Description

I recommend the rent-to-own (RTO) company, Aaron’s Inc.  Aaron’s reported earnings yesterday and missed 1Q13 consensus Revenue / EPS of $631 / $0.71 and reported $595 / $0.67.  Citing delays in tax refunds and the impact of higher payroll taxes on customers’ disposable income, management lowered full-year Rev / EPS guidance from $2.4B / $2.25 - $2.41 to $2.35B / $2.15 - $2.27.  The revised guidance represents a 2% decline in top-line and a 5% decline on EPS at the mid-point.  Their main competitor cited the exact same issues and I think today’s stock price represents an attractive entry point.  

Despite the headwinds they encountered this quarter, SSS were up 3.4%, customer count on a same store basis was up 4.1%, SSS at franchisees were up 2.6%, and SSS at stores two years and older were up 1.8%.  Also, in 2010 they rolled out a smaller store format called HomeSmart that caters to a slightly different customer and HomeSmart reported a loss of roughly $200k in Q1 vs. an expected loss of $1 million, so it’s doing much better than expected and what was a $7mm drag on EBITDA last year should be additive soon enough.

The stock is trading around $28 or about 6x forward EBITDA right now.  I think they are benefitting from a number of factors that should lead to accelerating growth over the next few years and they are not getting credit for the true earnings power of the business, which is being masked by store openings in the company-owned segment as well as the development of the HomeSmart business.  I estimate intrinsic value of roughly $40 or more.  Notable to the thesis is this target assigns no value to the HomeSmart division. The success of this division should provide attractive upside optionality.

The RTO Industry

RTO offers customers an alternative to traditional methods of obtaining durable household goods like electronics, home furnishings, computers, and appliances.  In a typical transaction, the customer has an option to acquire merchandise over a fixed term by making regular lease payments, usually over a period of 12 to 24 months.  The customer can cancel the agreement at any time by returning the merchandise to the store, generally with no further lease obligation.  Customers can obtain ownership of the item by leasing the item to the full term or purchasing it at the retail price within 120 days of entering the agreement.

Typical RTO Transaction

Aaron’s has provided details of a typical transaction in past presentations and this example comes from their 2Q 2010 Investor Presentation.  It’s indeed outdated but while the pricing may be different today, the concept hasn’t changed.

-          Aaron’s procures a 47” TV from Phillips for $940.

-          Aaron’s lists the TV at a retail price of $1,500, a 37% gross margin.

-          Aaron’s advertises a monthly lease payment of $100 with All-in Lease Ownership occurring after 24 months for a total of $2,400, a 61% gross margin. 

• Note: total receipt actually exceeds $2,400 due to fees

So, Aaron’s buys a TV and either sells it for a 37% gross margin within 120 days or for a 60% gross margin over the period of two years. Importantly, Aaron’s reports 45% of their customers rent products to term, which provides Aaron’s with a very attractive annuity.

The RTO Customer

The average RTO customer has a household income below $50k and Aaron’s focus is to provide access to durable household goods to these lower to middle income consumers who have limited or no access to traditional credit sources such as bank financing, installment credit, or credit cards.  The sales and lease ownership program enables customers to obtain “quality-of-life enhancing merchandise that they might otherwise not be able to afford, without incurring additional debt or long-term obligations.” (2012 Annual Report).  Importantly, there is generally no credit check performed when customers enter an agreement.  Instead, Aaron’s will verify items like employment, request personal references, confirm place of residence, etc.  Aaron’s has been successful controlling losses as all of their agreements require payments in advance and the merchandise is repossessed if a payment is significantly in arrears.  As a result, shrinkage has historically only run around 3%. 

This feature of the business should command some attention because the state of theU.S.economy has led to generally reduced access to credit.  The St. Louis Fed reports Seasonally adjusted Total Revolving Credit Owned and Securitized Outstanding (REVOLSL) peaked in the middle of 2008 at roughly $1.2 trillion and bottomed in 2011 at just under $840 billion.  Since then, REVOLSL has remained essentially flat at around $850 billion.

http://research.stlouisfed.org/fred2/graph/?s[1][id]=REVOLSL

This fact bodes well for Aaron’s and RTO in general because reduced access to credit means Aaron’s services are in greater need as they essentially provide financing to the underserved.  Couple this with fewer furniture retailers (a consequence of the great recession) and a limited number of retailers that focus on credit installment sales to lower and middle income consumers, and there are obviously favorable market conditions for RTO. 

