Winmark & The Evolving Retail Industry

July 13, 2016 Moats 1 Comment

 “Retailing is a tough, tough business, partly because your competitors are always attempting and very frequently successfully attempting to copy anything you do that’s working. And so the world keeps moving. It’s hard to establish a permanent moat that your competitor can’t cross. And you’ve seen the giants of retail…a lot of giants have been toppled.”

— Warren E. Buffett, CNBC Interview, May 5, 2014

Just a few years ago, Sports Authority was the biggest sporting-goods retailer in the nation, with 460 stores  and 14,000 employees two years ago.

On March 2, 2016, Sports Authority filed for Chapter 11 bankruptcy. amid debts topping $1 billion and pre-tax losses at $156 million in the fiscal year ending Jan. 30.  On May 18, 2016, the company’s stores were sold to a group of liquidators and will all be closed.

Retail Is Hard

If we needed more proof, the high-profile Sports Authority bankruptcy provides yet more evidence that succeeding in retail is hard.   The key problem, as Buffett points out in the quote above, is that switching costs are nearly non-existent.  Few retailers benefit from an enduring economic moat because many goods stocked on their shelves reside at their competitors.  At the local mall, you can walk from one clothing store to another with no effort whatsoever.  Similarly, as Sports Authority learned the hard way, most of us live with in a 15 minute drive of a big box sporting goods store.

Some retailers, like Wal-Mart, Amazon and Home Deport, are able to overcome this and build moats through economies of scale. Others, like Coach, can create moats by building strong brands.  But customers are fickle.   History is full of hot retail or restaurant concepts that have flopped after a few years of early success.  Even successful retailers have to manage inventory and stay on top of consumer trends.

Winmark

Yet at least one niche, bricks and mortar retailer seems to be thriving in the post-Amazon era, Winmark (WINA).  Winmark operates in three business segments: (1)  the retail sale of used clothes, sporting goods, and musical instruments (2) middle market leasing and (3) small-ticket financing.

The retail segment represented 63% of revenue and 73% of EBIT in 2015.  Accordingly, the retail segment will be the focus of this post.

How Does It Work?

WINA operates stores in 5 different segments:

  1. Plato’s Closet –  Plato’s Closet stores buy and sell used clothing and accessories geared toward the teenage and young adult market.
  2. Once Upon a Child – Once Upon A Child stores buy and sell used and, to a lesser extent, new children’s clothing, toys, furniture, equipment and accessories. This brand primarily targets parents of children ages infant to 12 years.
  3. Play It Again Sports -Play It Again Sports stores buy, sell, trade and consign used and new sporting goods, equipment and accessories for a variety of athletic activities including team sports (baseball/softball, hockey, football, lacrosse, soccer), fitness, ski/snowboard and golf among others.
  4. Music Go Round – Music Go Round stores buy, sell, trade and consign used and, to a lesser extent, new musical instruments, speakers, amplifiers, music-related electronics and related accessories.
  5. Style Encore – Style Encore focuses on buying and selling used women’s apparel, shoes and accessories.

The following table shows sales for each of the last 10 years for each of the five retail concepts.

Sales by Retail Concept, 2006-2015

Source:  Company filings via Sentieo.com

WINA’s stores work on a buy-sell-trade basis.  That is, individuals can exchange used items in their possession for cash or in-store credit.  The value proposition is clear.  WINA vividly describes it in this sales pitch to prospective Play It Again owners:

Think about it. The glove you sell today at full retail price is used for a season. The player moves on to the next size and instead of letting the glove sit in the garage or throwing it away they bring it back to your store where you buy it for cash and put it back out on the sales floor. A short while later the glove is purchased again at a savings to the customer and a great profit margin for your business. It’s a win for your customer, a win for the community by recycling gear instead of filling landfills, and a win for you and your business! Most sports equipment can be used for several years so this sales cycle repeats itself time and time again.

WINA’s model has proved to be remarkably resilient.  As you can see, the 2008-2010 period went by without a blip. What are the keys to WINA’s success?  Through its differentiated business model, WINA attacks most of the retail vulnerabilities discussed above.  There are two aspects to WINA’s business model that we find particularly important:  the marketplace business model and franchising.

