Winmark Corporation: Framing an investment in Nov. 2020
Diligence Report | 20 min read | How I framed this opportunity as a buy-and-hold investor
Originally published on midstoryventures.com in November 2020.
Before you read this segment in the Diligence Report series — please read the “Introduction: Diligence Report Series” post here.
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Designed for Capital Allocation
Winmark Corporation can best be described as a “system” run by brilliant capital allocators and true veterans in the SMB industry.
John Morgan, a friend of Warren Buffett and value investor at heart, turned around the failing business in the early 2000’s and grew the business to the special system that it is today.
This system has been able to generate royalties from its franchisees without making any capital investments, giving management the ability to reinvest that excess free cash flow towards opportunities that leverage their small business / franchising expertise.
From 2000 to 2020, Winmark has compounded its market value at 17.0%. Even more impressive is its 3-year CAGR of 16.0% since 2017, which nearly matches its 20-year CAGR.
The recent return on tangible assets are over 100%, implying a high-quality business with essentially free growth.
So any investment case in Winmark ultimately boils down to three questions:
Under what scenarios would Wimmark stop growing over the next 10 years?
Under what scenarios would Winmark have to invest capital into its franchise system, thereby losing its unique ability to generate free growth?
Under what scenarios would Winmark stop returning capital to its shareholders?
The Crux of the Business
Winmark sends out Franchise Documents for each of its concepts every year. Three of its concepts fall under apparel and clothing, while the other two fall under equipment.
The documents are nearly the same, and in every Franchise Document, Winmark describes the crux of their business: “The most successful store owners excel at following the franchise system [and] integrating their stores into their communities.”
These keys to success for every franchisee is (1) successful consignment and (2) successful local community integration. The endurance of its value proposition, stability of its gross margins, and defensibility against its competitors lie within these two factors.
KEY TO SUCCESS #1: Consignment
The consignment model turns the idea of retailing upside its head. It takes all the negatives out of traditional retail and uses them to its advantage.
The biggest killer in retail is inventory management. In retail segments like apparel and clothing, operators are subject to the rollercoaster of seasonality and fashion trends. They have to purchase inventory ahead of time to keep up with seasonality and trends, and any unsold inventory has to be marked down at an extreme discount, destroying their gross profit. Retailers have also been notorious for simply sending their unsold inventory into landfills, which has caused more than 5 billion pounds of waste every year. Not only does this destroy this gross margin, but it destroys the planet. To top it off, retailers don’t always win when they do sell their inventory. Certain pieces of clothing have a higher gross margin than others; while sales associates on the floor can direct customers to buy higher gross margin items, they don’t have full control over the stability of its gross margins, which makes a huge difference on the bottom line.
The consignment model improves upon the retail model in three different ways.
First, consignment retailers have more purchasing power than its traditional retail counterparts. Winmark’s apparel stores “buy low, sell high” because they operate with a “buy all seasons, everyday, all year round” motto. People selling at these resale stores are more likely to sell clothes out of season than in season because the person living in a Michigan winter is less likely to sell their thick, fur coat in the winter than in the summer because there is a slight chance that they might need it. As a result, resale stores are able to buy out-of-season items for cheaper prices. Retail stores are at the whim of the manufacturers to buy seasonal products, paying the average market price.
Second, the consignment model creates consistent gross margins for each item. Each store promises to sell products for about 90.0% of its retail price, and customers know this, so the store offers 30.0% of the price at which they would sell it for. For example, a pair of Levis that would normally go for $100.0 in retail will be on sale at a Winmark store for about $9.0, and the customer selling the pair of Levis would earn $3.0. The consistency is seen in every single one of Winmark’s franchise concepts -- the gross margin of the top quartile is the exact same as the gross margin of the median. The predictability of its gross margins means that they don’t have as many sales associates per hour on the floor to sell higher margin products, which ultimately helps the bottom line.
Third, and most importantly, consignment changes the nature of its customer relationship. Retailers are in the business of taking the hard-earned dollars of consumers; their relationship is based on the psychology “taking” from its customers. On the other hand, Winmark says that many individuals become customers after selling clothes to their stores. The basis of this customer relationship is on the psychology of “giving” to its customers. This difference in psychology provides a sustaining relationship with its customers.
