stores in the fourth quarter of 2003 and first quarter of 2004 and the elimination of related salary and rent expenses, partially offset by start up costs associated with leasing activity.

 

11

 

Loss from Equity Investment

 

For the second quarter ended June 26, 2004, the Company recorded a $58,100 loss from our investment in eFrame, LLC.  This represents our pro rata share of eFrame losses for the period.  As of June 26, 2004, the Company owned 27.2% of the outstanding membership interests of eFrame.

 

Gain on Sale of Marketable Securities

 

During the second quarter of 2004, the Company had a loss on the sale of marketable securities of $15,400 compared to a $112,400 gain in 2003.

 

Interest and Other Income

 

During the second quarter of 2004, the Company had interest and other income of $26,500 compared to $80,800 of interest and other income in the second quarter of 2003.  This decrease reflects a movement in the Company’s investment portfolio to a greater mix of money market securities.

 

Income Taxes

 

The provision for income taxes was calculated at an effective rate of 40.0% and 35.5% for the second quarter of 2004 and 2003, respectively.  The higher effective tax rate in 2004 compared to 2003 reflects a change in estimate of the effective annual rate for 2004 and a higher amount of non-deductible expenses.

 

Comparison of Six Months Ended June 26, 2004 to Six Months Ended June 28, 2003

 

Revenues

 

Revenues for the six months ended June 26, 2004 were $14.2 million compared to $15.8 million for the comparable period in 2003, a decrease of 9.9%.

 

Royalties increased to $8.6 million for the first six months of 2004 from $8.2 million for the same period of 2003, a 5.7% increase.  The increase is due to higher franchisee retail sales.

 

Merchandise sales include the sale of product to franchisees either through the Play It Again Sports^® buying group, or through our Computer Support Center (“Direct Franchisee Sales”) and retail sales at the Company-owned stores.  For the first six months of 2004 and 2003, they were as follows:

 

 

Direct Franchisee Sales revenues decreased $877,500, or 19.6%, for the six months ended June 26, 2004 compared to the same period last year.  This is a result of management’s strategic decision to have more Play It Again Sports^Ò franchisees purchase merchandise directly from vendors and having 23 fewer stores open than one year ago.  Retail store sales decreased $1,236,300, or 48.6%, for the six months ended June 26, 2004 compared to the same period last year.  The revenue decline was primarily due to selling two Company-owned Music Go Round^® Stores in the fourth quarter of 2003 and selling three additional Company-owned Music Go Round^® Stores in the first quarter of 2004.

 

12

 

Franchise fees increased to $392,700 for the first six months of 2004 compared to $270,000 for the first six months of 2003.  The increase is due to opening nineteen stores in the first six months of 2004 compared to fourteen in the same period of 2003.

 

Cost of Merchandise Sold

 

Cost of merchandise sold includes the cost of merchandise sold through the Play It Again Sports^Ò buying group, or through our Computer Support Center (“Direct Franchisee Sales”) and at Company-owned retail stores.  Direct Franchisee Sales cost of merchandise sold as a percentage of the Direct Franchisee Sales revenue and cost of merchandise sold at Company-owned stores as a percentage of Company-owned retail store revenue, respectively, for the first six months of 2004 and 2003 were as follows:

 

 

The 1.9 percentage point decrease in retail cost of goods sold is primarily due to selling five Company-owned Music Go Round^® stores within the last nine months.  Since Music Go Round^® stores have a higher cost of goods sold than the other brands of Company-owned stores, the mix of sales by brand and related cost of goods sold has improved.

 

Selling, General and Administrative

 

The $588,300, or 8.0%, decrease in selling, general and administrative expenses in the first six months ended June 26, 2004 compared to the first six months of 2003 is primarily due to selling a total of five Company-owned Stores in the fourth quarter of 2003 and first quarter of 2004 and the elimination of related salary and rent expenses, partially offset by start up costs associated with leasing activity.

 

Loss from Equity Investment

 

For the six months ended June 26, 2004, the Company recorded a $82,400 loss from our investment in eFrame, LLC.  This represents our pro rata share of eFrame losses for the period.  As of June 26, 2004, the Company owned 27.2% of the outstanding membership interests of eFrame.

 

Gain on Sale of Marketable Securities

 

During the first six months of 2004, the Company had a gain on the sale of marketable securities of $173,800 compared to $115,300 in 2003.

