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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarter ended September 27, 2008

or

o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                  to                 

Commission File Number: 000-22012

WINMARK CORPORATION

(Exact name of registrant as specified in its charter)

4200 Dahlberg Drive, Suite 100, Minneapolis, MN 55422-4837

(763) 520-8500

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days:

Yes  x                   No  o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See the definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act:

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act:

Yes  o                   No  x

Common stock, no par value, 5,454,520 shares outstanding as of November 3, 2008.

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WINMARK CORPORATION AND SUBSIDIARIES

INDEX

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PART I.              FINANCIAL INFORMATION

ITEM 1:   Financial Statements

WINMARK CORPORATION AND SUBSIDIARIES

CONSOLIDATED CONDENSED BALANCE SHEETS

(Unaudited)

The accompanying notes are an integral part of these financial statements

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WINMARK CORPORATION AND SUBSIDIARIES

CONSOLIDATED CONDENSED STATEMENTS OF OPERATIONS

(Unaudited)

The accompanying notes are an integral part of these financial statements

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WINMARK CORPORATION AND SUBSIDIARIES

CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS

(Unaudited)

The accompanying notes are an integral part of these financial statements

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WINMARK CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

1.     Management’s Interim Financial Statement Representation:

The accompanying condensed financial statements have been prepared by Winmark Corporation and subsidiaries (the “Company”), without audit, pursuant to the rules and regulations of the Securities and Exchange Commission.  The Company has a 52/53 week year which ends on the last Saturday in December.  The information in the condensed financial statements includes normal recurring adjustments and reflects all adjustments which are, in the opinion of management, necessary for a fair presentation of such financial statements.  The consolidated condensed financial statements and notes are presented in accordance with the instructions for Form 10-Q, and therefore do not contain certain information included in the Company’s annual consolidated financial statements and notes.  This report should be read in conjunction with the audited financial statements and the notes thereto included in the Company’s latest Annual Report on Form 10-K.

Revenues and operating results for the nine months ended September 27, 2008 are not necessarily indicative of the results to be expected for the full year.

2.     Organization and Business:

The Company offers licenses to operate franchises using the service marks Play it Again Sports®, Once Upon A Child®, Music Go Round®, Plato’s Closet® and Wirth Business Credit®.  In addition, the Company sells inventory to its Play It Again Sports® franchisees through its buying group.  The Company also operates both small-ticket and middle-market equipment leasing businesses.

3.     Long-Term Investments:

The Company has an investment in Tomsten, Inc. (“Tomsten”), the parent company of “Archiver’s” retail chain.  Archiver’s is a retail concept created to help people preserve and enjoy their photographs.  The Company has invested a total of $7.5 million in the purchase of common stock of Tomsten.  The Company’s investment currently represents 18.3% of the outstanding common stock of Tomsten.  The Company’s investment was originally accounted for using the cost method based upon an analysis that included the fact that no officers or directors of the Company served as officers or directors of Tomsten, and the existence of a voting agreement between the Company and Tomsten, appointing officers of Tomsten as the Company’s proxy with the right to vote the Tomsten shares held by the Company.

On October 2, 2007, the Company changed its relationship with Tomsten, primarily by (i) John Morgan, our Chairman and Chief Executive Officer, joining Tomsten’s board of directors and (ii) Tomsten and Winmark eliminating the voting agreement between the parties.  Due to these factors, the Company determined that it was necessary to change the accounting treatment for its investment in Tomsten from the cost method (which had been in place since the date of the Company’s first investment in August 2002) to the equity method of accounting.  At the date of the change in accounting treatment, the Company’s historical financial statements were adjusted retroactively to reflect the portion of Tomsten’s operating losses attributable to the Company’s ownership from the date of the original investment. (See Note 7).  As of September 27, 2008, $3.1 million of the Company’s investment, with a current carrying cost of $5.2 million, is attributable to goodwill.  The amount of goodwill was determined by calculating the difference between the Company’s net investment in Tomsten less its pro rata share of Tomsten’s net worth.

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On October 13, 2004, the Company made a commitment to lend $2.0 million to BridgeFunds Limited at an annual rate of 12% pursuant to several senior subordinated promissory notes.  BridgeFunds Limited advances funds to claimants involved in civil litigation to cover litigation expenses.  At December 29, 2007 and September 27, 2008, the Company had previously funded the $2.0 million commitment.  In addition, the Company has received a warrant to purchase approximately 257,000 shares of BridgeFunds which currently represents approximately 7.0% of the equity of BridgeFunds on a fully diluted basis.  On August 23, 2007, in connection with raising capital, BridgeFunds Limited completed a restructuring where all assets and liabilities, including the warrant, were assigned to and assumed by BridgeFunds, LLC.

