Aaron Rents RNT
December 31, 2007 - 4:58pm EST by
mickey203
2007 2008
Price: 19.26 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 10,630 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT

Sign up for free guest access to view investment idea with a 45 days delay.

  • Rental & Leasing
  • Credit Services
  • Subprime Lending
 

Description

RNT is a compelling investment right now for the following reasons:
 
Attractive industry with defensive characteristics: The Rent-to-Own (RTO) industry is a growing industry that has historically proven to be largely insensitive to economic conditions.     
 
RNT will continue to grow market share: Relative to its competitors, RNT offers a far more attractive customer value proposition and better overall customer experience, which will enable it to continue taking market share from Rent-a-Center and smaller, independent players.  RNT has consistently put up mid-to-high single digit comps and has plans to more than double its store base (from 1,400 to over 3,000), while market leader Rent-a-Center has had flattish comps and recently announced plans to close 8% of its store base.  Through a combination of same store sales growth and planned square footage growth of 10%-13%, RNT should conservatively be able to grow its top-line 13%-15% for the next several years.   
 
Significant opportunity for margin expansion and same store sales growth as new stores mature: At maturity, store-level economics are very good but a new store typically takes about 4 years to reach maturity and loses a lot of money in the first year.  Approximately 60% of RNT stores have been opened in the last three years, meaning that the company will see strong same-store sales and 300-500 bps of margin improvement from nothing more than the maturation of these immature stores.  Simply eliminating the new store drag would help margins by a couple hundred basis points.          
 
Valuation is very attractive:  RNT currently trades at 11.6x consensus 2008 EPS and about 6.3x EBITDA.  Backing out approximately $0.25/share of new store drag and the valuation is about 10x EPS and 5.7x EBITDA – extremely cheap for a business with very durable cash flows and long-term earnings growth potential of 15%-20% per year.  We believe that just the existing 1,431 company and franchised stores are currently worth $29, providing 50% upside from the current stock price.  This ascribes no value to the additional 1,500+ stores that the company believes it can open domestically.
 
Recent History
 
The stock has been weak recently, declining almost 40% from its 52-week high.  There are several reasons for this weakness, some company-specific and others market-related, but all of which we believe to be transitory.  The company-specific issues largely relate to the company’s overly aggressive square footage growth over the last 18 months.  This hurt them in two ways.  First, margins were hurt as they ramped up SG&A in anticipation of new store openings that got pushed back due to construction delays.  Second, store-level operations suffered as store managers and regional managers were too focused on opening new stores.  The result was an increase in the delinquency rate of about 100 bps, which not only hurt margins but caused investors to worry that RNT’s customers were being affected by macro conditions.  We strongly believe that the problems are execution-related and not macro-related, as the franchisee stores have continued to perform very well and have not seen any material weakness of their customer.  Management has recognized their mistake in trying to grow too fast and recently announced plans to slow down square footage growth and focus on improving store-level operations.  We expect that these problems will be fixed within the next 3-6 months.
 
The market-related issues relate generally to overall consumer weakness and general investor aversion of all things consumer, particularly those businesses that serve the lower-income demographic.  We think this is a mistake, as investors do not understand the business model or how the business will perform in a tougher economic environment.  RNT has the added misfortune of being lumped in with companies that provide credit to subprime borrowers.  This is another example of investors misunderstanding the business model - RNT does NOT take on any credit risk.  Title to the merchandise does not pass to the customer until the end of the rental term (i.e., after the merchandise has been paid for).  In the event that the customer fails to make the rental payments, Aaron Rents simply takes back the merchandise and rents it out to someone else.  That is why charge-offs across the industry have consistently been below 3% of revenues.  In addition, the typical RTO customer is not impacted by the tightening of subprime credit – the lack of available credit is what forces the customer into the rent-to-own transaction in the first place (a tightening of subprime credit will actually benefit RNT as the lack of credit makes rent-to-own the only viable alternative for more customers).            
 
Company Overview
 
With 1,369company and franchise stores, Aaron Rents is the number two competitor in the Rent-to-Own (RTO) industry, behind Rent-a-Center, which operates 3,361 stores.  Of the 1,369 Aaron Rents stores, 927 are company-owned with the rest being franchised.  Under the franchise agreement, the franchisee is required to pay a $50,000 per store up-front fee and, for new franchisees or existing franchisees who are renewing their agreements, a 6% royalty fee.  The royalty fee was recently increased from 5% to 6% so the blended rate is lower than 6% but will increase to 6% as existing franchisees renew their contracts. 
 
The company also operates 61 rent-to-rent stores (basically short-term furniture rentals to commercial customers) and 31 Rimco stores (rent-to-own stores focused on tires, rims, etc.).  The rent-to-rent business is in decline and is generally being run for cash.  The Rimco business is still in start-up mode.  Neither business is part of the investment thesis, though the Rimco division could provide some upside if the concept proves to be viable. 
 