The Marketplace Business Model

Much of WINA’s competitive advantage stems from employing a buy-sell-trade model rather the traditional retail model of selling new merchandise.

WINA operates a marketplace.  A marketplace is a type of network where money/transactions flow between two more sides with distinct (ie, heterogeneous) groups of users on one side.  A successful marketplace is one where supply and demand are attracted to the same place. Examples of successful marketplaces include eBay, Airbnb, and the New York Stock Exchange.  WINA’s retail segment brings together buyers of used items and sellers of used items in the same way.

The Winmark Marketplace

WINA Marketplace

Any two-sided marketplace faces three classic problems:

  1. Creating demand
  2. Creating supply (inventory)
  3. Maximizing the number of matches between a buyer and seller (based on price, filters, and so on.)

The long-term success of the marketplace turns on its ability to solve these three problems.  How does WINA do?

Creating Demand

Generating demand is the hardest part of the equation.  It is difficult for the simple reason that it requires participants to part with cash.  This is difficult for any business but particularly difficult for marketplaces which are often trying to convert users to a brand new, non-traditional business model.

Improved Pricing

Obviously, the whole WINA approach is premised upon the consumer receiving a better price versus new.  Nevertheless, there is a stigma attached to used clothing that deters many consumers despite the pricing advantage.

Switching Costs

Once in the store, WINA’s model works to heighten the consumer’s switching costs.  One such mechanism is the granting of in-store credit rather than cash when used goods are brought in.  WINA incentivizes the selection of the in-store credit option rather than cash by offering more credit.  So, rather than leaving the store, the seller is now converted to a buyer. This illustrates a unique aspect of the WINA marketplaces: there is overlap between supply (sellers) and demand (buyers).  In other words, sellers become buyers and buyers become sellers.  This helps increase engagement with the marketplace.

In this way, WINA’s model turns one of the chief weaknesses of retail, fickle customers, into strength. Consumers quickly tire of their clothes and want something new.  WINA makes it easy to trade in old clothes for new.  Similarly, the sporting goods stores benefit from the huge increase in interest in youth sports.  Most youth sports equipment can only be used for a year or two because kids out-grow them.  So this sales cycle repeats itself time and time again.

Bricks and Mortar

WINA also benefits from having bricks and mortar locations.  Items that require fitting such as clothing and sporting goods have survived the online onslaught.  The ability for consumers to personally inspect items and the instant gratification of purchase and owning has value.

Creating Supply

Pricing Strategy

A key consideration for any marketplace business is pricing strategy.  That is, how much should they charge for use of the marketplace?  Should they charge both sides?  Just sellers?  Just buyers?

Some marketplaces, like eBay, can get away with charging both sides.  WINA cannot.  To create supply, it must buy goods from sellers, albeit at very low prices compared to what it charges buyers

Clothes in good condition are sold for 50 to 70 per cent of the original retail price. People selling clothes get 30 to 40 per cent of the adjusted retail price.

So, if a pair of $100 Lululemon yoga pants were to sell at a Plato’s Closet for $50, the person who sold them would have received $15 to $20.

Thus, franchisees earn gross margins of ~60%.  That is, the marketplace operator is retaining 60% of the difference between the purchase price and the sales price.  Very few marketplace operators get to keep 60% of the gross marketplace sales.

Complementing the model is the data advantage WINA generates by being one of the few large-scale sellers of secondhand clothing and sporting goods.  No uniform pricing for used goods, highly fragmented group of sellers and buyers.   Play It Again Sports stores utilize Winmark’s Data Recycling System (“DRS”) point of sale and inventory management software to run its business. Winmark developed the DRS software over several years and at great expense. The DRS software contains detailed historical information on the prices at which items have been purchased and sold, inventory management reports, category and sub-category performance, gross margins, and other data to help operate the stores. The DRS software generates a unique price tag for all items entered into the system that allows tracking of the item and also generates receipts for customers.  Determining the proper purchase price to generate inventory without sacrificing margins would seem to be a key WINA competitive advantage.

