Description

As a few members have commented, it’s been refreshing seeing some larger, liquid value ideas presented here recently such as Disney, Borders, and Dollar General, as opposed to the more typical obscure micro-caps where you can sneeze your way into a reporting position and generally require an Ebay auction to unload. The party's over.

If you go one “sub” below sub-prime, what Circle of Dante’s Inferno have you reached?

One Sentence Thesis

Rainbow Rentals is a fundamentally good, growing business in a controversial industry which is in the midst of a minor turnaround, trading a very attractive absolute price, and an extremely attractive price relative to recent transactions and its publicly traded peers.

Brief Industry Primer

The Rent-to-Own (RTO) industry is 40 years old, and its primary function is to provide consumer goods to people who don’t have the capital or credit to purchase them outright. A typical rent-to-own customer will sign a weekly or monthly contract for the use of, say, a computer, piece of furniture, an appliance or television. The renter will pay the first period in advance and has the right to return the item and end the contract at the end the relevant week or month. Alternatively, the renter can continue to make advance payments and hold onto the item, until they either (1) want to return it or (2) have paid enough that they’ve bought it. The average total rental period is only 4 months, and only 20% of customers rent long enough to buy, which usually requires between 12 and 24 months of payments depending on the item.

There are six public rent-to-own retailers, the big three being Rent-A-Center (2700 stores), RentWay (766) and Aaron Rents (659). These three make up around half the ~8,000 rent-to-own stores in the US. They spent much of the 1990s consolidating a very splintered industry of Mon and Pops, and in recent year the acquisitions have continued on a larger scale.

Rainbow Overview

Rainbow Rentals is the 4th largest RTO company, and is far smaller than the big three, sporting only 123 stores. It was founded in 1986 by current management and came public in ’98 in the heart of the Russell 2K meltdown at $10 a share ($60m valuation) and 62 stores. The stock rose to around $14 a share as the business was basically on track through mid-2000, at which point comps and margins went unexpectedly south. Despite signs of a rebound, Rainbow’s business recovery has not been particularly swift, and the stock trades at around half of its IPO EV with double the store count.

The company's stores are mostly located towards the east cost, with 49 of the 123 in Ohio and PA. Store count has grown from 6 in 1986 to 123 at the end of 2002 (CAGR of 20.8%), and from 62 to 123 (17.5%) over the last five years. Unlike the big three, most of Rainbow’s growth as come from organic builds, which have constituted around 80% of total store adds since inception. RBOW did acquire 20 stores (while also building another 20) during 1999 and 2000, which contributed to its recent difficulties. Going forward, Rainbow expects to build 10-15 stores in 2003, which would equate to about a 10% unit increase, something they see as a reasonable bogey for the foreseeable future. They continue to emphasize building stores but are still willing to make “selective” acquisitions (as opposed to the many retailers who openly confess to be seeking irresponsibly arbitrary acquisitions).

Store Economics

A typical RBOW store is 4-5K square feet (stores are leased), and requires around a $500K investment, most of which (~$300+K) is for the rental merchandise. RTO boxes are inevitably unprofitable for their first year or so, because it takes a while to ramp up customer contracts, i.e. the business is more cumulative in nature than typical retail (thus, you sometimes see acquisitions of mere “customer tuck-ins” rather than stores). By year 3, the stores are generally mature, and can earn anywhere from 10%-30% store operating margins, depending on the company.

RBOW’s strategy is to be a high volume player, aiming to average $1m in revenue and generate 22% operating margins per mature store. The industry average is around $600K in revenue per store. They reached their goals in most core stores during 2000, and were leading the industry in sales/store and sales/square foot, before things started to slide a bit. Comps from 1993 to 1999 averaged 7.1%, until going negative in 2H00 (up 1.7% for the year) and down again (4.3%) for 2001. Comps have improved to +2% for the first 9 months of this year, including a 3.8% jump in Q3, but that has mostly come from recent price increases as opposed to improved traffic. This fairly weak performance is not solely an industry-wide phenomenon, as Rent-A-Center in particular has continued to comp well.

