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Table of Contents

 

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 


 

FORM 10-K

 

(Mark one)

 

x

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

 

For the fiscal year ended December 25, 2010, or

 

o

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, Minnesota

 

55441

(Address of Principal Executive Offices)

 

(Zip Code)

 

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

 

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

 

Title of Each Class

 

Name of Each Exchange On Which Registered

Common Stock, no par value per share

 

Nasdaq Global Market

 

Securities registered pursuant to Section 12(g) of the Act: None

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes o No x

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  Yes o No x

 

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 x No o

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted 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 and post such files).  Yes  o No o

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  x

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See the definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act (Check one): (Do not check if a smaller reporting company)

 

Large accelerated filer o

 

Accelerated filer o

 

 

 

Non-accelerated filer o

 

Smaller reporting company x

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act.  Yes o No x

 

The aggregate market value of the voting and non-voting common equity held by non-affiliates of the registrant, computed by reference to the price at which the common equity was last sold, or the average bid and asked price of such common equity, as of the last business day of the registrant’s most recently completed second fiscal quarter was $50,470,595.

 

Shares of no par value Common Stock outstanding as of March 7, 2011: 4,977,238 shares.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of the definitive Proxy Statement for the Registrant’s Annual Meeting of Shareholders to be held on April 27, 2011 have been incorporated by reference into Items 10, 11, 12, 13 and 14 of Part III of this report.

 

 

 



Table of Contents

 

WINMARK CORPORATION AND SUBSIDIARIES

INDEX TO ANNUAL REPORT ON FORM 10-K

 

 

 

PAGE

 

 

 

PART I

 

 

 

 

 

Item 1.

Business

1

 

 

 

Item 1A.

Risk Factors

12

 

 

 

Item 2.

Properties

15

 

 

 

Item 3.

Legal Proceedings

15

 

 

 

Item 4.

Reserved

15

 

 

 

 

 

PAGE

 

 

 

PART II

 

 

 

 

 

Item 5.

Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

16

 

 

 

Item 6.

Selected Financial Data

17

 

 

 

Item 7.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

18

 

 

 

Item 7A.

Quantitative and Qualitative Disclosures About Market Risk

26

 

 

 

Item 8.

Financial Statements and Supplementary Data

27

 

 

 

Item 9.

Changes in and Disagreements With Accountants on Accounting and Financial Disclosure

51

 

 

 

Item 9A.

Controls and Procedures

51

 

 

 

Item 9B.

Other Information

51

 

 

 

 

 

PAGE

 

 

 

PART III

 

 

 

 

 

Item 10.

Directors, Executive Officers and Corporate Governance

52

 

 

 

Item 11.

Executive Compensation

52

 

 

 

Item 12.

Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

52

 

 

 

Item 13.

Certain Relationships and Related Transactions, and Director Independence

52

 

 

 

Item 14.

Principal Accountant Fees and Services

52

 

 

 

 

 

PAGE

 

 

 

PART IV

 

 

 

 

 

Item 15.

Exhibits and Financial Statement Schedules

52

 

 

 

 

SIGNATURES

53

 



Table of Contents

 

PART I

 

ITEM 1: BUSINESS

 

Background

 

We are a franchisor of four value-oriented retail store concepts that buy, sell, trade and consign merchandise.  Each of our retail store brands emphasizes consumer value by offering high-quality used merchandise at substantial savings from the price of new merchandise and by purchasing customers’ used goods that have been outgrown or are no longer used.  The retail brands also offer new merchandise to customers.

 

We operate a middle-market equipment leasing business through our wholly owned subsidiary, Winmark Capital Corporation.  Our middle-market leasing business serves large and medium-sized businesses and focuses on technology-based assets which typically cost more than $250,000.  The businesses we target generally have annual revenue of between $50 million and several billion dollars.  We generate middle-market equipment leases primarily through business alliances, equipment vendors and directly from customers.

 

We also operate a small-ticket financing business through our wholly owned subsidiary, Wirth Business Credit®, Inc.  Our small-ticket financing business serves small businesses and focuses on assets which generally have a cost of $5,000 to $100,000.

 

The Company also provides management services to Tomsten, Inc. (d/b/a Archiver’s) for an annual fee.  In connection with these services, John L. Morgan, our Chairman and Chief Executive Officer serves as Chairman and Chief Executive Officer of Tomsten, Inc.

 

Our significant assets are located within the United States, and we generate all revenues from United States operations other than franchising revenues from Canadian operations of approximately $2.2 million, $1.8 million and $2.0 million for 2010, 2009 and 2008, respectively.  For additional financial information, please see Item 6 — Selected Financial Data and Item 8 — Financial Statements and Supplementary Data.   We were incorporated in Minnesota in 1988.

 

Franchise Operations

 

Our four retail brands with their fiscal year 2010 system-wide sales, defined as estimated revenues generated by all franchise owned locations, are summarized as follows:

 

Plato’s Closet® - $241 million.

 

We began franchising the Plato’s Closet brand in 1999.  Plato’s Closet franchises sell and buy used clothing and accessories geared toward the teenage and young adult market.  Customers have the opportunity to sell their used items to a Plato’s Closet franchise when gently-used or outgrown and to purchase quality used clothing and accessories at prices lower than new merchandise.  For the years ended 2010, 2009 and 2008, Plato’s Closet contributed royalties and franchise fees of $10.3 million, $8.5 million and $6.9 million , respectively.  As a percentage of consolidated revenues for 2010, 2009 and 2008, these amounts equaled 25.1%, 22.8% and 19.5%, respectively.

 

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Table of Contents

 

Play It Again Sports® - $236 million.

 

We began franchising the Play It Again Sports brand in 1988.  Play It Again Sports franchises sell, buy, trade and consign used and new sporting goods, equipment and accessories for a variety of athletic activities including hockey, wheeled sports (in-line skating, skateboards, etc.), fitness, ski/snowboard, golf and baseball/softball.  The franchises offer a flexible mix of merchandise that is adjusted to adapt to seasonal and regional differences.  Play It Again Sports is known for providing high value to the customer by offering a mix of new and used sporting goods.  For the years ended 2010, 2009 and 2008, Play It Again Sports contributed royalties and franchise fees of $9.7 million, $9.1 million and $9.8 million, respectively.   As a percentage of consolidated revenues for 2010, 2009 and 2008, these amounts equaled 23.7%, 24.3% and 27.6% respectively.

 

Once Upon A Child® - $168 million.

 

We began franchising the Once Upon A Child brand in 1993.  Once Upon A Child franchises sell and buy used and new children’s clothing, toys, furniture, equipment and accessories.  This brand primarily targets cost-conscious parents of children ages infant to 10 years with emphasis on children ages seven years old and under.  These customers have the opportunity to sell their used children’s items to a Once Upon A Child franchise when outgrown and to purchase quality used children’s clothing, toys, furniture and equipment at prices lower than new merchandise.  New merchandise is offered to supplement the used merchandise.  For the years ended 2010, 2009 and 2008, Once Upon A Child contributed royalties and franchise fees of $7.0 million, $6.4 million and $5.7 million, respectively.  As a percentage of consolidated revenues for 2010, 2009 and 2008, these amounts equaled 17.0%, 17.1% and 16.0% respectively.

 

Music Go Round® - $25 million.

 

We began franchising the Music Go Round brand in 1994.  Music Go Round franchises sell, buy, trade and consign used and new musical instruments, speakers, amplifiers, music-related electronics and related accessories for parents of children who play musical instruments, as well as professional and amateur musicians.  For the years ended 2010, 2009 and 2008, Music Go Round contributed royalties and franchise fees of $0.8 million each year, respectively.  As a percentage of consolidated revenues for 2010, 2009 and 2008, these amounts equaled 1.9%, 2.0% and 2.2% respectively.

 

The following table presents a summary of our retail brands franchising activity for the fiscal year ended December 25, 2010:

 

 

 

TOTAL
12/26/09

 

OPENED

 

CLOSED

 

TOTAL
12/25/10

 

AVAILABLE
FOR
RENEWAL

 

COMPLETED RENEWALS

 

% RENEWED

 

Play It Again Sports

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Franchises - US and Canada

 

341

 

7

 

(20

)

328

 

25

 

25

 

100

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Plato’s Closet

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Franchises - US and Canada

 

267

 

35

 

(1

)

301

 

22

 

22

 

100

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Once Upon A Child

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Franchises - US and Canada

 

235

 

13

 

(7

)

241

 

19

 

19

 

100

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Music Go Round

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Franchises - US

 

34

 

1

 

(2

)

33

 

1

 

1

 

100

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total Franchised Stores

 

877

 

56

 

(30

)

903

 

67

 

67

 

100

%

 

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Table of Contents

 

Retail Brands Franchising Overview

 

We use franchising as a business method of distributing goods and services through our retail brands to consumers.  We, as franchisor, own a retail business brand, represented by a service mark or similar right, and an operating system for the franchised business.  We then enter into franchise agreements with franchisees and grant the franchisee the right to use our business brand, service marks and operating system to manage a retail business.  Franchisees are required to operate their retail businesses according to the systems, specifications, standards and formats we develop for the business brand.  We train the franchisees how to operate the franchised business.  We also provide continuing support and service to our franchisees.

 

We have developed value-oriented retail brands based on a mix of used and new merchandise.  We franchise rights to franchisees who open franchised locations under such brands.  The key elements of our franchise strategy include:

 

·                  franchising the rights to operate retail stores offering value-oriented merchandise;

·                  attracting new, qualified franchisees; and

·                  providing initial and continuing support to franchisees.

 

We have and will continue to reinvest operating cash flow generated from our business into:

 

·                  supporting the current franchise systems;

·                  making investments in infrastructure to support our corporate needs;

·                  supporting Winmark Capital and Wirth Business Credit; and

·                  pursuing new business opportunities.

 

Offering Value-Oriented Merchandise

 

Our retail brands provide value to consumers by purchasing and reselling used merchandise that consumers have outgrown or no longer use at substantial savings from the price of new merchandise.  Our retail brands also offer value-priced new merchandise.  By offering a combination of high-quality used and value-priced new merchandise, we benefit from consumer demand for value-oriented retailing.  In addition, we believe that among national retail operations our retail store brands provide a unique source of value to consumers by purchasing used merchandise.  We also believe that the strategy of buying used merchandise increases consumer awareness of our retail brands.

 

Attracting Franchisees

 

Our franchise marketing program for retail brands seeks to attract prospective franchisees with experience in management and operations and an interest in being the owner and operator of their own business.  We seek franchisees who:

 

·                  have a sufficient net worth;

·                  have prior business experience; and

·                  intend to be integrally involved with the management of the business.

 

At December 25, 2010, we had 34 signed retail franchise agreements that are expected to open in 2011.

 

We began franchising in Canada in 1991 and, as of December 25, 2010, had 62 franchised retail stores open in Canada.  The Canadian retail stores are operated by franchisees under agreements substantially similar to those used in the United States.

 

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Table of Contents

 

Retail Brand Franchise Support

 

As a franchisor, our success depends upon our ability to develop and support competitive and successful franchise brands.  We emphasize the following areas of franchise support and assistance.

 

Training

 

Each franchisee must attend our training program regardless of prior experience.  Soon after signing a franchise agreement, the franchisee of one of our retail brands is required to attend new owner orientation training.  This course covers basic management issues, such as preparing a business plan, lease evaluation, evaluating insurance needs and obtaining financing.  Our training staff assists each franchisee in developing a business plan for their retail store with financial and cash flow projections.  The second training session is centered on store operations.  It covers, among other things, point-of-sale computer training, inventory selection and acquisition, sales, marketing and other topics.  We provide the franchisee with operations manuals that we periodically update.

 

Field Support

 

We provide operations personnel to assist the franchisee in the opening of a new business.  We also have an ongoing field support program designed to assist franchisees in operating their retail stores.  Our franchise support personnel visit each retail store periodically and, in most cases, a business assessment is made to determine whether the franchisee is operating in accordance with our standards.  The visit is also designed to assist franchisees with operational issues.

 

Purchasing

 

During training each franchisee is taught how to evaluate, purchase and price used goods.  In addition to purchasing used products from customers who bring merchandise to the store, the franchisee is also encouraged to develop sources for purchasing used merchandise in the community.  Franchisees typically do not repair or recondition used products, but rather, purchase quality used merchandise that may be put directly on display for resale on an ‘as is’ basis.  We have developed specialized computer point-of-sale systems for Once Upon A Child and Plato’s Closet stores that provide the franchisee with standardized pricing information to assist in the purchasing of used items.  Play It Again Sports, Once Upon A Child and Music Go Round also use buying guides and the point-of-sale system to assist franchisees in pricing used items.

