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Winmark Corporation (WINA) is a small cap stock on a winning streak

On July 16th 2013, Winmark announced second quarter earnings of .85 cents per share, which represents a 28% increase over the same quarter last year. This built upon on the first quarter's 16% earnings growth and 11% sales growth. Yet to focus on these short-term achievements, as significant as they are, is to miss the real story of Winmark Corporation.

So what is the real story? To put it simply, Winmark Corporation is a small cap company with an enviable track record of creating shareholder wealth. Winmark has these favorable characteristics:

  • Massive operating leverage - Gross margins stand at 95% of revenue, while pre-tax operating margins are around 50%
  • An "owner-operator" business - The CEO is also the largest shareholder. As of the last proxy statement, CEO John L. Morgan owned 34% of the outstanding shares. Mr. Morgan also has a long history of adding to his position on "dips" in the stock price, as can be seen in the graphic below
  • A new franchise concept (Style Encore) that uses the same business model as its most successful business, but with a different (and potentially huge) target market.

In some ways, Winmark reminds me of my favorite small-cap company, National Beverage (FIZZ). My latest article on National Beverage can be found here.

CEO John L. Morgan has a long history of buying back shares in the open market. Here are his most recent purchases:

So what is Winmark Corporation and what makes it special? Allow me to quote the company's own words:

"Winmark Corporation operates businesses in two sectors: retail franchising and leasing:

Retail Franchising:

Winmark is a franchisor of five value-oriented retail store concepts: Play It Again Sports®, Plato's Closet®, Once Upon A Child®, Music Go Round® and Style Encore™. Each store buys, sells, trades and/or consigns gently-used and new merchandise. All brands emphasize consumer value by offering high-quality merchandise at substantial savings and by purchasing customers' goods that have been outgrown or are no longer used.

Leasing:

Winmark operates a middle-market equipment leasing business through its subsidiary, Winmark Capital Corporation. Winmark Capital® is a technology equipment lessor to medium-sized and larger companies nationwide, with typical lease programs ranging in value from $250,000 to $10 million."

Two complementary businesses brought together by a talented "owner-operator" CEO

How two such disparate businesses ended up being tied together makes for an interesting story, as it is related to the unique history and talents of the company's CEO, John L. Morgan. Between 1982 and 1997, Morgan started, owned, and was the CEO of a very successful leasing business called Winthrop Resources. He ended up selling the company in 1997 for $325 million, and then staying on as CEO until 1999. It did not take Morgan long to find his next target of opportunity.

March 22, 2000 was an extraordinarily eventful day for both Winmark Corporation (which at that time was called Grow Biz International, Inc.) and Mr. John Morgan. On this date, Morgan:

  • Joined the board of directors
  • Became chairman of the board
  • Became CEO
  • Purchased 700,000 shares of the company's stock (A 13% ownership interest) from the company's former CEO at a price of $7 per share
  • Was given a salary of $50,000 per year
  • Was awarded long-term options to buy an additional 600,000 shares of the company's common stock

Think about what the above means. In one day, the company acquired a new CEO and chairman of the board who, not coincidentally, just invested almost five million dollars into the common stock. He was then given an extraordinarily modest salary and rewarded options contracts for long-term performance. If this is not a great example of shareholder/CEO alignment of interests and a huge expression of confidence by a new CEO, I don't know what would be.

An interesting characteristic of Winmark's franchise business is that it is an extraordinarily capital light, high margin business that generates substantial free cash flow. The one problem (if it could be called that!) is that it provides limited avenues to redeploy this free cash flow in a substantial way. After some (with what hindsight can be viewed as) investing missteps in 2003 and 2004, Morgan developed the overall Winmark business strategy of redeploying the cash spun off from the franchise business into the new leasing business and share buybacks. Winmark's franchise and leasing businesses have had a symbiotic relationship that has worked out well since 2005.

A solid track record of creating shareholder value over time

Let's look at how Winmark has grown earnings per share since the year 2004:


(Click to enlarge)

The EPS trajectory over this period is somewhat clouded by non-operating losses that resulted from write-downs on the ill-fated investments that occurred between 2003 and 2004. In particular, 2005, 2008, and 2012 saw substantial write-downs that cloud the operating performance from an EPS perspective. I believe the adjusted figure more accurately reflects the company's real economic performance. The good news is that since 2004, the company has invested almost exclusively in its leasing business and by repurchasing its own common stock. The 2003-2004 investments have now (As of Q1 2013) been completely written off, so they will no longer be impacting GAAP earnings.

The adjusted EPS issue is important because earnings stability and growth are used by many "quantitative screen" based investors to find prospects. The EPS figure also changes investor perception of value. For example, at the date of the full-year 2012 earnings announcement, use of the adjusted earnings created a P/E ratio of 21 vs. 25 for the unadjusted figure.

I did an exercise to determine what would have happened if Winmark had simply repurchased common stock in 2003 and 2004, rather than made the investments that it did. All else equal, the decision would have added about .23 to year end 2012 EPS, which I estimate would have led to a (all else equal) nearly $6 per share higher stock price. In other words, the 10.7 million dollar investment would have added over $27 million in market capitalization. This is in spite of the fact that at the time of the hypothetical purchase, the company had a P/E ratio of around 30. Clearly, Morgan has understood the buyback logic, as between 2004 and 2012, the share count fell by 20% due to share buybacks.