The comp decline killed margins, though RBOW has remained profitable throughout. Operating income went from $9.7m in 1999 (12% operating margins) to $3.1m last year (3.3%), and are superficially looking rather flat YoY. The company attributes its problems to a combination of the 20 acquisitions in 1999 and 2000 (after only having acquired 8 stores since inception) and severed labor shortages during the trough unemployment periods, which lack of focus and understaffing they estimate cost around 100 customers per store on average. They still believe they can re-attain their goal of $1m in mature store revenue and 22% store-level operating margins in the near future, and continue to meet these bogeys at many stores.

But Dorothy never used the “units of activity” method

You’ve got to appreciate an industry that can combine the depreciation quagmires of a container leasing company, the inventory issues of a teen retailer, and the collection problems of a Long Island bookie, all in one neat little package. RTO accounting has come under fire at times, including Avalon Research’s continuing negative opinion on Rent-a-Center and its depreciation methods, Off Wall Street’s criticism of RentWay’s accounting, and RentWay’s subsequent announcement it had cooked the books. Rent-a-Center is fairly near an all time high, but has 18% of its float sold short, while RentWay has imploded. Aaron Rents, the third biggest player by store count, has performed well and isn’t heavily shorted.

A good deal of the accounting controversy has swirled around the industry-standard depreciation method, called the units of activity method. It’s critical to understand that the bulk of an RTO’s COGS is non-cash depreciation of merchandise. When an RTO company buys, say, a couch for $400, and immediately rents it out for $50 in month 1, it does not record a $350 loss for the month. Instead, it records $50 in revenue, and estimates depreciation by calculating what percentage of the “total lifetime rental value” of the asset was received in that month. For example, if the company’s allowed for purchase after 24 months of $50 payments, it would depreciate 1/24 of its cost after month 1 (in this case, $16.67). If the couch becomes worthless (damaged beyond repair, stolen) while it still has carrying value, the remaining book value is immediately charged to COGS. But that’s not the part that’s attracted negative attention, this is:

Say, after a month, the NFL playoffs are over and the customer returns the couch, as is his contractual right. In month 2, said couch sits in the back of your local Rainbow Rentals, emitting just enough of a stench to keep anyone from bringing it home from the pound. At the end of month two, THE COMPANY RECORDS NO DEPRECIATION. Thus, idle inventory can (and does) sit in the store without impacting the P&L. You can see how this might create a serious quality of earnings problem. Triple your idle inventory to boost same store sales, and record no charge in the P&L for three dozen 27” TVs that have been sitting on the shelves for six months. The risk from this accounting method is real, but it’s also fairly easy to evaluate through the B/S and the SOCF. As Off Wall Street noted in its 2000 report on RentWay, if inventory is rising faster than sales, and thus NI is exceeding OCF by larger margins than you’d expect based upon business growth, you’ve got potential issues. On the other hand, it’s also important to note that there’s nothing inherently evil about this accounting method. Traditional retailers, for example, routinely keep inventory on their shelves for months without taking a depreciation charge. And note that computers are continually depreciated, even if they are idle, because of their rapid obsolescence.

It's also important to realize that despite the stank of subprime lending and the accounting thicket, Rainbow is NOT taking receivables risk. Payments are made in advance be customers, so this completely different than subprime credit story where revenues and earnings are wholly reliant on the accuracy of loss allowances.

Rainbow’s cash generation

Over the past eight years (through 9/30/02), Rainbow has generated $30.0 million in operating cash flows on $21.2m in net income. Despite this quality of earnings indicator, RBOW has in fact paid consistently more in cash inventory costs than the charge reflected on its P&L. Of course, that’s not surprising considering that revenue more than doubled ($43m to current run rate of $100m) during that time. A growing retailer will inevitably experience cash inventory costs that exceed the inventory charge on the P&L. The best way to measure whether Rainbow’s depreciation methods have overstated earnings is to see whether inventory grew faster than sales, putting true cash profitability into question. Net merchandise as percentage of total annualized revenue from 1995 through 2002 has been:

36.83%, 42.4%, 42.31%, 39.77%, 40.86%, 39.77%, 41.59% and 37.50%.