 

We provide centralized buying services, which on a limited basis include credit and billing for the Play It Again Sports franchisees.  Upon credit approval, Play It Again Sports franchisees may order through the buying group, in which case, product is shipped directly to the store by the vendor.  We are invoiced by the vendor, and in turn, we invoice the franchisee adding a 4% service fee to cover our costs of operating the buying group.  Our Play It Again Sports franchise system uses several major vendors including Horizon Fitness, Nautilus, Wilson Sporting Goods, Champro Sporting Goods, Easton-Bell Sports, RBK CCM Hockey and Bauer Hockey.   The loss of any of the above vendors would change the vendor mix, but not significantly change our products offered.  The amount of product being sold through the buying group has significantly decreased over the past few years as a result of our strategic decision to have more franchisees purchase merchandise directly from vendors.

 

To provide the franchisees of our Once Upon A Child and Music Go Round systems a source of affordable new product, we have developed relationships with our significant vendors and negotiated prices for our franchisees to take advantage of the buying power a franchise system brings.

 

Our typical Once Upon A Child franchised store purchases approximately 30% of its new product from Graco, Million Dollar Baby, Dorel Juvenile Group and North Gates.  The loss of any of the above vendors would change the vendor mix, but not significantly change our products offered.

 

There are no significant vendors to our typical Plato’s Closet franchised store.

 

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Table of Contents

 

Retail Advertising and Marketing

 

We encourage our franchisees to implement a marketing program that includes one or more of the following: television, radio, direct mail, point-of-purchase materials, in store signage and local store marketing programs.  Through these mediums, we advertise that we buy, sell and trade used and new items.  Franchisees of the respective retail brands are required to spend a minimum of 5% of their gross sales on approved advertising and marketing and are required to pay us an annual marketing fee.  Franchisees may be required to participate in regional cooperative advertising groups.

 

Computerized Point-Of-Sale Systems

 

We require our retail brand franchisees to use a retail information management computer system in each store, which has evolved with the development of new technology.  This computerized point-of-sale system is designed specifically for use in our franchise retail stores.  The current system includes our proprietary Data Recycling System software, a dedicated server, two or more work station registers, a receipt printer, a report printer and a bar code scanner, together with software modules for inventory management, cash management and customer information management.  Our franchisees purchase the computer hardware from us.  We charge a fee of approximately 4% for handling and configuration of systems sold through us.  The Data Recycling System software is designed to accommodate buying and consigning of used merchandise.  This system provides franchisees with an important management tool that reduces errors, increases efficiencies and enhances inventory control.  We provide point-of-sale system support through our Computer Support Center located at our Company headquarters.

 

Winmark Business Solutions

 

We established Winmark Business Solutions (“WBS”) to provide business support services to franchisees and other small businesses.  We provide a web site that:

 

·                  aggregates the purchasing power of small businesses, including our franchisees, which allows us to more effectively negotiate arrangements for products and services critical to most small businesses;

·                  provides an easy point of contact between vendors and small businesses;

·                  provides small business owners information and tools that will help them be successful at every stage of their small business;

·                  provides business critical products, including office supplies and small business books, through the WBS Marketplace, an online store done in partnership with Amazon.com;

·                  provides equipment leasing options for small businesses; and

·                  provides advertising and promotional opportunities for small businesses.

 

We have established preferred provider relationships with high quality vendors that provide small businesses a host of critical services.  Included in the array of services available through the web site are accounting, tax and payroll services, copying and printing services, purchase of office supplies, credit card processing, loss prevention, business insurance, computer/POS equipment, and more.  A small business becomes a member of Winmark Business Solutions by registration, which is free.

 

The Retail Franchise Agreement

 

We enter into franchise agreements with our franchisees.  The following is a summary of certain key provisions of our current standard retail brand franchise agreement.  Except as noted, the franchise agreements used for each of our retail brands are generally the same.

 

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Table of Contents

 

Each franchisee must execute our franchise agreement and pay an initial franchise fee.  At December 25, 2010, the franchise fee for all brands was $25,000 for an initial store in the U.S. and $26,000CAD for an initial store in Canada.  Once a franchisee opens its initial store, it can open additional stores, in any brand, by paying a $15,000 franchise fee for a store in the U.S. and $16,000CAD for a store in Canada, provided an acceptable territory is available and the franchisee meets the brand’s additional store standards.  The franchise fee for our initial retail store and additional retail store in Canada is based upon the exchange rate applied to the United States fee on the last business day of the preceding fiscal year.  The franchise fee in March 2011 for an initial retail store in Canada will be $25,000CAD, and an additional retail store in Canada will be $15,000CAD.   Typically, the franchisee’s initial store is open for business between eight and ten months from the date the franchise agreement is signed.  The franchise agreement has an initial term of 10 years, with subsequent 10-year renewal periods, and grants the franchisee an exclusive geographic area, which will vary in size depending upon population, demographics and other factors.  Under current franchise agreements, franchisees of the respective brands are required to pay us weekly continuing fees (royalties) equal to the percentage of gross sales outlined in their Franchise Agreements, generally ranging from 4% to 5% for Play It Again Sports, Plato’s Closet and Once Upon A Child and 3% for Music Go Round.

 

Each Franchisee is required to pay us an annual marketing fee of between $500 and $1,000.  Each new or renewing Play It Again Sports, Plato’s Closet, Once Upon A Child and Music Go Round franchisee is required to spend 5% of its gross sales for advertising and promoting its franchised store.  Existing franchisees with older Franchise Agreements may only be required to spend 3% to 4% of their gross sales on advertising and promotion.  Currently, for all of the retail brands except Play It Again Sports, we have the option to increase the minimum advertising expenditure requirement from 5% to 6% of the franchisee’s gross sales, of which up to 2% would be paid to us as an advertising fee for deposit into an advertising fund.  While we currently do not have the option to increase the advertising expenditure requirement for Play It Again Sports franchisees, we may also require those franchisees to pay 2% of their gross sales into an advertising fund.  This fund, if initiated, would be managed by us and would be used for advertising and promotion of the franchise system.

 

During the term of a franchise agreement, franchisees agree not to operate directly or indirectly any competitive business.  In addition, franchisees agree that after the end of the term or termination of the franchise agreement, franchisees will not operate any competitive business for a period of one year and within a reasonable geographic area.  We will pursue enforcement of our noncompetition clause vigorously; however, these noncompetition clauses are not enforceable in certain states or in all circumstances.

 

Although our franchise agreements contain provisions designed to assure the quality of a franchisee’s operations, we have less control over a franchisee’s operations than we would if we owned and operated a retail store.  Under the franchise agreement, we have a right of first refusal on the sale of any franchised store, but we are not obligated to repurchase any franchise.

 

Renewal of the Franchise Relationship

 

At the end of the 10-year term of each franchise agreement, each franchisee has the option to “renew” the franchise relationship by signing a new 10-year franchise agreement.  If a franchisee chooses not to sign a new franchise agreement, a franchisee must comply with all post termination obligations including the franchisee’s noncompetition clause discussed above.  We may choose not to renew the franchise relationship only when permitted by the franchise agreement and applicable state law.

 

We believe that renewing a significant number of these franchise relationships is important to the success of the Company.

 

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Table of Contents

 

Retail Franchising Competition

 

Retailing, including the sale of sporting goods, children’s and teenage apparel, and musical instruments, is highly competitive.  Many retailers have substantially greater financial and other resources than we do.  Our franchisees compete with established, locally owned retail stores, discount chains and traditional retail stores for sales of new merchandise.  Full line retailers generally carry little or no used merchandise.  Resale, thrift and consignment shops and garage and rummage sales offer some competition to our franchisees for the sale of used merchandise.  Also, our franchisees increasingly compete with online used and new goods retailers such as eBay, Harmony Central and many others. We are aware of, and compete with, one franchisor of stores which sells new and used sporting equipment, two franchisors of stores which sell used and new children’s clothing, toys and accessories and two franchisors of teen apparel stores.

 

Our Plato’s Closet franchise stores primarily compete with specialty apparel stores such as Gap, Abercrombie & Fitch, Old Navy, Banana Republic and The Limited.  We compete with two other franchisors in the teenage resale clothing retail market.

 

Our Play It Again Sports franchisees compete with large retailers such as Dick’s Sporting Goods, The Sports Authority as well as regional and local sporting goods stores.  We also compete with Target and Wal-Mart..

 

Our Once Upon A Child franchisees compete primarily with large retailers such as Babies “R” Us, Wal-Mart, Target and various specialty children’s retail stores such as Gap Kids. We compete with one other franchisor in the specialty children’s resale retail market.

 

Our Music Go Round franchise stores compete with large musical instrument retailers such as Guitar Center as well as local independent musical instrument stores.  We do not believe we compete with any other franchisor directly in the used and new musical instrument market.

 

Our retail franchises may face additional competition in the future.  This could include additional competitors that may enter the used merchandise market.  We believe that our franchisees will continue to be able to compete with other retailers based on the strength of our value-oriented brands and the name recognition associated with our service marks.

 

We also face competition in connection with the sale of franchises.  Our prospective franchisees frequently evaluate other franchise opportunities before purchasing a franchise from us.  We compete with other franchise companies for franchisees based on the following factors, among others: amount of initial investment, franchise fee, royalty rate, profitability, franchisor services and industry.  We believe that our franchise brands are competitive with other franchises based on the fees we charge, our franchise support services and the performance of our existing franchise brands.

 

Wirth Business Credit Franchise System

 

We began franchising the Wirth Business Credit business in 2006.  Franchisees in the Wirth Business Credit franchise system market and sell small business equipment leasing and financing services offered by us.  Wirth Business Credit franchisees are compensated for each leasing or financing transaction funded through Winmark or its affiliates, and as such Winmark Corporation does not receive royalties from Wirth Business Credit franchisees.

 

As of the beginning of the fiscal year covered by this report, we had 37 Wirth Business Credit franchised territories operating in the United States.  During fiscal 2010, we did not open any additional franchise territories and the franchise agreements covering 22 of the existing territories were terminated for various reasons.   During the first quarter of fiscal 2011, the franchise agreements covering the remaining 15 territories were terminated for various reasons, and as of the date of filing of this Form 10-K, we no longer offer Wirth Business Credit franchises.

 

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Table of Contents

 

Equipment Leasing Operations

 

We operate a middle-market leasing operation through Winmark Capital Corporation, a wholly owned subsidiary.  We operate a small-ticket financing operation through Wirth Business Credit, Inc., a wholly owned subsidiary.  We incorporated both of the corporations in April 2004.  To differentiate ourselves from our competitors in the leasing industry, we offer innovative lease and financing products and concentrate on building long-term, relationship-based associations with our customers and business alliances.

 

During the past year, our leasing operations have experienced improved financial results.  Contribution to consolidated operating income from this segment improved from a loss of $1.4 million in fiscal 2009 to income of $3.1 million in fiscal 2010.  Our leasing portfolio has decreased over this period from $37.0 million at the end of 2009 to $30.7 million at the end of 2010.  The decrease in the leasing portfolio during this period was primarily driven by decreased activity levels in our small-ticket financing business.

 

Winmark Capital Corporation

 

Winmark Capital Corporation is engaged in the business of providing non-cancelable leases for high-technology and business-essential assets to both larger organizations and smaller, growing companies.  We target businesses with annual revenue between $50 million and several billion dollars.  We focus on transactions that generally have terms from two to five years.  Such transactions are generally larger than $250,000 and include high-technology equipment and/or business essential equipment, including computers, telecommunications equipment, point-of-sale systems and other business-essential equipment.  The leases are retained in our portfolio to accommodate equipment additions and upgrades to meet customers’ changing needs.

 

Industry

 

The high-technology equipment industry has been characterized by rapid and continuous advancements permitting broadened user applications and reductions in processing costs.  The introduction of new equipment generally does not cause existing equipment to become obsolete but usually does cause the market value of existing equipment to decrease to reflect the improved performance per dollar cost of the new equipment.  Users frequently replace equipment as their existing equipment becomes inappropriate for their needs or as increased data processing capacity is required, creating a secondary market in used equipment.

 

Generally, high-technology equipment, such as data processing equipment, does not suffer from material physical deterioration if properly maintained.  Our leased equipment is kept under continual maintenance, in accordance with the manufacturer’s specifications, most often provided by the manufacturer.  The economic life and residual value of data processing equipment is subject to, among other things, the development of technological improvements and changes in sale and maintenance terms initiated by the manufacturer.

 

Business Strategy

 

Our business strategy allows us to differentiate ourselves from our competitors in the leasing industry.  Key elements of this strategy include:

 

·                  Relationship Focus.   We maintain a focused, long-term, customer-service approach to our business.

·                  Full Service.  We can service the equipment leasing needs of both large organizations as well as smaller, growing companies.

·                  Asset Ownership.  We differentiate ourselves with our commitment to retain ownership of our leases throughout the lease term.