In a typical rent-to-own transaction the customer takes possession (but not title) of the merchandise on a week-to-week or month-to-month rental contract.  At any time during the contract the customer can buy-out the contract and take immediate ownership or can cancel the contract with no penalty by simply returning the merchandise.  If the customer keeps current on the rental agreement for the stipulated period of time (e.g., 24 months), then title transfers and the customer owns the merchandise. 
 
The typical rent-to-own customer is someone who does not have the cash to buy the goods up front and does not have access to credit.  For these people, the only way that they can obtain their furniture, appliances, and electronics is on a rental basis – the “rent-to-own” feature allows them to eventually own the merchandise rather than be perpetual renters.  The downside, of course, is that by the time the customer takes ownership of the specific item they will have paid much more (e.g., 2x – 3x) than they would have had they purchased it up front.  Again, for these customers this is the only option that they have to acquire the goods.  Furthermore, in the event that the customer over-extends himself and finds that he cannot afford his flat-screen TV, he can simply return the TV without any obligation, no outstanding debt to pay off, no damage to his credit rating, etc.
 
It is important to understand that title does not pass to the customer until the end of the rental contract.  This explains why, despite the low-income consumer, the charge-off rate in the industry has consistently been so low (less than 3% of revenues).  The company is taking no credit risk - if the customer stops making the monthly payments, the company can simply repossess the item and lease it out to another customer.
 
Industry Overview
 
The RTO industry consists of approximately 8,500 stores and generates about $6.7 billion in annual revenue.  The target customer (75% of RTO customers) has a household income between $15,000 and $50,000.  The industry currently serves only 2.8 million of the 45 million households in the U.S. that fall within this demographic.  According to a recent Rent-a-Center investor presentation, there is the potential for another 3,000 – 5,000 RTO stores domestically.
 
Furniture is the largest product category, constituting 40% of all rentals.  Computers and electronics make up 38% of rentals, with the remainder being appliances and other miscellaneous items.  
 
One of the most attractive features of the industry, particularly given the current economic environment, is its general lack of cyclicality.  From 1996 to 2006 the industry grew revenues at a 5.6% CAGR without having any down years.  Even in the 2000 - 2002 period the industry grew at over 5% in each year.            
 
This industry has proven to be largely acyclical because of the recurring revenue from merchandise that is out on rental and because, for a large percentage of customers, these payments are not discretionary.  For a customer paying $30/month for a bed or a sofa, this is not a discretionary purchase.  While some categories are clearly more discretionary (e.g., not everyone needs a 42” plasma TV), these tend to be the items that customers value the most and once they have them they do not want to lose them. 
 
A lot of people in the industry would go so far as to argue that this industry is counter-cyclical, as tough economic times force people into the rent-to-own category.  This seems like a bit of a stretch but there is probably some element of this that occurs.
 
Regardless of the degree of acyclicality (or counter-cyclicality), there are some aspects of this industry that clearly make it very attractive relative to other consumer segments:
 
- It is not dependent on weather or mall-traffic
- There is no fashion element
- Not affected by housing turnover, housing prices, or mortgage resets (customers do not own homes)
- Not impacted by availability of subprime credit (this is one area where the industry may be counter-cyclical – lack of credit is what forces people to do rent-to-own transactions).
 
The one macro condition that will affect this industry (and many other industries) is the unemployment rate.  The typical RTO customer lives paycheck-to-paycheck and is highly dependent on his or her job for income.  If we do see a recession with a significant rise in unemployment it is logical that this industry will suffer (though the industry did grow through the 2001-2002 recession).   
 
Investment Thesis
 
The key aspects of this investment thesis are as follows:
 
Defensive business model with largely recurring revenues that will hold up well in an economic slowdown
 
As discussed in detail above, this business model should hold up reasonably well even in a tougher economic environment. 
 
Superior and differentiated business model will enable RNT to significantly grow its square footage and increase its market share over the next several years
 
Regardless of how the overall industry performs, Aaron Rents will continue to take significant market share (new stores and comp sales) because it offers customers a far superior value proposition and generally more positive customer experience. 
 
To understand the favorable value proposition, it is helpful to compare a typical transaction at Aaron Rents vs. Rent-a-Center:
 
 
RNT
RCII
Cost of Good
$1,000
$1,000
Approximate Retail Price
$1,300
$1,300
   Gross Margin
30%
30%
Total Cost of Ownership
$2,600
$4,000
Multiple of Cost
2.6x
4.0x
 
There is no real difference in the quality of brands or goods sold at Aaron Rents and Rent-a-Center.  The only difference is that RCII prices their rentals with the goal of achieving total rental revenues equaling about 4x their original cost, whereas RNT is targeting between 2x and 3x.  So why would anyone pay more to rent from RCII?  Really two reasons.  First, RCII has over twice as many locations so there is a convenience/awareness factor.  More importantly, RCII offers primarily weekly rentals (86% of rentals are weekly) whereas RNT only offers monthly (82%) or semi-monthly (17%) rentals, with only 1% of customers having weekly contracts.  The difference for the customer is the size of the rental payment – the monthly payments at RNT are obviously larger than the weekly payments at RCII.  So even though the total monthly cost is much less at RNT (average monthly rental revenue at RNT is $106 vs $161 at RCII), many people in this demographic simply can’t come up with enough cash to make a full monthly payment.  These customers have no choice but to rent from RCII.  From Aaron Rents’ perspective, the lower pricing results in a lower Gross Margin than RCII but store-level operating margins should be comparable as RNT has much higher volumes/store and operating expenses are lower since it is less costly to collect monthly than weekly.
 