KEY TO SUCCESS #2: Community relationship-based
The inherent nature of consignment and the integration in the community turns Winmark’s “localness” into an advantage that partially insulates them from online competition and creates stronger loyalty.
The nature of consignment is local, as buyers need to bring in all of their unused clothes and the sellers need to inspect the used clothing, determine the ones they would like to buy, and negotiate on the settled price and items. This process is most effective when there is human interaction and buyer/seller collaboration. It is even more important for the equipment concepts that buy higher-ticket items like keyboards, drum sets, and golf clubs where the buyer is looking for the best price possible.
Additionally, both concepts are tailored towards families. You can even see it in the names of the concepts and the brand signage. These types of names and logos are not meant to appeal to your average millenial in the ages of 18 and 34. Because these concepts are targeted towards families, franchise owners are often seen taking initiatives to support their local sports team or build relationships with the community.
The Winmark Way
If you study the resale industry, you’ll quickly realize that the keys to success for Winmark’s stores can be applied to other resale concepts as well. These levers are not proprietary to Winmark in any way.
So if these advantages can be copied, what explains the strong historical performance of Winmark’s franchise system?
Let’s start with the equipment category. There are very few national brands that buy, sell, and trade all types of used sports equipment or musical instruments. The value of not only receiving cash, but receiving cash the day you bring it in, is very attractive. Among consignment stores, Play It Again Sports and Music Go Round have very few national competitors.
In the apparel category, Style Encore, Plato’s Closet, and Once Upon a Child face much more direct competition with other consignment retailers. These include companies like Buffalo Exchange, Crossroads Trading, Beacon’s Closet, Kid to Kid, Children’s Orchard, Uptown Cheapskate, Hut no. 8, and NTY Clothing Exchange.
While there are a lot of players in this space, Winmark’s apparel concepts continue to succeed. This means that Winmark has to have some sort of edge against its competitors.
Let’s explore three other factors that could explain their superior performance: consignment, segmentation, and execution.
THE FIRST POSSIBLE FACTOR: Consignment Pricing
The pricing scheme of the consignment model is mostly undifferentiated across all resellers. While there are threads and discussions among customers about which reseller pays higher or lower, these conversations don’t really mean that their model is different. First, all resellers virtually use the same process: they develop a database of items across brands that they’re willing to accept, then offer 33.0% off what they would sell it at their store. Second, any difference in price (or items accepted) is always based on the inventory that each store is looking for. Even stores under the same brand will offer different amounts based on the quantity held in store. So we can eliminate the idea that Winmark has a unique advantage in consignment pricing model.
THE SECOND POSSIBLE FACTOR: Segmentation
In the apparel category, price segmentation matters more than demographic segmentation. On the surface, you would think that Plato’s Closet directly competes with Buffalo Exchange and Crossroads Trading because they all target teens and young adults. And while you will see the same customer shop at all three of these stores, these customers realize they are shopping with different price points in mind. Plato’s Closet’s average price point is much lower than Buffalo Exchange and Crossroads Trading have a higher price point because the nature of the brands they buy are less boutique and trendy than its peers. In essence, the customer segment at Plato’s Closet, along with Style Encore, is made up more of lower-income individuals and families than these other two. So while segmentation may explain some of their historical performance, it most likely does not explain all of it.
THE THIRD POSSIBLE FACTOR: Execution
Winmark’s execution is the most likely factor that has driven its historical performance. Management is extremely disciplined on selecting franchises who deeply know how to execute the model’s turnkey solution. This culture of discipline has been instilled for the past 20 years. In 2000, the original founders of the company faced bankruptcy after they “sold franchises to anyone who could come up with the money.”
John Morgan took over and instilled furious discipline into the franchise system, instantly turning the company’s $350 thousand loss into a $3.2 million profit within one year. John Morgan says his team made franchisees “work hard to find the right real estate” and challenged franchisees to prove “they can run the first one” before they built a second one.
With 1,250 stores nationwide, Winmark has most likely picked its locations territories where there is less competition (direct resale competitors) and greater accessibility to their main customer segment.