Background on Aaron’s

Aaron’s RTO business primarily consists of two divisions:

(i) Sales & Lease Ownership division (97% of revenue): This is a monthly payment model (92% of agreements are monthly) and represents the majority of Aaron’s business.  The lease period is typically 12, 18, or 24 months and Aaron’s has 1,995 units under this model (62% Company-owned and 38% Franchised) with the avg. store (unit) roughly 9k square feet.

(ii) HomeSmart division: Aaron’s established HomeSmart in 2010 to serve weekly customers with products similar to those leased through Aaron’s Sales & Lease Ownership stores.  The weekly RTO customer is a slightly different customer (lower income) than the monthly RTO customer so the rational is entering weekly RTO expands their business without cannibalizing sales at the traditional Aaron’s Sales & Lease Ownership units.  At HomeSmart, roughly 38% of agreements are monthly, 18% are semi-monthly, and 44% are weekly.  This leads to fewer customers renting products to term (typically about 25% vs. 45% in their monthly RTO model) and ultimately lower margins (still profitable, just not as profitable as monthly RTO). Other points of differentiation include a smaller avg. unit size of 5k square feet (generally more “local”), and the lease period is slightly different at typically 60, 90, or 120 weeks.  Aaron’s has 78 Company-operated HomeSmart stores.

In addition to these divisions, Aaron’s is the only major furniture leasing company in theU.S.that manufactures its own furniture.  They operate five furniture manufacturing plants and eight bedding manufacturing facilities.  They believe manufacturing allows them to control the quality, cost, delivery, styling, durability and quantity of furniture products, substantially all of which is leased and sold through their Company-owned and franchised stores.

Other Information on Aaron’s Sales & Lease Ownership Division (not HomeSmart)

-          Aaron’s stores draw from a six to ten mile urban radius or two to three rural counties. 

-          The avg. customer pays $130/month and over 45% of customers go to term.

-          Largest exposure is Texas at roughly 8% of units.

-          2012 Product mix: 35% Furniture, 32% Electronics, 20% Appliances, 10% Computers, 3% Other.

-          Offer leading brands: Sony, JVC, Philips, Sharp, Samsung, Dell, HP, JVC, Maytag, etc.

Competition

Aaron’s primarily competes with weekly RTO operator, Rent-A-Center (Nasdaq: RCII), which was last written up by Rightlanedriver on August 24, 2012 (a very good write-up, by the way, and a good source for additional background).  Together, RCII and Aaron’s account for roughly two-thirds of the RTO market (pg. 4 of the February 2013 RCII investor presentation shows RCII with 44% of total RTO industry locations and Aarons with 21%).  The rest of the market is comprised of much smaller operators (largest competitor has 256 locations vs. RCII with about 3k and AAN with about 2K).

The following items differentiate Aaron’s from RCII:

Three Growth Drivers: (i) General penetration of domestic market, (ii) Franchise expansion, and (iii) HomeSmart (free option).

(i) RCII has about 3k U.S. core stores with another 1k RAC acceptance kiosk locations.  AAN has 1.3k company owned locations and 749 franchise locations for just over 2k locations.  Using RCII as a guide to potential penetration indicates AAN could add another 1k units and expand their footprint by 50%.

(ii) AAN has 180 area development agreements in place with existing AAN franchisees.  This represents deals in place to expand the franchise footprint by 25% from 749 to 929.  Last year AAN earned $53mm in EBT from their franchisees (average of $70k in EBT per franchisee).  An additional 180 units represents potential incremental EBT of $12mm and total potential EBT of $65mm.  At 10-12x EBT, that would boost the enterprise value of the segment from $530-$636 to $650-$780, an incremental $120 to $144mm to the enterprise value of the segment.

(iii) They only have 79 HomeSmart locations but I think this is an attractive call option and management’s goal is to reach profitability this year which would eliminate a $7mm drag on EBITDA.  Also, management has indicated franchising will be a key piece of this growth initiative which will add higher quality revenue that should command a higher value than a pure retail model.