4.     Investment in Leasing Operations:

Investment in leasing operations consists of the following:

The Company had $974,200 and $75,700 of write-offs related to the lease portfolio during the first nine months of 2008 and 2007, respectively.

As of September 27, 2008, leased assets with one customer approximated 13% of our total assets, of which $2.3 million of the customer commitment is secured by a letter of credit.

Minimum lease payments receivable under lease contracts and the amortization of unearned lease income, net of initial direct costs and fees is as follows for the remainder of fiscal 2008 and the full fiscal years thereafter as of September 27, 2008:

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5.     Accounting for Stock-Based Compensation:

Financial Accounting Standards Board (FASB) Statement No. 123,  Share-Based Payment (revised 2004) requires the cost of all share-based payments to employees, including grants of employee stock options, to be recognized in the consolidated financial statements based on the grant date fair value of those awards.  In accordance with Statement No. 123R, this cost is recognized over the period for which an employee is required to provide service in exchange for the award.  Statement No. 123R requires that the benefits associated with tax deductions in excess of recognized compensation expense be reported as a financing cash flow rather than as an operating cash flow.  The Company uses the straight-line method of expensing graded vesting awards.  Compensation expense of $632,300 and $488,100 relating to the vested portion of the fair value of stock options granted was expensed to “Selling, General and Administration Expenses” in the first nine months of 2008 and 2007, respectively.

The Company estimates the fair value of options granted using the Black-Scholes option valuation model.  We estimate the volatility of our common stock at the date of grant based on our historical volatility rate, consistent with SFAS No. 123(R) and Securities and Exchange Commission Staff Accounting Bulletin No. 107 (SAB 107).  Our decision to use historical volatility was based upon the lack of actively traded options on our common stock.  We estimate the expected term based upon historical option exercises.  The risk-free interest rate assumption is based on observed interest rates for the volatility period.  We use historical data to estimate pre-vesting option forfeitures and record share-based compensation expense only for those awards that are expected to vest.  For options granted, we amortize the fair value on a straight-line basis.  All options are amortized over the vesting periods.

In accordance with SFAS 123R, the fair value of each option granted in 2008 and 2007 was estimated on the date of the grant using the Black-Scholes option pricing model with the following assumptions:

6.     New Accounting Pronouncements

Effective December 30, 2007, the Company adopted SFAS No. 157, “Fair Value Measurements” (“SFAS No.157”).  SFAS No. 157 defines fair value, establishes a framework for measuring fair value in accordance with generally accepted accounting principles and expands disclosures about fair value measurements.  The adoption of SFAS No. 157 did not have a material impact on the Company’s financial condition or results of operations.

SFAS No. 157 defines fair value as the price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date.  SFAS No. 157 also describes three levels of inputs that may be used to measure fair value:

·                  Level 1 – quoted prices in active markets for identical assets and liabilities.

·                  Level 2 – observable inputs other than quoted prices in active markets for identical assets and liabilities.

·                  Level 3 – unobservable inputs in which there is little or no market data available, which require the reporting entity to develop its own assumptions.

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The Company’s cash and cash equivalents are valued using quoted prices.  The fair values of the Company’s long-term investments (described in Note 3) were determined based on Level 3 inputs using a discounted cash flow model.

In February 2008, the FASB issued FSP FAS 157-2, Effective Date of FASB Statement No. 157 (“FSP FAS 157-2”).  FSP 157-2 delays the effective date of SFAS 157 for non-financial assets and non-financial liabilities, except those that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually).  The Company will adopt FAS 157 for non-financial assets and non-financial liabilities on December 28, 2008, and does not anticipate this adoption will have a material impact on the financial statements.

In February 2007, FASB issued FAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities Including an Amendment of FASB Statement No. 115 (“FAS 159”).  FAS 159 permits entities to choose to measure many financial instruments and certain other items at fair value.  The Company adopted FAS 159 on December 30, 2007.  The Company did not elect the fair value of accounting option for any of its eligible assets; therefore, the adoption of FAS 159 had no impact on the financial statements.