 

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Leasing and Sales Activities

 

Our middle-market lease products are marketed nationally through our principal office in Minneapolis, Minnesota and our satellite offices in Atlanta, Georgia; Boulder, Colorado and Santa Barbara, California.

 

We market our leasing services directly to end-users and indirectly through business alliances, and through vendors of equipment, software, value-added services and consulting services.  We directly market to customers and prospects by telephone canvassing and by establishing relationships with business alliances in the local business community.  We may also advertise in magazines or other periodicals in targeted industries.

 

We generally lease high-technology and other business-essential equipment for terms ranging from two to five years.  Additionally, we may lease operating system and application software to our customers, but typically only with a hardware lease.  Our standard lease agreements, entered into with each customer, are noncancelable “net” leases which contain “hell-or-high water” provisions under which the customer, upon acceptance of the equipment, must make all lease payments regardless of any defects or performance of the equipment, and which require the customer to maintain and service the equipment, insure the equipment against casualty loss and pay all property, sales and other taxes related to the equipment.  We retain ownership of the equipment we lease and, in the event of default by the customer, we or the financial institution to whom the lease payment has been assigned may declare the customer in default, accelerate all lease payments due under the lease and pursue other available remedies, including repossession of the equipment.  Upon expiration of the initial term or extended lease term, depending on the structure of the lease, the customer may:

 

·                  return the equipment to us;

·                  renew the lease for an additional term; or

·                  purchase the equipment.

 

If the equipment is returned to us, it will be either re-leased to another customer or sold into the secondary-user marketplace.

 

Wirth Business Credit, Inc.

 

Our small-ticket financing operation serves the needs of small businesses.  Small-ticket financing transactions are typically between $5,000 and $100,000, have terms of between two and five years and cover business essential assets, including computers, printing equipment, security systems, telecommunications equipment, car wash equipment, production equipment and other assets.  Small-ticket financing products are marketed under the trade name Wirth Business Credit through our direct efforts as well as through former Wirth Business Credit franchisees.  During the first quarter of 2011, we changed the nature of our relationship with four of our Wirth Business Credit franchisees.  The franchise relationship was terminated and each former franchisee signed a broker agreement that allows them to continue to submit small-ticket leasing transactions to us for our approval.  From an operating perspective, the former franchisees continue to have a mechanism to submit applications for their credit approval and ultimate booking.

 

Industry

 

The small ticket finance industry is highly fragmented and competitive. Small business owners typically finance their businesses through one of many possible sources including banks, vendor captive finance companies, leasing brokers, credit card companies and independent leasing companies.  These sources of funding typically limit their focus to certain types of transactions and may base their decision on credit quality, geography, size of transaction, type of asset or other criteria.  The small-ticket finance industry is very competitive, however, small business owners do not generally receive the same level of customer service as larger businesses do.  Small business owners desire products that are convenient, easy to understand, competitive and come from a trusted source.

 

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The small ticket finance industry has faced particularly unfavorable economic trends during the past few years that have significantly impacted the financial viability and credit quality of many small business owners.  These circumstances have the effect of not only reducing the pool of credit worthy customers, but increasing the level of non-performing and under-performing existing financing transactions of lending institutions and leasing companies.

 

Business Strategy

 

Key elements of our small-ticket business strategy include:

 

·                  Relationship Focus.  We establish relationships with companies that control or have influence over multiple smaller businesses such as franchisors, equipment vendors and associations.

·                  Customer Service.   We understand that small business owners desire a convenient, flexible financing solution.  We provide fast credit decisions, flexible terms and an easy to understand process.

 

Leasing and Sales Activities

 

We originate financing transactions through some of our former Wirth Business Credit franchisees and through our direct efforts.   We focus our sales efforts on establishing relationships with organizations with influence over many small businesses such as vendors, franchisors and trade associations.

 

We generally finance business-essential assets for terms ranging from two to five years.  Our financing transactions are generally full pay out transactions, which means, after paying all required payments under the financing agreement, the customer owns the asset.

 

Financing

 

Our ability to arrange financing is important to our middle-market leasing and our small-ticket financing businesses.

 

Winmark Capital Corporation will from time to time arrange permanent financing of leases through non-recourse discounting of lease rentals with various financial institutions at fixed interest rates.  The proceeds from the assignment of the lease rentals will generally be equal to the present value of the remaining lease payments due under the lease, discounted at the interest rate charged by the financial institution.  Interest rates obtained under this type of financing are negotiated on a transaction-by-transaction basis and reflect the financial strength of the customer, the term of the lease and the prevailing interest rates.  In the event of a default by a customer in non-recourse financing, the financial institution has a first lien on the underlying leased equipment, with no further recourse against us.  The institution may, however, take title to the collateral in the event the customer fails to make lease payments or certain other defaults by the customer occur under the terms of the lease.

 

To date, we have funded the vast majority of our leases internally using our available cash or debt.  Leases are funded internally for a variety of reasons, including:

 

·                  we may have a sufficient amount of cash on hand;

·                  lease amounts are too small to be attractive to financial institutions;

·                  the credit strength of the customer is acceptable only for recourse funding; or

·                  we intend to discount a lease but the discounting process has not been completed.

 

We will primarily rely on existing cash flow and recourse bank facilities to fund both our middle-market and small-ticket portfoliosWe currently have a $30 million line of credit with The PrivateBank and Trust Company and Harris N.A.

 

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Equipment Leasing Competition

 

We compete with a variety of equipment financing sources that are available to businesses, including:  national, regional and local finance companies that provide lease and loan products; financing through captive finance and leasing companies affiliated with major equipment manufacturers; credit card companies; and commercial banks, savings and loans, and credit unions.  Many of these companies are substantially larger than we are and have considerably greater financial, technical and marketing resources than we do.

 

Some of our competitors have a lower cost of funds and access to funding sources that are not available to us.  A lower cost of funds could enable a competitor to offer leases with yields that are much less than the yields that we offer, which might cause us to lose lease origination volume.  In addition, certain of our competitors may have higher risk tolerances or different risk assessments, which could enable them to establish more origination sources and end user customer relationships and increase their market share.  We have and will continue to encounter significant competition.

 

Government Regulation

 

Fourteen states, the Federal Trade Commission and four Canadian Provinces impose pre-sale franchise registration and/or disclosure requirements on franchisors.  In addition, a number of states have statutes which regulate substantive aspects of the franchisor-franchisee relationship such as termination, nonrenewal, transfer, discrimination among franchisees and competition with franchisees.

 

Additional legislation, both at the federal and state levels, could expand pre-sale disclosure requirements, further regulate substantive aspects of the franchise relationship and require us to file our Franchise Disclosure Documents with additional states.  We cannot predict the effect of future franchise legislation, but do not believe there is any imminent legislation currently under consideration which would have a material adverse impact on our operations.

 

Although most states do not directly regulate the commercial equipment lease financing business, certain states require licensing of lenders and finance companies, and impose limitations on interest rates and other charges, and a disclosure of certain contract terms and constrain collection practices.   We believe that we are currently in compliance with all material statutes and regulations that are applicable to our business.

 

Trademarks and Service Marks

 

Play It Again Sports®, Plato’s Closet®, Once Upon A Child®, Music Go Round®, Winmark®, Winmark Business Solutions®, Wirth Business Credit®, Winmark Capital® and LeaseManager®, among others, are our registered service marks.  These marks are of considerable value to our business.  We intend to protect our service marks by appropriate legal action where and when necessary.  Each service mark registration must be renewed every 10 years.  We have taken, and intend to continue to take, all steps necessary to renew the registration of all our material service marks.

 

Seasonality

 

Our Play It Again Sports and Music Go Round franchise brands have experienced higher than average sales volumes during the holiday shopping season.  Our Plato’s Closet and Once Upon A Child franchise brands have experienced higher than average sales volumes during the spring months and, along with our Music Go Round brand, also during the back to school season.  Overall, the different seasonal trends of our brands partially offset each other and do not result in significant seasonality trends on a Company-wide basis.  Our equipment leasing business is not seasonal; however, quarter to quarter results may vary significantly.

 

Employees

 

As of December 25, 2010, we employed 100 employees, all of which were full-time.

 

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ITEM 1A: RISK FACTORS

 

We are dependent on franchise renewals.

 

Each of our franchise agreements is 10 years long.  At the end of the term of each franchise agreement, each franchisee has the option to “renew” the franchise relationship by signing a new 10-year franchise agreement.  In 2010, of the 22 franchises that had Plato’s Closet franchise agreements expire, 22 signed new 10-year franchise agreements.  In 2011, 2012 and 2013, 23, 31 and 23 Plato’s Closet franchise agreements will expire, respectively.  In 2010, of the 25 franchisees that had their Play It Again Sports franchise agreement expire, 25 signed new 10-year franchise agreements.  In 2011, 2012 and 2013, 47, 71 and 42 Play It Again Sports franchise agreements will expire, respectively.  In 2010, of the 19 franchisees that had their Once Upon A Child franchise agreement expire, 19 signed new 10-year franchise agreements. In 2011, 2012 and 2013, 6, 3 and 38 Once Upon A Child franchise agreements will expire, respectively.  In 2010, of the 1 franchisee that had a Music Go Round franchise agreement expire, 1 signed a new 10-year franchise agreement.  In 2011, 2012 and 2013, 0, 0 and 3 Music Go Round franchise agreements will expire, respectively.  We believe that renewing a significant number of these franchise relationships is important to our continued success.  If a significant number of franchise relationships are not renewed our financial performance would be materially and adversely impacted.

 

We are dependent on new franchisees.

 

Our ability to generate increased revenue and achieve higher levels of profitability depends in part on increasing the number of franchises open.  While we believe that many larger and smaller markets will continue to provide significant opportunities for sales of franchises, continuing unfavorable macro-economic conditions may affect the ability of potential franchisees to obtain external financing and/or impact their net worth, both of which could lead to a lower level of openings than we have historically experienced.  There can be no assurance that we will sustain our current level of franchise openings.

 

We are dependent upon our chief executive officer.

 

Our success depends on the efforts and abilities of John L. Morgan, our chairman of the board and chief executive officer.  The loss of the services of Mr. Morgan could materially harm our business.  Such a loss would also divert management attention away from operational issues.

 

We may sell franchises for a territory, but the franchisee may not open.

 

We believe that a substantial majority of franchises sold but not opened will open within the time period permitted by the applicable franchise agreement or we will be able to resell the territories for most of the terminated or expired franchises.  However, there can be no assurance that substantially all of the currently sold but unopened franchises will open and commence paying royalties to us.  At December 25, 2010, we had 34 franchise agreements expected to open in 2011.

 

Our retail franchisees are dependent on supply of used merchandise.

 

Our retail brands are based on offering customers a mix of used and new merchandise.  As a result, the ability of our franchisees to obtain continuing supplies of high quality used merchandise is important to the success of our brands.  Supply of used merchandise comes from the general public and is not regular or highly reliable. In addition, adherence to federal and state product safety requirements may limit the amount of used merchandise available to our franchisees. There can be no assurance that our franchisees will avoid supply problems with respect to used merchandise.

 

We may be unable to collect accounts receivable from franchisees.

 

In the event that our ability to collect accounts receivable significantly declines from current rates, we may incur additional charges that would affect earnings.  If we are unable to collect payments due from our franchisees, it would materially adversely impact our results of operations and financial condition.

 

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We operate in extremely competitive industries.

 

Retailing, including the sale of sporting goods, children’s and teenage apparel and musical instruments, is highly competitive.  Many retailers have significantly greater financial and other resources than us and our franchisees.  Individual franchisees face competition in their markets from retailers of new merchandise and, in certain instances, resale, thrift and other stores that sell used merchandise.  To date, our franchisees have not faced a high degree of competition in the sale of used merchandise, but do so in connection with the sale of new merchandise.  However, we may face additional competition as our franchise systems expand and if additional competitors enter the used merchandise market.

 

Our equipment leasing businesses compete with a variety of equipment financing sources that are available to businesses, including: national, regional, and local finance companies that provide leases and loan products; financing through captive finance and leasing companies affiliated with major equipment manufacturers; and commercial banks, savings and loans, credit unions and credit cards.  Many of these companies are substantially larger than we are and have considerably greater financial, technical and marketing resources than we do.  There can be no assurances that we will be able to successfully compete with these larger competitors.

 

We are subject to credit risk from nonpayment or slow payments in our lease portfolio and our allowance for credit losses may be inadequate to absorb losses.

