2023-03-17 11:35:22 ET
Summary
- Winmark has beaten the market over the last five years, with over 150% in total shareholder returns between 2018 and 2022, compared to over 44% for the S&P 500.
- Amidst a retail apocalypse narrative, its franchise model has helped it to grow profitably.
- The business’s shrinking asset base is an attractive aspect that will likely yield higher returns.
Winmark Corp. ( WINA ) has handily outperformed the market over the last five years. This success is built on its ability to, not just grow profitably, but to grow profitably while reducing total firm assets. Onlookers have often described businesses such as Winmark's as being "asset-light", but Winmark goes beyond that: it is an asset-light business that is getting lighter every year. These three things, growth, profits, and shrinking assets, are driving higher returns and firm value. Investors have an opportunity to invest in what is really an investor's dream.
Winmark Beats the Market
In the last five years, Winmark, has easily outperformed the Vanguard Russell 2000 ETF ( VTWO ), Vanguard Russell 3000 ETF ( VTHR ) and the S&P 500 ( SPX ), earning shareholders a price appreciation of over 128% and a total shareholder return (TSR) of more than 150%, compared to a TSR of nearly 26% for the Vanguard Russell 2000 ETF, nearly 42% for the Vanguard Russell 3000 ETF and more than 44% for the S&P 500.
Source: Morningstar
Taking an industry perspective, we can see that in that 5-year period, the MSCI USA Retailing Index earned investors a gross annual return of 8.02% compared to a gross annual return of 9.77% for the MSCI USA. As an investor, the supply-side of an industry is vitally important, and seeing a business rise above its industry's returns suggests that business may have sustainable competitive advantages. This is especially true in an era where retail has been viewed through a cataclysmic lens, in which Amazon ( AMZN ) and Walmart ( WMT ) are seen as devouring everyone.
Source: MSCI
Winmark's Business Model
Over the last five years, Winmark has grown revenue from $72.5 million in 2018 to $81.4 million in 2022, at a 5-year revenue compound annual growth rate ((CAGR)) of 2.34%. According to Crédit Suisse's "The Base Rate Book" , in the 1950 to 2015 period, 28.8% of firms achieved a 5-year revenue CAGR of between 0% and 5%. The mean 5-year revenue CAGR was 6.9% and the median 5-year revenue CAGR was 5.2%. This gives us a sense of what Winmark's numbers look like on a historical, economy-wide basis.
The company has five revenue streams: royalties, leasing income, merchandise sales, franchise fees, and other. According to the 2022 Annual Report , in 2022, royalties were responsible for 82.48% of total revenues, while leasing income was responsible for 8.52%, merchandise sales were responsible for 4.82%, franchise sales were responsible for 1.94%, and other was responsible for 2.25%.
Sources: Winmark Corp. Fillings and Author Calculations
Winmark describes itself as a "franchisor focused on sustainability and small business formation". In that role, the firm operates five resale franchises with the following service marks: Plato's Closet, Once Upon A Child, Play It Again Sports, Style Encore and Music Go Round. As of the end of 2022, there were 1,295 operational franchises in the United States and Canada and more than 2,800 available territories. Winmark also sells point-of-sale system hardware to its franchisees and certain kinds of merchandise to its Play It Again Sports franchisees. The company also operates a middle-market equipment leasing business under its Winmark Capital service mark. Logically, then, the business has two reporting segments: franchising and leasing. In 2022, the franchising segment was responsible for 91.48% of revenues.
Source: Winmark 2022 Annual Report
The firm not only owns retail brands, it also has an operating system for its franchisees. Winmark enters into franchise agreements with franchisees and grants them the right to use the brands, service marks and operating system for their franchise. Franchisees have to meet wealth; experience, and involvement requirements to be eligible to become part of the Winmark family. The franchisees agree to operate their franchises according to the rules laid out by Winmark. In addition, Winmark provides training and support for franchisees. At the end of a 10-year period, the franchisee has an option to renew their franchise agreement. In the 2019-2022 period, 99% of franchises chose to renew their franchise agreements. This is a good sign of the value that franchisees get from the company.
Source: Winmark 2022 Annual Report
System-wide, the brands generated $1.5 billion in revenue in 2022, with Plato's Closet responsible for over 40% of system-wide sales, Once Upon a Time responsible for 30%, Play It Again Sports responsible for over 20%, and Style Encore and Music Go Round having the residual.
