2023-09-01 09:56:57 ET
Summary
- Winmark operates in a crisis-resistant market segment with a strong track record of share returns.
- The company's franchise model allows for low costs and enduring relationships with franchisees.
- Despite the excellent characteristics of the business, the current valuation is not attractive.
Investment Thesis
Winmark ( WINA ) is a company with an exemplary business model operating within a crisis-resistant market segment. One need only examine the impressive 19% Compound Annual Growth Rate ((CAGR)) in share returns over the past decade to appreciate this fact.
While the current valuation may not offer a substantial margin of safety, it remains the type of stock that is always worth keeping on your investment watchlist.
Winmark Stock Price (Seeking Alpha)
Business Overview
Winmark operates using a franchise model that centers on the resale of second-hand items.
The noteworthy advantage of this business model is that Winmark does not assume the responsibility of managing inventories. Instead, the company focuses on lending its brand, training franchisees to oversee operations, providing proprietary software for business management (known as the Data Recycling System), and, in return, collecting royalties, which typically amount to 5.6% of total franchise sales. In exchange for these services, franchisees gain the opportunity to become business owners without the need to establish a brand from scratch. The initial investment is modest, with $25,000 required for the first store and $15,000 for subsequent locations.
The concept behind the resale businesses revolves around offering used merchandise in good condition, allowing buyers to save money compared to purchasing new products while sellers can profit from items they no longer require.
Winmark operates through five distinct franchise brands, enumerated as follows:
- Plato's Closet: This brand originated in 1999. Franchisees of Plato's Closet buy and sell pre-owned clothing and accessories targeted at the teen and young adult market. Some of the brands they typically sell include Abercrombie, American Eagle, Adidas, Converse, Forever 21, and other youth-oriented clothing and footwear brands.
- Once Upon A Child: This brand was established in 1993. Franchisees of Once Upon A Child buy and sell children's clothing, toys, furniture, equipment, and various items. This brand primarily targets parents of infants and children up to 12 years old.
- Play It Again Sports: This brand was established in 1988, making it the oldest among the five franchises. Unlike the previous two, Play It Again Sports has an online purchasing platform in addition to physical stores. This store buys and sells sports supplies, equipment, and accessories for a variety of sports, including baseball/softball, hockey, football, lacrosse, soccer, fitness, golf, and more.
- Style Encore: The Style Encore brand was established in 2013. It specializes in buying and selling women's clothing, shoes, and accessories. They also operate an online store where they sell items from brands like Gucci and Louis Vuitton, as well as generic brand clothing.
- Music Go Round: This brand was founded in 1994. Franchisees of Music Go Round specialize in buying and selling musical instruments, speakers, amplifiers, and various music-related items.
As of December 31, 2022, there were 1,295 franchises in operation in the United States and Canada. Remarkably, nine out of ten franchisees renew their ten-year contracts, fostering enduring relationships in a sector that proves resilient even during economic downturns, as we will explore below.
(Source: Winmark 10-K )
Second Hand Clothes in Trend
Among younger generations, there is a clear trend towards buying second-hand items. According to a ThredUp study , 62% of Gen Z and Millennial consumers (ages 10-30) stated that they prefer shopping for second-hand items before considering new ones.
One of the primary reasons consumers are now turning to used clothing is the growing pressure of inflation and rising prices. Therefore, in a recessionary environment, Winmark stores could benefit significantly. Consumers have recently noticed higher prices on groceries, gas, restaurants, household bills, and clothing, with nearly half (44%) of all consumers stating that they are cutting spending on clothing. This percentage is higher than any other category, except for restaurants.
Anti-crisis
Second-hand goods are increasingly seen as a way for people to stretch their paycheck even further, especially when faced with high inflation or economic crises that erode consumer confidence. An example of this is Winmark's revenue performance during the 2008-2009 recession, one of the most severe economic downturns in US history.
Revenue during 2008 (Author's Representations)
Throughout 2009, the worst part of the recession, Winmark's revenues continued to grow, and its profit margins remained robust. This resilience is attributed to its franchise-based structure, which mitigates the operational costs typically associated with traditional retail businesses. Consequently, Winmark not only operates in a sector that tends to weather economic crises well, but it also boasts a business model that minimizes risks related to cost escalation.
Sustainable Consumption
The global thrift market is expected to growth by 15% CAGR , reaching an estimated $275 billion by 2032. While Winmark only has a presence in the United States and Canada, global growth indicates that this market is clearly trending.
I firmly believe that this growth is sustainable, reflecting a broader shift among consumers towards more sustainable and environmentally conscious consumption patterns. This transformation is particularly pertinent in light of the textile industry and fast fashion's significant environmental impact , with millions of liters of water consumed, tons of waste dumped into the sea, and substantial carbon emissions generated
Risks
The biggest risk for Winmark is that they are dependent on franchisee renewal for continued success, otherwise the company would have to open stores on its own and the capital-light nature of the business would be lost.
At December 31, 2022 the company had another 57 signed franchise agreements, of which the majority are expected to open in current year 2023. Also, according to the last annual report, the company has renewed 99% of the franchisees in the last 10 years, so it seems that Winmark has a good ability to keep their franchisees satisfied and the brands are profitable enough for them to decide continue with the business.