There are other features that lead to a more favorable customer experience at Aaron Rents.  Aaron Rents tends to have larger stores (9k square feet vs. 5k square feet) in better locations than Rent-a-Center.  Recently Aaron Rents has moved to having freestanding stores vs. the typical strip center locations.  In addition to having better economics, these stores look better and increase the overall image of the company. 
 
Aaron Rents also has a more customer-friendly culture, which impacts several aspects of the customer experience.  Aaron Rents wants every customer to end up owning the rented item rather than having the item come back to the store to be re-rented (over 45% of RNT customers end up owning the rented merchandise vs. 25% at RCII).  It is actually more profitable when the items get re-rented several times but customers are more satisfied when they end up owning the merchandise (70% of RNT customers are repeat customers).  Also, this strategy results in a greater percentage of new vs. used merchandise in the stores (60% of merchandise at RNT stores is new vs. 40% at RCII).        
 
The implication of RNT offering a better overall value proposition to the customer is that RNT will be able to continue taking market share by growing comp sales at existing stores and aggressively growing new stores.  The company believes that they can eventually have over 3,000 stores, which seems reasonable given that their stores do very well whenever they locate right next to a Wal-Mart and they have had a lot of success locating stores right next to Rent-a-Center stores.   
 
Immature store base masks true margin, cash flow, and return profile of the business
 
The unit-level economics of an Aaron Rents store are very good (40% cash-on-cash returns by Year 5, according to a recent investor presentation) but they operate at a significant loss in their first year and take about four years to reach maturity.  The rapid square footage growth over the last several years has resulted in a very immature store base that is negatively impacting overall results for Aaron Rents.  As these stores mature the company will generate very strong comps and several hundred basis points of margin improvement, compared to a significant operating loss currently ($0.06/share in the most recent quarter).
 
The sales and operating contribution of a new store (from a recent investor presentation):
 
 
Year 1
Year 2
Year 3
Year 4
Year 5
Revenue
505
959
1,117
1,233
1,310
Same-store sales growth
 
89.9%
16.5%
10.4%
6.2%
Store-level contribution
(108)
106
177
222
239
Margin
-21.4%
11.1%
15.8%
18.0%
18.2%
 
The breakdown of stores by age (from the most recent franchisee offering circular):
 
 
Year 1
Year 2
Year 3
Year 4
Year 5
Number of Stores
256
188
129
94
71
   % of Total
35%
25%
17%
13%
10%
 
So according to this data, 60% of the company-owned store base is less than 3 years old (this number is probably higher now, as this data is from the beginning of 2007 and they have opened a lot of stores in 2007).  As these stores mature, corporate-level margins and returns will improve dramatically. 
 
We believe that the core earnings power of just the existing company-owned stores (ignoring franchise stores, rent-to-rent stores, and any new stores) is approximately $2.84, compared to 2008 guidance for the entire company of $1.60 - $1.75.  We arrive at the $2.84 number by assuming that each of the existing stores eventually gets to the Year 5 company average (which should be conservative given that many of the older company stores are performing at much higher levels of profitability).
 
Number of Existing Company Stores
927
 
Sales / Store ($000)
1,310
 
EBIT Contribution per Store
239.0
 
   Margin
18.2%
 
 
 
 
Total
 
 
   Sales ($ millions)
1,214
 
   EBIT Contribution
313
 
   Less: Overhead / Field-Level Allocation
(61)
5% of sales
   EBIT
252
 
   Less: Taxes
(96)
38% tax rate
   Net Income
156
 
   EPS
$2.84
 
      Shares Outstanding
55.0
 
 
Recent decision to moderate square footage growth will result in improved operating performance and positive free cash flow
 
In October the company announced that it was going to slow its rate of square footage growth for 2008 to 10%-13%, down from an estimated 15% in 2007.  Furthermore, roughly half of new store openings in 2008 will be franchise stores whereas in 2007 about 75% of new stores will be company stores.  This is important for a few reasons.  First, it will allow the company to focus on improving store-level execution, which has suffered over the last year as management has been too focused on new store growth.  Second, it will enable the company to realize the benefits of store maturation – over the last couple years the benefit of store maturation has been more than offset by the addition of new stores and the associated start-up losses.  Third, the company will go from a significant user of cash ($66mm over the last 12 months and almost $100mm in aggregate since 2002) to a generator of free cash.  Management has not given guidance for 2008 free cash flow but the biggest drivers of free cash flow are additions to rental merchandise ($735mm over the last 12 months) and capex ($136mm over the last 12 months).  Both of these numbers will come down materially in 2008 which, along with increased net income, should result in positive free cash flow.       
 