Source: Winmark 2022 Annual Report
From these revenues, franchisees have to pay Winmark weekly royalties that amount to a percentage of gross sales given in their Franchise Agreements, which is usually about 4% to 5%. Franchisees also have to pay an annual marketing fee of $1,500, and they have to spend 5% of their gross sales on advertising and promoting their franchised store. Winmark has an option to raise the minimum advertising expenditure requirement from 5% to 6% of the franchisee's gross sales, of which as much as 2% would be paid to Winmark as an advertising fee for deposit into an advertising fund. If such an advertising fund was created, Winmark would manage it and be used for advertising and promoting the franchise system.
Consequently, Plato's Closet is, in terms of Winmark's revenue, the most important, earning 36.2% of revenues in 2022, compared to 25.9% for Once Upon a Child, 16.7% for Play It Again Sports, 3.8% for Style Encore, and 1.8% for Music Go Round.
Source: Winmark 2022 Annual Report
These resale brands aim to deliver consumer value through a combination of high-quality merchandise and vastly cheaper prices in comparison to similar, new merchandise, and by buying used goods that have outgrown or are no longer used by consumers. Winmark does also offer a limited selection of new merchandise.
Since 2021, Winmark has not solicited new leasing customers and is running-off its equipment leasing portfolio to its wholly owned subsidiary, Winmark Capital Corporation.
Winmark, of course, incurs costs and expenses from running the business. The biggest expenses are the selling, general and administrative (SG&A) expenses, which in 2022, were responsible for 83% of operating expenses. SG&A are mostly salaries, wages and benefits, advertising, travel, occupancy, legal and professional fees. Cost of merchandise sold was the second largest operating expense, and was responsible for 13% of operating expenses. Leasing expenses and provision for credit losses were responsible for the residual.
Sources: Winmark Corp. Fillings and Author Calculations
Winmark's History of Profitability
A marker of the profitability of the business is Winmark's gross profitability (gross profit scaled by total assets), which has risen from 1.45 in 2018 to 2.52 in 2022. According to Robert Novy-Marx' research , the threshold for determining if a stock is attractive is 0.33 and higher. Winmark is well past that threshold. Gross profitability is also a more useful screen than a price-earnings (P/E) multiple. A stock may be unattractive in terms of its P/E multiple, but attractive in terms of its gross profitability, and trusting the gross profitability may prove smarter. For instance, at the end of 2015, Amazon ( AMZN ) had a trailing P/E multiple of around 540, and a gross profitability of 0.54.
Winmark's operating income rose from $41.76 million in 2018 to $53.61 million in 2022, at a 5-year operating profit CAGR of 4.45%. Operating margin rose from 57.6% in 2018 to 65.85% in 2022. Let's return to our reference period, 1950 to 2015. In that period, the mean operating margin for consumer discretionary was 8.2% and the median operating margin was 8%. Winmark's operating margin is in the top quintile across all industries.
Source: Crédit Suisse
Net earnings rose from $$30.13 million in 2018 to $39.42 million in 2022, at a 5-year earnings CAGR of 5.52%. In our reference period, 34.1% of firms achieved a 5-year earnings CAGR of between 0% and 10%. The mean 5-year earnings CAGR was 7.3% and the median 5-year earnings CAGR was 5.9%.
Source: Crédit Suisse
Over that five year period, earnings have improved thanks to rising profit margins, which have gone from 41.55% in 2018 to 48.43% in 2022.
Sources: Winmark Corp. Fillings and Author Calculations
Between 2018 and 2022, the company grew free cash flow ((FCF)) from $11.14 million in 2018 to $43.66 million in 2022, at a 5-year FCF CAGR of 31.41%. That was driven by rising FCF margins, which went from 15.36% in 2018 to 53.63% in 2022, more than tripling in just five years. In that period, the company generated $183.39 million in FCF, amounting to 18.4% of the firm's market capitalization.
Sources: Winmark Corp. Fillings and Author Calculations
Asset Shrinkage and Rising ROIC
One metric that is often underappreciated is asset growth. There is an inverse relationship between asset growth and future returns. Cooper, Gulen & Shill found that over the 40-year period of their study, low asset growth stocks returned 20% more than high asset growth stocks. This relationship persists for up to five years. Their research has been extensively corroborated, not just for U.S. stocks, but internationally as well. The reasons for this are contested, but we can simplify the reasons in this way: managers tend to overestimate growth opportunities during booms, and underestimate growth opportunities during busts. When managers overestimate growth opportunities, they raise too much capital (through equity and bond issuance, and getting traditional loans), and invest too, i.e. beyond what is optimal, in capex to take advantage of those opportunities. However, it is very difficult, if not impossible, to make an accurate forecast about far-off future demand. For capital-intensive businesses, there is often a huge time lag between the decision to raise spending on capex, and raising actual supply and observing prices. Regardless of the time lag, businesses end up with infrastructure that is not economic, and capital exits the market, with investors shying away, and managers trying to repair their balance sheets. It is for that reason that businesses that are conservative with asset growth, or why can find ways to actually reduce total firm assets, who are more likely, in the long run, to beat the market.
