Description

RCII is a compelling buy at current levels, at a 15% FCF yield on 2017, a crisis-low 7x forward P/E, and a 6% dividend yield, all as $0.61 in EPS power is set to roll on from expense initiatives. RCII is a BUY with a $26 target for 68% upside.

Summary Thesis

As a former short, I’m surprised to say that RCII is a compelling buy at these levels. Why get involved in RCII now? Simply, the valuation is at lows,  estimates are finally achievable, and benefits from cost cutting initiatives are set to materialize. At the current price of $15.50 (the lowest since March 2008), RCII’s valuation is extremely favorable at a 7.2x forward P/E and a 15% FCF yield on 2017. The 7.2x forward P/E is down from 14.1x earlier this year, and is at crisis-low levels that have historically awarded investors for buying the stock. Furthermore, earnings estimates have finally reset lower to achievable levels, with 2016 down -18% to $2.14 since October, and 2017 down -27% to $2.35. Also, estimates have reset lower right as the gross margins is stabilizing and benefits from various cost initiatives are set to roll on over the next year.

In short, investors were too optimistic on the benefits of various company initiatives heading into 2014 (multiple at 14x), and now sentiment has swung to the other extreme (multiple at 7x). These initiatives were the introduction of selling smartphones in the core rent-to-own stores, growth in the third-party RTO kiosk business Acceptance Now, switching more expensive overtime labor for lower cost part time labor, and realizing cost savings from supply chain initiatives. As RCII shows that they can meet or exceed current estimates (should realize $0.61 of EPS upside from the expense initiatives alone), the P/E multiple should re-rate higher to a level in-line with the 3-year average of 10.9x. Assuming the 3-year average P/E, the current fair value of RCII is $23.50 for 56% upside. Moreover, using the 3-year average 10.9x multiple on my above-the-street 2017 estimate of $2.40, I reach a $26 price target for 68% upside.

Previous Appearances in VIC

RCII has been written up as a long in VIC five times before, most recently in August of 2012 by member Rightlanedriver, and I highly suggest you read his report for a thorough description of each of their business segments. To get a sense of the thought process involved in these previous recommendations, I briefly summarize them here:

• 8/24/12- Long at $36 by Rightlanedriver, $52.50 target- Paying for the core business and getting the RAC Acceptance business (now called Acceptance Now) and the international business for free. Aggressive growth in the third-party retail business, RAC Acceptance, should lead to an additional $170m in EBITDA (+43%) and $100m in unlevered FCF (+50%) by 2017.

• 10/4/07- Long at $17.33 by jim211, $26-30 target- Misperceived as a subprime lender, customers healthier than thought as they don’t typically have mortgages, solid $2 in earnings power, and cheap at 8.5x P/E for a market leader.

• 11/6/05- Long at $18.82 by bal602, no target- Trading at a large relative discount, EPS estimates look conservative, margins should improve with top line growth and cost cutting measures, and potential upside from new opportunities in the financial services business aren’t priced into the stock (payday lending, bill payment and money transfer).

• 12/8/04- Long at $24.90 by bode314, $40 target- Company has a dominant market position, consistent operating history, and generates enough cash for significant payouts to shareholders. It’s a good business that is struggling with same-store sales growth, but it’s cheap at an 11x P/E vs 24x for the industry.

• 8/8/03- Long at $69.30 ($24.99 split adjusted) by delta2delta, $120 target ($48 split adjusted)- Quality growth story selling at a significant discount to peers, growing faster than the retail sector while maintaining cost discipline. They have healthy margins and good cash generation, and the stock is cheap at 14x vs the 8-yr trailing multiple of 18x.