7.     Reclassifications:

Certain amounts in the September 29, 2007 financial statements have been reclassified to conform with the September 27, 2008 presentation.

Change in Accounting

As a result of the change in accounting treatment for our investment in Tomsten from the cost basis to the equity method of accounting in 2007 (See Note 3), the Company retroactively adjusted the accompanying 2007 historical financial statements to reflect the portion of Tomsten’s operating losses attributable to the Company’s ownership from the date of its original investment until the change in accounting treatment.  The table below reflects the effect of the change in accounting method on the September 29, 2007 financial statements.

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8.     Earnings Per Share:

The Company calculates earnings per share in accordance with SFAS No. 128 by dividing net income by the weighted average number of shares of common stock outstanding to arrive at the Earnings Per Share - Basic.  The Company calculates Earnings Per Share - Diluted by dividing net income by the weighted average number of shares of common stock and dilutive stock equivalents from the exercise of stock options and warrants using the treasury stock method.  The weighted average diluted outstanding shares is computed by adding the weighted average basic shares outstanding with the dilutive effect of 26,273 and 117,965 stock options and warrants for the three months ended and 29,208 and 120,874 for the nine months ended September 27, 2008 and September 29, 2007, respectively.

Stock options for 186,935 and 104,216 shares for the three months and 161,893 and 141,608 shares for the nine months ended September 27, 2008 and September 29, 2007, respectively, were outstanding but were not included in the calculation of Earnings Per Share – Diluted because their exercise prices were greater than the average market price of the common shares and, therefore, including the options in the denominator would be anti-dilutive.

9.     Shareholders’ Equity:

Repurchase of Common Stock

Under the Board of Directors’ authorization, the Company has the ability to repurchase up to 4,000,000 shares of its common stock, of which all but 153,384 shares have been repurchased through September 27, 2008.  Repurchases may be made from time to time at prevailing prices, subject to certain restrictions on volume, pricing and timing.  Since the inception of stock repurchase activities in November 1995 through September 27, 2008, the Company has repurchased 3,846,616 shares of its stock at an average price of $14.10 per share.  In the first nine months of 2008, the Company repurchased 31,370 shares for an aggregate purchase price of $556,670 or $17.75 per share.

Stock Option Plans

The Company has authorized up to 750,000 shares of common stock to be reserved for granting either nonqualified or incentive stock options to officers and key employees under the Company’s 2001 Stock Option Plan (“the 2001 Plan”).

Grants under the 2001 Plan are made by the Board of Directors or a Board-designated committee at a price of not less than 100% of the fair market value on the date of grant.  If an incentive stock option is granted to an individual who owns more than 10% of the voting rights of the Company’s common stock, the option exercise price may not be less than 110% of the fair market value on the date of grant.  The term of the options may not exceed 10 years, except in the case of nonqualified stock options, whereby the terms are established by the Board of Directors or a Board-designated committee.  Options may be exercisable in whole or in installments, as determined by the Board of Directors or a Board-designated committee.

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The Company also sponsors a Stock Option Plan for Nonemployee Directors (the “Nonemployee Directors Plan”) and has reserved a total of 300,000 shares for issuance to directors of the Company who are not employees.  At the April 30, 2008 Annual Shareholders Meeting, the Company’s shareholders approved a resolution (as described more completely in the Company’s definitive Proxy Statement filed with the United States Securities and Exchange Commission on March 19, 2008) to amend the Nonemployee Directors Plan by extending the term of future options granted under the Plan from a six (6) year term to a ten (10) year term, and by modifying the vesting schedule from 20% to 25% per year, beginning one year from the grant date.

Stock options granted and exercised under the 2001 Plan and Nonemployee Directors Plan as of September 27, 2008 were as follows:

All unexercised options at September 27, 2008 have an exercise price equal to the fair market value on the date of the grant.

As of September 27, 2008, the Company had $1.7 million of total unrecognized compensation expense related to stock options that is expected to be recognized over the remaining weighted average vesting period of approximately 2.8 years.

Other Options

On March 22, 2000, Sheldon Fleck, a former consultant to the Company, was granted a warrant to purchase 200,000 shares of common stock at an exercise price of $6 per share.  This warrant would have expired on March 22, 2008 if unexercised.  On October 4, 2007 and January 17, 2008, Mr. Fleck exercised 25,000 and 175,000 of the warrant shares, respectively.  The exercise of the warrant shares resulted in a $1,025,500 tax benefit in the first nine months of 2008 which was recorded as an increase to common stock.

