Description

We recommend buying Prog Holdings (“PRG”) stock at the current price.  PRG was last written up on VIC in February 2021 by MYetman.  We recommend reading that for additional background.

PRG is the dominant lease-to-own (“LTO”) business in the United States.  LTO is a small industry estimated at about $8-9B in sales, so PRG with about $2.6B, represents about 30% of the entire market.  For those unfamiliar, LTO is a financing option for consumer goods for customers with sub-prime credit.  Since these are leases, rather than loans, there is much less regulation compared to other consumer finance products.  To qualify as a lease, it must be short-term in duration and it must finance a tangible product (rather than a service).  The customer must also be able fully buy-out the lease at any time.  It’s an excellent business with high returns on capital.

It's a nascent industry which effectively began following the GFC as sub-prime and near-prime consumers lost access to traditional credit.  Pre-GFC, it was only offered by LTO branded retailers such as Rent-A-Center and Aaron’s (Aaron’s previously owned PRG and spun it off as a stand-alone in late 2020).  PRG effectively created the “virtual” LTO business which offers this financing option to other retailers (Best Buy, Lowes, etc).  The growth since this began has been impressive.  PRG did about $200 million of GMV in 2012 and should do about $2.2B this year or a 27% CAGR.  Aaron’s bought PRG in 2014 for $700 million, or 1.5x 2014 GMV.

Similar to what we wrote about CROX this summer, we think this opportunity exists with PRG because it operates in areas that investors do not want to touch at any price heading into an inflation/consumer-led recession: 1) retail and 2) sub-prime consumer credit.

We think both fears are overblown.  Starting with fears around retail, most customers using the LTO product are buying necessities that need to be replaced (furniture, mattresses, tires, laptops, etc.), not spontaneous or luxury purchases.  As many in this industry say, “our customer is always in a recession.”  While the industry was in its infancy during 2008 as previously mentioned, tightening credit standards from traditional financing products during recessions typically drive higher FICO customers down in the waterfall to LTO which can increase total LTO sales even if retail in aggregate is lower (LTO increases share).  These are obviously higher quality credit customers as well.  Also, a weak retail environment may drive more retailers towards providing an LTO solution for their customers, as was the case in 2008, to help drive increased sales.  While this continues to change as it has been demonstrated to drive increased sales, many retailers still have a stigma associated with an LTO offering at their store and don’t believe sub-prime customers are their target demographic.  Again, if sales are slumping and providing an LTO option can boost sales, retailers can be quick to change their minds. The increased adoption of buy-now-pay-later financing for prime customers is increasing the retailer adoption of LTO as it is an easy service to tack-on when customers are already looking for a financing option.

The desire to avoid sub-prime credit is a more valid concern, in our view.  Generally speaking, LTO delinquencies occur when a customer loses his job so a rise in unemployment will cause delinquencies to rise.  A common misperception, however, is that LTO is just like any other sub-prime lending product.  The difference is in duration as LTO has an average life of ~7 months.  PRG only had $615 million of leases on its balance sheet as of last quarter (relative to annual sales of $2.6 billion) so it’s not like other lending companies that can get severely upside down on bad loans.  PRG is getting payment data daily on its portfolio and is constantly tweaking its underwriting algorithm to maintain delinquencies in the optimal 6-8% range.  

It should be noted that PRG had delinquencies of 9.8% (obviously higher than the target 6-8% range) in the last quarter so it is not an exact science.  This was mostly related to an aberration from external data providers due to specific stimulus payments and occurred across all LTO providers.  Everyone in the industry continues to try to source their algorithm with proprietary data and rely less on external sources such as FICO to avoid this problem in the future.  They are all also tightening credit availability which will quickly bring this back into the target range.  Even with the outsized delinquencies in 2Q, the company still believes it will average around 8% or slightly less for the entire year.  Lastly, even with nearly 10% delinquencies, the company still generated $50 million of EBITDA for the quarter so it wasn’t exactly a catastrophic problem.

Valuation

Our favorite opportunities come from situations where naysayers completely ignore valuation in their decision to sell or short a stock.  Even if this industry/business is destined for a couple difficult years, we believe the current valuation more than compensates for this risk.

PRG’s LTM EBITDA is $260 million.  Consensus for this year, which has been a very difficult year, is for $250 million which is around where we are as well (down from $370 million in 2021).  It has $600 million of debt with a 6% coupon so $36 million of interest expense, $40 million of taxes, and $10 million of CapEx so free cash flow should be around $164 million. 

The current market cap is $835 million so this is a 20% free cash flow yield.  Its EV is $1.3 billion so it’s trading at 5.2x EV/EBITDA.  It’s a prodigious repurchaser of shares so we expect this FCF to be used to repurchase stock (it has bought $670 million of shares in the last twelve months). 

We believe this business has runway to grow top-line at 10% (much lower than its historical growth) for many years to come.  But let’s assume sales growth stagnates at $2.6 billion and assume the company gets back to its normal 12% EBITDA margin by 2024 while maintaining its current sub 10% margin for 2023.  The company would generate $312 million of EBITDA in 2024 which would be about $210 million of free cash flow.  Share buybacks (using only FCF) would reduce the market cap by 30% (at the current price) which would leave a $590 million market cap by the end of 2023.  So even with no sales growth and only a normalization of margins, this would be a 36% FCF yield in 2024. 

We also like the bonds

This is a stock pitch but we also want to highlight that we like and own the PRG bonds.  The only debt the company has is $600 million of 6% unsecured notes due in 2029.  These notes currently trade at 78 or a 10.5% yield to maturity.  We think this is a very attractive yield for very low risk notes in our view.

The company has $127 million of cash, $615 million of leases and $124 million of loans.  Conservatively, the leases and loans convert to cash at a 1.3x multiple so just these three line items represent $1.1 billion of balance sheet value, or 1.8x coverage on the notes.  At the current price of 78 on the notes, the balance sheet coverage is 2.3x.  Net debt is $473 million so net leverage at the current (hopefully trough) EBITDA of $250 million is 1.9x.  Interest coverage is 5.5x.  We think this is a very attractive yield for a very safe credit.

Catalyst

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