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.

 

 

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).            

 

 

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.

 

 

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).   

 

 

The key aspects of this investment thesis are as follows:

 

 

As discussed in detail above, this business model should hold up reasonably well even in a tougher economic environment. 

 

 

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:

 

 

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.   

 

 

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):

 

 

The breakdown of stores by age (from the most recent franchisee offering circular):

 

 

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).

 

 

 

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.       

 

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.

 

 

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.