Industry Description

According to the Association of Progressive Rental Organizations (APRO), the REO industry in the US, Mexico and Canada did $8.5b in annual revenue in 2012, and was comprised of 10,100 stores, serving 4.8m customers. The two largest players (RCII and AAN) accounted for 6,800 stores (67%), and the majority of the remaining players had fewer than 50 stores. So despite having experienced significant consolidation, the industry remains highly fragmented. The industry serves customers without sufficient funds to make purchases and that lack access to credit, and 83% of the customer base has an annual household income in the $15,000-50,000 range. Industry revenue has grown at a 6.2% CAGR over the last 7 years, and the market share is split with RCII at 34.3% (RAC RTO and Acceptance Now), AAN at 30.7% (Aaron’s and Progressive), and other competitors at 35.0%.

The industry is highly competitive, as RTO offerings are mostly undifferentiated across industry competitors such as RCII, AAN, Buddy’s, EasyHome, and BestWay. Other sources of competition are traditional retailers offering RTO transactions, and the availability of subprime credit. Competition is based primarily on convenience, store location, product selection and availability, customer service, rental rates and terms.

Company Description

RCII operates through two primary segments, the core rent-to-own (aka RTO) business (73% of sales in 3Q), and Acceptance Now (25% of sales in 3Q), with Mexico and Franchising representing the remaining 2-3%. At 3Q end, RCII had 4,515 staffed locations and 253 unstaffed locations. In 2014, RCII had ~34.3% market share of an estimated $9b industry, with the next largest competitor being Aaron’s (AAN) with an estimated 30.7% market share.

RCII’s product breakdown (for core RTO and Acceptance Now) for the last 12 months was 40% Furniture & Accessories, 25% Consumer Electronics, 17% Appliances, 9% Computers, and 6% Smartphones. The average credit profile for RCII’s core-RTO offering is 50% sub-520, 27% in the 521-580 range, and 23% over 581. The average credit profile for RCII’s AN customer is slightly higher, with 41% sub-520, 29% in the 521-580 range, and 30% over 581. Approximately 77% of RCII’s business is from repeat customers, and on average a product is rented (turned over) to three customers before a customer acquired ownership. Payments in the core RTO segment are generally made weekly, and payments in the AN segment are generally made monthly.

Core-RTO Segment- 73% of revenue, Revenue growing -1%/yr, Comps -0.2% MRQ, 11% EBIT margins, 2,697 stores.

Rent-A-Center’s core-RTO offering is a store-front operated rent-to-own business where they offer products to customers that don’t have the ability to pay up-front and don’t have access to credit. You can buy their products at the cash price (at an 80-90% markup vs the internet search price), use the 90 Days Same As Cash option, or make a fixed number of weekly, semi-monthly, or monthly payments with no growing interest. If you use one of their RTO agreements, you end up paying the equivalent of a 49-123% APR (average of 72% based on my small sample set) on top of the 80-90% markup (87% based on my small sample set) from the cheapest in-stock internet search price.

RCII justifies these prices by allowing the customer to return the product at any time with no penalty (and the payments stop with no obligation), and also allowing them to resume the payments at any time with the payment being applied to the previously stopped RTO agreement (lifetime reinstatement). Also, RCII guarantees and services the product for the life of the agreement.

The value proposition is that RTO is an affordable way for people to furnish their homes without incurring a continuing obligation and without needing access to credit. In order to get an agreement, you just need information they can verify about your residence, source of income and two personal references. According to management, this is a no or slow growth top line business, but there is a lot of opportunity to improve the profitability of this segment with changes to the labor and supply chain models.

Acceptance Now Segment- 25% of revenue, Revenue growing 27%/yr, Comps 24.5% MRQ, 14% EBIT margins, 1,468 staffed locations, 223 virtual/unstaffed locations.

RCII’s Acceptance Now business provides on-site RTO options at a third-party retailer’s location. Examples of third-party retailers who use Acceptance Now are Ashley HomeStore, Rooms To Go, Conn's, HH Gregg, Bob's, and many others. When a customer’s credit application for a retail purchase is declined, the customer is introduced to an in-store Acceptance Now representative who explains the alternative RTO transaction. Acceptance Now (RCII) buys the product from the retailer, then does a RTO transaction with the customer. The value proposition to the retailer is that they can capture more sales and drive more traffic as future rental payments are generally made at the retailer’s store location. The value proposition to the customer is that they are able to obtain the products they want and need without needing credit. When a customer stops payments, returned merchandise is moved to the core-RTO stores where it’s offered out for rent.

