In this episode of Industry Focus: Consumer Goods, Emily Flippen and Motley Fool analyst and Director of Investor Learning Buck Hartzell tell you everything you need to know about a small yet very promising fashion franchisor. There's no shortage of clothing resellers, so what sets this company apart from the competition? Learn about its many franchises, its growth trajectory, and much more.

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This video was recorded on June 2, 2020.

Emily Flippen: Welcome to Industry Focus. It's Tuesday, June 2, and I'm your host, Emily Flippen. Today we're going to be taking a deep dive into a little-known but extremely well-run company that focuses on clothing recycling and resale. Joining me today to take a deep dive into the world of Winmark (NASDAQ:WINA) is Motley Fool analyst and Director of Investor Learning Buck Hartzell. Buck, how are you doing?

Buck Hartzell: Thank you, Emily. I'm doing great. Thank you for having me.

Flippen: You know, we were just saying that it's hard to get a little bit of face time now that we're all social distancing and working from home. So it's nice to -- you know, I'm visually looking at you right now as we're recording this.

Hartzell: I know, yeah, it is good, it's good to see you as well.

Flippen: Well, I have to admit, I know [laughs] very little about Winmark. At a market cap of just over $500 million, this is a very small company. And we were chatting before we started recording and you mentioned that this was an even smaller company not too long ago. But while I may not know a lot about this company as an investment, I'm actually a frequent shopper at one of their many franchises, at least back when I was living in Texas. And I'd imagine that many of our listeners may not be familiar with the name Winmark but may be really familiar with their store. So maybe you can just tell us more. What is Winmark? What do they do?

Hartzell: Sure. I'm going to give you a rundown, and I'm also going to tell you, like, a little tip for those that are out there doing their own research on prospective small-cap companies. And this had one of the strongest signals years ago, probably a decade ago, for small-cap investors who were kind of paying attention. And that was they had an insider who's the founder, and Ronald Olson is his name, he still owns about 10% of Winmark. He's kind of up an age now. But he was an insider buyer.

And he wasn't just getting stock options, he was actually buying stock, acquiring it on the open market, regular prices, just as you and I would do as investors, and he was doing it all the way up, as the stock moved up. And for those of you who follow insider trading stuff, if you have a small-cap company where an insider owns a decent amount of stock and they're buying as the stock appreciates, as it keeps moving up, that's a super-strong signal for those of us who are following along. And anyhow, he did that for a long time, owned a big chunk of stock. He's older now. He's kind of stepped down from the CEO role, and he's selling out his position.

But let's first talk about what Winmark actually is as a business. And primarily, they're a franchisor. So they run a franchise model, which we like very much. And for those of you who aren't familiar with franchises, what that means is, you get yourself a qualified investor that comes along, and they put up the capital to start this business. You provide them with the brand and the operating manual on how to succeed at that investment. And by the way, the failure rate for franchises, whether they be restaurants or other businesses, is very low relative to your regular start-up of just somebody going out and starting up an independent store or restaurant or something like that. So franchise models, failure rate is very low. And you provide them with all that knowledge and the experience that they need. They bring the capital. So it's a very capital-light business, and it generates a lot of cash. So that's something we like. That's their primary business.

And some stores -- and, Emily, I'm not sure which one you shopped in -- we'll kind of do a little quick rundown of their stores. They have a bunch of different brands. Their largest is called Plato's Closet. And last year, that did $516 million in sales, over 483 units. So that's a little over $1 million/store, and that targets teens and young adults, with primarily selling clothes to them. And by the way, I would suggest that all their models are a very earth-friendly model, in that they use slightly used goods. So you can kind of see these as kind of high-end consignment store or gently used clothing.

Their second model is called Once Upon A Child, so it's children's clothes. And they did $376 million last year on 388 units, so just under $1 million/store. Targets for those is anybody who sells Gap Kids or baby clothes and that kind of thing.

Then we got Play It Again Sports with $227 million, and then we go down to their newer store, which is Style Encore, which did only $490 million, but that's a new brand, and that does women's clothing. And what they found when they kind of investigated and first launched this Style Encore brand is there's no kind of leading national brand that resonates with women that sells gently used clothing. And so, like, "Geez! If we could get in that space and become the name there." And it's grown pretty nice. Now, they have 68 units now.