 

In our leasing business, if we inaccurately assess the creditworthiness of our customers, we may experience a higher number of lease defaults than expected, which would reduce our earnings.  For our middle-market customers, we serve a wide range of businesses from smaller companies that may be financed by venture capital investors to larger organizations that may be financed by private equity firms and larger independent public or private companies.  In many cases, our credit analysis relies on the customer’s current or projected financials.  If we fail to adequately assess the risks of our customer’s business plans, we may experience credit losses.  For our small-ticket customers, there is typically only limited publicly available financial and other information about their businesses.  Accordingly, in making credit decisions, we rely upon the accuracy of information from the small business owner and/or third party sources, such as credit reporting agencies. If the information we obtain from small business owners and/or third party sources is incorrect, our ability to make appropriate credit decisions will be impaired.

 

If losses from leases exceed our allowance for credit losses, our operating income will be reduced.  In connection with our leases, we record an allowance for credit losses to provide for estimated losses.  Determining the appropriate level of the allowance is an inherently uncertain process and therefore our determination of this allowance may prove to be inadequate to cover losses in connection with our portfolio of leases.  Losses in excess of our allowance for credit losses would cause us to increase our provision for credit losses, reducing or eliminating our operating income.

 

Deteriorated economic or business conditions may negatively impact our leasing business.

 

In an economic slowdown or recession, our equipment leasing businesses may face an increase in delinquent payments, lease defaults and credit losses.  The volume of leasing business for our new and existing customers may decline, as well as the credit quality of our customers.  Because we extend credit to many emerging companies through our subsidiary Winmark Capital Corporation and primarily to small businesses through our subsidiary Wirth Business Credit, Inc., our customers may be particularly susceptible to economic slowdowns or recessions Any protracted economic slowdowns or recessions may make it difficult for us to maintain the volume of lease originations for new and existing customers, and may deteriorate the credit quality of new leases.   Any of these events may slow the growth of our leasing portfolio and impact the profitability of our leasing operations.

 

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We have suffered losses from investments outside of our franchise and leasing businesses and may continue to suffer losses in the future

 

We currently have investments in two private companies.  We currently own 18.3% of the common stock of Tomsten, Inc. (d/b/a Archiver’s), a privately held corporation.  Archiver’s is a retail concept created to help people preserve and enjoy their photographs. In addition, we currently have an investment of subordinated debt with warrants in BridgeFunds Limited (“BridgeFunds”). BridgeFunds advances funds to claimants involved in civil litigation to cover litigation expenses.

 

Since the inception of our investment in 2002, Archiver’s has incurred over $14.8 million in losses.  As of December 25, 2010, the carrying value of our $7.5 million investment equaled $2.0 million. If Archiver’s continues to sustain losses, it may need to seek external financing in the form of equity and/or debt.   There can be no assurance that Archiver’s will be able to obtain additional financing.  Any continued losses or inability to obtain financing on attractive terms may result in a further impairment of the carrying value of our investment and a reduction in our book value and profitability.  Also, there is not a market for the equity of Archiver’s and our ability to recover our investment and realize a cash return on our investment will depend on the development of a market for Archiver’s equity or the sale of Archiver’s.

 

During 2009, the board of BridgeFunds decided to cease advancing funds to new claimants and place its portfolio of receivables in run-off.  We have entered into two modification agreements with BridgeFunds, whereby the maturity date of our investment was changed to June 30, 2011, the annual rate of interest on the notes was increased to 15% and monthly prepayments of the principal of such notes in an amount equal to Available Cash Flow (as defined within the modification agreements) is required.  As of December 25, 2010, we have not received any payments of principal and have received only $60,400 in payments of interest since the date of the initial modification agreement on October 22, 2009.  As such, we have stopped accruing interest on the investment.  Our ability to recover our investment and realize a cash return on our investment will depend on the successful run-off of the BridgeFunds portfolio. In addition, the warrant we hold in BridgeFunds may be of no value.

 

The loss of our entire investment in any one or both of these investments would have a material adverse impact on our financial results.

 

From time to time, we have and will continue to make investments outside of our franchise and leasing businesses.  There can be no assurance that such investments will be profitable.

 

We are subject to restrictions and counterparty risk in our credit facility.

 

The terms of our $30.0 million line of credit impose certain operating and financial restrictions on us and require us to meet certain financial tests including tests related to minimum levels of debt service coverage and tangible net worth and maximum levels of leverage.  As of December 25, 2010, we were in compliance with all of our financial covenants under this facility; however, failure to comply with these covenants in the future may result in default and could result in acceleration of the related indebtedness.  Any such acceleration of indebtedness would have an adverse impact on our business activities and financial condition.

 

Recent events in the worldwide credit markets have had an adverse impact on the general availability of credit.  Although our credit facility does not expire until July, 2014, continued market deterioration could jeopardize the counterparty obligations of one or both of the banks participating in this facility, which could have an adverse impact on our business if we are not able to replace such credit facility or find other sources of liquidity on acceptable terms.

 

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We are subject to government regulation.

 

As a franchisor, we are subject to various federal and state franchise laws and regulations.  Fourteen states, the Federal Trade Commission and four Canadian Provinces impose pre-sale franchise registration and/or disclosure requirements on franchisors.  In addition, a number of states have statutes which regulate substantive aspects of the franchisor-franchisee relationship such as termination, nonrenewal, transfer, discrimination among franchisees and competition with franchisees.

 

Additional legislation, both at the federal and state levels, could expand pre-sale disclosure requirements, further regulate substantive aspects of the franchise relationship and require us to file our franchise offering circulars with additional states.  Future franchise legislation could impose costs or other burdens on us that could have a material adverse impact on our operations.

 

Although most states do not directly regulate the commercial equipment lease financing business, certain states require licensing of lenders and finance companies, impose limitations on interest rates and other charges, constrain collection practices and require disclosure of certain contract terms.  Laws or regulations may be adopted with respect to our equipment leases or the equipment leasing industry, and collection processes. Any new legislation or regulation, or changes in the interpretation of existing laws, which affect the equipment leasing industry could increase our costs of compliance.

 

ITEM 2: PROPERTIES

 

We lease 33,513 square feet at our headquarters facility in Minneapolis, Minnesota, under a lease that commenced in March 2009.  We are obligated to pay rent monthly under the Lease, and will pay an estimated $5.1 million in total rental payments over the entire term of the Lease which runs ten years and six months from the commencement date.  We are also obligated to pay estimated taxes and operating expenses as described in the Lease, which change annually.  The total rentals, taxes and operating expenses paid may increase if we exercise any of our rights to acquire additional space described in the Lease.

 

ITEM 3: 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 4: RESERVED

 

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PART II

 

ITEM 5:

MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS, AND ISSUER PURCHASES OF EQUITY SECURITIES

 

Market Information, Holders, Dividends

 

Winmark Corporation’s common stock trades on the Nasdaq Global Market under the symbol “WINA”.  The table below sets forth the high and low sales prices of our common stock as reported by Nasdaq for the quarterly periods indicated:

 

FY 2010:

 

First

 

Second

 

Third

 

Fourth

 

High

 

22.46

 

34.86

 

35.50

 

35.18

 

Low

 

19.48

 

21.61

 

29.13

 

31.38

 

 

FY 2009:

 

First

 

Second

 

Third

 

Fourth

 

High

 

13.99

 

17.14

 

21.95

 

23.00

 

Low

 

8.20

 

9.50

 

16.02

 

19.87

 

 

At March 7, 2011, there were 4,977,238 shares of common stock outstanding held by approximately 108 shareholders of record.  Shareholders of record do not include holders who beneficially own common stock held in nominee or “street name”.  We did not declare any cash dividends during fiscal 2009, and declared and paid cash dividends of $0.02 per common share in each of the second, third and fourth quarters of fiscal 2010.  Any future declaration of dividends will be subject to the discretion of our Board of Directors and subject to our results of operations, financial condition, cash requirements and other factors deemed relevant by our Board of Directors.

 

Purchases of Equity Securities by the Issuer and Affiliated Purchasers

 

 

 

Total Number of
Shares Purchased

 

Average Price Paid
Per Share

 

Total Number of
Shares Purchased as
Part of a Publicly
Announced Plan(1)

 

Maximum Number
of Shares that may
yet be Purchased
Under the Plan

 

 

 

 

 

 

 

 

 

 

 

September 26, 2010 to October 30, 2010

 

 

 

 

97,389

 

 

 

 

 

 

 

 

 

 

 

October 31, 2010 to November 27, 2010

 

 

 

 

97,389

 

 

 

 

 

 

 

 

 

 

 

November 28, 2010 to December 25, 2010

 

2,023

 

$

33.35

 

2,023

 

95,366

 

 


(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 as of December 25, 2010 was limited to 4,500,000 shares, of which 95,366 may still be repurchased.

 

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Table of Contents

 

ITEM 6: SELECTED FINANCIAL DATA

 

The following table sets forth selected financial information for the periods indicated.  The information should be read in conjunction with the consolidated financial statements and related notes discussed in Item 8 and 15, and Management’s Discussion and Analysis of Financial Condition and Results of Operations discussed in Item 7.

 

 

 

Fiscal Year Ended

 

 

 

(in thousands except per share data)

 

 

 

December 25,
2010

 

December 26,
2009

 

December 27,
2008

 

December 29,
2007

 

December 30,
2006(2)

 

Revenue:

 

 

 

 

 

 

 

 

 

 

 

Royalties

 

$

26,489

 

$

23,616

 

$

21,804

 

$

20,447

 

$

19,212

 

Leasing income

 

9,896

 

9,537

 

8,093

 

4,416

 

1,853

 

Merchandise sales

 

2,345

 

2,387

 

3,268

 

3,999

 

4,469

 

Franchise fees

 

1,366

 

1,073

 

1,705

 

1,724

 

1,246

 

Other

 

1,107

 

683

 

554

 

579

 

591

 

Total revenue

 

41,203

 

37,296

 

35,424

 

31,165

 

27,371

 

Cost of merchandise sold

 

2,231

 

2,290

 

3,121

 

3,837

 

4,283

 

Leasing expense

 

1,624

 

2,288

 

1,882

 

1,031

 

227

 

Provision for credit losses

 

189

 

2,796

 

2,570

 

604

 

341

 

Selling, general and administrative expenses

 

18,620

 

19,142

 

19,760

 

19,267

 

17,158

 

Income from operations

 

18,539

 

10,780

 

8,091

 

6,426

 

5,362

 

Gain (loss) from equity investments(1)

 

(259

)

(100

)

(3,163

)

(359

)

117

 

Interest expense

 

(980

)

(1,309

)

(1,305

)

(1,457

)

(729

)

Interest and other income

 

258

 

459

 

224

 

539

 

867

 

Income before income taxes

 

17,558

 

9,830

 

3,847

 

5,149

 

5,617

 

Provision for income taxes

 

7,229

 

3,981

 

2,708

 

2,104

 

2,279

 

Net income

 

$

10,329

 

$

5,849

 

$

1,139

 

$

3,045

 

$

3,338

 

 

 

 

 

 

 

 

 

 

 

 

 

Earnings per common share - diluted

 

$

1.98

 

$

1.10

 

$

.21

 

$

.54

 

$

.56

 

Weighted average shares outstanding - diluted

 

5,210

 

5,338

 

5,531

 

5,591

 

6,007

 

Balance Sheet Data:

 

 

 

 

 

 

 

 

 

 

 

Working capital

 

$

3,595

 

$

12,556

 

$

6,164

 

$

(598

)

$

2,297

 

Total assets

 

42,122

 

56,805

 

58,110

 

56,947

 

36,012

 

Total debt

 

8,800

 

30,508

 

34,431

 

37,261

 

15,978

 

Shareholders’ equity

 

23,013

 

15,329

 

13,891

 

12,669

 

14,161

 

Selected Financial Ratios:

 

 

 

 

 

 

 

 

 

 

 

Return on average assets

 

20.9

%

10.2

%

2.0

%

6.6

%

10.9

%

Return on average equity

 

53.9

%

40.0

%

8.6

%

22.7

%

19.1

%

 


(1)          Included in gain (loss) from equity investments is a $2,839,100 impairment charge for the partial write off of the Company’s investment in Tomsten, Inc. in 2008.

 

(2)          In accordance with GAAP, prior periods are presented assuming the Company had used the equity method of accounting since the inception of the Company’s investment in Tomsten, Inc.  Prior to 2007, the Company had accounted for its investment in Tomsten, Inc. under the cost method.

 

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ITEM 7:

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

Overview

 

As of December 25, 2010, we had 918 franchises operating under the Plato’s Closet, Play it Again Sports, Once Upon a Child, Music Go Round and Wirth Business Credit brands and had a leasing portfolio of $30.7 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 profitable source of franchising revenue is royalties received from our franchise partners.  During 2010, our royalties increased $2,873,100 or 12.2% compared to 2009.

