|Shares Out. (in M):||60||P/E||0.0x||0.0x|
|Market Cap (in $M):||2,153||P/FCF||0.0x||0.0x|
|Net Debt (in $M):||729||EBIT||0||0|
I recommend a long position in the common equity of Rent-A-Center Inc (NDSQ:RCII) at $36.00 per share. I calculate that the stock has an intrinsic value of $52.20 per fully diluted share today (45% upside), and believe that the company will continue to compound intrinsic value for many years to come through cash flow generation and investment in high ROIC adjacencies to its core business.
I. INVESTMENT THESIS:
II. BUSINESS DESCRIPTION:
RCII, headquartered in Plano, TX, has four reportable segments:
1) Core U.S.: RCII’s Core U.S. division is comprised of a chain of 2,973 company-owned stores in the U.S. and Puerto Rico that offer new and used furniture, electronics, and appliances to consumers on a rent-to-own (RTO) basis. The Core U.S. Division contributed $2.7 billion of sales (88.5%) and $401 million of EBITDA (94.8%) in the LTM period.
2) RAC Acceptance: RCII’s RAC Acceptance division places kiosks within third-party retail locations (retail partners). When a customer does not qualify for the retail partners’ credit program, the customer is introduced to a RAC Acceptance salesperson, who offers the RTO financing option to the customer. If the customer accepts the RTO agreement, RAC Acceptance purchases the item from the store at retail, and enters into a rental contract with the customer. As of 2Q12, RCII operates 811 RAC Acceptance kiosks, which contributed $279 million of sales (9.2%) and $38.5 million of EBITDA (9.1%) in the LTM period
3) International: RCII operates 67 and 32 company-owned stores in Mexico and Canada, respectively. These stores are substantially the same as in the U.S. segment. The international division contributed $26.9 million of sales (0.9%) and -$19.3 million of EBITDA (-4.6%) in the LTM period.
4) ColorTyme: RCII also owns ColorTyme, which franchises the RTO model to 219 locations (as of 2Q12). ColorTyme contributed $41 million of sales (1.4%) and $3.1 million of EBITDA (0.7%) in the LTM period.
The actual Rent-To-Own transaction involves a customer purchasing a brand name durable good (electronics, furniture, appliances) without a traditional credit check:
|($mm except per share)|
|Share Price (8/24/12)||$36.00|
|Cash and Equivalents:||$101.1|
|Working Capital Adjustment||$62.7|
|DTL Reversal Adjustment:||$100.0|
IV. CORE U.S. DIVISION: DISCUSSION AND VALUATION
The Core U.S. division provides both the margin of safety (in that this division alone is worth more than RCII’s current EV), and the cash flow required to fund RCII’s growth initiatives. This business caters to customers with very low or no credit, generally with income of $15,000 to $50,000, who are always pressured by the economic environment and for whom the only way to obtain the durable goods they need or want is often RTO. The business model is widely disliked by investors due to misperception that the company is a closeted subprime lender, with all the curb appeal of a $3 billion pawn shop. In reality, there are many qualitative and quantitative reasons that support the assertion that this is a good business:
Because RCII’s Core U.S. division is mature and predictable, I value it by simply capitalizing its normalized unlevered FCF at its cost of capital less its perpetual growth rate. Per the financials below, the division should generate $220.5 million of normalized UFCF in FY13. ColorTyme, RCII’s franchise business, produces an additional $2m/year of unlevered FCF, so for ease of use I will include that in my valuation, for a total UFCF of $222.5 million. I capitalize that at a 9.3% WACC (11% Ke, 6% Kd, 35% taxes, 25d:75e) and a 1.5% perpetual growth rate (at the low end of SSS comps), and discount it back to today to arrive at a stand-alone enterprise valuation for Core U.S. of $2.8 billion, or roughly 1x the current adjusted EV of RCII. This valuation implies a multiple of 6.9x EV/LTM EBITDA, which is in line with the RTO industry’s historical trading multiples.
|Core U.S. Division; Calculation of Normalized Unlevered Free Cash Flow|
|Yoy growth %||0.2%||0.8%||2.2%||2.8%||1.5%||1.5%||1.5%|
|% of sales||73.1%||73.3%||72.9%||72.0%||71.6%||71.6%||71.6%||71.6%|
|% of sales||11.1%||13.3%||12.8%||12.6%||12.6%||12.9%||13.1%||13.2%|
|% of sales||13.7%||15.8%||15.1%||15.0%||15.2%||15.5%||15.6%||15.7%|
|% of sales||11.1%||13.3%||12.8%||12.6%||12.6%||12.9%||13.1%||13.2%|
|Unlevered Net Income||187,754||225,121||218,789||218,743||222,426||230,868||236,949||243,154|
|Less: Maint. CapEx||65,757||65,857||66,353||67,576||68,231||69,254||70,293||71,348|
|Unlevered Cash Earnings:||189,945||224,397||214,086||215,296||222,690||232,561||238,076||241,947|
|Less: Change in Rental Inventory||39,223||13,072||6,838||12,055||12,236||12,419|
|Unlevered Free Cash Flow||185,174||201,014||215,852||220,506||225,841||229,528|
GMs have declined slightly over the last 12- 18 months due to a higher rate of early prepayment on rental contracts, as well as some deflation on the retail prices of certain electronic products.Some quick notes on the financials:
V. RAC ACCEPTANCE BUSINESS: DISCUSSION AND VALUATION
The RAC Acceptance business involves partnering with third party retail establishments in order to provide the rent-to-own transaction to customers outside of the normal core RCII network. If a potential customer of one of RAC’s retail partners does not qualify for store credit, he or she will be introduced to a RAC salesperson (located on-site, generally in the back of the store with a desk and a computer), who will offer the RTO transaction for a particular item. If the customer agrees to the transaction, the RAC kiosk will purchase the item at retail price from the retailer, and then rent it to the customer. The retailer will provide delivery, set up, and whatever maintenance/customer service it would have otherwise provided to the customer. If a customer is unable to continue payments, the item is collected and distributed through a normal RCII core store.