AN doesn’t require or perform a formal credit check for approval, so applicants who meet the basic criteria are generally approved. One area of differentiation for AN is that they don’t require the applicant to have a bank account. This is in contrast to AAN’s Progressive offering which does requires a bank account, so AN typically has higher acceptance rates vs Progressive.

An AN Kiosk is an area with a computer, desk and chairs, and AN occupies the space without paying rent. The setup costs are minimal, and exit costs are immaterial on a per store basis. According to the company, the operating model is highly agile and dynamic because they can open and close locations quickly and efficiently. The total financing requirements of a new AN location are ~$350,000, with 80% of that going to purchasing rental merchandise. A newly opened Acceptance Now location is typically profitable on a monthly basis within one year of its initial opening, and achieves cumulative break-even profitability in the second year after its initial opening.

Think of AN as RCII being able to continue to earn the high APR’s that they can earn on a core-RTO transaction, but only on the cheaper cash price that a third party retailer offers, not on the core-RTO store price that is marked up 80-90%. However, they can do this without the associated expense load, so operating margins are higher.

How the Accounting Works

• Revenue recognition- Rental revenue is recognized over the rental term and merchandise sales revenue is recognized when the customer exercises the purchase option and pays the cash price due.

• Depreciation- Depreciation of rental merchandise is included in the cost of rentals and fees (COGS). Merchandise is depreciated under the income forecasting method, where merchandise held for rent is not depreciated and merchandise on rent is depreciated in the proportion of rents received to total rents due according to the rental contract. For example, RCII recognized a $35m charge related to older generation smartphone inventory in 3Q that didn’t sell well, and this charge was recognized in the “Other store expenses” line item of Cost of rentals and fees, reducing gross profit.

• Skips and stolens expense- When inventory can’t be repossessed, RCII books a skips and stolens expense in the “Other store expenses” line item of the income statement. This removes the BV of the inventory from the BS, increases the cost of revenue, and reduces gross profit.

• Bad debt expense- RCII does not have a bad debt expense because their accounting is different from AAN. RCII stops recording the revenue when a customer stops paying. AAN’s Progressive continues to record the revenue, and if a customer becomes a charge off, they zero out the revenue with the bad debt expense. This means that if there is a shock to the system and both RCII and AAN customers are equally impacted, it should show up at RCII in the revenue line before it shows up at AAN in the bad debt expense.

Collections

When a customer doesn’t pay, store managers attempt to contact the customer to obtain payment and reinstate the agreement. If they can’t, they terminate the account and arrange to regain possession of the merchandise, typically by the seventh day following the default of the rental purchase agreement. If a customer doesn’t return the product or make a payment, the remaining BV of the rental merchandise associated with the delinquent account is generally charged off. This occurs on or before the 90th day following the time the account became past due in the core-RTO segment, and on or before the 150th day the account became past due in the AN segment.

Company Strategies and Initiatives

Recently, RCII has been focused on multiple initiatives, all aimed at either growing revenue (smartphones in Core-RTO and growing AN locations) or reducing expenses (flexible labor model and sourcing and distribution initiatives). They’re currently undertaking several initiatives, and are in varying stages, having realized varying degrees of success. Going forward, investors should be focused on RCII’s ability to realize benefits from their expense initiatives, which combined could remove $45-60m in annual costs, adding ~$0.53-70 in EPS.