Key Ratios
The company has a slow but sustainable growth, only being affected in 2020 due to the fact that people will not be able to go out and buy any clothes at all. So unless there is a lockdown again, revenue should be predictable.
Between 2017 and 2022, sales have demonstrated a CAGR of 7%, while net profits have exhibited a more robust growth rate of 14%. This performance can be attributed to the evolving business model, which increasingly emphasizes franchising. This strategic shift leads to improved margins as it entails minimal costs for Winmark.
Revenue Growth and Margins (Author's Representations)
To give examples of other businesses based on receiving royalties, we have HireQuest with EBITDA margins of 60% or Franco Nevada with 84%. Despite the fact that they all operate in different sectors, the idea is to show that these types of margins are perfectly sustainable in this type of business model.
For this same reason, the Free Cash Flow margin has been over 50% in recent years, since being an asset-light business does not require as much CapEx and most of it is used to reacquire franchises. Basically Winmark is a cash generating machine.
Free Cash Flow (Author's Representations)
And this profitability comes along with a ROCE (Return on Capital Employed) and FCF ROCE (FCF Return on Capital Employed) greater than 200% in recent years. In other words, for every dollar invested (typically it would be in opening a new franchise) Winmark would generate 2 dollars. This gives us an idea of ??the value generation that the company can provide in the long term.
ROCE and FCF ROCE (Author's Representations)
And thanks to the EBITDA generation, the company's leverage ratio is quite low and is usually around 1x Net Debt/EBITDA. Calculating Net Debt as Total Liabilities - Short-Term Assets .
Net Debt/EBITDA (Author's Representations)
Management Team
Skin in the Game
Brett Heffes has been the CEO since February 2016 and currently holds just over 3% of the company's shares, which amounts to more than 40 times his base annual salary of $600,000. Additionally, he is eligible for a bonus, which can range from 0-100% of his annual salary, determined by the compensation committee. Even factoring in potential bonuses, Heffes total compensation would be around $1.8 million per year. This figure is notably reasonable when compared to the average annual CEO compensation of nearly $4 million in companies of similar size to Winmark. Notably, stock options are not commonly utilized within the company and account for only about 3% of Free Cash Flow.
(Source: Winmark Proxy Statement)
Brett Heffes is characterized by his tendency not to engage in conference calls after quarterly results presentations, the absence of guidance provision, and infrequent interviews. These are rare traits for a Wall Street CEO, but they show that he is focused solely on running the business and not grabbing magazine covers.
Capital Allocation
As evident in the Key Ratios, Winmark is a cash-generating machine with a 55% Free Cash Flow ((FCF)) margin. Therefore, it's crucial to understand how all this generated cash is utilized.
Over the past five years, the company has primarily financed itself through cash generated from operations. It has allocated 65% of this cash to return value to shareholders and the remainder to pay down the limited debt issued during the same period.
In essence, Winmark's capital management strategy is strongly oriented toward directly returning value to shareholders. This approach is adopted because there are limited opportunities for reinvesting this cash within the business, because as mentioned earlier, the company requires minimal capital expenditure ((CAPEX)) to sustain its growth.
Capital Allocation (Author's Representations)
Valuation
I will perform a Reverse DCF valuation, a model designed to assess a company's current stock price by deducing the market's underlying assumptions.
Based on the data from FY2022, which includes:
- Shares Outstanding: 3.59 million
- Cash: $13.96 million
- Debt: $77.57 million
- FY2022 Free Cash Flow ((FCF)): $43.66 million
Considering the countercyclical, predictable, and stable nature of this business, I would be content with a 12% annualized return on my investment. Additionally, I estimate a terminal growth rate of 4%, given the business's resilience to disruption, despite moderate competition.
DCF (Author's Representations)
With these assumptions, the FCF would need to grow by 18% annually over the next 10 years to achieve a 12% return from the current stock price. However, this growth rate seems demanding to me, especially since I anticipate mid-single-digit revenue growth and limited FCF margin expansion.
Intrinsic Value (Author's Representations)
Therefore, my estimate is more conservative, targeting an FCF growth rate of around 8%. At current prices, this would result in an annualized return of approximately 8% to 9% CAGR. While not a poor return, it falls short of my investment criteria.
Final Thoughts
This is a buy-and-hold type of business. While the current valuation may not be attractive, it's also not advisable to bet against high-quality stocks, as this could lead to unfavorable outcomes.
This becomes even more apparent when we consider the current valuation multiples, which are currently at levels not seen since 2006-2008. Therefore, the reason for this unattractive valuation could be the market's anticipation of a severe recession, and WINA could be perceived as a safe-haven asset in such a scenario.
Valuation Metrics (Seeking Alpha)
In any case, buying at this time would not be advisable, as a return to the average valuation would result in a negative return. This assumption is based on a potential decline in the multiple of nearly 30%, assuming it moves from the current P/FCF of 30x to the historical average (and a reasonable multiple) of 20x. Therefore, my conclusion is that it's best to wait and closely monitor the situation until better prices become available.
For further details see:
Winmark: A Top-Class Business, But No Margin Of Safety