Same-Store Sales will Benefit from Lapping of Early Buyout Price Increase
 
Reported same-store sales are being negatively impacted by a decision made last year to increase the price charged for early buyouts.  What happens in this industry is that when customers come into money (e.g., tax refund) they will often use that money to buyout the rental contract and take ownership of the merchandise.  This helps revenue (and same-store sales) in the short-term but hurts profitability since these sales come at much lower gross margins than the rentals (30% vs. 60%).  During the first few quarters of 2006 the company was experiencing an unusually high level of early buyouts, which was hurting margins.  To discourage buyouts, management increased the prices to purchase merchandise.  The impact has been fewer (and more profitable) early buyouts, but also a negative impact to comp sales.  This trend will reverse and comp sales will benefit when the price increase starts to lap in 4Q07 and to a greater extent in 1Q08.  Although this is more cosmetic than fundamental, investors and analysts are very focused on comp sales so the stock should benefit as this trend plays out.
 
Valuation
 
RNT currently trades at 11.6x consensus 2008 EPS of $1.66 and 6.3x consensus 2008 EBITDA of 191mm.  Adjusting for approximately $0.25/share of new store drag gets to a valuation of 10x EPSor about 5.7x EBITDA. 
 
As detailed above, we believe the core earnings power of just the existing company-owned stores is $2.84.  Using a conservative 13x multiple on the $2.84 gets to a valuation of $37 for the existing company stores.  Using the same analysis for existing franchise stores adds another $3.25 of value ($0.25 of earnings power at 13x) for a total valuation of just over $40.  Discounting back at a 10% rate over the four years or so that it will take for these stores to reach maturity gets to a present value of $27.  Adding another $2 for the rent-to-rent business (5.5x EBITDA) gets to a total valuation – just for existing stores – of $29, 50% above the current price.  This analysis ascribes no value to the next 1,500 – 2,000 stores that the company is planning to open over the next 7-10 years.  For reference, based on a store-level DCF analysis we believe that the NPV of a new company store is ~$850,000 and for a new franchise store it is ~$600,000.
 
Risks
 
The most significant fundamental, longer-term risk for this stock is a material rise in the unemployment rate, particularly among the lower-income demographic.  A shorter-term risk is that it takes the company longer than expected to fix the store-level operational issues that have arisen as a result of the rapid growth over the last couple years.  There is also general market risk if this stock continues to be lumped in with other discretionary consumer stocks and/or financial companies that cater to the subprime consumer.

Catalyst

Improvement in store-level operations (mainly collections) and more strong same-store sales from company and franchise stores over the next couple quarters will get investors comfortable that this business will perform well even in a weak economy. Will see significant earnings growth and multiple expansion over the next twelve months.
    sort by   Expand   New

    Description

    RNT is a compelling investment right now for the following reasons:
     
    Attractive industry with defensive characteristics: The Rent-to-Own (RTO) industry is a growing industry that has historically proven to be largely insensitive to economic conditions.     
     
    RNT will continue to grow market share: Relative to its competitors, RNT offers a far more attractive customer value proposition and better overall customer experience, which will enable it to continue taking market share from Rent-a-Center and smaller, independent players.  RNT has consistently put up mid-to-high single digit comps and has plans to more than double its store base (from 1,400 to over 3,000), while market leader Rent-a-Center has had flattish comps and recently announced plans to close 8% of its store base.  Through a combination of same store sales growth and planned square footage growth of 10%-13%, RNT should conservatively be able to grow its top-line 13%-15% for the next several years.   
     
    Significant opportunity for margin expansion and same store sales growth as new stores mature: At maturity, store-level economics are very good but a new store typically takes about 4 years to reach maturity and loses a lot of money in the first year.  Approximately 60% of RNT stores have been opened in the last three years, meaning that the company will see strong same-store sales and 300-500 bps of margin improvement from nothing more than the maturation of these immature stores.  Simply eliminating the new store drag would help margins by a couple hundred basis points.          
     
    Valuation is very attractive:  RNT currently trades at 11.6x consensus 2008 EPS and about 6.3x EBITDA.  Backing out approximately $0.25/share of new store drag and the valuation is about 10x EPS and 5.7x EBITDA – extremely cheap for a business with very durable cash flows and long-term earnings growth potential of 15%-20% per year.  We believe that just the existing 1,431 company and franchised stores are currently worth $29, providing 50% upside from the current stock price.  This ascribes no value to the additional 1,500+ stores that the company believes it can open domestically.
     