Revenue Initiatives

• Smartphones in Core-RTO stores (advanced initiative, slight net positive)- The primary revenue initiative in the core-RTO stores was the 2H14 rollout of smartphones. Smartphones are now ~9% of core-RTO sales, and have helped push core-RTO comps from -4.7% in 2Q14 to +1.4% in 2Q15. The rollout of smartphones hasn’t been without issues though, as RCII has seen (i) higher “skips and stolens” expense, (ii) some cannibalization, (iii) a $35m COGS write-down related to older phone inventory, and (iv) lower gross margins. All in, smartphones have only been a slight net-positive, not a game-changer. Overall, smartphones helped comp sales in the core-RTO segment to move from consistently down LSD-MSD to positive, but this was a one-time benefit, and comp sales should start to decline again as they anniversary the smartphone roll-out.   

• Skips and stolen losses- Skips and stolens are when someone signs up for an agreement and stops making payments without returning the product. Smartphones pushed the core-RTO skips and stolens ratio +100 bps yoy to 3.8% in 1Q, but management addressed the issue by adding locking software to the phones, and now 65% of their inventory on rent has the software, and the software is on all of the new smartphones sold. This isn’t expected to be an issue going forward.

• Cannibalization- Regarding cannibalization, management said on the 4Q14 call that smartphone sales have had a cannibalization rate of 25-50%, primarily within the computers and tablets category of their business. Of note is that on the 3Q15 call, management said that the computer and tablet category was challenged.

• Smartphone inventory charge- RCII took a $35m charge in 3Q15 related to the  COGS of older generation smartphones. When they rolled out the smartphone category, about 35% of their inventory was older generation smartphones which didn’t sell very well. They learned that customers want the newer smartphones, and they’re going to skew toward those going forward. The reason there was a charge is because this merchandise wasn’t on rent, and therefore wasn’t being depreciated.

• Lower gross margins- Smartphones carry a lower gross margin that the overall business, so given the higher mix of smartphones, the overall gross margin is now -200-300 bps yoy.

• Growing Acceptance Now Locations and Virtual Kiosks (middle stages, successful revenue generator but with too much gross margin pressure)- RCII’s strategy has been to increase the number of AN locations by growing their number of retail partners and by growing their penetration with each partner. In the last year, RCII has grown the number of staffed AN locations by +105 (+8%), and added 223 new unstaffed/virtual AN locations (a virtual location is used in stores where the retailer doesn’t have enough credit-constrained customers to justify creating a manned AN location). Mid-20’s comp sales growth and a growing number of locations have helped AN grow revenue by +27% yoy, but lower gross margins from the roll-out of the 90-day same as cash pricing option has weighed on gross profit, hurting margins (we discuss this in more detail below) and making the AN growth initiative a disappointment over the last year.

Expense Initiatives

• Flexible Labor Initiative (early stages, meaningful opportunity)- RCII expects to generate $20-25m of annual run-rate savings ($0.26 in EPS upside) by mid-2016 by rolling out a flexible labor model that reduces higher cost overtime hours and replaces them with lower cost part-time labor hours. RCII has historically used a fixed labor model in the core-RTO stores that generally uses five employees who perform all tasks including sales, customer verification, collections, merchandising receiving, delivery and setup. The fixed labor model regularly schedules overtime (an average of ~24 hours per store per week), and does not allow them to scale their costs to match the revenue cycle. The new flexible labor model RCII is implementing uses part-time employees, allowing them to staff up in peak operating hours and gain cost efficiencies in off-peak hours. According to the company, the part-time labor being used is being primarily concentrated in back of the house functions like deliveries and recovering rental inventory, so they’re not expecting a negative impact on sales. As of 3Q, the new labor model had been introduced in ~75% of their core-RTO stores, but only about 100 stores had moved to the full flexible labor model where no overtime hours were being used. Management stated that the benefits have just started, and the full effects will be seen in 2016.