In that vein, it is not surprising that Winmark has so handily beaten the market, given that it shrunk its total assets from $46.63 million in 2018 to $30.46 million in 2022, at a 5-year assets CAGR of -8.16%. Winmark is often described as an asset-light business, which it is, but it is also a business that is getting lighter with every year, while growing profitably. The effect is, of course, to raise return on invested capital ((ROIC)). By definition, even if Winmark's earnings did not change, but its asset growth carried on at the same pace, ROIC would rise. Of course, as we have seen; earnings actually have gone up, and so has ROIC, which has risen from 54.4% in 2018 to 69.7% in 2022.
Sources: Winmark Corp. Fillings and Author Calculations
It is axiomatic that the value of a firm is the sum of the present value of future cash flows, and so, by improving a business' profitability, it increases the value of those future cash flows, and therefore, the value of the business itself. In balancing growth and ROIC, managers and investors tend to favor growth, but ROIC is much more sustainable , whereas growth tends to decay with time. Indeed, 1% more ROIC produces more value than 1% more growth.
Source: McKinsey & Company
Winmark's ROIC is attractive because retail is very competitive and tends to generate low-ROICs, with retail firms having a median ROIC of around 10%.
Winmark's ability to generate such high ROIC in an industry that is often described in end-of-the-world tones, is because of the franchise model that it has, that allows it to grow without making any meaningful investments in infrastructure. Those costs are, instead, taken on by the franchises. So, for instance, in 2022, Winmark had a net store growth of 24 stores, and still managed to grow revenue from $78.2 million in 2021 to $81.4 million in 2022, and operating income from $51.34 million in 2021 to $53.6 million in 2022 (earnings declined due to interest expense). The franchise model is not just about being asset-light: Winmark can grow profitably while becoming even lighter.
Source: Winmark 2022 Annual Report
How light is light? In 2022, net plant, property and equipment was just 8.9% of assets. Deferred income taxes, some $3.5 million, is a bigger balance sheet item than net PPE. Rather than asset growth, what Winmark invests in to grow the business are its SG&A expenses.
An Intelligent Use of Cash
In the last three years (2020-2022), the company has spent $142.32 million on share repurchases, and $66.65 million on dividends, while making $12.25 million in payments on its notes payable, $$50.3 million in payments credit/term loans. These have been partially offset with proceeds from borrowings on its credit/term loans ($80.3 million), proceeds from borrowing on its notes payable ($30 million), proceeds from exercise of stock options ($27.3 million), and proceeds from discounted lease rentals ($$1.16 million). Shareholders have, thanks to the share repurchases and dividends paid, been the biggest beneficiaries of the company's financing activity, thanks to $208.97 million (21% of market capitalization) of share repurchase and dividend issuance activity in that 3-year period. In 2022 alone, the firm spent $49 million on share repurchases and $19.26 million on dividends, for a total of $68.26 million, or 6.8% of market capitalization. With a buyback yield of 5.72% and a dividend yield of 2.04% (compared to 0.94% for the MSCI USA Retailing), shareholders can earn a shareholder yield of 7.74%.
Valuation
Winmark has a P/E multiple of 26.24, compared to a P/E multiple of 42.73 for the MSCI USA Retailing. Thus, on a relative basis, Winmark appears cheaper than its peers. In addition, we have mentioned the firm's highly attractive gross profitability, which was 2.52 in 2022. With $43.66 million in FCF in 2022, and an enterprise value of $1.06 billion, Winmark has an FCF yield of 4.12%, compared to an FCF yield of 1.8% for the 2000 largest firms in the United States, according to financial services firm; New Constructs' calculations. When we take into account the shareholder yield, on balance, there is sufficient margin of safety for investors to make a long-term bet on the business.
Conclusion
Retail has been viewed through an apocalyptic lens ever since software and Amazon started eating the industry. Yet, within that tale of woe, Winmark has been able to grow profitably. Winmark's success is due to its franchise model, a model which frees it from the need to make meaningful capital investments. Indeed, the company's SG&A spending is its largest bill every year. Winmark's most impressive feat has been to grow profitably while reducing total firm assets. This reflects the powerful economics of the business. Winmark is not just asset-light, it is getting lighter every year. Revenue growth, earnings, and shrinking assets, are driving rising ROIC, and firm value. Winmark is what investors dream about, and the market still undervalues the business, perhaps because it cannot shake off its worries about retail. That presents investors with an opportunity to invest in a wonderful business.
For further details see:
Winmark Is An Investor's Dream