A Bird’s-eye View of the System
Here is a summary of the highlighted financial information.
The number of stores when John Morgan took over in 2000 was approximately 850. His strategy to prune weak franchisees/stores reduced store count to 800 by 2005, but since then, Winmark has experienced healthy growth.
In that 15-year period, Winmark opened 30 net stores every year, or a 3.0% CAGR.
This is no easy feat, especially since Peter Lynch in Beating the Street suggests that a company should open no more than 100 stores per year in order to operate sustainably.
Winmark has certainly profited extensively from this growth. Over the same period, franchise-wide sales grew by $49.0 million dollars every year, or a 7.0% CAGR, with $1.2 billion by 2019. Since 2009, they have maintained an average franchise system sales-to-investment ratio above 2.0. In the franchise industry, a sales-to-investment ratio of 2.0 is extremely attractive. In this most recent year, the sales-to-investment ratio was 2.8.
In 2009, the franchise system AUV was $629.0 thousand and sales per square foot was approximately $200 thousand. These metrics represent the benchmark for which Winmark will achieve a sales-to-investment ratio of 2.0 or above. Over this 10-year period, AUV grew by $27.0 thousand every year, or at a 3.0% CAGR, and sales per square foot grew at the same rate.
This strong unit economic performance explains the franchise-wide renewal rate of 98.0% over the past 10 years. Only 15 stores of the 850+ franchises available-for-renewal did not renew. This 2.0% opt-out of the renewal is most likely due to people who reach the age of retirement and do not want to participate as an active owner (as the Franchise Disclosure Document mandates), rather than the dissatisfaction of the franchisee’s returns.
In reality, the best indicator of franchise churn is in the closure rate. Approximately 200 stores closed over the past 10 years. Of these stores closed, only about 10 units were closed because their owner’s did not renew their franchise agreement. The other 190 were therefore closed by poor unit performance, bankruptcy, or some other type of operational failure. This 190 represents a 2.0% churn, which is a metric that is more indicative of franchisee’s failure to follow the system or capture the market in its exclusive territory. While there is no current information that tells us the average life of a store before closing, it would be extremely helpful to know because it would indicate whether Winmark is picking the wrong franchisees (short life) or franchisees realize the model does not work in its market (longer life). A google search for X franchise concept “permanently closed” will probably list a few different articles in local news sites or Yelp Reviews that explain when and why the store closed.
The success of the franchise system has generated over $450 million in royalty rates and franchise fees over the past 10 years, which represents a 4.2% take rate. About $250 of that $450 million, or 55.0%, is pure free cash flow. This free cash flow has grown a little more than 6.0% for the past 20 years, and slightly outpaces overall franchise-wide sales growth because Winmark has higher take rates on its apparel concepts, which are the largest and fastest growing.
A Closer Look at the System
While the overall franchise system is performing strong, some concepts are clearly stronger than others.
Play It Again Sports and Music Go Round currently has 280 and 37 stores, respectively, and have experienced flat sales or slightly negative sales over the past 20 years. Their net store count has decayed (which is not to be confused with churn, which does not include new stores opened) by as much as 4.0% every year over the past 15 years. After Morgan pruned the bad franchises in the early 2000’s, store growth has improved and the 10-year CAGR is 3.0%.
Of the two franchise concepts, Play It Again Sports has faced much more trouble. Its AUV growth is only attributable to the fact that store count decreased at a faster rate than total sales, which remained flat. Music Go Round, on the other hand, has experienced some sales growth, with a 10-year sales CAGR of 3.0% and store CAGR of 1.0%. The stronger performance of Music Go Round is most likely due to its formidable expansion into eCommerce, with over $4 million, or 10.0%, of its sales online.
Plato’s Closet is the largest concept among all Winmark brands. It does really well with female teens and young adults. Plato’s has 515 stores with an AUV of $1.1 million and a sales-to-investment ratio of 3.1. It has also experienced the highest store growth over the 20-year period with a CAGR of 17.0%. However, its growth has dramatically slowed in the most recent years. Fortunately, sales have consistently grown at 5.0% per year, offsetting store growth of 1.0%.