10.  Long-Term Debt:

On June 10, 2008, the Company amended and restated its 364-Day Revolving Credit Agreement with LaSalle Bank National Association (“LaSalle”) to, among other things, join The PrivateBank and Trust Company as lender and Documentation Agent, appoint LaSalle as Administrative Agent, increase the aggregate commitment to $55.0 million and extend the term to June 15, 2013.  The Amended and Restated Revolving Credit Agreement (the “Credit Facility”) permits the Company to borrow up to the aggregate commitment subject to certain borrowing base limitations.

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The Credit Facility allows the Company to choose between three interest rate options in connection with its borrowings.  The interest rate options are the Base Rate, LIBOR and Fixed Rate (all as defined within the Credit Facility) plus an applicable margin of 0%, 2.00% and 2.00%, respectively.  Interest periods for LIBOR borrowings can be one, two, three or six months, and interest periods for Fixed Rate borrowings can be one, two, three, four or five years as selected by the Company.  The Credit Facility also provides for non-utilization fees of 0.25% per annum on the daily average of the unused commitment.

As of September 27, 2008, the Company’s borrowing availability under the Credit Facility was $55.0 million (the lesser of the borrowing base or the aggregate line of credit).  There were $14.0 million in borrowings outstanding under the Credit Facility bearing Fixed Rate interest ranging from 4.58% to 5.76% and having initial terms ranging from three years to five years, leaving $41.0 million available for additional borrowings.

The Credit Facility will be used for growing the Company’s leasing business, stock repurchases and general corporate purposes.  The Credit Facility is secured by a lien against substantially all of the Company’s assets, contains customary financial conditions and covenants, and requires maintenance of minimum levels of debt service coverage and tangible net worth and maximum levels of leverage (all as defined within the Credit Facility).  As of September 27, 2008, the Company was in compliance with all of its financial covenants.

Renewable Unsecured Subordinated Notes

In May 2006, the Company filed a public offering of up to $50 million of Renewable Unsecured Subordinated Notes that was declared effective in June 2006.  In March 2007, the Company filed Post-Effective Amendment Number 2 to the public offering that was declared effective March 30, 2007.  In November 2007, the Company filed a Post-Effective Amendment Number 3 to the public offering that was declared effective November 29, 2007.  In March 2008, the Company filed a Post-Effective Amendment Number 4 to the public offering that was declared effective March 27, 2008.  As of September 27, 2008, the Company has $20,916,900 outstanding in renewable unsecured subordinated notes.  The table below presents the Company’s outstanding notes payable as of September 27, 2008:

The Company made interest payments of $1,495,300 and $875,900 on the renewable unsecured subordinated notes during the first nine months of 2008 and 2007, respectively.  The weighted average term of the outstanding renewable unsecured subordinated notes at September 27, 2008 is 40 months.

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The Company incurred $231,800 in costs related to the issuance of the Renewable Unsecured Subordinated Notes in 2006.  The costs can be broken into three distinct categories (i) offering costs (ii) on going costs, (iii) annual costs.  These costs have been capitalized and will be amortized as a component of interest expense.  The offering and on going costs associated with the debt offering are being amortized over the weighted-average term of the debt.  In connection with the debt offering, the Company will incur certain additional annual costs that are being amortized over a 12-month period.

11.  Discounted Lease Rentals

The Company utilized certain lease receivables and underlying equipment as collateral to borrow from financial institutions at a weighted average rate of 5.69% at September 27, 2008 on a non-recourse basis.  In the event of a default by a customer in non-recourse financing, the financial institution has a first lien on the underlying leased equipment, with no further recourse against the Company.  As of September 27, 2008, $962,300 of the $2.4 million liability balance is current.

12.  Other Contingencies:

In addition to the operating lease obligations disclosed in Note 12 of the Company’s Form 10-K for the year ended December 29, 2007, the Company has remained a guarantor on Company-owned retail stores that have been either sold or closed.  At September 27, 2008 and September 29, 2007, $72,000 and $88,000, respectively, are included in accrued liabilities relating to these obligations.  These leases have various expiration dates through 2008.  The Company believes it has adequate accruals for any future liability.