Let's examine how the pre-tax margin contribution of the leasing business has grown since 2005:

The above table documents that the leasing business is making a substantial contribution to Winmark's bottom line. In fact, much of the ramp-up of earnings that has occurred over the past five years is due to the success of the leasing business.

A powerful new retail concept has left the starting gates

Finally, let's discuss the development that I am personally most excited about: On January 15 2013, Winmark announced a new franchise concept called Style Encore. Morgan described it this way in the press release:

"There has been a major change in the consumer acceptance of gently used merchandise. Winmark Corporation, with nearly a billion dollars a year in sales of these products, has taken a logical next step in providing a retail store selling gently used merchandise to women. Customers that will look for ways to intelligently manage budgets and to keep up with practical and fashionable clothing and accessories will find our new concept the perfect shopping experience. Women's apparel is an ideal category to further enhance our family of franchised resale brands, and we are excited to share this news with our employees, shareholders and current franchisees."

This announcement exited me for a number of reasons. First, the concept is extremely similar to the company's very successful business, Plato's Closet. Plato's Closet is a store concept that focuses on selling gently used fashion apparel to teens. I believe we can understand the potential of Style Encore by examining the performance of Plato's Closet.

When I first began investigating Winmark for investment purposes a few years ago, one of my first steps was to consult my wife, who is an invaluable consultant on all topics retail (my idea of style is buying the same items from L.L Bean for 20 years). She told me that Plato's Closet is quite popular with the students at the university where she works. Being more than a bit skeptical, I visited a local store location in Lincoln Park, Chicago. I was surprised by the level of traffic, and also by the fact that people will spend good money on used apparel - the prices were not as cheap as I expected. In my mind, "used clothing store" means charity store. Plato's Closet is not like that. It really caters to young people that want the good brands, but want to spend less money on them. I think this "brand" angle is the key that took me a while to understand - the power of branding does not die when a clothing or Apparel item has been gently used.

Plato's Closet generated 15.2 million in franchise fees and royalties for Winmark in 2012, which is a 50% increase over 2010 levels. 30 new Plato's Closet stores were opened, zero stores were closed, and 100% of franchise agreements (29) that were available for renewal were renewed. The company ended 2012 with 354 Plato's Closet stores, and added a net 13 new stores in the first quarter of 2013. In other words, Plato's Closet is a fast growing, ultra-high margin business that in and of itself is an exciting growth story.

I believe that Winmark has a significant opportunity to create a similar success story with Style Encore. Today's brand and style conscious woman drives an enormous economy that few men can fully understand or even grasp, yet that does not diminish its reality. Closets are continually being filled with new goods and then purged, only to be filled again. At the same time, wages are stagnating and the gap between those who can afford designer items and those who can't seems to be widening. Style Encore has the opportunity to step into this market and create a unique value proposition for both franchisees and end customers.

With the Plato's Closet model as a guide, I believe Winmark has the opportunity to role the Style Encore concept out more quickly and even more successfully. In a press release dated May 15, 2013, John Morgan stated that:

"We are thrilled with the response to Style Encore and are excited with the progress we have made since announcing the concept four months ago. Our initial store design, operational guidelines and marketing campaigns are complete and we are ready to open our first franchised stores in 2013. Our goal is to build the leading brand in the women's resale market."

Catalysts:

  • Style Encore is positioned to blast off out of the gates, and the early reception of the concept seems to confirm this. The potential of Style Encore is not presently being recognized by the market
  • The write down of 2003-2004 era investments is now complete. This will improve Winmark's earnings profile to the many "quantitative screen" investors who look for steady earnings growth
  • While the stock is presently fairly valued, I believe that the odds favor the stock becoming extremely overvalued before the current cycle completes itself. I will be looking to add on any dips that might occur

Key Risks:

  • Both the franchise and leasing business operate in extremely competitive markets. While Winmark has done an admirable job adapting to change over the past 10 years, this does not guarantee the performance will continue
  • A few of the franchise businesses are stable or slowly declining. This could continue or it could accelerate
  • Key man risk - The company depends on the unique talents and leadership of its "owner-operator" CEO, John Morgan

Unseen opportunity:

  • I believe that there is substantial room to tap into the Winmark's franchise expertise in different markets. Teaming up with professionals who have substantial business experience in new, desirable market segments could further unlock Winmark's full potential
  • A goal of becoming the most desired, most successful franchise partner for small business franchise owners

Just a quick note about investing in small cap stocks. In terms of trading less liquid names, I believe it is sound practice to always use limit orders. Market orders, particularly near the opening price, can result in horrible fills. It is also important to fit individual investments into an overall perspective that limits what I call "unforced errors." I wrote an article on these errors and how to avoid them which can be found here.

References:

Source: Winmark Corporation: A High Margin, Owner-Operator Small Cap That Is Breaking Out