HomeSmart

One thing I think is notable is the change in leadership at HomeSmart and management’s decision to temporarily halt the expansion of the unit base in the 1H13.  This should give the new VP a chance to get situated instead of face the pressure of having to hit the ground running.  It will also allow the company to focus on the profitability of HomeSmart.  Roger Estep was promoted to VP of HomeSmart to run the division and Roger brings with him an entire career in the weekly rental pay industry (25 year veteran).  Prior to his promotion to VP, Roger was a Regional Manager for Aaron’s after spending over nine years as an Associate.  I’m absolutely speculating here but climbing the ranks from Associate to VP in charge of a relatively new segment would probably motivate anyone in Roger’s position to view this as a big opportunity.

Management comments on Roger’s promotion from the 4Q12 Earnings Call:

William K. Butler

Chief Operating Officer and Director

“As Ron mentioned, we promoted Roger Estep to VP of HomeSmart, and he and his team are working diligently to make HomeSmart a brand that we will be proud of and a brand that can follow the same pathway already put in place with Aaron's with new company-operated stores and a new franchise concept as well. We have no new stores on the horizon at this hour, as our mission is to stabilize the management team, focus on the business fundamentals of the model and bring the system to profitability this year. We continue to see no signs of cannibalization to the nearest Aaron's store with the model.”

Management comments on HomeSmart:

Ronald W. Allen

Chairman, Chief Executive Officer, President and Member of Special Committee

”Yes, it's supply and demand. You have more product to sell, you're going to sell more franchises. So at the end of the day, that's one of the reasons why we created the HomeSmart model that would give us another whole group of stores we can franchise and open corporately as well. We've got lots of opportunities in franchising beyond just the borders of the United States, too, that we we're going to be looking at in the future. And a part of that rides with the investment we have in the U.K. And we're certainly watching what's happening with some of our competitors that are opening stores in Mexico. And there's lots of other places to go, too. So we're not thinking beyond just the core U.S. of A.”

Gilbert L. Danielson

Chief Financial Officer, Executive Vice President and Director

“The reason -- that's the reason why the HomeSmart initiative is so important for us also, that if we can have another concept, HomeSmart, that can successfully do business in – with competitors and even our Aaron's stores around, it gives us another franchising vehicle down the road, big franchising vehicle. And then certainly, a lot of our franchisees are very interested in how we're coming on HomeSmart. So we're hopeful that will be a boost for us in the future years.”

Other Positive Items

• In Q4 AAN reached a record level of avg. # of agreements per customer of 1.5 (first time in history)
• Recently reported Q1 comps were decent (figures mentioned in the beginning) and this is a continuation of strong SSS in Q4 when SSS were up 4.6% for company-owned units and 6.5% for franchise units and around 5% in each segment for the year.  Even stores older than five years were comping positively at almost 2%.  
• Customer counts in Q1 were also strong, and this too followed a strong Q4 when counts were up 11.8% at company-owned units and 9.5% in franchised units (11% system-wide).
• For 2012 the company grew the unit base 6.6% and plans for a similar, if slightly lower level of growth (4-6%) in 2013.
• Average monthly customer payment has stabilized (likely with TV prices stabilized). It was $155-$160 a few years ago and dropped to $130 but has been flat at $130 all year.  “This was the first year in at least four years where it has not been declining.”
• As an annuity it will take time to build it back up but the stabilization is notable.
• Aaron’s has repurchased $190mm worth of stock in the past three years, reducing the share count by 6%.  Four million shares remain under a buyback program (amounts to 5% of outstanding shares.)
• Since 2003 the equity value has increased from $320mm to $1.1B, a CAGR of 15%.

Earnings Power Valuation using P/E Multiple

I can find $0.18 of earnings per share that should be added back to 2012 EPS to arrive at the true 2012 underlying earnings power of the business.  New store openings in the company owned segment were a $0.12 cent drag on EPS, new store openings at HomeSmart were a $0.02 cent drag, and the net loss at HomeSmart was a $0.04 cent drag.  Adding $0.18 to the $2.25 they earned in 2012 implies earnings power on 2012 results of $2.43.  At today’s price of $28 the stock is trading for 12.5x 2012 EPS, and 11.5x 2012 earnings power. 