And their last one is Music Go Round, which sells musical instruments and that kind of stuff that are used. And they did only $35 million on sales on 37 units. So as you can see, most of their units are doing about $1 million/year in sales. And they collect both the franchise fee when you set up the business, but then they also take a royalty from every sale that you make as a franchisor.

Flippen: Yeah, so the franchise of theirs that I'm familiar with is actually Plato's Closet, and that goes back to when I was in high school actually. I think it was either middle school or high school. I remember my town -- I grew up in McKinney, Texas -- got a Plato's Closet. And it was the talk of the town for quite a while. I remember my mom, you know, collecting up all of my clothing, all the clothing I hadn't worn in so long, taking me over to Plato's Closet and turning it into, essentially, cash or store credit that we could then use to purchase other goods at their stores. So it was definitely, you mentioned, kind of like an ecofriendly model, because they're mostly selling clothes that have been -- and virtually all of their stores are like this, not just Plato's Closet -- that they're selling goods that have been used before that would otherwise potentially be wasted.

I want to dig into Style Encore a little bit more, because you mentioned, there isn't really an option out there for older women. I shouldn't say older; I'm 25 years old. But, for instance, myself, I live next to the University of Maryland, and the closest thing I can get to resell clothing are these resellers next to the university that target college kids. Which, you know, I've gotten past that age now where I need a little bit more differentiation when it comes to clothes, but it's definitely an interesting market.

There's really no shortage of resellers available today, especially those that are online. There are companies that come to mind, maybe thredUP, which recently made an agreement with Walmart, companies like TheRealReal, which is more focused on luxury goods.

But what makes you think that Winmark's franchises, like Style Encore or Plato's Closet, how do they stack up against this type of competition?

Hartzell: Well, it's interesting. I'm not a regular shopper at Style Encore, so I'm not certainly their target audience or Plato's Closet, for that matter, but I'd say, Plato's Closet has a long history of being successful. So I'd say, like, when you have good operators, and I think this particularly happens in retail, they succeed. And as we can see, they don't have just one brand, they have a bunch of different brands there.

If you look at the spend in my household, there's two girls, my wife and my daughter; and then there are three boys, myself and two sons. If you look at where most of the money is spent in our household, it's the two, not the three, right? And so I think from a business standpoint, it makes sense to target women's clothes more than it does, and we don't see, you know, an option here on the list that's slightly used men's clothes. Because anybody will tell you, my wife included, I'm still wearing clothes that I wore in high school or college. Guys don't throw clothes out just because they have a hole in them; they kind of move down a shelf where now it's workout clothes. So everybody [laughs] laughs when I go to the gym, they're like that T-shirt, that's like 1988, you know, and I'm like, "Yeah, it's got a couple of holes in it, but it's good for working out now."

So anyhow, I think it makes sense to target that women's area. Now what I would say is, you know, as you mentioned, there's a lot of competition, particularly on the new end in apparel.

And apparel, we haven't talked about this yet, but in retail, over the last 10 years, everybody wants to write retail off, but that's not the case, really, there's been some areas that have really thrived in retail. And we can talk about those if you want, or not. Apparel has been an area where it's really struggled. You had The Limited, you had Forever 21, you got Hollister, you got American Eagle, you certainly have the big-box retailers. Target is really known for doing a good job with their clothes, Walmart probably not so much. I mean, I think they've tried and tried and not done very well there.

So there's a whole bunch, and you probably know more than I do of all those retailers that are in there. But I'd say on the used side, and what they said is not that there's no competition there, it's just that nobody resonates as a brand across women nationwide as this is the go-to spot. And so, what I think they thought was, "Okay, we're really good and we've done well with the young teens and young adults at Plato's Closet. We're just going to step up a notch, and why can't we do the same thing?"

And so, I'd say, they've done it once, it's not a guarantee, but it's off to a fairly good start now with 68 units, and they've been adding units. Their numbers are pretty good. So why not, why not then?

