Description

Business Overview

Winmark (WINA) is a North-American franchisor of five value-oriented retail concepts. Customers can sell/trade-in their used merchandise for cash or store credit. The store then marks up the used merchandise and sells it back to other customers at a ~60% gross margin, but still significantly below retail price. The company currently has 1,264 franchised stores (128 in Canada and 1,136 in US) and generates revenue from five sources. The largest most significant source of operating income is from royalty income that WINA collects from franchisees. This capital-light model has allowed the company to generate >100% ROIC over the past decade.

The five retail concepts are:

·   Plato’s Closet (43% of royalties)

o   Began franchising in 1999, $444 million in system-wide sales across 485 stores

o   Fashion clothing (e.g. lululemon, American eagle, adidas, Birkenstock, etc.)

o   Ages 13 – 22

·   Once Upon A Child (29% of royalties)

o   Began franchising in 1993, $312 million in system-wide sales across 399 stores

o   Toddler’s clothes, toys, furniture, equipment, etc.

o   Ages 0 – 13

·   Play It Again Sports (22% of royalties)

o   Began franchising in 1988, $250 million in system-wide sales across 274 stores

o   Used and new sporting goods and equipment

·   Style Encore (4% of royalties)

o   Began franchising in 2013, $36 million in system-wide sales across 69 stores

o   Higher quality used women’s clothing and accessories selling at 40-50% below retail

o   Ages 25 -- 54

·   Music Go Round (2% of royalties)

o   Began franchising in 1994, $33 million in system-wide sales across 37 stores

o   Used music instruments, equipment, and related accessories

Royalties (70% of revenue)

Franchisees are required to pay WINA royalties of 5% of system-wide sales.

Franchise Fees (2% of revenue)

Initial franchise agreements are typically 10 years in length with 10-year renewal periods. Franchisees pay WINA fees at inception and renewal. Franchisees are also responsible for finding locations, renovating the leased space, and purchasing start-up inventory from customers during a start-up period (i.e. no incremental capex is required from WINA as its footprint increases).

Equipment Leasing (22% of revenue)

WINA uses some of its cash flow generated by the royalties and franchise fees segments to purchase and lease high-tech assets to mid-market businesses.

Merchandise Sales (3% of revenue)

WINA sells new merchandise at wholesale price to Play It Again Sports franchisees.

Management

WINA’s previous Executive Chairman, John Morgan, joined the company in 2000, turning the company around from the brink of bankruptcy. He sold off failing concepts and placed a larger focus on screening for quality franchisees. It is worth noting that during this his tenure, John opted to receive no equity grants and purchased all of the stock he owned in the open market; prior to the company’s tender offer in 2020, John owned almost 1/3 of the company. He has since retired in March 2020 and CEO Brett Heffes took over as Chairman. Brett has been at Winmark for 18 years, where he has served as CFO, President, and most recently CEO in 2016. I believe his two decades working under John will pay dividends as he takes on the Chairman role as well. What is unusual is that Ronald Olson, co-founder of Winmark, continues to own 9.8% of the company’s stock despite being President of NTY Franchise company, a franchisor that owns rival retail concepts (which we will touch on later).

Opportunity

WINA’s a small cap stock (~700M market cap) that is overlooked because of its low investor outreach (no earnings calls, investor relations page, or analyst coverage).

Thesis I: Opportunities for Style Encore Expansion

WINA’s store count growth has slowed as it reaches penetration in its Music Go Round, Plato’s Closet, Once Upon a Child, and Play It Again Sports banners. However, I believe Style Encore still has runway for growth. Within the more luxury second-hand merchandise category, it competes primarily with franchisor Clothes Mentor (whose parent company is NTY Franchise, Ronald Olson’s company) which has 127 stores across the US, the majority of locations being in the Midwest and South.

By my estimates, there are 10 states where Clothes Mentor operates in, but Style Encore has no presence in; Clothes Mentor currently only has 21 stores in these markets. As a result, I believe these states are underpenetrated and Style Encore is well positioned to expand into these areas.

In addition, Style Encore launched their e-commerce site in late 2019, whereas Clothes Mentor’s website didn’t launch until August 2020. From an execution perspective, Clothes Mentor seems to still be figuring out their online model. On Style Encore’s website, a customer can easily search for items based on zip code, whereas Clothes Mentor requires the customer to manually filter through a long list of cities. As Style Encore continues its expansion into new markets, a flywheel effect can occur: new customers find a product on the website -> decide to pick up in their nearby store -> return to store/website in the future for future purchases.

The question then becomes whether it makes financial sense for new and/or existing franchisees to want to open a new Style Encore store. Based off conversations with Style Encore franchisee, I estimate the average store runs at ~10-13% pre-tax margin, depending on the sqft lease price. I believe franchisees should be able to find affordable real estate in these suburban regions to make a new location attractive.

Thesis II: B&M stores like WINA’s banners still provide value to consumers despite e-commerce

The long-term sentiment around B&M consignment shops seems to be clumped in with those of other retailers. With recently IPO’d online marketplaces like Poshmark and thredUP, the market seems to believe that B&M stores like Style Encore provide little value. However, I believe the market overlooks two factors in the customer selling/buying process:

-    WINA’s retail concepts provide sellers an instant decision as to which items they want to buy, while sellers also receive immediate cash payment. The average seller on marketplaces like Poshmark and Depop find inventory turnover to be unpredictable and a longer time to cash payment. This is because online marketplaces have sorting algorithm that are based on a users’ online “store” traffic (i.e. the burden is on seller to drive demand to their online storefront). One Reddit user on r/poshmark even goes as far to say the average time to sell an item is “forever and a day”.

-    WINA’s franchises are in the business of selecting good products that will sell; the average second-hand goods seller is not. WINA’s franchises use a proprietary POS system to track which items sell and how much to purchase them for. In addition, sellers using online marketplaces need to spend time setting up their store (i.e. taking pictures of their goods and uploading them) as well as having to deal with shipment costs.

Thesis III: Shareholder-friendly capital allocation

WINA’s management team have historically acted very favorably for shareholders. During John Morgan’s tenure, the company retired ~25% of shares outstanding (albeit majority of tendered shares were from John himself). The company still has the ability to purchase 130,604 shares (3.3% of diluted shares outstanding) under its most recent tender offer. It’s not unlikely that the board authorizes a new tender offer and continues to repurchase shares at attractive prices. The company also pays out a small quarterly dividend (0.4% yield as of 07/04/21). What’s more interesting though is the company’s history of issuing dividend recaps. Over the past decade, the company has returned $65M of value back to shareholders since 2012 through these special dividends. Given 81% of CEO Brett’s net worth and 85% of CFO Anthony’s net worth are tied in WINA shares, I believe management is incentivized to continue issuing special dividends to shareholders and buying back stock. 

Valuation

My valuation assumes 2.0% annual store unit growth (vs. 1.9% trailing 5Y CAGR), 2% system-wide sales growth per store, $20M in annual share buybacks (i.e. retiring 8.4% of current diluted s/o by 2025) and a 24x exit earnings multiple. At its current price, I believe investors can buy a high-quality business in Winmark at a reasonable price.

Risks: Inability to attract quality franchisees in untapped markets, deterioration in store performance post-pandemic

Catalyst

Share buybacks, special dividend, strong comparable sales in franchisee stores, acquisition of new retail concept through Winmark Franchise Partners