Once Upon a Child has 376 stores and is the oldest apparel concept. While it is second in size to Plato’s, it has the most consistent, profitable growth by far. With an AUV of $970 thousand, the concept generates the highest sales-to-investment ratio of 3.2 and has grown sales about 7.0% to 8.0% per year for the past 20 years. Its recent store growth has slightly outpaced Plato’s Closet at approximately 4.0% per year, but its AUV is outpaced by Plato’s. This is because Plato’s sales growth and store growth have grown in lock step with each other. Once Upon a Child’s future AUV is expected to expand once new stores reach maturation.
Style Encore is the last, and youngest, apparel concept. Style Encore appeals to a slightly older crowd than Plato’s Closet, targeting women who are young professionals and mature adults. Started nearly 25 years later than all the other concepts, the 7-year-old franchise concept has grown its number of stores more than 10.0% per year over its lifetime, and its sales growth has grown even faster. With 68 stores, it only contributes 4.0% of total franchise sales and generates $720 thousand in AUV, so there is a lot of room for improvement across all aspects. In fact, 2019 was the first year that Style Encore hit a sales-to-investment ratio above 2.0.
The variation in each concept’s performance can be explained by their natural fit with consignment.
The consignment models that work the best exhibit three characteristics: (1) operators have more used inventory (2) consumers have lower selling expectations (3) operators have less competition with ecommerce.
Used Inventory: As mentioned before, used inventory is the key to these resale business models. First, and most importantly, it creates predictable customer visits since individuals initially become customers because they want to sell. This is apparent in Winmark’s apparel concepts since their customers have excess clothing and a faster need to replace them due to outgrowing sizes and trends. Second, it generates predictable gross margins. Third, it generates higher gross margins since store operators avoid buying new clothes from manufacturer’s at higher prices. Winmark’s apparel concepts operate with nearly 96.0% used inventory, whereas Music Go Round and Play It Again Sports operate with 80.0% and 40.0%, respectively. Many of Winmark’s apparel stores face the benevolent problem of having “too many people selling their items.”
Cheaper expectation for items sold: A seller is more price inelastic when they are selling cheaper items. If you watch YouTube videos on people selling their clothes to these stores, you’ll notice that they are typically bringing a laundry bag full of items. They hardly quarrel over price because the difference is only a few dollars. However, sellers care much more when they are selling more expensive items, thus becoming price elastic. Oftentimes, sellers are only bringing one or two items to the store, whether it’s their golf clubs or their keyboard, and they are hoping to get 100.0% of what they deem to be fair value. They are unwilling to accept a difference in 10.0% because that can mean missing out on $10 to $20 dollars. Consequently, these sellers will look for other ways to sell their product, including online channels.
Selling through online marketplaces: The nature of selling online through P2P marketplaces makes it extremely difficult to sell many items at once. The items that do well on these marketplaces are high-quality items at high prices with popular brands. It is very rare that you see someone selling one used T-Shirt for $2.00 or less (the price range that Winmark usually offers) because $2.00 really isn’t worth their time. It’s only worth their time if they sell 10+ T-Shirts at $2.00 a piece. Brick-and-mortar stores are well-built for these types of transactions, so they have partial insulation from these types of online marketplaces. However, retail resale sports and music equipment stores face intense competition from online marketplaces like eBay, Amazon, Craigslist, Facebook Marketplace, etc. These types of sellers are more inclined to cut out the middleman like Play It Again Sports and Music Go Round because they are more concerned about getting the highest price possible rather than immediate liquidity.
Long-term Challenges
Winmark’s equipment-based franchises are likely to struggle as online transactions become universally accepted. While the company’s apparel franchises are likely to maintain its performance in the short-term, it faces considerable risk in the long-term.
Retail stores are effective in providing a thrilling, “treasure hunt” feel and a “bartering” type of experience, but it is not the most efficient way to buy and sell secondhand clothing. Online marketplaces and e-tailers provide a way for customers to buy, sell, and trade used clothes without needing to step into “dirty” thrift stores (#1 Most Common Misconception of Thrift Stores) and wait needlessly for 15 to 30 minutes before a representative has processed your clothes. In fact, the biggest pain point for these customers is not the wait, but combination of waiting such a long time, only to receive such little cash.