The RAC acceptance business is an exceptional, high ROIC continuation of RCII’s core business for several reasons:
In order to value the 950 RAC Acceptance stores that have been opened or announced thus far, I used company-provided store level economics (Initial Investment, Annual Sales, Annual EBITDA before corporate allocation for first 5 years of store’s life) to forecast normalized unlevered FCF based on store vintage (see table below). I then run a DCF (as above, 9.6% WACC, 1.5% perpetual growth included in TV), to calculate a net present value of $1.1 billion, or $18.71/FD share.
Perhaps even more importantly, I see no reason why RAC kiosks shouldn’t be spokes for Core U.S. Rent-a-Center stores/”hubs”, with multiple RAC kiosks located near each Core U.S. retail location. Viewed in this light, there could be thousands more potential locations, each of which carries an expected NPV of $905k the day it opens.
|RAC Acceptance Division; Calculation of Normalized Unlevered Free Cash Flow|
|Yoy growth %||466.5%||961.9%||44.2%||52.7%||54.4%||20.2%||8.0%||2.7%||0.5%|
|EBITDA Before Corporate Overhead:||67,625||124,506||169,912||190,321||196,787||197,760|
|% of sales||22.9%||28.9%||32.9%||34.1%||34.3%||34.3%|
|Corporate Overhead Allocation||13,576||19,798||23,790||25,683||26,368||26,496|
|% of sales||4.6%||4.6%||4.6%||4.6%||4.6%||4.6%||4.6%|
|EBITDA, After Corporate:||(1,836)||(4,977)||24,697||38,450||54,049||104,708||146,122||164,638||170,419||171,264|
|% of sales||(57.1%)||(27.3%)||12.8%||13.8%||18.3%||24.3%||28.3%||29.5%||29.7%||29.7%|
|% of sales||(59.2%)||(29.5%)||9.8%||11.4%||16.1%||23.3%||27.3%||28.5%||28.7%||28.7%|
|Unlevered Net Income||(1,902)||(5,372)||12,275||20,719||30,883||65,263||91,617||103,386||107,046||107,578|
|Less: Growth CapEx||239||1,450||5,881||5,553||3,684||-||-||-||-||-|
|Unlevered Cash Earnings||(2,075)||(6,427)||12,206||21,740||30,785||65,263||91,617||103,386||107,046||107,578|
|Less: Change in Rental Inventory||1,524||45,578||93,512||27,314||9,144||48,885||32,633||20,570||7,450||1,390|
|Unlevered Free Cash Flow||(3,599)||(52,005)||(81,306)||(5,574)||21,641||16,377||58,985||82,816||99,596||106,188|
Notes on the financials:
VI. INTERNATIONAL BUSINESS: DISCUSSION AND VALUATION
The international business is the same as the Core U.S. RTO business, but for the fact that the stores are located in Canada and Mexico. RCII is focusing most of its international growth efforts on the Mexican market, which is deeper than Canada, with more attractive store-level economics. RCII has 67 Mexican and 32 Canadian stores as of 2Q12, and expects to end FY12 with 108 and 40 stores, respectively.
Management has stated that there is a 1,000 store opportunity in Mexico, though they haven’t provided guidance for a timeline to get to that number. Based on an RCII-provided model for store-level economics in Mexico, the consolidated opportunity in Mexico allows the company to invest ~$775 million in CapEx, Inventory, and start-up losses, in order to achieve $140 - $150 million of consolidated EBITDA 3-5 years later (essentially creating EBITDA at ~5.5x). This compares to EBITDA of ($19.3) million in the LTM period, and $18.9 million of LTM CapEx. Although management has stated that existing stores in Mexico are running at their model, I ascribe no value to the division in my base case, and view the international expansion largely as a free call option/upside.
|Mexico - Consolidated Potential|
|($000s except %)||Year 0||Year 1||Year 2||Year 3||Year 4||Year 5|
|New Store Openings||933.0||933||933||933||933||933||933|
|EBITDA Before Corp G&A:||-||144,615||172,605||181,935||181,935|
|Less: Corp G&A||4.6%||18,455||30,686||33,476||34,549||35,193|
|EBITDA After Corp:||(18,455)||113,929||139,129||147,386||146,742|
|% of sales||(4.6%)||17.1%||19.1%||19.6%||19.2%|
|Unlevered Net Income:||(28,484)||63,213||78,608||83,596||82,950|
|Cash Flows and DCF:|
|Initial Investment - CapEx||240.0||(223,920)|
|Initial Investment - Inventory||560.0||(522,480)|
|Operating Cash Flows:||(28,484)||63,213||78,608||83,596||82,950|
|Consolidated Cash Flows:||(746,400)||(28,484)||63,213||78,608||83,596||1,156,012|
|NPV of Mexico Growth:||138,530|
I derive my price target as follows:
Core U.S. Division: $2.74 billion
RAC Acceptance Division: $1.11 billion
International Division: $0
Less: Net Debt: $729 million
Consolidated Equity Value: $3.15 billion
Per FD Share: $52.20
Appreciation to Target: 45%