Description

I believe Rent-A-Center shares are grossly mispriced, and provide an attractive opportunity to rerate over the next few years. 

Discussion on RCII, as well as on other LTOs and VLTOs, has been fairly active recently, so I will refrain from rehashing the business model. If you’d like a good intro into their business model, I suggest reading bigvic’s 2021 writeup covering RCII and its acquisition of Acima, as well as RiskReward’s 2015 writeup for a more in-depth description of RCII’s legacy business. 

Overview

As a brief overview, RCII as it stands today is a combination of Rent-A-Center (RAC) and Acima. RAC purchased Acima in early 2021. The core RAC business is brick & mortar LTO (lease-to-own). This segment offers merchandise in its own stores which customers can acquire through lease-to-own agreements, in which customers either own the merchandise after a certain number of lease payments or return the product. Acima is a VLTO (virtual LTO) provider. As a VLTO, Acima partners with retailers who then offer Acima’s lease-to-own solution through the retailer’s POS or their website. Acima has nearly 40k retail partners. 

Opportunity

VLTO providers have been viewed at 2 ends of the spectrum over the past year. Originally, they were viewed as extremely valuable, high-growth fintech platforms. More recently, sentiment has moved towards them being high-growth consumer finance companies with underwriting issues (in other words, an investor’s worst nightmare). I think reality lies somewhere in between.

So what has happened over the past half a year that has cut RCII’s share price in half? In short, it has been a combination of normalized loss rates in the core business as well as underwriting issues at Acima. 

Core Business Loss Rates

For most of the duration of 2020-2021, skip/stolen loss rates were temporarily low as their customers benefited from the effects of stimulus. For the core b&m business, loss rates in a normal year fall around 3.5%. During the covid stimulus quarters, loss rates fell on average to 2.4%, which is a fairly large boon to earnings. In Q4 of 2021, loss rates finally normalized, but are still falling within their desired range of 3-4%. There are really no issues on the b&m side of the business, and it is still generating a very healthy amount of earnings. The fact that there are people that didn’t see this coming and overreacted to the news…. is what makes a market I guess? 

Acima Underwriting Issues

This is the much larger issue. Due to the historically low losses in recent memory, Acima’s underwriting majorly faltered. During 2021, Acima basically adopted a policy of pushing volume at all costs. For some reason they (along with the market) didn’t account for a normalization once stimulus ended. Loss rates at Acima, which were running around 8-9% in 2021, ballooned to over 12% in the most recent Q which is significantly higher than the normal range for that business. I am not going to make any excuses here - this was just poor execution. But this is where my previous point comes into play - this isn’t your typical example of a nightmare, fast-growing consumer finance company with underwriting issues. VLTO has no long-tailed liabilities. When underwriting falters, you find out almost immediately and old vintages cycle through the portfolio in less than a year. Acima had underwriting issues plague them in the back half of 2021, and that part of their portfolio should be completely cycled through by the back half of 2022. More importantly, management took steps to correct this as soon as they identified the issue - they sacked the head of Acima that oversaw the poor underwriting, brought the founder back to lead Acima, and tightened their underwriting in a big way. They significantly scaled back on GMV, which had been growing between 20-40% yoy during 2021, to get underwriting under control. GMV for Q1 2022 was down 21% vs Q1 2021. Per management, these changes have already made a huge impact. Loss rates have come down significantly, and they say the first payment missed rate (means exactly as it sounds) has come down 30% in March from the December high. 

This doesn’t seem to be a situation where turning around results is a herculean task. Previous management simply got carried away with pushing volume during a period where you basically couldn’t lose. The issues should already be fixed and should roll off the financials in the next quarter or 2.  

Regarding the long-term, normalized loss rate for Acima, management claims it should be 6-8%. I am skeptical of those numbers, but other VLTOs have seen and claim the same numbers.

Benefits of Shrinking GMV

Despite all of the negatives surrounding the idea of Acima momentarily shrinking in size, there is one large positive. As GMV and revenues shrink, we will see a large working capital unwind and massive FCF for the year. RCII saw FCF of nearly $200mm in Q1 2022, and is guiding for upwards of $400mm for the year. This is on a company with a market cap of $1.5B, net debt of $1.3B, and a $500mm share repurchase authorization (after it completed a $250mm authorization in 2021). In the short-term, management is aiming to get net debt down to 1.5x (from 2.3x currently), which unfortunately makes share repurchases unlikely for the next few Qs… but any share repurchases at this level would be very attractive.   

Valuation

RCII was a covid beneficiary and has been over-earning for the past 2 years, there’s no doubt about that. But even putting a reasonable multiple on very conservative earnings for this business shows massive upside.

 To highlight this, consider the following scenario: 

• Core RAC B&M has had quite a lot of revenue growth and margin expansion in the past 2 years. Some of this margin expansion is due to operating leverage, some of it is due to management right-sizing the store footprint. For conservatism’s sake, let’s assume margins and revenue per store falls back to 2019 levels. 

• Acima has historically grown revenue and earnings at a breakneck pace. EBITDA (while not the right metric to value this business with) quadrupled from 2017 to 2020. Now obviously this has come with underwriting issues as has been discussed. So, let’s assume that in order to get underwriting back under control, Acima cuts GMV by 20% for a full year. Management and competitors claim normalized loss rates of 6-8%. Let’s use 9% for conservatism.

• The other segments are not meaningful profit contributors, let’s just take them at face value. 

Putting the above together, I see RCII doing about $3.5/share (fully diluted for Acima purchase) in cash earnings. I view this as the normalized floor for the business, outside of some serious operational missteps. This puts them around a 7x earnings multiple.

If you take off your conservatism cap for a second and believe that core RAC holds current revenue per store and Acima achieves a normalized loss rate of 7%, that puts cash earnings somewhere around $5/share. This puts them around a 4.5x multiple.

LTOs have historically traded at lower multiples than VLTOs, but even LTOs typically sit in a range of 10-20x earnings. The only time we have ever really seen them dip below that multiple is in the past year. If RCII simply traded up to a 10x multiple on floor earnings, that represents nearly 50% upside. If it trades up to a 10x multiple in a scenario where Acima hits its loss rate targets and the core RAC business maintains its SSS (albeit with higher loss rates than 2020/2021), that represents over 100% upside. Whichever situation unfolds, I believe it is achievable within a year as we will know the result of the underwriting changes within the next 6 months.  

Catalyst

Normalized loss rates for Acima