 

During 2010, we purchased $15.3 million in equipment for lease contracts compared to $15.5 million in 2009.  Overall, our leasing portfolio (net investment in leases — current and long-term) decreased to $30.7 million at December 25, 2010 from $37.0 million at December 26, 2009.  Leasing income in 2010 was $9.9 million compared to $9.5 million in the same period last year, an increase of 3.8%.  (See Note 12 — “Segment Reporting”).  Our earnings are also impacted by credit losses.  During 2010, our provision for credit losses decreased to $0.2 million from $2.8 million in 2009, as we experienced a lower level of net write-offs and delinquencies, primarily in the small-ticket financing business portion 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 2010, selling, general and administrative expense decreased $521,400, or 2.7%, compared to the same period last year.

 

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 fiscal year ended December 25, 2010:

 

 

 

TOTAL
12/26/09

 

OPENED

 

CLOSED

 

TOTAL
12/25/10

 

AVAILABLE
FOR
RENEWAL

 

COMPLETED
RENEWALS

 

% RENEWED

 

Play It Again Sports

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Franchises - US and Canada

 

341

 

7

 

(20

)

328

 

25

 

25

 

100

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Plato’s Closet

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Franchises - US and Canada

 

267

 

35

 

(1

)

301

 

22

 

22

 

100

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Once Upon A Child

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Franchises - US and Canada

 

235

 

13

 

(7

)

241

 

19

 

19

 

100

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Music Go Round

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Franchises - US

 

34

 

1

 

(2

)

33

 

1

 

1

 

100

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total Franchised Stores

 

877

 

56

 

(30

)

903

 

67

 

67

 

100

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Wirth Business Credit

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Territories - US

 

37

 

0

 

(22

)

15

 

 

 

N/A

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total Franchises/Territories(1)

 

914

 

56

 

(52

)

918

 

67

 

67

 

100

%

 


(1)          During the first quarter of 2011, the franchise agreements for the 15 Wirth Business Credit territories were terminated for various reasons.  As of the filing date of this Form 10-K, we did not have any Wirth Business Credit franchisees.

 

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Table of Contents

 

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.  In 2010, we renewed 100% of franchise agreements up for renewal.  This percentage of renewal has ranged between 96% and 100% during the last three years.

 

Our ability to grow our profits 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 portfolios, and (iv) control our selling, general and administrative expenses.  A detailed description of the risks to our business along with other risk factors can be found in Item 1A “Risk Factors”.

 

Results of Operations

 

The following table sets forth selected information from our Consolidated Statements of Operations expressed as a percentage of total revenue and the percentage change in the dollar amounts from the prior period:

 

 

 

Fiscal Year Ended

 

Fiscal 2010

 

 

 

December 25, 2010

 

December 26, 2009

 

over (under) 2009

 

Revenue:

 

 

 

 

 

 

 

Royalties

 

64.3

%

63.3

%

12.2

%

Leasing income

 

24.0

 

25.6

 

3.8

 

Merchandise sales

 

5.7

 

6.4

 

(1.8

)

Franchise fees

 

3.3

 

2.9

 

27.4

 

Other

 

2.7

 

1.8

 

62.0

 

Total revenue

 

100.0

 

100.0

 

10.5

 

 

 

 

 

 

 

 

 

Cost of merchandise sold

 

(5.4

)

(6.2

)

(2.6

)

Lease expense

 

(3.9

)

(6.1

)

(29.0

)

Provision for credit losses

 

(0.5

)

(7.5

)

(93.2

)

Selling, general and administrative expenses

 

(45.2

)

(51.3

)

(2.7

)

Income from operations

 

45.0

 

28.9

 

72.0

 

Loss from equity investments

 

(0.6

)

(0.2

)

157.8

 

Interest expense

 

(2.4

)

(3.5

)

(25.1

)

Interest and other income

 

0.6

 

1.2

 

(43.9

)

Income before income taxes

 

42.6

 

26.4

 

78.6

 

Provision for income taxes

 

(17.5

)

(10.7

)

81.6

 

Net income

 

25.1

%

15.7

%

76.6

%

 

Revenue

 

Revenues for the year ended December 25, 2010 totaled $41.2 million compared to $37.3 million for the comparable period in 2009.

 

Royalties and Franchise Fees

 

Royalties increased to $26.5 million for 2010 from $23.6 million for the same period in 2009, a 12.2% increase.  The increase was due to higher Plato’s Closet, Play It Again Sports and Once Upon A Child royalties of $1,645,000, $660,000 and $564,000, respectively.  The increase in royalties for these brands is primarily due to higher franchisee retail sales in these brands as well as having 34 additional Plato’s Closet franchise stores in 2010 compared to the same period last year.

 

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Table of Contents

 

Franchise fees include initial franchise fees from the sale of new franchises and transfer fees related to the transfer of existing franchises.  Franchise fee revenue is recognized when the franchise opens or when the franchise agreement is assigned to a buyer of a franchise.  An overview of retail brand franchise fees is presented in the Franchising subsection of the Business section.  Franchise fees increased to $1,366,400 for 2010 from $1,072,900 for 2009 primarily as a result of opening seven more franchises in 2010 compared to 2009 and an increase in the franchise fee for an initial store.

 

Leasing Income

 

Leasing income increased to $9,896,300 in 2010 compared to $9,536,900 for the same period in 2009, a 3.8% increase.  The increase is due to an increase in leasing income from the middle-market equipment leasing business portion of our leasing segment, partially offset by a decrease in leasing income from the small-ticket financing business portion of our leasing segment.

 

Merchandise 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 (together, “Direct Franchisee Sales”).  Direct Franchisee Sales decreased 1.8% to $2,344,800 in 2010 from $2,386,700 in 2009.  This is a result of lower franchisee purchases through the Play It Again Sports buying group, partially offset by increased technology purchases by our franchisees.

 

Other Revenue

 

Other revenue includes marketing and software license fees received from franchisees as well as management fees received for management services that we provide Tomsten, Inc. (“Tomsten”).  Other revenue increased to $1,106,800 for 2010 from $683,300 for 2009 due to the management fees received from Tomsten.

 

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 decreased 2.6% to $2,231,100 in 2010 from $2,290,200 in 2009.  The decrease was primarily due to a decrease in Direct Franchisee Sales discussed above.  Cost of merchandise sold as a percentage of Direct Franchisee Sales for 2010 and 2009 was 95.2% and 96.0%, respectively.

 

Leasing Expense

 

Leasing expense decreased to $1,624,200 in 2010 compared to $2,288,200 in 2009.  The decrease is primarily due to lower borrowing costs in connection with the lease portfolio.

 

Provision for Credit Losses

 

Provision for credit losses decreased to $189,000 in 2010 compared to $2,795,500 in 2009.  The decrease is primarily due to a lower level of net write-offs and delinquencies, primarily in the small-ticket financing business portion of our leasing segment.  During 2010, we had total net write-offs of $620,600 compared to $2,995,000 in 2009.

 

Selling, General and Administrative Expenses

 

The $521,400, or 2.7%, decrease in selling, general and administrative expenses in 2010 compared to the same period in 2009 is primarily due to a decrease in outside services.

 

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Table of Contents

 

Loss from Equity Investments

 

During 2010 and 2009, we recorded losses of $259,100 and $100,500, respectively, from our investment in Tomsten (representing our pro-rata share of losses for the periods).  (See Item 1A “Risk Factors” as well as Note 3 — “Investments”).

 

Interest Expense

 

Interest expense decreased to $980,200 in 2010 compared to $1,309,000 in 2009.  The decrease is primarily due to lower corporate borrowings.

 

Interest and Other Income

 

During 2010, we had interest and other income of $257,800 compared to $459,300 of interest and other income in 2009.  The decrease is primarily due to a decrease in income from our marketable securities.

 

Income Taxes

 

The provision for income taxes was calculated at an effective rate of 41.2% and 40.5% for 2010 and 2009, respectively.  The higher effective rate in 2010 compared to 2009 reflects our recording of a deferred tax asset valuation allowance for losses from our equity investments.

 

Segment Comparison of the Year Ended December 25, 2010 to
Year Ended December 26, 2009

 

We currently have 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, our middle-market equipment leasing business and (ii) Wirth Business Credit, Inc., our small-ticket financing business.  Segment reporting is intended to give financial statement users a better view of how we manage and evaluate our businesses.  Our internal management reporting is the basis for the information disclosed for our business segments and includes allocation of shared-service costs.  The following tables summarize financial information by segment and provide a reconciliation of segment contribution to operating income:

 

 

 

Year Ended

 

 

 

December 25, 2010

 

December 26, 2009

 

Revenue:

 

 

 

 

 

Franchising

 

$

31,227,300

 

$

27,748,300

 

Leasing

 

9,976,300

 

9,547,700

 

Total revenue

 

$

41,203,600

 

$

37,296,000

 

 

 

 

 

 

 

Reconciliation to operating income:

 

 

 

 

 

Franchising segment operating income

 

$

15,434,600

 

$

12,205,600

 

Leasing segment operating income (loss)

 

3,104,400

 

(1,425,200

)

Total operating income

 

$

18,539,000

 

$

10,780,400

 

 

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Table of Contents

 

Franchising segment operating income

 

The franchising segment’s 2010 operating income increased by $3.2 million, or 26.5%, to $15.4 million from $12.2 million for 2009.  The increase in segment contribution was primarily due to increased royalty and franchise fee revenues.

 

Leasing segment operating income (loss)

 

The leasing segment generated operating income of $3.1 million for 2010 compared to a loss of ($1.4 million) during 2009.  This improvement was primarily due to a decrease in the provision for credit losses which resulted from a lower level of net write-offs and delinquencies in our leasing portfolio.

 

Liquidity and Capital Resources

 

Our primary sources of liquidity have historically been cash flow from operations and borrowings.  The components of the consolidated statement of operations that affect our liquidity include non-cash items for depreciation, compensation expense related to stock options and loss from equity investments.  The most significant component of the consolidated balance sheet that affects liquidity is investments.  Investments include $4.0 million of illiquid investments in two private companies: Tomsten, Inc. and BridgeFunds LLC.

 

We ended 2010 with $2.3 million in cash and cash equivalents and a current ratio (current assets divided by current liabilities) of 1.2 to 1.0 compared to $9.5 million in cash and cash equivalents and a current ratio of 1.6 to 1.0 at the end of 2009.

 

Operating activities provided $12.4 million of cash during 2010 compared to $13.7 million during 2009.  Cash provided by operating assets and liabilities include an increase in deferred and current income taxes of $0.8 million, primarily due to tax depreciation on lease equipment purchases.  Cash utilized by operating assets and liabilities include a $0.5 million decrease in advance rents and security deposits due to a decrease in activity levels in our small-ticket financing business.

 

Investing activities provided $5.4 million of cash during 2010 compared to $2.4 million provided during 2009.  The 2010 activities consisted primarily of the purchase of equipment for lease contracts of $15.3 million and collections on lease receivables of $20.0 million.

 

Financing activities used $25.0 million of cash during 2010 compared to $8.7 million used during 2009.  The 2010 activities consisted primarily of net proceeds from exercises of stock options of $0.9 million, net payments of $21.2 million on our subordinated notes, net payments on our line of credit of $0.5 million, $4.0 million used to purchase 165,590 shares of our common stock and $0.3 million for the payment of dividends.

 

We have future operating lease commitments for our corporate headquarters.  As of December 25, 2010, we had no other material outstanding commitments.  See Note 11 to the consolidated financial statements.

 

As of December 25, 2010, we had no off balance sheet arrangements.

 

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Table of Contents

 

On July 13, 2010, we terminated our $40.0 million Amended and Restated Revolving Credit Agreement (the “Credit Facility”) with Bank of America, N.A. and the PrivateBank and Trust Company and entered into a new credit agreement with the PrivateBank and Trust Company (the “Line of Credit”).  We repaid the borrowings under the Credit Facility on the termination date with existing cash balances and have completed our obligations under this agreement.

 

The Line of Credit, which provides for an aggregate commitment over its four year term of $30.0 million subject to certain borrowing base limitations, allows us to choose between three interest rate options in connection with our borrowings.  The interest rate options are the Base Rate, LIBOR and Fixed Rate (all as defined within the Line of Credit) plus an applicable margin of 0.50%, 2.75% and 2.75%, respectively.  Interest periods for LIBOR borrowings can be one, two or three months, and interest periods for Fixed Rate borrowings can be one, two, three or four years as selected by us.  The Line of Credit also provides for non-utilization fees of 0.25% per annum on the daily average of the unused commitment.

 

As of December 25, 2010, our borrowing availability under the Line of Credit was $30.0 million (the lesser of the borrowing base or the aggregate commitment).  There were $8.8 million in borrowings outstanding under the Line of Credit bearing interest ranging from 3.04% to 3.75%, leaving $21.2 million available for additional borrowings.

 

The Line of Credit was used to complete the redemption of the Renewable Unsecured Subordinated Notes (as indicated below) and has been and will continue to be used for general corporate purposes.  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 December 25, 2010, we were in compliance with all of our financial covenants.