    Recent History
     
    The stock has been weak recently, declining almost 40% from its 52-week high.  There are several reasons for this weakness, some company-specific and others market-related, but all of which we believe to be transitory.  The company-specific issues largely relate to the company’s overly aggressive square footage growth over the last 18 months.  This hurt them in two ways.  First, margins were hurt as they ramped up SG&A in anticipation of new store openings that got pushed back due to construction delays.  Second, store-level operations suffered as store managers and regional managers were too focused on opening new stores.  The result was an increase in the delinquency rate of about 100 bps, which not only hurt margins but caused investors to worry that RNT’s customers were being affected by macro conditions.  We strongly believe that the problems are execution-related and not macro-related, as the franchisee stores have continued to perform very well and have not seen any material weakness of their customer.  Management has recognized their mistake in trying to grow too fast and recently announced plans to slow down square footage growth and focus on improving store-level operations.  We expect that these problems will be fixed within the next 3-6 months.
     
    The market-related issues relate generally to overall consumer weakness and general investor aversion of all things consumer, particularly those businesses that serve the lower-income demographic.  We think this is a mistake, as investors do not understand the business model or how the business will perform in a tougher economic environment.  RNT has the added misfortune of being lumped in with companies that provide credit to subprime borrowers.  This is another example of investors misunderstanding the business model - RNT does NOT take on any credit risk.  Title to the merchandise does not pass to the customer until the end of the rental term (i.e., after the merchandise has been paid for).  In the event that the customer fails to make the rental payments, Aaron Rents simply takes back the merchandise and rents it out to someone else.  That is why charge-offs across the industry have consistently been below 3% of revenues.  In addition, the typical RTO customer is not impacted by the tightening of subprime credit – the lack of available credit is what forces the customer into the rent-to-own transaction in the first place (a tightening of subprime credit will actually benefit RNT as the lack of credit makes rent-to-own the only viable alternative for more customers).            
     
    Company Overview
     
    With 1,369company and franchise stores, Aaron Rents is the number two competitor in the Rent-to-Own (RTO) industry, behind Rent-a-Center, which operates 3,361 stores.  Of the 1,369 Aaron Rents stores, 927 are company-owned with the rest being franchised.  Under the franchise agreement, the franchisee is required to pay a $50,000 per store up-front fee and, for new franchisees or existing franchisees who are renewing their agreements, a 6% royalty fee.  The royalty fee was recently increased from 5% to 6% so the blended rate is lower than 6% but will increase to 6% as existing franchisees renew their contracts. 
     
    The company also operates 61 rent-to-rent stores (basically short-term furniture rentals to commercial customers) and 31 Rimco stores (rent-to-own stores focused on tires, rims, etc.).  The rent-to-rent business is in decline and is generally being run for cash.  The Rimco business is still in start-up mode.  Neither business is part of the investment thesis, though the Rimco division could provide some upside if the concept proves to be viable. 
     
    In a typical rent-to-own transaction the customer takes possession (but not title) of the merchandise on a week-to-week or month-to-month rental contract.  At any time during the contract the customer can buy-out the contract and take immediate ownership or can cancel the contract with no penalty by simply returning the merchandise.  If the customer keeps current on the rental agreement for the stipulated period of time (e.g., 24 months), then title transfers and the customer owns the merchandise. 
     
    The typical rent-to-own customer is someone who does not have the cash to buy the goods up front and does not have access to credit.  For these people, the only way that they can obtain their furniture, appliances, and electronics is on a rental basis – the “rent-to-own” feature allows them to eventually own the merchandise rather than be perpetual renters.  The downside, of course, is that by the time the customer takes ownership of the specific item they will have paid much more (e.g., 2x – 3x) than they would have had they purchased it up front.  Again, for these customers this is the only option that they have to acquire the goods.  Furthermore, in the event that the customer over-extends himself and finds that he cannot afford his flat-screen TV, he can simply return the TV without any obligation, no outstanding debt to pay off, no damage to his credit rating, etc.
     
    It is important to understand that title does not pass to the customer until the end of the rental contract.  This explains why, despite the low-income consumer, the charge-off rate in the industry has consistently been so low (less than 3% of revenues).  The company is taking no credit risk - if the customer stops making the monthly payments, the company can simply repossess the item and lease it out to another customer.
     
    Industry Overview
     
    The RTO industry consists of approximately 8,500 stores and generates about $6.7 billion in annual revenue.  The target customer (75% of RTO customers) has a household income between $15,000 and $50,000.  The industry currently serves only 2.8 million of the 45 million households in the U.S. that fall within this demographic.  According to a recent Rent-a-Center investor presentation, there is the potential for another 3,000 – 5,000 RTO stores domestically.
     
    Furniture is the largest product category, constituting 40% of all rentals.  Computers and electronics make up 38% of rentals, with the remainder being appliances and other miscellaneous items.  
     
    One of the most attractive features of the industry, particularly given the current economic environment, is its general lack of cyclicality.  From 1996 to 2006 the industry grew revenues at a 5.6% CAGR without having any down years.  Even in the 2000 - 2002 period the industry grew at over 5% in each year.            
     
