Following Up on Winmark

July 21, 2016 Moats 0 Comments

In last week’s on Winmark (WINA), we noted that the company’s free cash flow had been flat for the past five years.  But, we left the reason for this phenomena open.  Specifically, we wrote:  “Somewhat oddly, as the chart below shows, the main driver of the stagnation has been taxes and interest.  (It is important to note that FCF on a per share basis has risen by a 4% CAGR due to buybacks.)  Odd because interest expense usually reduces taxes.  It is not exactly clear to us why this is happening.  In any case, the rate of increase is unsustainable and will normalize.”

Thankfully, alert reader “PJK” dug into the issue a bitter deeper.  He notes that there are differences in the way GAAP and tax deal with the initial direct costs of leasing arrangements.  For GAAP purposes, the costs are capitalized and expensed over the course of the lease.  For tax purposes, the expenses are recognized and deducted immediately.  This causes cash taxes to be lower relative to income.  Over time, however, this difference begins to reverse.  This reversal is the phenomenon we have seen over the past 5 years.

PJK also points out a second factor.  WINA has an income tax receivable on its balance sheet that has been bouncing around.  Presumably,  a state or federal tax authority owed WINA a refund of some sort that was collected in 2013.  As a result, 2014 cash taxes look high by comparison.

Beyond these considerations, it is for these reasons that many investors, such as Buffett, look at EBIT rather than post-tax cash flows.  Such investors feel these fluctuations will even out over time and it is not worth getting caught up in short term volatility.