WINMARK CORP (WINA) FY 2021 MD&A

ITEM 7:     MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

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The following is management’s discussion and analysis of certain significant factors which have affected our financial position and operating results during the periods included in the accompanying consolidated financial statements and should be read in conjunction with those consolidated financial statements. This section of this 10-K generally discusses 2021 and 2020 items and year-to-year comparisons between 2021 and 2020. Discussions of 2019 items and year-to-date comparisons between 2020 and 2019 that are not included in this Form 10-K, can be found in ‘Management’s Discussion and Analysis of Financial Condition and Results of Operations’ in Part II, Item 7 of our Annual Report on Form 10-K for the fiscal year ended December 26, 2020.

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COVID-19 Pandemic

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The emergence of the coronavirus (COVID-19) and new variants of the virus around the world, and particularly in the United States and Canada, continues to present significant risks to the Company, not all of which the Company is able to fully evaluate or even to foresee at the current time. The pandemic affected the Company’s financial results and business operations in the Company’s fiscal years ended December 25, 2021 and December 26, 2020, and economic and health conditions in the United States and across most of the globe have continued to change since the beginning of the pandemic. Notably, a number of the Company’s franchised store locations were temporarily closed to in-store consumer activities from time to time due to various restrictions. Such temporary store closings may reoccur and customer traffic may continue to be impacted depending on the duration and severity of the pandemic, the length of time it takes for normal economic and operating conditions to resume, additional governmental actions that may be taken and/or re-imposition of restrictions that have been imposed to date, and numerous other uncertainties.

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Even as governmental restrictions are relaxed and markets reopen, the ongoing economic effects and health concerns associated with the pandemic may continue to affect consumer behavior, spending levels and shopping preferences. Changes in consumer purchasing patterns or government stimulus programs may increase demand at our franchised stores in one quarter, resulting in decreased demand in subsequent quarters. We continue to see shifts in product and channel preferences as markets move through varying stages of restrictions and re-opening at different times. In addition, we continue to see an increase in demand in the e-commerce channel and any failure to capitalize on this demand could adversely affect our franchised stores ability to maintain and grow sales and erode our competitive position.

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Management cannot predict the full impact of the COVID-19 pandemic on the Company’s management and employees, its franchisees or leasing customers nor to economic conditions generally, including the effects on consumer spending. The ultimate extent of the effects of the COVID-19 pandemic on the Company is highly uncertain and will depend on future developments, and such effects could exist for an extended period of time even after the pandemic might end.

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Overview

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We are a franchising business focused on sustainability and small business formation. As of December 25, 2021, we had 1,271 franchises operating under the Plato’s Closet, Once Upon A Child, Play It Again Sports, Style Encore and Music Go Round brands. Our franchise business is not capital intensive and is designed to generate consistent, recurring revenue and strong operating margins.

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The financial criteria that management closely tracks to evaluate current business operations and future prospects include royalties and selling, general and administrative expenses.

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Our most significant source of franchising revenue is royalties received from our franchisees. During 2021, our royalties increased $14.5 million or 31.3% compared to 2020.

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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 2021, selling, general and administrative expense increased $1.1 million, or 5.2%, compared to the same period last year.

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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, 2021:

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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 2021, we renewed 99% of franchise agreements up for renewal. This percentage of renewal has ranged between 98% and 99% during the last three years.

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Our ability to grow our operating income is dependent on our ability to: (i) effectively support our franchise partners so that they produce higher revenues, (ii) open new franchises, and (iii) 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”.

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In May 2021, we made the decision to no longer solicit new leasing customers and will pursue an orderly run-off of our middle-market leasing portfolio, the operations of which constitute our leasing segment. Leasing income net of leasing expense for the fiscal year of 2021 was $9.3 million compared to $11.9 million in 2020. During 2021, we purchased $0.2 million in equipment for lease customers compared to $4.1 million in 2020. Our leasing portfolio (net investment in leases – current and long-term), was $3.1 million at December 25, 2021 compared to $13.3 million at December 26, 2020. Given the decision to run-off the portfolio, we anticipate that leasing income net of leasing expense, purchases of equipment for lease customers and the size of the leasing portfolio will continue to decrease through the run-off period. See Note 3 – “Investment in Leasing Operations” for information regarding the lease portfolio, including future minimum lease payments receivable under lease contracts and the amortization of unearned lease income.

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Results of Operations

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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:

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Revenue

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Revenues for the year ended December 25, 2021 totaled $78.2 million compared to $66.1 million in 2020.

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Royalties and Franchise Fees

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Royalties increased to $60.8 million for 2021 from $46.3 million for the same period in 2020, a 31.3% increase. The increase is primarily due to higher franchisee retail sales in 2021 compared to 2020. Lower franchisee retail sales in 2020 were directly attributable to the temporary store closings and reduced customer traffic resulting from the COVID-19 pandemic. For illustrative purposes, royalties for 2019 were $51.4 million.

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Franchise fees of $1.5 million for 2021 were comparable to $1.4 million for 2020. 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 over the estimated life of the franchise, beginning when the franchise opens. An overview of retail brand franchise fees is presented in the Franchising subsection of the Business section (Item 1).

