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Stock Strategist

Seeking Small-Cap Moats: Winmark

This intriguing retail franchising and equipment rental company finds its niche.

One of Warren Buffett's more notable sayings is, "I am a better investor because I am a businessman, and a better businessman because I am an investor."

As such, I find it encouraging when a company's CEO or CFO is also a student of investing. In fact, the CEO of this month's small cap is himself an active value investor, and in an interview published last year he said that he follows the investing principles of Benjamin Graham, David Dodd, and Buffett. His favorite business aphorism is, "Profit is fiction; cash is fact."

That's music to my ears, as there's a good chance that this executive is also using Graham's, Dodd's, and Buffett's investing principles when making capital-allocation decisions, with an eye toward generating free cash flow and enhancing long-term value per share--exactly what we look for in exemplary stewards of shareholder capital.

Hitting the Mark
A regular reader of this column was kind enough to bring Winmark Corporation (WINA) and its CEO, John Morgan, to my attention. Here are some quick facts about Winmark, as of Aug. 15:

  • Market capitalization: $350 million
  • Headquarters: Minneapolis, Minnesota
  • Analysts covering: None
  • Industries: Specialty retail franchising, equipment rental

Morgan, the aforementioned Buffett disciple (who, incidentally, is also from Omaha), owns 33% of Winmark's outstanding shares and has steadily bought shares in the open market over the past two years. As of the most recent proxy filing, other directors and executive officers owned another 12.5% of the company. This is encouraging--we can expect Winmark's leaders to act like owners of the business precisely because they are owners.

In March 2000, a few years after selling an equipment leasing company that he had run successfully, Morgan became CEO of a struggling specialty retail franchising business called Grow Biz, which would be renamed Winmark a year later.

You might wonder, as I did, why Morgan would move from equipment leasing to retail franchising, but it seems Morgan's attraction to the business was the steady cash flows produced by retail franchising that could then be reinvested elsewhere.

The master plan began to take shape in April 2004. Once Morgan and his team got the retail franchise business back on firmer ground, the company launched Winmark Capital, an equipment leasing business that finances and leases high-technology equipment to large- and medium-size businesses, and Wirth Business Credit, which leases equipment and provides small-ticket financing to emerging businesses. Today, the leasing operations account for about 26% of Winmark's total revenue and operating income, with operating margins of about 54% in 2013.

Despite Morgan's impressive stewardship--Winmark stock is up nearly 1,600% since he took over as CEO, versus a 32% gain in the S&P 500--I was very skeptical that a franchisor of brick-and-mortar specialty retail concepts might be moatworthy, given that most retailers lack both meaningful switching costs and pricing power, particularly in the face of online competition.

Though the leasing business has potential, retail franchising remains the largest profit engine at Winmark, and I think it should be the main factor that determines whether the company currently has an economic moat.

At Morningstar, when we evaluate a franchisor for a potential moat, we want to see, among other things, that the franchise system is cohesive and that the overall financial health of franchisees is strong. Additionally, operational efficiencies and bargaining power over suppliers should be considered. Using that framework, let's consider Winmark's potential moat.

As of June, Winmark had 1,047 franchised stores in the U.S. and Canada.

Winmark's niche in the industry is that its franchise concepts target different end markets, but all the stores follow a similar business model in which customers can buy, sell, trade, and consign lightly used merchandise.

What makes this franchise model attractive from a moat perspective is that, since each concept has a similar system of recycling lightly used merchandise, Winmark can apply best practices in one concept to other concepts. A competitor focused on just one end market, on the other hand, would likely lack the know-how or coordination abilities that Winmark possesses.

Further, the recycled and resale retailer generally has bargaining power over its suppliers (that is, consumers trading in items), as evidenced by the fact that the retailer purchases the item at a steep discount to market value. As long as the retailer has a keen eye for which merchandise will appeal to consumers and can turn the product over quickly at market prices, margins are very attractive.

Consumer trends in the specialty retail market come and go, of course, and franchise concepts change along with them. Fortunately for Winmark, its focus on value-minded consumers has reduced some of the natural cyclicality in specialty retail, and even though the number of Play It Again Sports and Music Go Round stores has fallen over the past decade, Plato's Closet and Once Upon a Child have more than offset those negatives. This also speaks to the adaptability of Winmark's retail business model.

Even though Morningstar doesn't cover Winmark and the company hasn't been vetted by our moat committee to produce an official Morningstar Economic Moat Rating, I'd argue that it has established a narrow economic moat based partially on cost advantages and intangible asset advantages in its retail franchising business.

Risks and Valuation
In addition to the risks outlined in the company's 10-K, the most obvious risk facing Winmark is what the company looks like after Morgan, who is 72 years old, retires. In the case of Winmark, you're betting on the jockey as much as you're betting on the horse. I've seen no indication that he plans to retire anytime soon, however, and if he follows the 83-year-old Buffett's lead, he might be around for a bit longer than people think.

Morgan has made a few mistakes on the capital-allocation front during his tenure at Winmark, including the company's investment in Tomsten, which operated a scrapbooking retail concept and filed for Chapter 11 bankruptcy protection in 2013. Further capital allocation missteps are possible, particularly if the company steps away from its core competencies.

At about $69 per share (as of Aug. 18), Winmark's stock remains well off its 52-week high of $94.20, making this perhaps an attractive entry point. It currently trades with a trailing price/earnings ratio of 19.3 times, which compares with its five-year average of 21.5 times, and a trailing price/cash flow ratio of 18.4 times, which is slightly above its three-year average of 17.8 times.

I'm going to keep this one on my watchlist for now, as I'd like to visit a few of the retail stores to get a better feel for the operations. The stock is very thinly traded, so if you do consider an investment, be sure to use a limit order.

Trading Update
On July 31, I bought some shares of WD-40 Company, a stock we discussed in a previous article in this series.

Other stocks highlighted in this series:

Todd owns shares of Sun Hydraulics and WD-40 Company. You can follow him on Twitter at @toddwenning.