On September 9, 2008, the Company signed a letter agreement (“Amendment”) amending its lease for its corporate headquarters, with Stan Koch & Sons Trucking, Inc. (“Koch”). The Amendment, among other things, allows the Company to either vacate the premises and cancel the lease anytime after December 1, 2008 by giving 90 days prior written notice or receive a payment from Koch if the Company occupies the premises through the current end of the lease term.

On September 26, 2008, the Company signed a Lease (“Lease”) with Utah State Retirement Investment Fund (“Landlord”).  The Company plans to use the approximately 33,513 rentable square feet of space (“Premises”) as its corporate headquarters.  Provided that the Landlord delivers the Premises as described in the Lease, the initial term of the Lease will be ten years and six months, commencing on the later of February 1, 2009 or upon substantial completion of the leasehold improvements agreed upon by the parties.  The Company is obligated to pay rent monthly under the Lease, and will pay an estimated $5.1 million in total rental payments over the entire term of the Lease.  The Company is also obligated to pay Landlord’s estimated taxes and operating expenses as described in the Lease, which change annually.  The total rentals, taxes and operating expenses paid may increase if the Company exercises any of its rights to acquire additional space described in the Lease.

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13.  Segment Reporting:

The Company currently has two reportable business segments, franchising and leasing.  The franchising segment franchises value-oriented retail store concepts that buy, sell, trade and consign merchandise.  The leasing segment includes (i) Winmark Capital Corporation, a middle-market equipment leasing business and (ii) Wirth Business Credit, Inc., a small ticket equipment leasing business.  Segment reporting is intended to give financial statement users a better view of how the Company manages and evaluates its businesses. The Company’s internal management reporting is the basis for the information disclosed for its business segments and includes allocation of shared-service costs.  Segment assets are those that are directly used in or identified with segment operations, including cash, accounts receivable, prepaids, inventory, property and equipment and investment in leasing operations. Unallocated assets include corporate cash and cash equivalents, long-term investments, deferred tax amounts and other corporate assets.  Inter-segment balances and transactions have been eliminated.  The following tables summarize financial information by segment and provide a reconciliation of segment contribution to operating income:

14.  Related Party Transactions:

On February 12, 2007, in connection with Winmark Corporation’s (“Winmark”) existing stock repurchase plan, Winmark agreed to repurchase 50,000 shares of common stock from K. Jeffrey Dahlberg, a greater than 5% shareholder of the Company at the time, for aggregate consideration of $900,000, or $18.00 per share.

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On February 27, 2007, John L. Morgan, chief executive officer and chairman of Winmark, subscribed for and purchased $500,000 of two year maturity unsecured subordinated notes on a monthly interest payment schedule as described in the Interest Rate Supplement filed on Form 424B2 with the Securities and Exchange Commission on June 16, 2006 offered by Winmark pursuant to the Prospectus and related documents declared effective June 14, 2006.  In connection with their investment, Mr. Morgan agreed that his notes would be voted consistent with the majority of the remaining note holders in an event of default.

On April 5, 2007, John L. Morgan, subscribed for and purchased $400,000 of four year maturity unsecured subordinated notes on a monthly interest payment schedule at the rates described in the Interest Rate Supplement filed on Form 424B2 with the Securities and Exchange Commission on April 3, 2007 (“April Interest Rate Supplement”) offered by Winmark pursuant to a prospectus and related documents declared effective on March 30, 2007 (“March Prospectus”).  In connection with his investment, Mr. Morgan agreed that his notes would be voted consistent with the majority of the remaining note holders in an event of default.

On May 15, 2007, in connection with Winmark’s existing stock repurchase plan, Winmark agreed to repurchase 50,000 shares of common stock from K. Jeffrey Dahlberg for aggregate consideration of $850,000, or $17.00 per share.

On June 28, 2007, John L. Morgan subscribed for and purchased $1 million of three year maturity unsecured subordinated notes on a monthly interest payment schedule as described in the April Interest Rate Supplement offered by Winmark pursuant to the March Prospectus.  In connection with this investment, Mr. Morgan agreed that his notes would be voted consistent with the majority of the remaining note holders in an event of default.

On September 18, 2007, in connection with the Winmark’s existing stock repurchase plan, Winmark agreed to purchase 41,138 shares of common stock from Mark T. Hooley, a former executive officer and son-in-law of John L. Morgan, for aggregate consideration of $771,700 or $18.76 per share.