 

Interest and Other Income

 

During the first six months of 2004, the Company had interest and other income of $103,000 compared to $147,700 of interest and other income in the first six months of 2003.  This decrease reflects a movement in the Company’s investment portfolio to a greater mix of money market securities.

 

Income Taxes

 

The provision for income taxes was calculated at an effective rate of 41.1% and 38.3% for the first six months of 2004 and 2003, respectively.  The increase is the result of a state tax liability relating to prior years that was settled during the first quarter of 2004 and a higher amount of non-deductible expenses.

 

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Liquidity and Capital Resources

 

The Company’s primary sources of liquidity have historically been cash flow from operations and credit agreement borrowings.  The components of the income statement that affect the liquidity of the Company include the following non-cash items: depreciation and amortization, compensation expense related to granting of stock options and deferred gain on sale of building.  The most significant component of the balance sheet that affects liquidity is in the other category under Long-Term Investments.  The Company ended the second quarter of 2004 with $8.6 million in cash and current marketable securities and a current ratio (current assets divided by current liabilities) of 4.2 to 1.0 compared to $6.3 million in cash and marketable securities and a current ratio of 2.9 to 1.0 at the end of the second quarter of 2003.

 

Ongoing operating activities provided cash of $2.3 million for the first six months of 2004 compared to $2.2 million for the first six months of 2003.  Components of the cash provided by operating assets and liabilities for the first six months of 2004 include a $100,800 decrease in accounts receivable as a result of lower buying group activity, partially offset by an increase in royalties receivable.  Inventory provided cash of $139,000 as a result of a selling three Company-owned Music Go Round^® stores.  Deferred franchise fee revenue provided cash of $202,900, mainly due to increased deposits on future store openings.  Prepaid expenses provided cash of $142,900 due to decreases in prepaid conference expenses and prepaid insurance.  Components of cash utilized by operating assets and liabilities include a $386,500 decrease in accounts payable mainly due to a decrease in buying group activity and a $336,700 decrease in accrued liabilities primarily due to lower bonus/profit sharing accruals.

 

Investing activities used $578,800 of cash during the first six months of 2004 compared to $1.3 million for the same period last year, primarily due to the purchase of investments in both periods, including the Company’s additional $1.5 million equity investment in Tomsten, Inc., the parent company of Archiver’s.

 

Financing activities provided $1.3 million of cash during the first six months of 2004 compared to using $1.6 million in the first six months of 2003.  The first six months of 2004 consists of amounts received on the exercise of stock options.  The first six months of 2003 included $1.9 million used to repurchase 200,000 shares of Company common stock, offset by $325,200 received from the exercise of stock options.  As of June 26, 2004, the Company has the authorization to repurchase up to an additional 230,272 shares.

 

As of June 26, 2004, the company had no material outstanding commitments for capital expenditures.

 

The Company believes that cash generated from future operations and cash and investments on hand, will be adequate to meet the Company’s current obligations and operating needs.  The Company has and intends to continue using a portion of its cash on hand to fund the start up of its leasing operations.

 

Critical Accounting Policies

 

We prepare the consolidated financial statements of Winmark Corporation and Subsidiary in conformity with accounting principles generally accepted in the United States of America.  As such, we are required to make certain estimates, judgments and assumptions that we believe 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 following critical accounting policies that we believe are most important to aid in fully understanding and evaluating our reported financial results include the following:

 

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Revenue Recognition

 

The Company collects royalties from each 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 historical sales information.  If there are significant changes in the estimates of franchise sales our revenue would be impacted.

 

The Company collects franchise fees when franchise agreements are signed and recognizes the franchise fees as revenue when the store is opened, which is when the Company has performed substantially all initial services required by the franchise agreement.  Franchise fees collected from franchisees but not yet recognized as income, are recorded as deferred revenue in the liability section of our balance sheet.  Merchandise sales through the buying group are recognized when the product has been shipped.  Revenue from sales at our Company-owned stores are recognized at the time of the merchandise sale.

 

Allowance for doubtful accounts

 

We must make estimates of the uncollectability of our accounts and notes receivables.  We base the adequacy of the allowance on historical bad debts, current economic trends and specific analysis of each franchisee’s payment trends and credit worthiness.  If any of the above noted items would be significantly different than estimates, our results could be different.