Friction of Supplier Sign-Up

A major advantage of the WINA bricks-and-mortar model versus its online competition is reduced friction of supplier sign-up.  Friction of supplier sign-up is the ease with which suppliers can join the marketplace.  For example, how long does it take a homeowner to sign-up with Airbnb as host?  Friction of supplier sign-up is a two-edged sword.  On the one hand, all things being equal, of course it is better to make as easy as possible for suppliers to sign-up.  Why put obstacles in their path?  On the other hand, high supplier friction can increase retention and reduce the multi-homing risk.

WINA greatly reduces friction vis-a-vis its online competitors.  If one was to sign-up with eBay or Thred-Up, it can take quite a long to receive money and you might not receive any at all.  With a WINA outlet, the supplier learns immediately how much, if anything, his/her goods are worth.  There is also no need to bag up your old clothes and mail them out (Thred-Up) or take pictures of individual items and post them (eBay).

Matchmaking

High buyer and supplier fragmentation is a huge positive for an online marketplace.   The higher the search costs for buyers and sellers the more attractive a single, central marketplace becomes.  This is how eBay came to dominate the market for unique collectibles.

Here, the market for used goods is highly fragmented, with most trades being on a peer-to-peer basis.  There are no suppliers that can undermine their entry into a market.  Similarly, there is no concentration of buyers who can prevail upon them to lower prices.

Network Effects

The goal of any marketplace is to produce network effects.

A network effect occurs when a product or a services becomes more valuable to its users as more people use it.  Network effects help build moats.  It is difficult for new entrants to gain critical mass if there is a successful incumbent.  Further, existing competitors cannot win customers simply by cutting price.

In the marketplace context, network effects really mean liquidity.  More sellers attract more buyers and vice versa.  Simply put, sellers want to be where the buyers are to earn more money and buyers want to be where the sellers are so as to gain access to the widest variety of items for sale.  This dynamic can lead to markets tipping to a winner-take-all scenario as buyers and sellers congregate around a single marketplace.

It stands to reason that successful WINA outlets have built critical mass and made it difficult for competitors to compete.  After all, if I am looking for used hockey skates, I have a higher probability of finding them at the successful Play It Again Sports store than at Joe’s Used Sporting Goods with sparsely populated shelves.

A similar dynamic took hold at GameStop (GME) until it was disrupted by technological change.  The more people who trade used games in the more used game inventory GameStop has and the more used games GameStop has the more people want to go to GameStop to trade their games in and buy other used games. And so the cycle goes.  This will lead to more sales later as the virtuous cycle of buy-sell-trade-in continues.

On The Other Hand . . .

On the other hand, how hard is it to compete with WINA?  I haven’t explored it any great detail but it seems like I could rent cheap retail space, stock the shelves with clothes from Goodwill, my own closet or other sources, and get started.  With this initial jolt of liquidty, could I establish a thriving marketplace?  Can WINA really get to scale?  Can it get the market to tip to a winner-take-all scenario?

WINA has a limited ability to scale, It can’t truly aggregate buyers and sellers like online marketplaces because of the value of in-store experience.  By taking a hyper-localized approach, WINA is not able to build a global marketplace like Airbnb.  It can’t even build a citywide marketplace like Uber.  Instead, the market for used goods still remains highly fragmented and is likely to remain so.

Franchising

The second interesting aspect of WINA’s business model is franchising. Franchising is a method of doing business by which a franchisee is licensed the right to engage in offering, selling, or distributing goods or services under a marketing format which is designed by the franchisor. The franchisor permits the franchisee to use the franchisor’s trademark, name, and advertising.

The most common form of franchising is business format franchising.  Business format franchising consists of a continuing commercial relationship between a firm with a proven business system (the franchisor) and a third-party (the franchisee), whereby the franchisor grants rights to the franchisee for a given period of time to operate their business system using a common brand and common format for promoting, managing, and administering this business. Examples of business format franchising are quick service restaurants (McDonald’s, Burger King) and lodging (Marriott, Hilton).

How Does It Work?