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Leasing Income

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Leasing income decreased to $11.1 million in 2021 compared to $14.5 million for the same period in 2020. The decrease is primarily due to lower levels of interest income and customer activity, including equipment sales to customers, from the smaller lease portfolio when compared to last year.

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Merchandise Sales

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Merchandise sales include the sale of product to franchisees either through our Computer Support Center or through the Play It Again Sports buying group (together, “Direct Franchisee Sales”). Direct Franchisee Sales increased to $3.1 million in 2021 from $2.2 million in 2020. The increase is due to an increase in technology and buying group purchases by our franchisees.

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Cost of Merchandise Sold

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Cost of merchandise sold includes in-bound freight and the cost of merchandise associated with Direct Franchisee Sales. Cost of merchandise sold increased to $2.9 million in 2021 from $2.1 million in 2020. The increase was due to an increase in Direct Franchisee Sales discussed above. Cost of merchandise sold as a percentage of Direct Franchisee Sales for 2021 and 2020 was 94.9% and 95.0%, respectively.

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Leasing Expense

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Leasing expense decreased to $1.9 million in 2021 compared to $2.6 million in 2020. The decrease was primarily due to a decrease in the associated cost of equipment sales to customers noted above.

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Provision for Credit Losses

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Provision for credit losses of $(0.2) million in 2021 was comparable to $(0.1) million in 2020.

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Selling, General and Administrative Expenses

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Selling, general and administrative expenses increased 5.2% to $22.3 million in 2021 from $21.2 million in 2020. The increase was primarily due to an increase in compensation, benefits and advertising production expenses.

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Interest Expense

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Interest expense was $1.5 million in 2021 compared to $1.7 million in 2020. The decrease is primarily due to lower average corporate borrowings when compared to last year.

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Income Taxes

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The provision for income taxes was calculated at an effective rate of 19.9% and 22.6% for 2021 and 2020, respectively. The decrease is primarily due to higher tax benefits on the exercise of non-qualified stock options.

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Segment Comparison of Fiscal Years 2021 and 2020

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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 our equipment leasing 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 income from operations:

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Revenues are all generated from United States operations other than franchising revenue from Canadian operations of $4.9 million and $4.0 million in each of fiscal 2021 and 2020, respectively.

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Franchising Segment Operating Income

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The franchising segment’s 2021 operating income increased by $12.9 million, or 40.6%, to $44.8 million from $31.9 million for 2020. The increase in segment contribution was primarily due to increased royalty revenues, partially offset by an increase in selling, general and administrative expenses.

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Leasing Segment Operating Income

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The leasing segment’s operating income for 2021 decreased by $1.8 million, or 21.9%, to $6.5 million from $8.3 million for 2020. The decrease in segment contribution was due to a decrease in leasing income net of leasing expense, partially offset by a decrease in provision for credit losses and a decrease in selling, general and administrative expenses.

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Liquidity and Capital Resources

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Our primary sources of liquidity have historically been cash flow from operations and borrowings. The components of the Consolidated Statements of Operations that reduce our net income but do not affect our liquidity include non-cash items for depreciation and compensation expense related to stock options.

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We ended 2021 with $11.4 million in cash, cash equivalents and restricted cash compared to $6.7 million in cash, cash equivalents and restricted cash at the end of 2020.

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Operating activities provided $48.3 million of cash during 2021 compared to $43.2 million provided during 2020. The increase in cash provided by operating activities in 2021 compared to 2020 was primarily due to net income, partially offset by a decrease in principal collections on lease receivables.

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Investing activities used $0.3 million of cash during 2021 compared to $4.2 million used during 2020. Our most significant investing activities consisted of the purchase of equipment for lease contracts as our franchising business is not capital intensive. Purchase of equipment for lease customers in 2021 was $0.2 million compared to $4.1 million in 2020.

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Financing activities used $43.3 million of cash during 2021 compared to $57.6 million used during 2020. Our most significant financing activities over the past two years have consisted of net borrowings/payments on our debt facilities, the payment of dividends, repurchase of common stock, and net proceeds received from the exercise of stock options. During 2020, we used $49.0 million to purchase 300,000 shares of our common stock in a tender offer (the “2020 Tender Offer”), paid $14.2 million in cash dividends (including a $3.00 per share special cash dividend; the “2020 Special Dividend”) and made net payments on our line of credit and notes payable of $3.8 million; partially offset by $8.3 million of proceeds from exercise of stock options and $1.2 million in proceeds received from discounted lease rentals. During 2021, we used $44.2 million to purchase 225,839 shares of our common stock, paid $33.2 million in cash dividends (including a $7.50 per share special cash dividend; the “2021 Special Dividend”), had net borrowings on our notes payable of $25.8 million and $8.3 million of proceeds from the exercise of stock options. (See Note 5 — “Shareholders’ Equity (Deficit)” and Note 6 — “Debt”).

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We have debt obligations and future operating lease commitments for our corporate headquarters. As of December 25, 2021, we had no other material outstanding commitments. (See Note 12 — “Commitments and Contingencies”). The following table summarizes our significant future contractual obligations at December 25, 2021:

[table omitted - see filing]