Flippen: So when we had originally scheduled to talk about this, we stuck on today's schedule, I wrote in that we're talking about Winmark; Motley Fool analyst, Nick Sciple, actually shot me a message. And all of the listeners are probably familiar with Nick, because he hosts Industry Focus alongside a few of us. But Nick Sciple is a huge fan of Winmark, and he shot me a message that, "You have to talk about Style Encore, if you miss Style Encore then you're missing all the really compelling reasons to invest in Winmark."

And in addition to the enthusiasm behind [laughs] Style Encore, he also sent over some really interesting data about product sales, especially resale. It's a study done by thredUP, so you can take it with a grain of salt if you like, but they have some really interesting numbers from this study. They're saying that 64% of women are willing to buy a secondhand product as compared to only 45% three years ago; and that does generationally depend.

So younger women who are now becoming a little bit older grew up in a generation that tends to be a little bit potentially more ecofriendly, ecoconscious, maybe a little worse-off in terms of financials. So they may be more willing to buy secondhand products. And it could potentially be this long-term tailwind for companies like Style Encore, as generations like my own get to that point where they're looking for a place to shop. And to an extent, I think it can be expressed with the success of consignment retailers like TJ Maxx or Ross. So those are just some of the things that I think I like about investing in the resale industry.

So I want to pass it off to you. What's compelling to you about Winmark as an investment, whether that be resale or the other lines of business? Because we forgot to mention one of the other lines of business that Winmark is involved in. [laughs]

Hartzell: Yeah, we didn't mention, and that's pretty unique. I think we kind of teased it a little bit at the beginning, but they also do equipment leasing. And this is, like, really business-essential equipment. So if you think about servers to run your online store, that's the kind of stuff that these guys lease.

And it seems kind of odd. When I first looked at Winmark many years ago, before I bought it, this was kind of like a red flag to me, because I had looked at a lot of specialty retailers and things before but never seen anyone that did equipment leasing before. It didn't make any sense. But that Founder we talked about, who owned a lot of stock, who was buying all the way up, it turns out he made his first millions in running a leasing business. So what I think he realized after he kind of started this model as the franchise started getting steam and generating a lot of cash for the business, he's like, "What am I going to do with that cash? I could just pay it out in a dividend or if I can reinvest it at a high rate of return." And it turns out, he had run a leasing business very well. I think he ended up selling that business for, like, $300 million.

So he started a small leasing business, so you have this capital-light model, the franchising model that generates a lot of cash, and then the leasing business, which is capital intensive. And if you do a good job and are disciplined at that, that generates even more money.

And to give you some context, their equipment leasing business was about 22% of revenues last year and about 18% of their operating income. Now, I would add that they've kind of changed leadership in that leasing business. In 2016, they bought $26 million worth of equipment, and last year, they bought $9 million worth of equipment. And so that's kind of on the decline. They wanted to see it go up, but there's a lot of competition in that area for mid-market small-business type of equipment leasing. And with interest rates near 0% now, I think that also, that environment plays a little bit of role in that. But anyhow, they run it well for a very long time. And it's an essential equipment that they lease but hopefully they can, kind of, turn around and do a little bit better on equipment leasing. But, anyhow, that's the second part.

So what do we like about the business? It's been run by an owner/operator that's been shareholder friendly. That person is selling off their stake now. But this company generates an incredible amount of cash relative to just about any metric. They've grown their sales dramatically over the years, and I think they have less employees than they did 10 years ago; they have 98 employees now. So it's not a capital-intensive business, but it's not even an employee-intensive business, [laughs] right? You don't need that many people, and it generates a lot of cash.

And what do they do with that cash? They generally buy back stock. They've been buying back stock recently; they've kind of buy back one of their founders, and that's where a lot of the stock buybacks have come, but I think they've reduced their share count 15% to 16% over the last five years from 4.5 million shares down 3.8 million shares roughly, today. That's the only reason they have a little bit of debt on their balance sheet, and they'll pay that off pretty quickly. So I think they're well run from a shareholder standpoint.