    This industry has proven to be largely acyclical because of the recurring revenue from merchandise that is out on rental and because, for a large percentage of customers, these payments are not discretionary.  For a customer paying $30/month for a bed or a sofa, this is not a discretionary purchase.  While some categories are clearly more discretionary (e.g., not everyone needs a 42” plasma TV), these tend to be the items that customers value the most and once they have them they do not want to lose them. 
     
    A lot of people in the industry would go so far as to argue that this industry is counter-cyclical, as tough economic times force people into the rent-to-own category.  This seems like a bit of a stretch but there is probably some element of this that occurs.
     
    Regardless of the degree of acyclicality (or counter-cyclicality), there are some aspects of this industry that clearly make it very attractive relative to other consumer segments:
     
    - It is not dependent on weather or mall-traffic
    - There is no fashion element
    - Not affected by housing turnover, housing prices, or mortgage resets (customers do not own homes)
    - Not impacted by availability of subprime credit (this is one area where the industry may be counter-cyclical – lack of credit is what forces people to do rent-to-own transactions).
     
    The one macro condition that will affect this industry (and many other industries) is the unemployment rate.  The typical RTO customer lives paycheck-to-paycheck and is highly dependent on his or her job for income.  If we do see a recession with a significant rise in unemployment it is logical that this industry will suffer (though the industry did grow through the 2001-2002 recession).   
     
    Investment Thesis
     
    The key aspects of this investment thesis are as follows:
     
    Defensive business model with largely recurring revenues that will hold up well in an economic slowdown
     
    As discussed in detail above, this business model should hold up reasonably well even in a tougher economic environment. 
     
    Superior and differentiated business model will enable RNT to significantly grow its square footage and increase its market share over the next several years
     
    Regardless of how the overall industry performs, Aaron Rents will continue to take significant market share (new stores and comp sales) because it offers customers a far superior value proposition and generally more positive customer experience. 
     
    To understand the favorable value proposition, it is helpful to compare a typical transaction at Aaron Rents vs. Rent-a-Center:
     
     
    RNT
    RCII
    Cost of Good
    $1,000
    $1,000
    Approximate Retail Price
    $1,300
    $1,300
       Gross Margin
    30%
    30%
    Total Cost of Ownership
    $2,600
    $4,000
    Multiple of Cost
    2.6x
    4.0x
     
    There is no real difference in the quality of brands or goods sold at Aaron Rents and Rent-a-Center.  The only difference is that RCII prices their rentals with the goal of achieving total rental revenues equaling about 4x their original cost, whereas RNT is targeting between 2x and 3x.  So why would anyone pay more to rent from RCII?  Really two reasons.  First, RCII has over twice as many locations so there is a convenience/awareness factor.  More importantly, RCII offers primarily weekly rentals (86% of rentals are weekly) whereas RNT only offers monthly (82%) or semi-monthly (17%) rentals, with only 1% of customers having weekly contracts.  The difference for the customer is the size of the rental payment – the monthly payments at RNT are obviously larger than the weekly payments at RCII.  So even though the total monthly cost is much less at RNT (average monthly rental revenue at RNT is $106 vs $161 at RCII), many people in this demographic simply can’t come up with enough cash to make a full monthly payment.  These customers have no choice but to rent from RCII.  From Aaron Rents’ perspective, the lower pricing results in a lower Gross Margin than RCII but store-level operating margins should be comparable as RNT has much higher volumes/store and operating expenses are lower since it is less costly to collect monthly than weekly.
     
    There are other features that lead to a more favorable customer experience at Aaron Rents.  Aaron Rents tends to have larger stores (9k square feet vs. 5k square feet) in better locations than Rent-a-Center.  Recently Aaron Rents has moved to having freestanding stores vs. the typical strip center locations.  In addition to having better economics, these stores look better and increase the overall image of the company. 
     
    Aaron Rents also has a more customer-friendly culture, which impacts several aspects of the customer experience.  Aaron Rents wants every customer to end up owning the rented item rather than having the item come back to the store to be re-rented (over 45% of RNT customers end up owning the rented merchandise vs. 25% at RCII).  It is actually more profitable when the items get re-rented several times but customers are more satisfied when they end up owning the merchandise (70% of RNT customers are repeat customers).  Also, this strategy results in a greater percentage of new vs. used merchandise in the stores (60% of merchandise at RNT stores is new vs. 40% at RCII).        
     
    The implication of RNT offering a better overall value proposition to the customer is that RNT will be able to continue taking market share by growing comp sales at existing stores and aggressively growing new stores.  The company believes that they can eventually have over 3,000 stores, which seems reasonable given that their stores do very well whenever they locate right next to a Wal-Mart and they have had a lot of success locating stores right next to Rent-a-Center stores.   
     
    Immature store base masks true margin, cash flow, and return profile of the business
     
    The unit-level economics of an Aaron Rents store are very good (40% cash-on-cash returns by Year 5, according to a recent investor presentation) but they operate at a significant loss in their first year and take about four years to reach maturity.  The rapid square footage growth over the last several years has resulted in a very immature store base that is negatively impacting overall results for Aaron Rents.  As these stores mature the company will generate very strong comps and several hundred basis points of margin improvement, compared to a significant operating loss currently ($0.06/share in the most recent quarter).
     
