Rent-A-Center RCII
November 06, 2005 - 2:46am EST by
bal602
2005 2006
Price: 18.82 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 1,336 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT

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Description

Introduction:

Rent-A-Center (NYSE: RCII) has been written up twice. First by delta2delta in August, 2003 and second by bode314 in December, 2004. Both of these write-ups presented excellent descriptions of the business. It will be redundant for me to repeat the background of the company. I will refer the readers to these two excellent write-ups. Rather, I will attempt to focus on the changes that are happening in RCII that make me feel that the intrinsic value of the company will increase. The price of the shares of RCII has declined since the two excellent write-ups. With the changes that will increase intrinsic value and the price decline, RCII shares present a good value acquisition at this time.

I will not attempt to repeat all the details about the RCII that were presented by delta2delta and bode314, but will refer to their write-ups in discussing the net changes.

Summary of investment thesis by delta2delta and bode314 with some updates:

- Dominant market share leader of the rent-to-own industry with 38% share by store count.
- Significant free cash flow. About $100 - $120 millions expected in 2005 (FCC/EV yield of 5% to 6%). Peak FFC was $280 millions in 2003, representing a FCC/EV yield potential of 14% based on today’s EV of $2B.
- Low forward PE ratio of approximately 9, based on management’s 2006 EPS guidance of $2.00 to $2.10.
- Management has been buying back shares with the FCC.
- PE ratio of RCII is low compared to the rental industry overall PE of 19.

Factors that caused RCII to be a poor investment in the last 2 years:

- Reduction in EBITDA margin, from a high of 19.6% in 2002 to an expected low of about 13% this year.
- This reduction in margin is primarily caused by poor same store sales, resulting in de-leveraging of expenses. In the nine months ended September 30, 2005, SSS declined 2.8%. SSS for year 2004 declined 3.6%. Operating expenses have increased as well.
- The reduction in SSS comes primarily from (a) poor performing stores as a result of acquisitions; (b) economic conditions stressing RCII’s core customers; and ( c) competition.
- RCII is perceived as a no-growth or very low-growth business based on its domination of market share.

RCII’s plan to turn the tide of its core business:

- RCII plans to close 164 of its under-performing stores. This represents a little over 5% of its stores. About 100 stores have been closed by the end of 3Q.
- Improved marketing, both advertising to draw traffic into its stores and improved product mix
- Cost reduction in store operations as well as SG&A.
- Continue to add new stores at a 5% annual rate by opening new stores and by acquisition.

New business opportunities in financial services:

RCII is testing pay-day-loan services in 27 of its stores. So far, this limited test is showing very encouraging results. The test results so far showed that each store can generate between $15,000 to $20,000 of fees per month, with drop-through as high as 50%. On a running basis, management expects that for each 150 stores generating this level of fee, these stores will generate approximately 12 cents in EPS per year.

The incremental capital investment is very modest per store at between $45,000 to $65,000. There are currently 35 states that have favorable or enabling legislation for this line of business. There are approximately 1,800 stores in these 35 states, with approximately 1,400 located in areas that have a potential strong demand for this service. Currently, management expects that there is a 30% overlap of its current customer base with customers that will use this service.

Management is planning to test this service in another 25 stores in 4Q, adding another 25 to 40 store per quarter in 2006 and ramping up more aggressively in 2007. It is still early to forecast the success of this business and the rate at which RCII can ramp. Using a simple scenario and extrapolating RCII’s test results, one can model a total of over 600 stores providing this service at the end of 2007, adding about 35 cents EPS for the year 2007.

If this and other similar scenarios pan out, this line of business will cause EPS growth > 17% in 2007 for the financial service business alone, based on a $2 per share EPS in 2006 guided by RCII. Further growth of same magnitude beyond 2007 is likely in the financial services business if the roll out is successful. This will revive the growth rate of the company and put it in the category of a “growth” company once again.

Additional financially services such as bill payment and money transfer will be tested as well. These financial services fit very well with the needs of RCII’s core of “under-banked” customers.

Clearly, there are risks in entering a new line of business, but the upside is enormous with very small investment in capital, which clearly can be supported by internally generated funds.

Summary of investment thesis:

1. Conservative 2006 EPS projection with potential upsides. RCII’s 2006 guidance assumes flat SSS, low sales growth of 2%, higher fuel price and no improvement in the economy. Hence there is potential upside as management turns around the SSS trend (3Q SSS improved to -0.2%), fuel price stabilizes, and its customer base adjusts to the new interest rate environment.

2. Improvement in margin as SSS improves (comps are easier to beat), cost reduction and store closure benefits hit the bottom line. As the results improves, one can expect that the PE ratio to expand as RCII shares are trading at a large relative discount to the rest of the rental industry.

3. Significant upside of the financial services business is hardly priced in the stock at this time.

Catalyst:

1. Improvement in SSS
2. Margin expansion back to historical level
3. Recognition by investors of the potential of the financial services business

Full disclosure:

I own shares in RCII.

Catalyst

1. Improvement in SSS
2. Margin expansion back to historical level
3. Recognition by investors of the potential of the financial services business
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