Applying a 16x P/E multiple to 2012 earnings power of $2.43 leads to a target of roughly $39.  Over the last ten years, the average P/E multiple the market has paid for Aarons has been 16x and considering the optionality with HomeSmart, agreements in place to expand the Franchise footprint, and the general potential to grow the total domestic store count, the growth prospects haven’t deteriorated much, so I think 16x is reasonable.

SOTP Analysis

The Franchise stores produced $46, $50, and $53mm in EBT in 2010, 2011, and 2012.  Over the same time period the store count increased from 664, to 713, to 749.  I estimate run-rate EBT could reach $56mm in F13 and $60mm in 2014. See below (assumptions in bold).

The company-owned stores produced $205, $233, and $265mm in adjusted EBITDA in 2010, 2011, and 2012 (includes corporate expense and excludes impairments, a lawsuit, gains on sales of assets, and one-time retirement charges elated to founder and former chairman).  Over the same time period the store count increased from 1,150, to 1,232, to 1,324.  I estimate run-rate EBITDA will reach $288mm in F13 (guidance is 4-6% unit growth and I assume 5%) and $317mm in 2014. See below (assumptions in bold).

Below is my SOTP valuation table (assumptions in bold).  I ignore the HomeSmart drag when analyzing 2012 numbers, assume it’s breakeven in F13, and assign it no value in F14 (I consider it a free option).

I applied a 10-12x multiple to Franchise EBT for base and bull case scenarios and a 7.5-8.5x multiple to EBITDA in the Company-owned segment.  Using my estimates and these multiples leads me to a target range of $37.85 to $43.08 on F13 earnings and $41.21 to $46.92 for F14.  In each case, I wind up with blended multiples of 8x to 9x system-wide EBITDA which I don’t believe to be unreasonable considering the growth prospects and resiliency of the business in the 2008/2009 time period (SSS were up 3% and 8%, respectively).  My valuation also assumes no share repurchases (buyback in place to repurchase an additional 4mm shares, over 5% of shares outstanding).

Risks

Regulatory Risk

I think there is limited risk here as nearly every state has favorable legislation for RTO and the Dodd-Frank and Consumer Protection Act excludes leases with terms of 90 days or less and these are weekly or monthly terms.

Perfect Home

In 2011, Aaron’s spent $15.4 million to purchase an 11.5% interest in the common stock of a UK Based, privately held, 55 store RTO company called Perfect Home, which implied a total value of $134mm at the time.  As part of the transaction, Aaron’s also received notes and an option to acquire the remaining interest at any time through December 31, 2013.  If Aaron’s does not exercise the option prior to December 31, 2013, it will be obligated to sell the common stock and notes back to Perfect Home at the original purchase price plus interest. 

Assuming Perfect Home is worth sub $200mm, Aaron’s has ample room in their covenants (debt/ebitda of 3:1 vs. 0.4x today) to buy this even with large cash tax bills coming due in 2013 and 2014 so there is real potential for this deal to happen.  The only thing that gives me comfort regarding the deal is Aaron’s stock appears to be very cheap already, so perhaps the risk they overpay is priced in to some extent.  One could also make the argument this is an attractive opportunity but I’d prefer they stick to the U.S. as there is ample opportunity to create value domestically without spending a bunch of money on an acquisition.

DISCLAIMER: This write-up is not an offer to provide investment advice or a solicitation of such an offer. No one should rely on the information contained in this write-up to make any investment decision. The write-up contains and is based upon information the author believes to be correct but may be innacurate.  The author assumes no liability if such information is incorrect. The author has no duty to correct or update the information contained herein. The author may buy, sell or sell short the security at any time without notice. This document contains forward-looking statements based on the author’s expectations and projections. Those statements are sometimes indicated by words such as “expects”, “believes”, “will” and similar expressions. In addition, any statements that refer to expectations, projections or characterizations of future events or circumstances, including any underlying assumptions, are forward-looking statements. Such statements are not guarantees of future performance and are subject to certain risks, uncertainties and assumptions that are difficult to predict. Therefore, actual returns could differ materially and adversely from those expressed or implied in any forward-looking statements as a result of various factors.

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