• Sourcing and Distribution Initiative (very early stages, meaningful opportunity)- RCII expects to generate $25-35m of annual run-rate savings ($0.35 in EPS upside) by the end of 2016 from their supply chain optimization initiatives concentrated on product sourcing and distribution. Since the company’s inception, RCII has relied on rental merchandise being shipped directly from the manufacturer or distributor directly to the stores, not utilizing centralized warehousing and distribution. This model allowed them flexibility in opening and closing stores and made it easy for them to enter new markets, but it reduced their ability to leverage their expenses, created longer lead times, and led to higher costs. Under the new supply chain optimization initiative, RCII is creating new direct supplier partnerships, implementing new distribution systems, implementing a new network of distribution centers through a third-party logistics partnership, and automating the replenishment process from the distribution centers to the stores. As of 3Q, the up-front work for the sourcing and distribution initiative was substantially complete, and management stated that they remain on track to realize their targeted $25-35m of annual run-rate cost savings by the end of 2016.

Underperformance from the Rollout of the 90-day Same as Cash Option at Acceptance Now

RCII has had a mixed year operationally, having beat earnings for 3 consecutive quarters but with reductions to full-year guidance in 2Q and 3Q. In 2Q, RCII beat the quarter but reduced 2015 guidance by -2% to a $2.13 midpoint, pointing to a weaker 2H due to greater than expected gross margin pressure at AN (related to the roll-out of the 90-day same-as-cash option). In 3Q, RCII beat the quarter but reduced 2015 guidance by -3.5% to a $2.05 midpoint, pointing to expectations for lower core-RTO comps, lower AN comps, and higher expected losses from AN. Management pointed to expecting skips and stolens at AN to be ~10% in 4Q, up from 7.7% in 3Q, and cited the need to bolster the AN collections function to better manage losses.

Overall, the primary fundamental reason for the RCII’s recent underperformance has been the gross margin pressure related to the roll-out of the 90-day same as cash option at Acceptance Now. Over the course of the last year, AN has been rolling out a 90-day same as cash option in order to defend market share from Progressive, the third party RTO business owned by AAN. This has helped boost comp sales, but had led to gross margins at AN being -760 bps yoy. According to management, about 1/3rd of their AN transactions use the 90-day same as cash option.

As a result of the rollout of this option, management has had to repeatedly talk down gross margins at AN. However, the full impact should now be in the stock, with 100% of stores having the 90-day option since 2Q. Margins stabilized in 2Q, but management isn’t happy with the profitability of this feature, so they’re working with retail partners to reprice this product. According to management, they expect the profitability of the 90-day same as cash option to improve going forward, and gross margins at AN should improve in 2016.

“Over the past quarter, we had committed to you that we would identify ways to work with our partners to enhance the profitability of this offering while maintaining the compelling value proposition to the customers. As promised, we have had discussions with a number of our retail partners regarding 90 day option economics and they have been very productive. Our retail partners have collaborated with us to ensure the partnership is truly a win-win relationship. And we expect the profitability of the 90 day option to improve as we move into 2016 and beyond.”

“I think it's fair to say that we don't want to have top-line growth that's not productive from a bottom-line perspective. And so as we're seeing that feature if you will or that proposition to the customer gaining popularity, we believe it was necessary to address the overall profitability of that option. So, we have been in conversation with some of our top partners from a retailer perspective and those have been very productive. So, we would expect that to enhance as we move into 2016 and beyond.”

