Description

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:

• At $36.00/share, investors have the opportunity to purchase RCII’s Core U.S. rent-to-own (RTO) retail business at fair value (12.5x unlevered FCF), while receiving the company’s two high ROIC growth initiatives – RAC Acceptance (49.8% post-corporate, fully-taxed IRR on new stores) and International RTO (13.4% IRR) for free. (See Section IV. for Discussion and Valuation of Core U.S. Division)
• By the end of 2012, RCII will have 950 RAC Acceptance kiosks located within third party retail locations, up from less than 100 at the beginning of 2010. These 950 stores will reach maturity by 2015, at which point they will contribute an additional $170 million of EBITDA and $100 million of unlevered free cash flow under conservative assumptions. Although I only include the 950 stores expected to be open by the end of 2012 in my valuation, I believe there could be a multi-thousand store domestic opportunity for RAC kiosks, offering substantial upside relative to my base case. (See Section V. for Discussion and Valuation of RAC Acceptance division)
• Lastly, RCII has 148 International Rent-to-own retail locations – 108 in Mexico and 40 in Canada. Management believes that there is a 1,000+ store market opportunity in Mexico, and appears to be accelerating investment in that market. Although I ascribe no value to the international division in my base case, I note that the Mexican market opportunity could contribute over $140 million of EBITDA and over $80 million of unlevered FCF at maturity. (See Section VI. for Discussion of International Opportunity)
• Paid to wait: Management is focused on returning capital to shareholders in the form of both dividends and share repurchases. In the LTM period, RCII has repurchased $88 million worth of shares and paid $38 million of dividends, suggesting an LTM return-of-capital yield of 6.0% per fully diluted share.

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:

• Credit Check: RCII uses a customer’s personal references to verify his employment and residence
• Rental Payments: Customer makes payments every week, two weeks, or month. 78% of contracts are on weekly terms. The first 90 days of the rental are “same as cash,” and for the remainder of the rental duration (typically 7 – 24 months), a portion of each subsequent payment reduces the principal balance required to achieve ownership, and the remainder is effectively a rental/interest expense. Customers may elect to purchase the item outright with an early prepayment option, provided they are able to come up with the requisite cash. In the Core U.S. division, ~25% of contracts end in ownership. In RAC, ~80% of contracts end in ownership.
• Free Delivery, Set-Up, and Pick-Up
• Lifetime reinstatement: If a customer defaults, RCII simply picks up the item from the customer’s home and makes it available for rent to another customer. If the original customer wishes at any time to resume payment, RCII will allow them to resume their initial contract with the same or similar unit. Reinstatement helps keep theft and property damage rates at a relatively low and consistent ~2.5% of sales, as most consumers find the idea of simply temporarily returning an item consequence-free to be more palatable than the alternatives.

III.  CAPITALIZATION:

• I include a $62.7 million working capital adjustment to account for a below-normal level of working capital in RCII’s Core U.S. division at the latest B/S date
• I include a $100 million liability for deferred tax liabilities that are potentially reversing in the next several years. This is an estimate/reserve, not a calculated NPV of a cash liability. The DTL balance, net of valuation allowance, is $301 million at the latest B/S date.

 
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:

• Mature business that produces predictable and substantial free cash flow
• Same store sales growth: Averages 1-3% across market cycle (2.5% - 4.0% FY12 guidance)
• Muted cyclicality: through the financial crisis, the worst SSS comp was (3.5%) in FY09, followed by (0.4%) in FY10
• Attractive Return Characteristic: Core U.S. division produces a healthy 13.6% return on total assets (EBIT/Total Assets), and a 27.0% return on tangible assets (EBIT/Total Tang. Assets)
• Dominant Market Position: RCII’s Core U.S. division is the largest player in the $7 billion domestic RTO industry, with 38.3% market share by sales; 34.6% share by store count; and a 1.3x relative market share as compared to Aaron’s Inc. (NYSE:AAN), the next largest player
• Competitive moat: Established RTO players have a sustainable moat due to their relative purchasing power vs. durable goods vendors; regional density (delivery and collections); brand recognition (75% of customers are repeat customers; IT systems (RCII has invested hundreds of millions into its IT systems); and capital requirements (each new RTO store requires a $625k initial investment, of which 35% is for PP&E, and 65% is for working capital)
• Best-In-Class Retail Metrics: RCII has small stores (avg. 4,700 square feet, of which 75% is showroom) and just-in-time inventory management, which facilitates best-in-class sales and profitability per ft2 metrics

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.

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:

• I am only including my estimate of normalized CapEx, which includes store remodelings, new trucks, computers, and all such expenses incurred in the normal course of business (including new openings). This deviates from actual CapEx in 2010 and 2011 due to a one-time overhaul RCII’s point of sale system, which has cost an estimated $97 million cumulatively. I believe the overhaul is nearly complete, and that CapEx should moderate to its normalized level of roughly 2.5% of sales in the next 2-4 quarters. 

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:

• Large growth runway: Any durable goods retailer that loses sales to low credit customers, that isn’t already established in the RTO business (see Section IV for brief discussion of barriers to entry/moat), is a potential RAC Acceptance partner. Even retailers that closely resemble, but are not ultimately RTO companies – For example, Conn’s – partner with RAC Acceptance to fully capture the subprime customer. Consequently, RCII opened 445 kiosks in FY11, and will open 261 additional locations in FY12 to end the year with 950 total locations. I am not giving RCII any credit for locations beyond the 950 thus far announced, but it is reasonable to believe that RCII will continue opening kiosks at a triple digit pace for several years to come.
• Very low start-up investment and operating costs: RCII only invests $26.5k per RAC Acceptance kiosk in equipment. The primary expense of each kiosk is the cost of the sales associates that sit within each store, who are aligned with shareholders in that their compensation is dependent on the level of sales and profitability of their store. Every 8-10 RAC stores are supported by an office with two RCII associates and a truck, who handle customer service and collections.
• High ownership rates in contracts: Unlike in the Core RTO business, where only ~25% of rental agreements carry through to ownership, the typical RAC Acceptance customer has thus far exhibited a higher intent/propensity to buy, with ~80% of contracts ending in ownership (either full-term, or through pre-payment options.
• Low risk of permanent capital loss: An additional $238.5k is generally invested in rental inventory in the first year, and that amount directly corresponds to revenue generated. In the event a kiosk is closed, customers in rental agreements are simply transferred to the nearest core Rent-a-Center location, such that the excess inventory can continue generating revenues.
• Margins: The downside of the kiosks is that RCII has to purchase the inventory at retail value, and the customers prepay more frequently, which results in lower gross margins than exist in the core business. However, the end result is higher EBITDA margins than are available in the core business, due to almost no real estate-related expenses, and a much lower collections rate.

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.

Notes on the financials:

• The projections are built using average store-level Sales and EBITDA economics provided by the company, to which I have conservatively allocated an additional 4.6% of sales for corporate G&A, in line with broader RCII.
• I assume depreciation/CapEx run at ~1% of sales each, in line with RAC results but below the Core U.S. division. Every 8-10 RAC kiosks are supported by just one truck and there are no real estate expenses.
• For Amortization, I have allocated all future expected amort to the Core U.S. division, so I forecast none in this division to avoid double counting.

 
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. 

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%    

Catalyst