And the other thing is, I think, they play into a pretty nice spot in retail. When I am looking at retailers here, would I like to invest in a Nordstrom? I like the rack stores very much, but their full-store stores have been a drag forever -- when we're looking down the barrels of 20% unemployment? Probably not. Do I want to go to Macy's? Probably not. Those kind of department stores have all been squeezed.

But there are some areas that have done really well over the last 10 years and I think will do well during this downturn as well as they did in 2008-2009. Dollar stores, it seems like -- and I was wrong on this -- I thought 2008-2009, dollar stores did great, and I'm like, once the economy recovers, dollar stores, nobody is going to go there anymore. Turns out people love their dollar stores.

So dollar stores have done well. Convenience and gas stations have done very well. Drugstores, they got one on every corner; liquor stores. And you get down to home improvement, warehouse club, if you kind of look at the theme there, dollar stores, convenience stores, discounters, home improvement, and warehouse clubs, a lot of these are on the high-value proposition. And that's kind of what I'd consider Winmark is. You get a slightly used piece of clothing that you can try on and make sure it fits, it's in perfect shape, and you pay a lot less than you would pay at retail. So I think that's a sweet spot for the market, not only for the downturn with 20% unemployment, but people that are looking for bargains, right?

Flippen: Yeah. And I, kind of, want to ask you a quiz question here, you might know the answer, you might not, but maybe people listening can play along. Between luxury department and consignment store shoppers, which do you think are the most likely to buy a piece of secondhand clothing?

Hartzell: Interesting. I'm going to go to the luxury people.

Flippen: Yeah, you might have figured out my game here. Luxury -- people who are into buying luxury brands, 26% of them have -- this is from that same study I mentioned earlier by thredUP -- have bought secondhand. And it's marginally above those who are shopping at department or consignment stores. So it's not to say it's a really huge amount different, but I do think it's interesting, and it goes back to what you were just talking about, about the changing demographics of the customers and their willingness to shop in different areas.

And it goes back to, you know, the dollar stores, the warehouse stores. I mean, the people who we have in our minds, who may be more likely to buy luxury clothing, are not against buying secondhand clothing either. And I love the fact that a company like Winmark seems to play into all of these different value changes regardless of the socioeconomic class of a person or the perceived socioeconomic class of the shopper.

Hartzell: Right. And the other great thing about that, like, we were at a dollar store actually two weeks ago. We have a bay house in the Chesapeake Bay, it's a small town, and they have a dollar store, and we went to pick up some stuff. And my one son was like, "How can they sell this stuff and make any money? We just saw that in the grocery store for 3 times as much." I think we bought Twizzlers, licorice or something like that, it was candy and things.

But as you mentioned, the other thing I like about them, these guys aren't opening up stores in New York City for $2,000 a square foot, right? They're going to -- where are you from Texas, I forget?

Flippen: McKinney, Texas. At the time, it was nowhere.

Hartzell: Okay. So there, not a whole lot there. And there's a big area throughout rural America where you can get a really good deal in real estate. The cost to open those stores is relatively low, and you give people a bargain and they're very happy to shop there. You're not competing on all the style and the brand image and all the stuff that can kind of change pretty quickly, as we know, particularly among teens and young adults. Like, they're fickle, right? Things can change quickly. At these other places, it doesn't change as quickly. So I like the location and the areas that they're targeting as well.

Flippen: And I know we hadn't planned to discuss this, but it's hard for me to pass up this opportunity. When we started off, Buck, I mentioned that you were the director of investor learning here at The Motley Fool. And when I was first coming on as an intern a number of years back and as a new hire myself, you spent a lot of time talking about management and evaluating the performance of management. And as we've been discussing, you mentioned a few times the insider buying that was happening on the way up. The specific aspects that made that founder/CEO really interesting, and now the insider selling.

So I have two questions for you: (A) because we get this question a lot, where do I find information about insider buying and selling? And (B) how do I evaluate whether or not that insider buying or selling is a good or bad signal or just noise?