    The sales and operating contribution of a new store (from a recent investor presentation):
     
     
    Year 1
    Year 2
    Year 3
    Year 4
    Year 5
    Revenue
    505
    959
    1,117
    1,233
    1,310
    Same-store sales growth
     
    89.9%
    16.5%
    10.4%
    6.2%
    Store-level contribution
    (108)
    106
    177
    222
    239
    Margin
    -21.4%
    11.1%
    15.8%
    18.0%
    18.2%
     
    The breakdown of stores by age (from the most recent franchisee offering circular):
     
     
    Year 1
    Year 2
    Year 3
    Year 4
    Year 5
    Number of Stores
    256
    188
    129
    94
    71
       % of Total
    35%
    25%
    17%
    13%
    10%
     
    So according to this data, 60% of the company-owned store base is less than 3 years old (this number is probably higher now, as this data is from the beginning of 2007 and they have opened a lot of stores in 2007).  As these stores mature, corporate-level margins and returns will improve dramatically. 
     
    We believe that the core earnings power of just the existing company-owned stores (ignoring franchise stores, rent-to-rent stores, and any new stores) is approximately $2.84, compared to 2008 guidance for the entire company of $1.60 - $1.75.  We arrive at the $2.84 number by assuming that each of the existing stores eventually gets to the Year 5 company average (which should be conservative given that many of the older company stores are performing at much higher levels of profitability).
     
    Number of Existing Company Stores
    927
     
    Sales / Store ($000)
    1,310
     
    EBIT Contribution per Store
    239.0
     
       Margin
    18.2%
     
     
     
     
    Total
     
     
       Sales ($ millions)
    1,214
     
       EBIT Contribution
    313
     
       Less: Overhead / Field-Level Allocation
    (61)
    5% of sales
       EBIT
    252
     
       Less: Taxes
    (96)
    38% tax rate
       Net Income
    156
     
       EPS
    $2.84
     
          Shares Outstanding
    55.0
     
     
    Recent decision to moderate square footage growth will result in improved operating performance and positive free cash flow
     
    In October the company announced that it was going to slow its rate of square footage growth for 2008 to 10%-13%, down from an estimated 15% in 2007.  Furthermore, roughly half of new store openings in 2008 will be franchise stores whereas in 2007 about 75% of new stores will be company stores.  This is important for a few reasons.  First, it will allow the company to focus on improving store-level execution, which has suffered over the last year as management has been too focused on new store growth.  Second, it will enable the company to realize the benefits of store maturation – over the last couple years the benefit of store maturation has been more than offset by the addition of new stores and the associated start-up losses.  Third, the company will go from a significant user of cash ($66mm over the last 12 months and almost $100mm in aggregate since 2002) to a generator of free cash.  Management has not given guidance for 2008 free cash flow but the biggest drivers of free cash flow are additions to rental merchandise ($735mm over the last 12 months) and capex ($136mm over the last 12 months).  Both of these numbers will come down materially in 2008 which, along with increased net income, should result in positive free cash flow.       
     
    Same-Store Sales will Benefit from Lapping of Early Buyout Price Increase
     
    Reported same-store sales are being negatively impacted by a decision made last year to increase the price charged for early buyouts.  What happens in this industry is that when customers come into money (e.g., tax refund) they will often use that money to buyout the rental contract and take ownership of the merchandise.  This helps revenue (and same-store sales) in the short-term but hurts profitability since these sales come at much lower gross margins than the rentals (30% vs. 60%).  During the first few quarters of 2006 the company was experiencing an unusually high level of early buyouts, which was hurting margins.  To discourage buyouts, management increased the prices to purchase merchandise.  The impact has been fewer (and more profitable) early buyouts, but also a negative impact to comp sales.  This trend will reverse and comp sales will benefit when the price increase starts to lap in 4Q07 and to a greater extent in 1Q08.  Although this is more cosmetic than fundamental, investors and analysts are very focused on comp sales so the stock should benefit as this trend plays out.
     
    Valuation
     
    RNT currently trades at 11.6x consensus 2008 EPS of $1.66 and 6.3x consensus 2008 EBITDA of 191mm.  Adjusting for approximately $0.25/share of new store drag gets to a valuation of 10x EPSor about 5.7x EBITDA. 
     
    As detailed above, we believe the core earnings power of just the existing company-owned stores is $2.84.  Using a conservative 13x multiple on the $2.84 gets to a valuation of $37 for the existing company stores.  Using the same analysis for existing franchise stores adds another $3.25 of value ($0.25 of earnings power at 13x) for a total valuation of just over $40.  Discounting back at a 10% rate over the four years or so that it will take for these stores to reach maturity gets to a present value of $27.  Adding another $2 for the rent-to-rent business (5.5x EBITDA) gets to a total valuation – just for existing stores – of $29, 50% above the current price.  This analysis ascribes no value to the next 1,500 – 2,000 stores that the company is planning to open over the next 7-10 years.  For reference, based on a store-level DCF analysis we believe that the NPV of a new company store is ~$850,000 and for a new franchise store it is ~$600,000.
     