On October 4, 2007, John L. Morgan subscribed for and purchased $800,000 of unsecured subordinated notes of various maturities ($200,000 of six month maturity, $200,000 of one year maturity, $200,000 of two year maturity and $200,000 of three year maturity) all on a monthly interest payment schedule at the rates described in the Interest Rate Supplement filed on Form 424B2 with the Securities and Exchange Commission on August 23, 2007 offered by Winmark pursuant to the March Prospectus.  In connection with his investment, Mr. Morgan agreed that his notes would be voted consistent with the majority of the remaining note holders in an event of default.

On November 6, 2007, Sheila Morgan, spouse of John L. Morgan, subscribed for and purchased $2,000,000 of unsecured subordinated notes of various maturities ($500,000 of one year maturity, $500,000 of two year maturity and $1,000,000 of three year maturity) all on a monthly interest payment schedule at the rates described in the Interest Rate Supplement filed on Form 424B2 with the Securities and Exchange Commission on October 12, 2007 offered by Winmark pursuant to the March Prospectus. In connection with her investment, Mrs. Morgan agreed that her notes would be voted consistent with the majority of the remaining note holders in an event of default.

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15.  Subsequent Events:

On September 29, 2008, William D. Dunlap, a member of the Company’s Board of Directors, retired effective September 29, 2008.

ITEM 2:   Management’s Discussion and Analysis of Financial Condition and Results of Operations.

Overview

As of September 27, 2008, we had franchises operating under the following brands:  Play it Again Sports®, Once Upon a Child®, Plato’s Closet®, Music Go Round® and Wirth Business Credit®.  Management closely tracks the following financial criteria to evaluate current business operations and future prospects: royalties, franchise fees, leasing activity, selling, general and administrative expenses.

Our most profitable sources of franchising revenue are royalties earned from our franchise partners and franchise fees for new openings and transfers.

During the first nine months of 2008, our royalties increased $1,167,900 or 7.7% compared to the first nine months of 2007.  Franchise fees increased $44,000 or 3.4% compared to the same period last year.  During the first nine months of 2008, revenue generated from the Company’s leasing activities was $5,920,000 compared to $2,944,700 in the same period last year.  (See Note 13 – “Segment Reporting.”)  The Company’s leasing portfolio was $45.8 million at September 27, 2008 compared to $33.2 million at September 29, 2007.

Management continually monitors the level and timing of selling, general and administrative expenses.  The major components of selling, general and administrative expenses include salaries, wages and benefits, advertising, travel, occupancy, legal and professional fees.  During the first nine months ended September 27, 2008, selling, general and administrative expense increased $678,000, or 4.7%, compared to the same period last year primarily due to amortization of initial direct costs, stock option expenses, sales commissions and bank charges.

Management also monitors several nonfinancial factors in evaluating the current business operations and future prospects, including franchise openings and closings and franchise renewals.  The following is a summary of our franchising activity for the first nine months ended September 27, 2008:

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Renewal activity is a key focus area for management.  Our franchisees sign 10-year agreements with us.  The renewal of existing franchise agreements as they approach their expiration is an indicator that management monitors to determine the health of our business and the preservation of future royalties.  During the nine months ended September 27, 2008, the Company renewed 16 franchise agreements of the 16 franchise agreements that were available for renewal.

Our ability to grow our profits is dependent on our ability to: (i) effectively support our franchise partners so that they produce higher revenues, (ii) open new franchises, (iii) increase lease originations and minimize write-offs in our leasing portfolios, and (iv) control our selling, general and administrative expenses.

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Results of Operations

The following table sets forth for the periods indicated, certain income statement items as a percentage of total revenue:

Comparison of Three Months Ended September 27, 2008 to Three Months Ended September 29, 2007

Revenue

Revenue for the quarter ended September 27, 2008 totaled $9.1 million compared to $7.9 million for the comparable period in 2007.

Royalties increased to $5.7 million for the third quarter of 2008 from $5.2 million for the same period in 2007, a 10.2% increase.  The increase was due to higher Plato’s Closet® and Once Upon A Child® royalties of $487,000 and $114,000, respectively.  The increase in Plato’s Closet® and Once Upon A Child® royalties is primarily due to having 24 additional Plato’s Closet® and five additional Once Upon A Child® franchise stores in the third quarter of 2008 compared to the same period last year and higher franchisee retail sales in both brands.