 

On April 19, 2006, we announced the filing of a “shelf registration” on Form S-1 registration statement with the Securities and Exchange Commission for the sale of up to $50 million of Renewable Subordinated Unsecured Notes with maturities from three months to ten years.  In June 2006, the Form S-1 registration became effective.  Every year since the S-1 registration became effective, we have filed Post-Effective Amendments to keep the registration statement effective.  On July 30, 2010, we redeemed all of our outstanding Renewable Unsecured Subordinated Notes and subsequently deregistered all securities pursuant to the registration.  The redemption price equaled 100% of the principal amount, plus accrued and unpaid interest up to the redemption date.  We borrowed $16.0 million on our Line of Credit to finance the redemption.

 

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.

 

We believe that the combination of our cash on hand, the cash generated from our franchising business, cash generated from discounting sources and our Line of Credit will be adequate to fund our planned operations, including leasing activity, through 2011.

 

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Table of Contents

 

Critical Accounting Policies

 

The Company prepares the consolidated 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 our 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 applying historical weekly sales information to the number of weeks of unreported franchisee sales.  If there are significant changes in the actual performances of franchisees versus the Company’s estimates, its royalty revenue would be impacted.  During 2010, the Company collected $94,600 more than it estimated at December 26, 2009.  As of December 25, 2010, the Company’s royalty receivable was $999,400.

 

The Company collects initial franchise fees when franchise agreements are signed and recognizes the initial franchise fees as revenue when the franchise 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 the consolidated balance sheet.  As of December 25, 2010, deferred franchise fees were $789,900.

 

Leasing Income Recognition

 

Leasing income 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.  Generally, when a lease is more than 90 days delinquent (when 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.

 

In certain circumstances, the Company may re-lease equipment in its existing portfolio.  This may give rise to dealer profit and require the Company to account for the lease as a sales-type lease.  At inception of a sales-type lease, revenue is recorded that consists of the present value of the future minimum lease payments discounted at the rate implicit in the lease.  In subsequent periods, the recording of income is consistent with the accounting for a direct financing lease.

 

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 the 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.

 

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Table of Contents

 

A provision is charged against earnings to maintain the allowance for credit losses at the appropriate level.  The Company’s policy is to charge-off against the allowance the estimated unrecoverable portion of accounts once they reach 121 days delinquent.  The allowance for credit losses is considered a significant estimate that could materially change within the next year.  See Note 4 for disclosures related to the Company’s allowance for credit losses.

 

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.

 

Impairment of Long-term Investments

 

The Company evaluates its long-term investments for impairment on an annual basis or whenever events or changes in circumstances indicate the carrying amount may not be recoverable.  The impairment, if any, is measured by the difference between the assets’ carrying amount and their fair value (as prescribed by applicable accounting guidance) based on the best information available, including market prices, discounted cash flow analysis or other financial metrics that management utilizes to help determine fair value.  Judgments made by management related to the fair value of its long-term investments are affected by factors such as the ongoing financial performance of the investees, additional capital raised by the investees as well as general changes in the economy.  If there are significant changes in the actual performance of the long-term investments versus the Company’s estimates, the carrying values of these investments could be significantly impacted.

 

New Accounting Pronouncements

 

In July 2010, the FASB issued new accounting guidance that requires new disclosures about an entity’s allowance for credit losses and the credit quality of its financing receivables.  Existing disclosures are amended to require an entity to provide certain disclosures on a disaggregated basis by portfolio segment or by class of financing receivables.  The new and amended disclosures that relate to information as of the end of a reporting period are effective for interim and annual reporting periods ending on or after December 15, 2010.  The disclosures about activity that occurs during a reporting period are effective for interim and annual reporting periods beginning on or after December 15, 2010.  The Company has adopted the new and amended disclosures that relate to information as of the end of a reporting period in this annual report on Form 10-K for the fiscal year ending December 25, 2010; see Note 4 for disclosures related to this adoption. The Company will begin to include the disclosures that relate to information for activity that occurs during a reporting period in its quarterly report on Form 10-Q for the fiscal period ending March 26, 2011.  The adoption of these disclosure requirements has not and will not have an impact on the consolidated results of the Company.

 

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Table of Contents

 

Outlook

 

Forward Looking Statements

 

The statements contained in the letter from the CEO, Item 1 “Business”, Item 1A “Risk Factors”, in this Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations”, and in Item 8 “Financial Statements and Supplemental Data” that are not strictly historical fact, including without limitation, the Company’s statements relating to growth opportunities, prospects for Winmark Capital Corporation and Wirth Business Credit, contribution of the leasing business to financial results, anticipated operations of the leasing businesses, its ability to open new franchises, its ability to manage costs in the future, the number of franchises it believes will open, its future cash requirements, allowance for credit losses, possible losses related to its investments and its 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 which may cause actual results to differ materially from those contemplated by such forward looking statements.  Investors are cautioned to consider these forward looking statements in light of important factors which may result in material variations between results contemplated by such forward looking statements and actual results and conditions including, but not limited to, the risk factors discussed in Section 1A of this report.  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 statement for any reason.

 

ITEM 7A:              QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

The Company incurs financial markets 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 December 25, 2010, the Company had available a $30.0 million line of credit with the PrivateBank and Trust Company and Harris, N.A.  The interest rates applicable to this agreement are based on either the bank’s base rate or LIBOR for short-term borrowings (less than three months) or the bank’s index rate for borrowings one year or greater.  The Company had $8.8 million of debt outstanding at December 25, 2010 under this line of credit, all of which was in the form of short-term borrowings subject to daily changes in the bank’s base rate or LIBOR.  The Company’s earnings would be affected by changes in these short-term interest rates.  With the Company’s borrowings at December 25, 2010, a one percent increase in short-term rates would reduce annual pretax earnings by $88,000.  The Company had no interest rate derivatives in place at December 25, 2010.

 

None of the Company’s cash and cash equivalents at December 25, 2010 was invested in money market mutual funds, which are subject to the effects of market fluctuations in interest rates.

 

Although the Company conducts business in foreign countries, international operations are not material to its consolidated financial position, results of operations or cash flows.  Additionally, foreign currency transaction gains and losses were not material to the Company’s results of operations for the year ended December 25, 2010.  Accordingly, the Company is not currently subject to material foreign currency exchange rate risks from the effects that exchange rate movements of foreign currencies would have on its future costs or on future cash flows it would receive from its foreign activity.  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.

 

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Table of Contents

 

ITEM 8:                 FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

 

Winmark Corporation and Subsidiaries

Index to Consolidated Financial Statements

 

Consolidated Balance Sheets

 

Page 28

Consolidated Statements of Operations

 

Page 29

Consolidated Statements of Shareholders’ Equity and Comprehensive Income

 

Page 30

Consolidated Statements of Cash Flows

 

Page 31

Notes to the Consolidated Financial Statements

 

Page 32

Report of Independent Registered Public Accounting Firm

 

Page 50

 

27



Table of Contents

 

WINMARK CORPORATION AND SUBSIDIARIES

Consolidated Balance Sheets

 

 

 

December 25, 2010

 

December 26, 2009

 

ASSETS

 

 

 

 

 

CURRENT ASSETS:

 

 

 

 

 

Cash and cash equivalents

 

$

2,257,100

 

$

9,490,800

 

Marketable securities

 

161,000

 

1,274,000

 

Investments

 

 

2,000,000

 

Receivables, less allowance for doubtful accounts of $17,000 and $35,700

 

1,841,300

 

1,761,100

 

Net investment in leases - current

 

13,856,700

 

17,575,900

 

Income tax receivable

 

294,700

 

 

Inventories

 

85,900

 

111,400

 

Prepaid expenses

 

382,600

 

398,800

 

Total current assets

 

18,879,300

 

32,612,000

 

NET INVESTMENT IN LEASES — LONG-TERM

 

16,802,500

 

19,423,700

 

LONG-TERM INVESTMENTS

 

3,973,800

 

2,232,900

 

PROPERTY AND EQUIPMENT:

 

 

 

 

 

Furniture and equipment

 

2,460,200

 

2,351,500

 

Building and building improvements

 

1,171,200

 

1,171,200

 

Less - accumulated depreciation and amortization

 

(1,845,500

)

(1,679,200

)

Property and equipment, net

 

1,785,900

 

1,843,500

 

OTHER ASSETS

 

680,500

 

692,400

 

 

 

$

42,122,000

 

$

56,804,500

 

LIABILITIES AND SHAREHOLDERS’ EQUITY

 

 

 

 

 

CURRENT LIABILITIES:

 

 

 

 

 

Line of credit

 

$

8,800,000

 

$

3,983,100

 

Renewable subordinated notes
(including $5,688,000 due to related parties)

 

 

9,166,900

 

Accounts payable

 

1,274,200

 

1,415,200

 

Income tax payable

 

 

183,500

 

Accrued liabilities

 

1,513,600

 

1,794,100

 

Discounted lease rentals

 

530,400

 

972,600

 

Rents received in advance

 

291,800

 

294,400

 

Deferred revenue

 

1,041,700

 

1,188,800

 

Deferred income taxes

 

1,832,500

 

1,057,700

 

Total current liabilities

 

15,284,200

 

20,056,300

 

LONG-TERM LIABILITIES:

 

 

 

 

 

Line of credit

 

 

5,298,900

 

Renewable subordinated notes
(including $7,260,400 due to related parties)

 

 

12,058,700

 

Discounted lease rentals

 

26,500

 

507,600

 

Rents received in advance

 

696,900

 

1,332,000

 

Deferred revenue

 

767,600

 

709,500

 

Other liabilites

 

1,678,000

 

1,298,400

 

Deferred income taxes

 

655,800

 

214,400

 

Total long-term liabilities

 

3,824,800

 

21,419,500

 

COMMITMENTS AND CONTINGENCIES

 

 

 

SHAREHOLDERS’ EQUITY:

 

 

 

 

 

Common stock, no par, 10,000,000 shares authorized, 5,020,739 and 5,125,025 shares issued and outstanding

 

513,700

 

 

Accumulated other comprehensive income

 

 

9,600

 

Retained earnings

 

22,499,300

 

15,319,100

 

Total shareholders’ equity

 

23,013,000

 

15,328,700

 

 

 

$

42,122,000

 

$

56,804,500

 

 

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

 

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WINMARK CORPORATION AND SUBSIDIARIES

Consolidated Statements of Operations

 

 

 

Fiscal Year Ended

 

 

 

December 25, 2010

 

December 26, 2009

 

REVENUE:

 

 

 

 

 

Royalties

 

$

26,489,300

 

$

23,616,200

 

Leasing income

 

9,896,300

 

9,536,900

 

Merchandise sales

 

2,344,800

 

2,386,700

 

Franchise fees

 

1,366,400

 

1,072,900

 

Other

 

1,106,800

 

683,300

 

Total revenue

 

41,203,600

 

37,296,000

 

COST OF MERCHANDISE SOLD

 

2,231,100

 

2,290,200

 

LEASING EXPENSE

 

1,624,200

 

2,288,200

 

PROVISION FOR CREDIT LOSSES

 

189,000

 

2,795,500

 

SELLING, GENERAL AND ADMINISTRATIVE EXPENSES

 

18,620,300

 

19,141,700

 

Income from operations

 

18,539,000

 

10,780,400

 

LOSS FROM EQUITY INVESTMENTS

 

(259,100

)

(100,500

)

INTEREST EXPENSE

 

(980,200

)

(1,309,000

)

INTEREST AND OTHER INCOME

 

257,800

 

459,300

 

Income before income taxes

 

17,557,500

 

9,830,200

 

PROVISION FOR INCOME TAXES

 

(7,228,500

)

(3,981,200

)

NET INCOME

 

$

10,329,000

 

$

5,849,000

 

EARNINGS PER SHARE - BASIC

 

$

2.05

 

$

1.10

 

EARNINGS PER SHARE - DILUTED

 

$

1.98

 

$

1.10

 

WEIGHTED AVERAGE SHARES OUTSTANDING - BASIC

 

5,044,995

 

5,303,177

 

WEIGHTED AVERAGE SHARES OUTSTANDING - DILUTED

 

5,210,614

 

5,337,668

 

 

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

 

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WINMARK CORPORATION AND SUBSIDIARIES

Consolidated Statements of Shareholders’ Equity and Comprehensive Income

Fiscal years ended December 26, 2009 and December 25, 2010

 

 

 

Common Stock

 

Retained

 

Accumulated
Other
Comprehensive

 

 

 

 

 

Shares

 

Amount

 

Earnings

 

Income (Loss)

 

Total

 

 

 

 

 

 

 

 

 

 

 

 

 

BALANCE, December 27, 2008

 

5,433,610

 

$

427,500

 

$

13,502,200

 

$

(38,500

)

$

13,891,200

 

 

 

 

 

 

 