Hartzell: Okay, yeah, great question. So Form 4 filings, the SEC filings, are the ways. So every time an insider trades, buys or sells, they have to file a Form 4. That can be kind of daunting unless you're geeks like us. And today I was opening up every Form 4 on a couple of companies to see what's -- mostly around this time of year, they've had their annual meeting and they issue share grants to directors and that kind of stuff that they do annually.

There's a website that's pretty handy that's called Form4Oracle.com, and so you can go in there, Form4Oracle.com -- and we have no relationship; with The Fool -- you can type in the ticker, and you can see the most recent insider trades over the last three months or a year where there was more buying or more selling. And there's been lots of research published on insider trading. And what I would tell folks is, selling is not a big signal. The only time selling is really meaningful, when insiders do it, is when they're selling a lot after the stock has depreciated. [laughs] So if the stock has already caved and they're selling out at a pretty high rate, that's actually a pretty strong signal, and it's a negative signal. Avoid those stocks.

The strongest signal, though, is a buy on the open market, because we can sell for a variety of reasons. You could be buying a home, you could be paying for your kids' college, you could be going through a divorce, you could be helping to pay for a parent's medical care, there's all kinds of things you could do, but there's only one reason you really buy, right? Because you think it's a good deal. And the strongest signal that you can look for as an investor is strong insider buying after a stock has already appreciated, particularly for small-cap stocks; it's not as meaningful for large-cap stocks.

But the last couple of months, I have been paying attention to insiders and who's buying, because when stocks go down 30% right away, it's kind of interesting to see who's buying. But anyhow, the strongest signal is buying after the stock has already appreciated substantially.

And it's rare to see insiders, these days, buy stock on the open market alongside the rest of us, right? I like that. That's what investing is supposed to be. And owners/operators are supposed to put their capital at risk, they're not just supposed to be getting options and restricted stock for free. Go ahead and put some capital to risk, you know?

All these things that we read; we read proxy statements a lot. Emily, I know you do Form 14-A. And that tells us how the compensation goes for not only the board of directors but for the people that are running the company. And some of them require that the CEO owns a certain multiple of their base salary in stock and all that kind of stuff. Mostly that's just a farce, right? Because their base salary is very low, they get issued stock every year regarsdless of how well the company does or not, and in a couple of years, they have 5 times their salary. The big part of their salary is the incentive compensation, and that comes in both short-term and long-term incentives. But anyhow, so I'm getting a little off track here.

Flippen: I'm about to ask you another question that's going to get you even more off track, because I love this conversation, maybe we have to rename this podcast episode [laughs] now that we are going down here. But it got me thinking about a company that I follow and I like, it's Axon Enterprise. And they make the Taser, they normally were known as TASER, tasers and body cameras for police officers, and obviously, that's an increasingly important thing here in the United States after the horrible protest we saw across the nation this weekend.

But what I think is really interesting is that their Founder and CEO has completely cut his salary. I think he's getting paid something like $70,000/year as a base salary. Anything he'll get paid above that for the rest [laughs] of his tenure as CEO is going to be dependent upon the market cap of Axon itself. So depending on how fast he increases or to what size he increases the size of the company, and there's caveats in there for acquisitions and such, that's how much he'll get paid. How do you feel about a compensation structure like that?

Hartzell: I like that, and I like it particularly if it's long term. My main thing that I want in compensation when I look at those plans, when I'm looking at the proxy statements or the 14-As, is alignment with shareholders. And I try to think in my mind, I try to take it to an extreme in each direction that I can. And what I don't want to be able to happen is that person to make millions of dollars and me, as a shareholder, be losing money, right?

And so, I mean, it's very important, and what I've learned over time is the simpler the compensation plans, the better they typically are. The ones that have six different parts of long-term, short-term incentives and they have different things, parts calculated, part of it is, you know, qualitative that the board decides, and there's another part that's done this way and they're making changes every year to it. I don't like that. I like ones that are static, and I like ones that's really nice -- and you don't see this too often -- where companies have a long-term portion where they don't just measure results this year, it's over three-year or five-year rolling periods. Then it's like, it's hard to game that system, you can't game it because it includes a couple of years.