Prior to allowing a franchisee to open a store under one of the five brand names, WINA vets potential franchisees for general business experience and capital requirements. This general background check, as simple as it may seem, can help the company choose franchisees that will help its business succeed and look good in the eyes of consumers.

WINA first collects an initial fee that the franchisee pays at the time when the franchise agreement is made.  At December 26, 2015, the franchise fee for all brands was $25,000 for an initial store in the U.S. and $29,000CAD for an initial store in Canada.  Once a franchisee opens its initial store, it can open additional stores, in any brand, by paying a $15,000 franchise fee for a store in the U.S. and $17,500CAD for a store in Canada.  After that the franchisee pays WINA a royalty fee of 5% of gross sales for all stores except Music Go Round which is 3%.

A franchisee also pays a fee of $500 or $1,000 on top of the royalty fee, and this goes into an advertising fund which WINA manages. Plus, franchisees are required to spend 3-5% of gross sales on marketing and advertising.

The table below shows the growth in franchised stores by each of the five concepts as well as in total.

Source: Company filings via Sentieo.com

Source: Company filings via Sentieo.com

Each franchise agreement runs for 10 years.  At the end of the 10-year term of each franchise agreement, each franchisee has the option to “renew” the franchise relationship by signing a new 10-year franchise agreement.  As can be seen in the table below, WINA has a very high renewal rate.

Source: Company filings via Sentieo.com

Source: Company filings via Sentieo.com

What Does The Franchisee Get?

What does the franchisee get for his/her money?

  • Brand Name –  Use of the WINA brand names creates some customer loyalty.
  • Inventory Management
  • Centralized Purchasing of New Goods – Buying at scale gives the franchisees much greater bargaining power with suppliers than if they negotiated on their own.
  • Inventory Management – Ensuring that inventory remains fresh and appealing and priced market levels is a key benefit.
  • Real Estate – WINA does provide assistance in selecting the proper location. Given the importance of location in determining retail success or failure, this seems like a big benefit.
  • Franchisee Screening – As described above, WINA screens all applicants to ensure that brand is not tarnished.
  • Training – WINA provides classroom training as well as field support.

The Economics of Franchising

One often underappreciated fact about the retail industry is that operating stores and franchising stores are two completely different business models.  Operating stores is generally a tough business – capital-intensive, low margin, high fixed costs, limited bargaining power with suppliers, and exposed to macroeconomic and consumer weakness.  Franchising, on the other hand, if executed successfully, is arguably one of the best businesses in existence – it requires almost no capital to set up or grow, and provides a high margin, recurring cash flow stream with minimal operating leverage as the franchisor takes a cut of revenue of all the franchisee-operated stores in return for use of the brands, purchasing assistance, and other minimal franchisee-supporting activities.

Franchising solves two big problems that business run into as they expand:  the principal/agent problem and resource scarcity.

Principal/Agent Problem

In a traditional, direct ownership model, WINA would hire a manager to run a store and delegate decision-making authority to said manager.  Because WINA’s interest and the manger’s interest mny not coincide, the potential for a conflict of interests exists.  A salaried manager may not always put forth his/her best effort and therefore may produce sub-optimal performance.

Franchising, addresses this problem by providing powerful incentives for the owner-manager of the franchised unit to perform well. For example, the owner-manager (i.e., the franchisee) has a direct claim to the residual profits of her/his unit. Also, because the franchisee has put her/his own capital at risk she/he has a powerful incentive to make her/his franchised unit successful.  Because franchising aligns the interests of the two parties (the franchisor and the franchisee), there is less need for monitoring and a greater probability for maximum performance by the franchisee. who tend to be entrepreneurial and perhaps in some cases a little more invigorated running individual or multi-unit businesses than some of the corporate franchise restaurant operating divisions.

Resource Scarcity

As a business expands into new territories, it will run short on two valuable commodities:  capital to fund growth and local market knowledge.

Growth through franchising is attractive because it allows the franchisor to collect royalties on profits without deploying its own capital.  Franchisees source the capital and deploy understanding of local markets to drive growth in the brand sales.  Using other people’s money  to fund expansion is a wonderful thing.