 

Inventory Reserve

 

The Company values its inventory at the lower of cost, as determined by the average weighted cost method, or market.  We make estimates to establish our inventory reserve.  We base the adequacy of our reserve on detailed analysis of existing inventory, the age of the inventory and current trends.  If any of the above noted items would be significantly different than estimates, the results could be different.

 

Factors That May Affect Future Results

 

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, our statement that we will have adequate capital to meet our current and contingent obligations and operating needs 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.

 

Item 3:   Quantitative and Qualitative Disclosures About Market Risk

 

Approximately $0.8 million of our investments at June 26, 2004 were invested in fixed income securities and $5.3 million of cash and cash equivalents in money market mutual funds, which are subject to the effects of market fluctuations in interest rates.  A one percent change in interest rates may have a significant impact on the fair value of our fixed income investments.

 

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Item 4:   Disclosure 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 the Company’s 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 on this 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.  There was no change in the Company’s internal control over financial reporting during the Company’s most recently completed fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

 

PART II.      OTHER INFORMATION

 

Items 1 – 3 and 5

 

Not applicable.

 

Item 4:   Submission of Matters to a Vote of Security Holders

 

At the Annual Shareholders meeting held on April 28, 2004, the Company submitted to a vote of security-holders the following matters which received the indicated votes:

 

1.     Approving setting the number of members of the Board of Directors at seven (7):

 

For:  4,354,916

Against:  3,605

Abstain:  500

Broker Non-Vote:  0

 

2.     Election of Directors:

 

		For:		Withhold:
John L. Morgan		4,351,486		7,535
Stephen M. Briggs		4,356,886		2,135
William D. Dunlap, Jr.		4,339,516		19,505
Jenele C. Grassle		4,349,716		9,305
Kirk A. MacKenzie		4,357,216		1,805
Paul C. Reyelts		4,344,116		14,905
Mark L. Wilson		4,344,116		14,905

 

3.               Approve 100,000 share increase in shares reserved for issuance under the Stock Option Plan for Non-Employee Directors:

 

For:  2,452,878

Against:  206,152

Abstain:  770

Broker Non-Vote:  1,699,221

 

4.               Ratifying the appointment of KPMG LLP as independent auditors for the current fiscal year:

 

For:  4,339,953

Against:  18,335

Abstain:  733

Broker Non-Vote:  0

 

5.               In their discretion, upon such other business as may properly come before the meeting or any adjournment thereof:

 

For:  4,186,445

Against:  65,576

Abstain:  107,000

Broker Non-Vote:  0

 

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Item 6:   Exhibits and Reports on Form 8-K

 

(a)  Exhibits

 

Exhibit 31.1 –	Certification of Chief Executive Officer under Section 302 of the Sarbanes-Oxley Act of 2002.
Exhibit 31.2 –	Certification of Chief Financial Officer and Treasurer under Section 302 of the Sarbanes-Oxley Act of 2002.
Exhibit 32.1 –	Certification of Chief Executive Officer under Section 906 of the Sarbanes-Oxley Act of 2002.
Exhibit 32.2 –	Certification of Chief Financial Officer and Treasurer under Section 906 of the Sarbanes-Oxley Act of 2002.

 

(b)  Reports on Form 8-K

 

On April 14, 2004, the Company filed an 8-K dated April 13, 2004 furnishing its first quarter 2004 results.

 

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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:  August 6, 2004	By:	/s/	John L. Morgan
			John L. Morgan
			Chairman of the Board and
			Chief Executive Officer
Date:  August 6, 2004	By:	/s/	Brett D. Heffes
			Brett D. Heffes
			Chief Financial Officer and
			Treasurer

 

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EXHIBIT INDEX

WINMARK CORPORATION

FORM 10-Q FOR QUARTER ENDED JUNE 26, 2004

 

Exhibit No.		Description
Exhibit 31.1	–	Certification of Chief Executive Officer under Section 302 of the Sarbanes-Oxley Act of 2002.
Exhibit 31.2	–	Certification of Chief Financial Officer and Treasurer under Section 302 of the Sarbanes-Oxley Act of 2002.
Exhibit 32.1	–	Certification of Chief Executive Officer under Section 906 of the Sarbanes-Oxley Act of 2002.
Exhibit 32.2	–	Certification of Chief Financial Officer and Treasurer under Section 906 of the Sarbanes-Oxley Act of 2002.

 

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