Poshmark, The RealReal, and ThredUp are just a few of the many companies that are taking the first step towards making consignment more efficient.
Poshmark — As a recent investment in my previous venture capital fund, Poshmark provides a social P2P marketplace for all types of used clothing. Poshmark charges about 20.0% (sellers earn 80.0%) for all transactions. Sellers have the ability to list their price, but they also have the responsibility of marketing it and negotiating with potential buyers on the price.
The RealReal — A venture-backed company that went public in 2019, The RealReal is an online marketplace that specializes in luxury fashion. Their success with bringing consigners onto the platform sells 60.0% of its products within 30 days and 80.0% in 90 days. They charge approximately 35.0% (sellers earn 65.0%) for creating the marketplace and handling all the shipping and photography.
ThredUp — A startup backed by Upfront Ventures, ThredUp competes directly for the same customers as Winmark. They buy Value & Mall Brands such as GAP, F21, and Nike, as well as Premium & Designer Brands like J. Crew, Lululemon, and Gucci. A seller who sends their ThredUp Clean Out bag will earn anywhere from 5.0% to 80.0% of the selling price.
While these platforms are gaining fast traction, they are still working through kinks of their own.
Poshmark buyers are outraged by the return policy. When a buyer receives something that does not fit or match the seller’s representation, the platform has been known to do nothing about it.
The RealReal has faced backlash on pricing, marking down items for consignors without their knowledge. This means that a customer expecting to sell a luxury dress for $875 might end up being sold for $375.
Many ThredUp customers have sworn to never use ThredUp again after waiting nearly 7 weeks for their bag to be processed, and in the end, they end up not receiving the cash they expected.
Let’s assume these kinks are fixable over the long-term. Will these online resale platforms make brick-and-mortar stores obsolete? And if you say yes, when will that happen? In the next 5 years, 10 years, or 20 years?
The consignment stores/platforms that will succeed over the long-term will be the ones who are able to get people to sell their clothes to them. As emphasized heavily throughout this report, the ability to buy used clothes is the key to a reseller’s success. While customers can sell their used clothes from the comfort of their home with online platforms, they may also be able to do the same through curbside pickup, mail-ins, or a vehicle pick-up system.
How much value can I get from one franchise?
Let’s say that Winmark has 1,250 franchises at the time of this analysis. For the sake of simplicity, let’s also assume that franchising makes up the entire value of the company. Realistically, franchising contributes about 80.0% of the profit and leasing contributes 20.0%. So this 80/20 ratio is a good way to think about a sum of the parts valuation. But since the majority of the value comes from the franchise system, and leasing is a value-destroying business, let’s assume that the company’s value in the long-term will be 100.0% based on franchising.
Let’s say Winmark’s market cap is $500 million. That means that the market is valuing each franchise at $400 thousand. Would you pay $400 thousand for each franchise?
To answer that question, let’s make a few assumptions.
Take Rate of 4.5%
Long-term franchise AUV of $700 thousand
Pre-tax profit is 55.0%
Tax rate is 25.0%
The franchising business requires no CAPEX or working capital
With these numbers, Winmark generates about $18 thousand in free cash flow from each franchisee and the market is offering a free cash flow yield of 4.4%.
Key Questions
As implied throughout the diligence report, Winmark is a high quality company, not because it has the biggest moat, but because they have an incredibly patient management team that executes successfully. Their franchisees operate in local environments, but they will soon compete on a more national scale as sellers have more places to send their clothing. Here are three key ideas you should think about as you continue to dig more into Winmark:
If you called the shots for the franchise system, would you be inclined to move your established resale operations online (in order to compete) or continue operating as you have been through brick-and-mortar stores (with the hopes of not being affected)?
If you called the shots for the franchise system, what ways would you make the selling process easier for your consigners?
If you called the shots for the franchise system, would you be willing to make any investments necessary to make the process easier for your consignors? At what cost would you stop making investments?
Thank you for reading. I hope to sharpen my skills every month and develop meaningful relationships along the way. What points do you agree with? What points would you like to share your own perspective?