The last thing I want is somebody so focused on the stock price that they get something that happen to the stock or the market cap and they maybe buy back a lot of stock or do something to kind of job the system and it gets it up there, it releases all their money, and then they're like, OK, I'm gone, I'm going over to the next place, and then everything kind of goes to heck after they leave.

So anyhow, I like long term in it, I like it to be aligned with shareholders, and the simpler, the better the things that they measure their metrics on.

Flippen: I appreciate your humor --

Hartzell: You've heard that before, haven't you, Emily?

Flippen: [laughs] I have, although it is nice to hear it again. That compensation structure at Axon, that was particularly interesting, and as we were talking, I thought to myself, I want to hear what Buck has to say about this. So you humored me, if I can say it correctly. [laughs]

Hartzell: ... I like that. And you know what, and the thing that I would say, and I think this is something that the press has wrong over and over again, I don't mind if my executive makes money. Like, as a matter of fact, I want them to get wildly rich. [laughs] I just want to benefit from it, right? What I don't like is those people, and there's lots of them, that get wildly rich with average or subaverage performance; that I don't like, especially -- and those tend to be in companies with professional managers, not owners/operators, they're professional managers that run big companies. And they think the bigger they make their enterprise, the more they should get paid, as opposed to being paid on how well the business actually performs. Yeah, there's lots of pretenders out there in that space that get rich off of not doing very much, unfortunately.

Flippen: [laughs] Well, fair to say that Winmark's co-founder has not acted in that way yet.

Hartzell: No.

Flippen: And before we sign off, I do have one last question for you. I'd be remiss if I didn't ask about the pandemic and how Winmark has been handling the pandemic and how much of a business risk that is for them. So how do you view their leadership in regard to the current crisis?

Hartzell: I mean, the nice thing is, as we've mentioned, to being a franchise model is you are asset-light. They only have 98 employees. This was not some gigantic organization like Sears or something else where you have to lay off thousands of people and do all this kind of stuff. I mean, the reality is, a lot of their stores were closed. And they had to close them in order to be safe for not only their employees but for their customers.

I would say though, this is my personal take, and I'm not a doctor or a researcher, but most of the things that I've read about COVID and the pandemic is, it's very, very unlikely for anyone to catch this virus in a retail environment. Though we shut all the malls and we did all that kind of stuff, the primary ways that this spread, you need time near infected people. So big sporting events where you're in close proximity, you're cheering and literally spitting out the virus as you're doing that, and you're there for three or four hours, is not a great thing. Schools are not a great thing where you're close for eight or nine hours, and eating at restaurants where you're eating and laughing and doing all that stuff for hours on end. But if you're in a store and you're going in and out, and I've gone to the grocery store several times early on -- I didn't have the mask; now we wear a mask like we're supposed to -- I don't think retail is that big of a threat to people, I really don't, and I think so this is, kind of, an overreaction there.

But they closed a lot of their retail stores, obviously. Their leasing business is still going, but the nice thing about being a company with very low operating cost is they're going to close their stores and it's a hit, but they're going to reopen, and I don't have any concerns about them getting through the pandemic, where there's other retailers where I think, Jeez! They've taken on a lot of leverage, you know, over the last couple of years or done that kind of stuff and now they're in trouble because their spigot is cut off. Well, the nice thing is, they do have the leasing business, so that's still coming in. And their other stores are starting to open now, you know, so.

Flippen: Well, Buck, thank you so much for taking the time out of your day to stay and chat with me for this episode of Industry Focus. It's been great.

Hartzell: You're welcome, Emily. Thank you. It's great seeing you again. Stay safe, stay healthy. Hope we'll see you in Fool HQ in not too long. I look forward to seeing you again. Okay. Thanks for having me.

Flippen: [laughs] Yeah. Listeners, that does it for this episode of Industry Focus. If you have any questions or just want to reach out to say hi, you can shoot us an email at IndustryFocus@Fool.com or tweet us @MFIndustryFocus.

As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against any stocks mentioned, so don't buy or sell anything based solely on what you hear.

Thanks to Austin Morgan for his work behind the screen today. For Buck Hartzell, I'm Emily Flippen. Thanks for listening, and Fool on!