 

 

 

 

 

 

Repurchase of common stock

 

(313,585

)

(1,251,400

)

(4,032,100

)

 

(5,283,500

)

Stock options exercised net of related tax benefits

 

5,000

 

55,500

 

 

 

55,500

 

Compensation expense relating to stock options

 

 

768,400

 

 

 

768,400

 

Unrealized gain on marketable securities, net of related tax expense of $30,000

 

 

 

 

48,100

 

48,100

 

Net income

 

 

 

5,849,000

 

 

5,849,000

 

Total comprehensive income

 

 

 

 

 

5,897,100

 

 

 

 

 

 

 

 

 

 

 

 

 

BALANCE, December 26, 2009

 

5,125,025

 

 

15,319,100

 

9,600

 

15,328,700

 

Repurchase of common stock

 

(165,590

)

(1,150,000

)

(2,847,600

)

 

(3,997,600

)

Stock options exercised net of related tax benefits

 

61,304

 

938,200

 

 

 

938,200

 

Compensation expense relating to stock options

 

 

725,500

 

 

 

725,500

 

Cash dividends

 

 

 

(301,200

)

 

(301,200

)

Unrealized loss on marketable securities net of reclassification adjustments, net of related tax benefits of $5,900

 

 

 

 

(9,600

)

(9,600

)

Net income

 

 

 

10,329,000

 

 

10,329,000

 

Total comprehensive income

 

 

 

 

 

10,319,400

 

BALANCE, December 25, 2010

 

5,020,739

 

$

513,700

 

$

22,499,300

 

$

 

$

23,013,000

 

 

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

 

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WINMARK CORPORATION AND SUBSIDIARIES

Consolidated Statements of Cash Flows

 

 

 

Fiscal Year Ended

 

 

 

December 25, 2010

 

December 26, 2009

 

OPERATING ACTIVITIES:

 

 

 

 

 

Net income

 

$

10,329,000

 

$

5,849,000

 

Adjustments to reconcile net income to net cash provided by operating activities:

 

 

 

 

 

Depreciation

 

466,200

 

530,100

 

Provision for credit losses

 

189,000

 

2,795,500

 

Compensation expense related to stock options

 

725,500

 

768,400

 

Loss/(gain) on sale of marketable securities

 

50,500

 

(76,700

)

Gain from disposal of property and equipment

 

 

(1,200

)

Loss from equity investments

 

259,100

 

100,500

 

Deferred initial direct costs

 

(407,700

)

(644,900

)

Amortization of deferred initial direct costs

 

723,100

 

916,700

 

Change in operating assets and liabilities:

 

 

 

 

 

Receivables

 

(80,200

)

327,300

 

Income tax receivable / payable

 

(472,200

)

945,800

 

Inventories

 

25,500

 

30,100

 

Prepaid expenses

 

16,200

 

620,000

 

Deferred income taxes

 

1,216,200

 

1,809,800

 

Accounts payable

 

(141,000

)

307,000

 

Accrued and other liabilities

 

99,100

 

(885,300

)

Advance and security deposits

 

(521,000

)

8,900

 

Other assets

 

11,900

 

 

Deferred revenue

 

(89,000

)

273,300

 

Net cash provided by operating activities

 

12,400,200

 

13,674,300

 

INVESTING ACTIVITIES:

 

 

 

 

 

Proceeds from sale of marketable securities

 

1,612,000

 

311,500

 

Purchase of marketable securities

 

(565,100

)

(992,500

)

Proceeds from sale of property and equipment

 

 

1,800

 

Purchase of property and equipment

 

(408,600

)

(789,700

)

Purchase of equipment for lease contracts

 

(15,294,200

)

(15,457,600

)

Principal collections on lease receivables

 

20,015,600

 

19,325,900

 

Net cash provided by investing activities

 

5,359,700

 

2,399,400

 

FINANCING ACTIVITIES:

 

 

 

 

 

Proceeds from borrowings on line of credit

 

19,300,000

 

 

Payments on line of credit

 

(19,782,000

)

(4,307,500

)

Proceeds from issuance of subordinated notes

 

146,800

 

5,038,400

 

Payments on subordinated notes

 

(21,372,400

)

(4,653,900

)

Repurchases of common stock

 

(3,997,600

)

(5,283,500

)

Proceeds from exercises of stock options

 

920,600

 

50,000

 

Dividends paid

 

(301,200

)

 

Proceeds from discounted lease rentals

 

74,600

 

428,100

 

Tax benefits on exercised stock options and warrants

 

17,600

 

5,500

 

Net cash used for financing activities

 

(24,993,600

)

(8,722,900

)

INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS

 

(7,233,700

)

7,350,800

 

CASH AND CASH EQUIVALENTS, beginning of year

 

9,490,800

 

2,140,000

 

CASH AND CASH EQUIVALENTS, end of year

 

$

2,257,100

 

$

9,490,800

 

SUPPLEMENTAL DISCLOSURES:

 

 

 

 

 

Cash paid for interest

 

$

2,258,900

 

$

2,701,500

 

Cash paid for income taxes

 

$

6,585,500

 

$

1,222,100

 

Non-cash landlord leasehold improvements

 

$

 

$

1,072,400

 

 

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

 

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WINMARK CORPORATION AND SUBSIDIARIES

 

Notes to the Consolidated Financial Statements

December 25, 2010 and December 26, 2009

 

1.                                      Organization and Business:

 

Winmark Corporation and subsidiaries (the Company) offers licenses to operate franchises using the service marks Plato’s Closet®, Play It Again Sports®, Once Upon A Child®, Music Go Round® and Wirth Business Credit®.  In addition, the Company sells inventory to its Play It Again Sports franchisees through its buying group.  The Company also operates both middle market and small-ticket equipment leasing businesses under the Winmark Capital® and Wirth Business Credit® marks.  The Company has a 52/53-week fiscal year that ends on the last Saturday in December.  Fiscal years 2010 and 2009 were 52-week fiscal years.

 

Following is a summary of our franchising activity for the fiscal year ended December 25, 2010:

 

 

 

(Unaudited)

 

 

 

TOTAL
12/26/09

 

OPENED

 

CLOSED

 

TOTAL
12/25/10

 

Play It Again Sports

 

 

 

 

 

 

 

 

 

Franchises - US and Canada

 

341

 

7

 

(20

)

328

 

Plato’s Closet

 

 

 

 

 

 

 

 

 

Franchises - US and Canada

 

267

 

35

 

(1

)

301

 

Once Upon A Child

 

 

 

 

 

 

 

 

 

Franchises - US and Canada

 

235

 

13

 

(7

)

241

 

Music Go Round

 

 

 

 

 

 

 

 

 

Franchises - US

 

34

 

1

 

(2

)

33

 

Total Franchised Stores

 

877

 

56

 

(30

)

903

 

Wirth Business Credit

 

 

 

 

 

 

 

 

 

Territories - US(1)

 

37

 

0

 

(22

)

15

 

Total Franchises/Territories

 

914

 

56

 

(52

)

918

 

 


(1)          During the first quarter of 2011, the franchise agreements for the 15 Wirth Business Credit territories were terminated for various reasons.  As of the filing date of this Form 10-K,

we did not have any Wirth Business Credit franchisees.

 

2.                                      Significant Accounting Policies:

 

Principles of Consolidation

 

The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries, Winmark Capital Corporation, Wirth Business Credit, Inc. and Grow Biz Games, Inc. All material inter-company transactions have been eliminated in consolidation.  The consolidated financial statements also include the Company’s investment in and share of net earnings or losses for its investment in Tomsten, Inc. (“Tomsten”), which is recorded on the equity method of accounting.

 

Cash Equivalents

 

Cash equivalents consist of highly liquid investments with an original maturity of three months or less.  Cash equivalents are stated at cost, which approximates fair value.  As of December 25, 2010 and December 26, 2009, the Company had $156,200 and $148,600 of cash located in Canadian banks.  The Company holds its cash and cash equivalents with financial institutions and at times, such balances may be in excess of insurance limits.

 

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WINMARK CORPORATION AND SUBSIDIARIES

 

Notes to the Consolidated Financial Statements

December 25, 2010 and December 26, 2009

Receivables

 

The Company provides an allowance for doubtful accounts on trade and notes receivable.  The allowance for doubtful accounts was $17,400 and $37,100 at December 25, 2010 and December 26, 2009, respectively.  If receivables in excess of the provided allowance are determined uncollectible, they are charged to expense in the year the determination is made.  Trade receivables are written off when they become uncollectible (which generally occurs when the franchise terminates and there is no reasonable expectation of collection), and payments subsequently received on such receivable are credited to the allowance for doubtful accounts.  Historically, receivables balances written off have not exceeded allowances provided.

 

Investment in Leasing Operations

 

The Company uses the direct finance method of accounting to record income from direct financing leases.  At the inception of a lease, the Company records the minimum future lease payments receivable, the estimated residual value of the leased equipment and the unearned lease income.  Initial direct costs related to lease originations are deferred as part of the investment and amortized over the lease term.  Unearned lease income is the amount by which the total lease receivable plus the estimated residual value exceeds the cost of the equipment.

 

Leasing Income Recognition

 

Leasing income 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.  Generally, when a lease is more than 90 days delinquent (when 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.

 

In certain circumstances, the Company may re-lease equipment in its existing portfolio.  This may give rise to dealer profit and require the Company to account for the lease as a sales-type lease.  At inception of a sales-type lease, revenue is recorded that consists of the present value of the future minimum lease payments discounted at the rate implicit in the lease.  In subsequent periods, the recording of income is consistent with the accounting for a direct financing lease.

 

Leasing Expense

 

Leasing expense includes the cost of financing equipment purchases as well as the cost of equipment sales.  Additionally, at inception of a sales-type lease, cost is recorded that consists of the equipment’s book value, less the present value of its residual and is included in leasing expense.

 

Initial Direct Costs

 

The Company defers initial direct costs incurred to originate its leases in accordance with applicable accounting guidance.  The initial direct costs deferred are part of the investment in leasing operations and are amortized to leasing income using the effective interest method.  Initial direct costs include commissions and costs associated with credit evaluation, recording guarantees and other security arrangements, documentation and transaction closing.

 

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WINMARK CORPORATION AND SUBSIDIARIES

 

Notes to the Consolidated Financial Statements

December 25, 2010 and December 26, 2009

 

Lease Residual Values

 

Residual values reflect the estimated amounts to be received at lease termination from lease extensions, sales or other dispositions of leased equipment.  The leased equipment residual values are based on the Company’s best estimate.

 

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 the 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.  The Company’s policy is to charge-off against the allowance the estimated unrecoverable portion of accounts once they reach 121 days delinquent.  The allowance for credit losses is considered a significant estimate that could materially change within the next year.

 

Rents Received in Advance

 

Rents received in advance represent advance payments from customers that will be applied to future payments.  For example, if the Company is holding one advance payment, it will be applied to the customer’s last payment.  If the Company is holding two advance payments, they will be applied to the customer’s last two payments.

 

Inventories

 

The Company values its inventories at the lower of cost, as determined by the average weighted cost method, or market.  Inventory consists of computer hardware and related accessories and store sign packages.

 

Impairment of Long-lived Assets and Investments

 

The Company reviews its long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount may not be recoverable.  If the carrying amount of the asset exceeds expected undiscounted future cash flows, the Company measures the amount of impairment by comparing the carrying amount of the asset to its fair value.

 

The Company evaluates its long-term investments for impairment on an annual basis or whenever events or changes in circumstances indicate the carrying amount may not be recoverable.  The impairment, if any, is measured by the difference between the assets’ carrying amount and their fair value (as prescribed by applicable accounting guidance), based on the best information available, including market prices, discounted cash flow analysis or other financial metrics that management utilizes to help determine fair value.

 

Property and Equipment

 

Property and equipment is stated at cost.  Depreciation and amortization for financial reporting purposes is provided on the straight-line method.  Estimated useful lives used in calculating depreciation and amortization are: three years for computer and peripheral equipment, five years for furniture and equipment and the shorter of the lease term or useful life for leasehold improvements.  Major repairs, refurbishments and improvements which significantly extend the useful lives of the related assets are capitalized.  Maintenance and repairs, supplies and accessories are charged to expense as incurred.

 

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WINMARK CORPORATION AND SUBSIDIARIES

 

Notes to the Consolidated Financial Statements

December 25, 2010 and December 26, 2009

 

Goodwill

 

The Company reviews its goodwill for impairment on an annual basis or whenever events or changes in circumstances indicate that there has been a permanent impairment in the value of its goodwill.  Goodwill is included in other assets in the consolidated balance sheet.

 

Use of Estimates

 

The preparation of financial statements in conformity with generally accepted U.S. accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period.  The ultimate results could differ from those estimates.  The most significant estimates relate to allowance for credit losses and impairment of other long-term investments.  These estimates may be adjusted as more current information becomes available, and any adjustment could be significant.