Franchisors can also draw on the local market knowledge of the franchisees.  In addition to a closer tie to the community, this results in reduces corporate overhead. It also allows management to focus on strategic issues such as brand development, international expansion, marketing and capital allocation.  If the franchisor can put more energy into product, pricing, and promotion, and less human and financial resources into operating businesses, they’re going to be able to intensify their focus and deliver better results. They focus on their skill set and try to leave the operational activities to franchisees.

Specialization

Another edge WINA has over more traditional retailers is specialization.  WINA’s 5 brands each drive their respective categories, targeting a clear market segment and customer at scale. This allowed them to avoid the big box arms race that has killed so many retailers, including Sports Authority.

WINA has also demonstrated that its core competencies are transferable from one segment to another.  It has cut underperforming stores in sporting goods and grown apparel without missing a beat.  Between 2006 and 2015, the retailer closed 183 Play It Again Sports stores and reduced the total store count by 23%.

Source: Company filings via Sentieo.com

Source: Company filings via Sentieo.com

Reliable Free Cash Flow and ROIC

As you can imagine, with limited capital expense and fixed royalty flows, the franchising business model drives reliable FCF and high ROIC.  ROIC for WINA is routinely triple digits and sometimes infinite due to negative working capital.

This enable WINA to return cash to shareholders via buybacks and dividends.  Over the past ten years, WINA has reduced its float by 23%.  It also enables WINA to fund its high ROIC leasing and financing businesses.

The leasing business has been growing nicely and has big margins, but it is hard to imagine how there could be any kind of moat.  Nevertheless, it is a nice outlet for the FCF the franchising business generates.

If it’s such a great company, why has FCF been flat for five years?

It’s true that free cash flow has been essentially flat for the past five years.  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.

Free Cash Flow, 2011-2015

Source: Company filings via Sentieo.com

Source: Company filings via Sentieo.com

Poor Disclosures

One big problem is the lack of disclosure.  WINA makes it impossible to track per store economics and other standard retail metrics.  They provide (1) Franchise costs, (2) average sales and (3) average gross profit margin.  That’s it.  No overhead expenses.  No rent.  No ability to calculate same-store sales without dilution from new stores (which presumably perform worse than existing stores during a typical ramp-up period).

 Valuation

At a current (7/13/16) FCF yield of 5%, we would like to see a growth rate of 10% per year over the next 10 years to hit my hurdle rate of 15%.  This means FCF would have to total approximately $40 million in 2025 or approximately $11.87 per share.

To hit this target, we make the following assumptions:

  1. The store count will increase by its historical growth rate of 4% per annum. This growth rate will result in approximately 1,700 stores by 2025.  This compares to 4,000 stores for GameStop in 2015.  As GameStop is the closest analog to WINA, this store count seems reasonable. We kept the franchise fee flat at the 2015 average of $24,500.
  2. We used a projected growth rate of 8% per annum for consolidated store sales. As this is the 10 year average growth rate, this also seems reasonable.  We keep the royalty rate flat at the 2015 rate of 5%.
  3. We used a projected growth rate for leasing and other revenue of 3%. This is well below its 10 year growth rate of 18% per annum has growth has slowed dramatically over the past 5 years.
  4. We assume some margin expansion. We used an average FCF margin of 33% rather than the 2015 margin of 31%.  This is because we expect cash taxes to normalize as discussed above.  We also think the company can grow with a significant increase in headquarters expense.
  5. We assume that the company will continue reduce the share count by the historical rate of 3% per year. This would reduce the share count by 26% in total over the period 2015-2025.  This would require spending 59% of FCF on buybacks.  This is below historical averages but we also assumed no incremental debt to fund share buybacks.

The relative impact of each of these assumptions is seen in the chart below.

 

Source: Punch Card Calculations

Source: Punch Card Calculations

Individually none of these assumptions seem terribly aggressive to us.  But, assuming a 10% growth rate per annum for 10 years in the aggregate doesn’t let us sleep well at night.  As such, this is a little too rich for our blood.