Opportunity and Target

RCII’s stock price is now at the lowest level since March 2008, trading at 7.2x forward earnings (vs 14.1x earlier this year, vs peers at 10.8x), at a 15% FCF yield on my $2.28 in 2017 FCF per share, and at a 6.3% dividend yield. Importantly, there are no covenant issues, as the most restrictive covenant is their  Fixed Charge Ratio covenant, which they easily surpass at 1.83x vs the 1.50x limit. Furthermore, analysts have revised their estimates dramatically lower, with 2016 having come down by -18% to $2.14 and 2017 down by -27% to $2.35. Given this massive reset lower in expectations, RCII’s estimates finally look achievable. Additionally, this is at a time when the multiple is at 5-yr lows (crisis levels). Based on my estimated, RCII should be able to conservatively earn $2.14 in 2016, and $2.40 in 2017 as they realize a full year of benefits from their flexible labor and sourcing and distribution initiatives. As RCII proves that they can stabilize their business, the multiple should re-rate higher to a level more consistent with the 3-year average multiple of 10.9x. Based on my estimated $2.40 in 2017 EPS, this returns a $26 target for 68% upside from the current price. As a cross check, this represents a 7.4x EV/EBITDA level vs AAN at 7.8x 2016 currently, and a 7.8% FCF yield, which is slightly wider than the ~6-7% level the unsecured debt typically trades at.

Financial Projections

Risks

Increasing Competition in the Acceptance Now Channel

Management feels that they’re making progress on repricing the 90-day same as cash option higher to help their AN gross margins, but if they need to defend market share from Progressive it’s possible that they could come back and cut pricing again.

Expansion of Subprime Credit

The RTO industry is negatively levered to an expansion in subprime credit, so a dramatic return to subprime lending will negatively impact industry players. This includes all types of credit, not just subprime credit card lending. For example, an expansion in subprime auto loans is also bad because it eats into a customer’s discretionary income.

Regulatory Risk

The RTO industry is regulated at the state level, and thus far the CFPB hasn’t been interested in regulating the rent-to-own transaction given that it can’t lead to a permanent debt trap, the customer simply returns the merchandise and there are no more charges and no liabilities. But should the CFPB get involved, all industry players including RCII and AAN will get hurt as investors question the viability of the RTO model.

Catalyst

Catalysts

Stabilization in Margins

As RCII shows stabilization in their margins over the next few quarters, fears of subprime underwriting issues should fade and the stock should be able to re-rate higher.

Execution on Cost Initiatives

According to management, the company is “on track” to realize their targeted $20-25m in annual run-rate cost savings from their flexible labor initiative by mid-2016, and to realize their targeted $25-35m in annual run-rate cost savings from their sourcing and distribution initiatives by 2016-end. Execution on these cost savings should provide more confidence in future cash flows and help lift the multiple.

Normalization in Credit Markets

Recently, RCII’s unsecured debt yields have sored given the disruption in the credit markets. RCII’s senior unsecured 4.75% bonds due may 2021 now have a yield to worst of 10.9%, and their senior unsecured 6.625% bonds due November 2020 have a yield to worst of 10.8%. Given the relative illiquidity of the bonds relative to the equity, it’s possible that debt holders that haven’t been able to sell have been hedging by shorting RCII stock. Regardless, as the unsecured debt yields normalize, there will be more room for the equity yield to decline (currently at 13.9%, inverse of the 7.2x forward P/E), and the P/E ratio will have room to expand. Obviously given their junior position in the capital structure, RCII’s equity should not have a lower yield than its unsecured bonds.

Potential M&A

Given it's cheap valuation and their ability to realize efficiencies from the cost structure, it’s possible that RCII gets acquired, either by a competitor or by private equity.  

DISCLAIMER:  DO NOT RELY ON THE INFORMATION SET FORTH IN THIS WRITE-UP AS THE BASIS UPON WHICH YOU MAKE AN INVESTMENT DECISION - PLEASE DO YOUR OWN WORK.  THE AUTHOR AND HIS FAMILY, FRIENDS, EMPLOYER, AND/OR FUNDS IN WHICH HE IS INVESTED MAY HOLD POSITIONS IN AND/OR TRADE, FROM TIME TO TIME, ANY OF THE SECURITIES MENTIONED IN THIS WRITE-UP.  THIS WRITE-UP DOES NOT PURPORT TO BE COMPLETE ON THE TOPICS ADDRESSED, AND THE AUTHOR TAKES NO RESPONSIBILITY TO UPDATE THIS WRITE-UP IN THE FUTURE.