Merchandise sales include the sale of product to franchisees either through the Play It Again Sports® buying group, or through our Computer Support Center (together, “Direct Franchisee Sales”).  For the third quarter of 2008, Direct Franchisee Sales were $777,600 compared to $797,600 for the third quarter of 2007.  The decrease is a result of management’s strategic decision to have more franchisees purchase merchandise directly from vendors and having 16 fewer Play It Again Sports® stores open than one year ago.

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Franchise fees decreased to $431,900 for the third quarter of 2008 compared to $584,100 for the third quarter of 2007.  The decrease is due to opening 19 franchises in the third quarter of 2008, compared to 30 in the same period of 2007.

Leasing income increased to $2,060,400 for the third quarter of 2008 compared to $1,173,200 for the same period in 2007.  The increase is due to a larger lease portfolio in 2008 compared to 2007.

Cost of Merchandise Sold

Cost of merchandise sold includes in-bound freight and the cost of merchandise associated with Direct Franchisee Sales.  Cost of merchandise sold decreased $33,500 or 4.4% for the third quarter of 2008 compared to the same period last year.  The decrease was primarily due to a decrease in Direct Franchisee Sales discussed in the revenue section.  Cost of merchandise sold as a percentage of Direct Franchisee Sales for the third quarter of 2008 and 2007 were 94.0% and 95.8%, respectively.

Leasing Expense

Leasing expense increased to $471,000 in the third quarter of 2008 compared to $268,700 in the third quarter of 2007.  The increase is due to interest on increased borrowings in connection with the growth of our lease portfolio.

Provision for Credit Losses

Provision for credit losses increased to $571,800 in the third quarter of 2008 compared to $142,100 in the third quarter of 2007.  The increase is due to a higher provision level for net charge-offs in the leasing segment.

        Selling, General and Administrative

The $156,600, or 3.4%, increase in selling, general and administrative expenses in the third quarter of 2008 compared to the same period in 2007 is primarily due to increases in amortization of initial direct costs, legal fees and a decrease in capitalized initial direct costs of $104,000, $42,000 and $86,000, respectively, partially offset by a $68,000 decrease in franchisee commissions.

Loss from Equity Investments

During the third quarter of 2008 and 2007, we recorded losses of $145,200 and $92,400, respectively, from our investment in Tomsten.  This represents our pro rata share of losses for the period.  As of September 27, 2008, the Company owns 18.3% of the outstanding common stock of Tomsten.

Interest Expense

Interest expense decreased to $309,600 in the third quarter of 2008 compared to $381,300 in the third quarter of 2007.  The decrease is due to lower interest rates and $2.2 million net repayment on the line of credit since year end.

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Income Taxes

The provision for income taxes was calculated at an effective rate of 40.5% and 38.4% for the third quarter of 2008 and 2007, respectively.  The lower effective rate in 2007 compared to 2008 reflects a lower amount of non-deductible expenses.

Comparison of Nine Months Ended September 27, 2008 to Nine Months Ended September 29, 2007

Revenue

Revenue for the nine months ended September 27, 2008 totaled $26.7 million compared to $23.1 million for the comparable period in 2007.

Royalties increased to $16.4 million for the first nine months of 2008 from $15.2 million for the same period in 2007, a 7.7% increase.  The increase was due to higher Plato’s Closet® and Once Upon A Child® royalties of $1,098,000 and $311,000, respectively, partially offset by lower Play It Again Sports® royalties of $281,000.  The increase in Plato’s Closet® and Once Upon A Child® royalties is primarily due to having 24 additional Plato’s Closet^® and five Once Upon A Child® franchise stores in the first nine months of 2008 compared to the same period last year and higher franchisee retail sales in both brands.

Merchandise sales include the sale of product to franchisees either through the Play It Again Sports® buying group, or through our Computer Support Center (together, “Direct Franchisee Sales”).  For the first nine months of 2008, Direct Franchisee Sales were $2,685,400 compared to $3,250,300 for the first nine months of 2007.  The decrease is a result of management’s strategic decision to have more franchisees purchase merchandise directly from vendors and having 16 fewer Play It Again Sports® stores open than one year ago.

Franchise fees increased to $1,345,500 for the first nine months of 2008 compared to $1,301,500 for the first nine months of 2007.  The Company opened 63 franchise territories in the first nine months of 2008, compared to 66 in the same period of 2007.

Leasing income increased to $5,920,000 for the first nine months of 2008 compared to $2,944,700 for the same period in 2007.  The increase is due to a larger lease portfolio in 2008 compared to 2007.