 

Advertising

 

Advertising costs are charged to operating expenses as incurred.  Advertising costs were $116,500 and $122,900, for fiscal years 2010 and 2009, respectively.

 

Accounting for Stock-Based Compensation

 

The Company recognizes the cost of all share-based payments to employees, including grants of employee stock options, in the consolidated financial statements based on the grant date fair value of those awards.   This cost is recognized over the period for which an employee is required to provide service in exchange for the award.  The benefits associated with tax deductions in excess of recognized compensation expense are reported as a financing cash flow rather than as an operating cash flow.  Compensation expense of $725,500 and $768,400 relating to the vested portion of the fair value of stock options granted was expensed to “Selling, General and Administrative Expenses” in 2010 and 2009, respectively.

 

The Company estimates the fair value of options granted using the Black-Scholes option valuation model.  The Company estimates the volatility of its common stock at the date of grant based on its historical volatility rate.  The Company’s decision to use historical volatility was based upon the lack of actively traded options on its common stock.  The Company estimates the expected term based upon historical option exercises.  The risk-free interest rate assumption is based on observed interest rates for the volatility period.  The Company uses historical data to estimate pre-vesting option forfeitures and record share-based compensation expense only for those awards that are expected to vest.  For options granted, the Company amortizes the fair value on a straight-line basis.  All options are amortized over the vesting periods.

 

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WINMARK CORPORATION AND SUBSIDIARIES

 

Notes to the Consolidated Financial Statements

December 25, 2010 and December 26, 2009

 

Revenue Recognition

 

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.  The Company collects initial franchise fees when franchise agreements are signed and recognizes the initial franchise fees as revenue when the franchise is opened, which is when the Company has performed substantially all initial services required by the franchise agreement.  The Company had deferred franchise fee revenue of $789,900 and $984,500 at December 25, 2010 and December 26, 2009, respectively.  The Company recognizes deferred software license fees over the 10-year life of the initial franchise agreement.  The Company had deferred software license fees of $899,400 and $833,800 at December 25, 2010 and December 26, 2010, respectively.  Merchandise sales through the buying group are recognized when the product has been invoiced by the vendor.

 

Sales Tax

 

The Company’s accounting policy is to present taxes collected from customers and remitted to government authorities on a net basis.

 

Discounted Lease Rentals

 

The Company may utilize its lease rentals receivable and underlying equipment as collateral to borrow from financial institutions at fixed rates on a non-recourse basis.  In the event of a default by a customer in non-recourse financing, the financial institution has a first lien on the underlying leased equipment, with no further recourse against the Company.  Proceeds from discounting are recorded on the balance sheet as discounted lease rentals.  As customers make payments, lease income and interest expense are recorded and discounted lease rentals are reduced by the effective interest method.

 

Earnings Per Share

 

The Company calculates earnings per share 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 — Diluted 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 dilutive effect of stock options equivalent to 165,619 shares and 34,491 shares for the years ended December 25, 2010 and December 26, 2009, respectively, were used in the calculation of Earnings Per Share — Diluted.  Options totaling 38,762 and 208,105 shares for the year ended December 25, 2010 and December 26, 2009, respectively, were outstanding but were not included in the calculation of Earnings Per Share — Diluted because their exercise prices were greater than the average market price of the common shares and, therefore, including the options in the denominator would be anti-dilutive.

 

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WINMARK CORPORATION AND SUBSIDIARIES

 

Notes to the Consolidated Financial Statements

December 25, 2010 and December 26, 2009

 

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.

 

The Company’s marketable securities are valued based on Level 1 inputs using quoted prices.

 

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

 

New Accounting Pronouncements

 

In June 2009, the Financial Accounting Standards Board (“FASB”) amended its guidance on accounting for variable interest entities (“VIEs”), effective for fiscal years beginning after November 15, 2009.  Among other things, the new guidance requires a more qualitative than quantitative approach to identifying a controlling financial interest in a VIE, requires ongoing assessment of whether an entity is a VIE and whether an interest in a VIE makes the holder the primary beneficiary of a VIE, and enhances disclosures about an enterprise’s involvement with a VIE.  The Company adopted the new guidance on December 27, 2009 and such adoption has not impacted the Company’s financial condition or results of operations.

 

In July 2010, the FASB issued new accounting guidance that requires new disclosures about an entity’s allowance for credit losses and the credit quality of its financing receivables.  Existing disclosures are amended to require an entity to provide certain disclosures on a disaggregated basis by portfolio segment or by class of financing receivables.  The new and amended disclosures that relate to information as of the end of a reporting period are effective for interim and annual reporting periods ending on or after December 15, 2010.  The disclosures about activity that occurs during a reporting period are effective for interim and annual reporting periods beginning on or after December 15, 2010.  The Company has adopted the new and amended disclosures that relate to information as of the end of a reporting period in this annual report on Form 10-K for the fiscal year ending December 25, 2010; see Note 4 for disclosures related to this adoption. The Company will begin to include the disclosures that relate to information for activity that occurs during a reporting period in its quarterly report on Form 10-Q for the fiscal period ending March 26, 2011.  The adoption of these disclosure requirements has not and will not have an impact on the consolidated results of the Company.

 

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 as previously reported.

 

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WINMARK CORPORATION AND SUBSIDIARIES

 

Notes to the Consolidated Financial Statements

December 25, 2010 and December 26, 2009

 

3.                                      Investments

 

Marketable Securities

 

The following is a summary of marketable securities classified as available-for-sale securities:

 

 

 

December 25, 2010

 

December 26, 2009

 

 

 

Cost

 

Fair Value

 

Cost

 

Fair Value

 

Equity securities

 

$

161,000

 

$

161,000

 

$

1,258,500

 

$

1,274,000

 

 

The Company’s unrealized gains and losses for marketable securities classified as available-for-sale securities in accumulated other comprehensive income (loss) are as follows:

 

Year-ended

 

Unrealized
Gains

 

Unrealized
Losses

 

Net Unrealized
Gains / (Losses)

 

December 25, 2010

 

 

 

 

December 26, 2009

 

$

77,700

 

$

(62,200

)

$

15,500

 

 

As of December 25, 2010, the Company held one marketable security with a fair value less than its cost basis.  The Company evaluated the security for other than temporary impairment and determined that impairment existed based upon the Company’s intent and ability to sell the security before it would expect the fair value of the security to recover up to its cost.  Accordingly, the Company recognized an impairment loss of $27,100 on this security at December 25, 2010.

 

The Company’s realized gains and losses recognized on sales of available-for-sale marketable securities are as follows:

 

Year-ended

 

Realized
Gains

 

Realized
(Losses)

 

Net Realized
Gains (Losses)

 

December 25, 2010

 

$

94,100

 

$

(144,600

)

$

(50,500

)

December 26, 2009

 

$

76,700

 

$

 

$

76,700

 

 

Amounts reclassified out of accumulated other comprehensive income into earnings is determined by using the average cost of the security when sold.

 

Other Long-term Investments

 

The Company’s long-term investments consist of:

 

 

 

December 25, 2010

 

December 26, 2009

 

Tomsten, Inc.

 

$

1,973,800

 

$

2,232,900

 

BridgeFunds, LLC

 

2,000,000

 

2,000,000

 

 

 

3,973,800

 

4,232,900

 

Less current portion

 

 

2,000,000

 

 

 

$

3,973,800

 

$

2,232,900

 

 

Tomsten, Inc.

 

The Company has an investment in Tomsten, the parent company of “Archiver’s” retail chain.  Archiver’s is a retail concept created to help people preserve and enjoy their photographs.  The Company has invested a total of $7.5 million in the purchase of common stock of Tomsten.  The Company’s investment currently represents 18.3% of the outstanding common stock of Tomsten.  The Company applies the equity method of accounting to this investment as the Company’s Chairman and Chief Executive Officer serves on Tomsten’s board of directors.

 

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WINMARK CORPORATION AND SUBSIDIARIES

 

Notes to the Consolidated Financial Statements

December 25, 2010 and December 26, 2009

 

In addition, beginning in December 2009, the Company began providing management services to Tomsten.  Management fees received by the Company are recorded as other revenue.

 

In 2010 and 2009, the Company recorded $259,100 and $100,500, respectively, for its pro-rata share of Tomsten’s losses in the statement of operations on the line item captioned Loss from Equity Investments.  As of December 25, 2010, $0.2 million of the Company’s investment with a current carrying cost of $2.0 million is attributable to goodwill.  The amount of goodwill was determined by calculating the difference between the Company’s net investment in Tomsten less its pro rata share of Tomsten’s net worth.

 

BridgeFunds, LLC

 

On October 13, 2004, the Company made a commitment to lend $2.0 million to BridgeFunds Limited at an annual rate of 12% pursuant to several senior subordinated promissory notes.  BridgeFunds Limited advances funds to claimants involved in civil litigation to cover litigation expenses.  At December 25, 2010 and December 26, 2009, the Company had funded the $2.0 million commitment.  In addition, the Company has received a warrant to purchase approximately 257,000 shares of BridgeFunds at $1 per share, which currently represents 6.4% of the equity of BridgeFunds on a fully diluted basis.  On August 23, 2007, in connection with raising capital, BridgeFunds Limited completed a restructuring where all assets and liabilities, including the warrant, were assigned to and assumed by BridgeFunds, LLC.

 

During 2009, the board of BridgeFunds decided to cease advancing funds to new claimants and place its portfolio of receivables in run-off, thereby allowing equity holders the opportunity to receive distributions after collection of receivables and the payment in full to all debt holders, including the Company’s notes.  Entry by BridgeFunds into transactions contemplated by these actions necessitated consent by its debt holders.  On October 22, 2009, the Company entered into a modification agreement with BridgeFunds, LLC, whereby the maturity date of all of the outstanding promissory notes was changed to September 30, 2010, the annual rate of interest on the notes was increased to 15% and monthly prepayments of the principal of such notes in an amount equal to Available Cash Flow (as defined within the agreements governing the notes) is required.  On October 20, 2010, the Company entered into an amendment to the agreements governing the notes that extended the maturity date on the notes to June 30, 2011.  During 2010, the Company received $60,400 in payments of interest and did not receive any payments of principal on the notes.  In consideration of the need to extend the maturity dates as well as the amount of cash received during 2010, the Company stopped accruing interest on this investment as of the September 30, 2010.  The Company has deemed this investment to be impaired, but in evaluating the investment for impairment has determined that its present value of expected future cash flows, discounted at the effective interest rate of the notes, exceeds its carrying amount and that no impairment charge is warranted.  As of December 25, 2010, the $2.0 million investment balance is classified as long-term based on expected payments from Available Cash Flow, and $0.2 million of related interest receivable is included in current receivables.

 

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WINMARK CORPORATION AND SUBSIDIARIES

 

Notes to the Consolidated Financial Statements

December 25, 2010 and December 26, 2009

 

4.             Investment in Leasing Operations:

 

Investment in leasing operations consists of the following:

 

 

 

December 25, 2010

 

December 26, 2009

 

Minimum lease payments receivable

 

$

30,244,700

 

$

40,868,500

 

Estimated residual value of equipment

 

3,449,400

 

2,954,400

 

Unearned lease income net of initial direct costs deferred

 

(4,925,200

)

(6,412,900

)

Security deposits

 

(2,044,900

)

(1,928,200

)

Equipment installed on leases not yet commenced

 

4,843,000

 

2,857,200

 

Total investment in leases

 

31,567,000

 

38,339,000

 

Allowance for credit losses

 

(907,800

)

(1,339,400

)

Net investment in leases

 

30,659,200

 

36,999,600

 

Less: net investment in leases — current

 

(13,856,700

)

(17,575,900

)

Net investment in leases — long-term

 

$

16,802,500

 

$

19,423,700

 

 

The Company had $620,600 and $2,995,000 of write-offs, net of recoveries, related to the lease portfolio during 2010 and 2009, respectively.

 

As of December 25, 2010 and December 26, 2009, no customer had leased assets totaling more than 10% of the Company’s total assets.

 

Minimum lease payments receivable under lease contracts and the amortization of unearned lease income, net of initial direct costs deferred, is as follows as of December 25, 2010:

 

Fiscal Year

 

Minimum Lease
Payments Receivable

 

Income
Amortization

 

2011

 

$

17,813,100

 

$

3,664,700

 

2012

 

9,832,600

 

1,103,100

 

2013

 

2,493,900

 

135,100

 

2014

 

93,800

 

16,300

 

2015

 

11,300

 

6,000

 

Thereafter

 

 

 

 

 

$

30,244,700

 

$

4,925,200

 

 

The activity in the allowance for credit losses for leasing operations is as follows:

 

 

 

December 25, 2010

 

December 26, 2009