    Risks
     
    The most significant fundamental, longer-term risk for this stock is a material rise in the unemployment rate, particularly among the lower-income demographic.  A shorter-term risk is that it takes the company longer than expected to fix the store-level operational issues that have arisen as a result of the rapid growth over the last couple years.  There is also general market risk if this stock continues to be lumped in with other discretionary consumer stocks and/or financial companies that cater to the subprime consumer.

    Catalyst

    Improvement in store-level operations (mainly collections) and more strong same-store sales from company and franchise stores over the next couple quarters will get investors comfortable that this business will perform well even in a weak economy. Will see significant earnings growth and multiple expansion over the next twelve months.

    Messages


    SubjectRe: Comments and Questions
    Entry01/11/2008 05:50 PM
    Membermickey203
    Compass,

    Thanks for the questions.

    1) You are right - I misread the way the data was presented in the UFOC. The correct data is below and is as of September 30. 40% of stores are less than 4 years old. I think the general point still applies.

    Year 1 Year 2 Year 3 Year 4 Year 5 Over 5
    146 105 124 111 93 348

    2) To the best of my knowledge there is no data going back to the early 90s. The industry association (APRO) began to hire a third party in the mid-90s so that is when all the data comes from. Beyond that, my knowledge is just anecdotal but I think pretty reliable. I have spoken with a lot of outside parties who have been in the industry for 20+ years (including the General Counsel of APRO) and the feedback is pretty consistent that this business does well in tougher economic times. Again, it is a stretch to say it is counter-cyclical or even acyclial but it clearly has defensive qualities. The key thing to focus on is employment - in areas where the job market is tough this business will face challenges.

    Incidentally, I have spent the last few days following up with some of the franchisees that I speak to regularly. It sounds like business is going very well, at least for the franchisees. Their third largest franchisee had the best November he has ever had. It also sounds like the company is doing better but maybe not as well as the franchisees. I don't think the collections issue has gotten any worse and may on the margin be getting a bit better. They are certainly focused on the issue. And they are definitely not seeing the same weakness in demand that other retailers are seeing.

    3) Hard to say the impact of lapping the early payout issue. I talked to Gil Danielson (CFO) and he guessed that it may help comps by 1 or 2 points. It will start to have a positive impact this quarter but becomes a bigger driver next quarter.

    SubjectChannel Checks
    Entry01/14/2008 09:20 AM
    Memberengrm842
    "Incidentally, I have spent the last few days following up with some of the franchisees that I speak to regularly. It sounds like business is going very well, at least for the franchisees. Their third largest franchisee had the best November he has ever had."

    How was business in December? A fair number of companies had great October/November, only to see a significant fall off in December.



    SubjectRe: Channel Checks
    Entry01/14/2008 04:03 PM
    Membermickey203
    December was good as well - these franchisees did not see any drop-off in business.

    The one thing that I want to emphasize is that these are franchisees stores not company stores so they may not be a good indication of how the quarter is going to come in. I was just focused on how the current economic environment affects the RTO customer since it has been quite a few years since the defensive nature of this industry has been tested. Over the last year or so there has been a significant divergence in the performance of the company stores vs. the franchise stores. The company is saying that these are execution issues rather than macro issues. As long as the franchisee stores perform well then I can buy the company's argument.

    My guess is that the company will show signs of improvement this quarter though I doubt they are doing as well as the franchisees. Given the low expectations in the stock, I think incremental improvement will be viewed very favorably.

    SubjectUpdate?
    Entry04/17/2008 10:21 AM
    Memberruby831
    Mickey -
    Curious to hear if you have any update from store owners. I am wondering about the ability of RNT customers to keep up with monthly payments during these times...

    Would be grateful for anything you can add.

    Thank you.

    Subjectre: Update
    Entry04/18/2008 10:58 AM
    Membermickey203
    As best I can tell trends are still good. I checked in with one of their franchisees a couple days ago and his business is better than ever. They just had their management convention a few weeks ago and in talking to other franchisees it seems like their business is strong as well. Even the two franchisees from Florida (where the market is awful) are starting to see things stabilize. I met with Charlie (CEO) and Gil (CFO) a few weeks ago as well and I got the sense that their business is improving as well. They said that the charge-off issue is getting better.

    The thing to pay attention to is the unemployment rate. As long as RNT customers have jobs this business does well. As management says, "our customers are always in a recession." But if they lose their jobs they will clearly stop paying bills since they don't have any cash saved up.

    The rebate checks that are coming out in May and June will help RNT a lot. They get a big boost to their business during tax refund season so this is like a second refund season. It is especially good because it comes during a time in the year that is generally pretty slow.
      Back to top