This same flat-line pattern emerges when you use merchandise at cost as opposed to net, indicating that purchases have been consistent with revenue growth regardless of depreciation schedules used. In fact, the P&L actually overstated the cash costs of inventory purchases through the first nine months of this year by $3.2m, despite revenue being up 5% YoY.

Finally, note that Rainbow has recently begun breaking out its idle (not on rent) inventory in its 10K, and it stood at only $7.4m (net) as of 12/01, versus $8.3m in 12/00. Rainbow has never taken a single material inventory write down to clear out idle inventory (or otherwise), nor does it take one time extraordinary charges (they’ve never taken any), such as acquisition big baths, to set up reserves, and its current inventory is the leanest it has been in years. In sum, there is no evidence that Rainbow’s P&L has been overstating the cash economics of the business or masking a growing hoard of bad inventory. Incidentally, RBOW has no short interest, although that may be more a function of its small float than the market’s implied approval of its accounting practices.

Management and Governance

Rainbow is conspicuous for its lack of red flags in an industry that has raised some eyebrows at times. The three most senior officers (Wayland Russell (CEO and Chairman), Lawrence Hendricks (COO), and Michael Viveiros (46)) have been with the company since inception (CFO Michael Pecchia as been on board since 1991). Together, they control approximately 56% of the company, with Russell holding 43% himself, and none of them have sold a share since RBOW’s ’98 IPO. Another thing none of them have done is granted themselves a single option or paid themselves huge salaries since the company went public, and RBOW’s shares outstanding have been flat at 5.9m since it IPO’d. Russell’s total salary, including bonus, has been less than $400K from 99-01. The biggest change the company made upon going public was capping the unusually large percent of earnings it donated to charity as a private company in the 1990s.

It’s also worth noting here that Rainbow’s business model is unique in the industry in that less than 3% of its revenues come from fees, such as fees charged to customers for picking up on rent merchandise after non-payment. The average company in the RTO industry in contrast generated upwards of 11% of their revenue various add-on fees that are much more numerous than the two basic fees RBOW imposes. Without getting into a discussion of the moral hazards of running a business that includes a form of sub-prime lending, it speaks well of Russell and Company in my view that they operate with the cleanest revenues in the industry and thus arguably with the most straightforward value proposition to customers.

Relative and Strategic Valuation

Although not normally my favorite phrase, this subheading is worth a look in this case. RTO acquisitions are extremely common, and very reliably occur at 8-12X monthly revenue. RBOW itself has not been an important acquirer, but has paid between 9 (Rent Mart, 1999) and 12 (Blue Ribbon, 1999) time monthly revenues (i.e. .75 to 1X sales), and Rent-A-Center has paid similar prices for its larger acquisitions, Thorn and Central Rents. Very recently, a significant transaction was announced that provides the most up to date comp.

Last month, Rent-A-Center agreed to pay $101.5 million to buy 295 of RentWay’s worst performing stores. Specifically, those stores were averaging approximately $411K in revenue a year ($34K a month), much lower than the rest of RentWay’s already low volume store base ($583K a year on average). Thus, RCII is paying a multiple of 10X monthly revenue for these under-performing stores, which, according to RWY, are generally *unprofitable*. Notably, this was hardly a bidding war but rather more like a distress sale for RWY, which has been having trouble refinancing its debt that comes due in December, thanks to lingering problems from its 2000 accounting fraud revelation and the related lawsuits and federal investigations.

Even with its recent lackluster results, Rainbow is averaging $850K per store, and its stores are already profitable. At 10X monthly revenue, RBOW would fetch $87m for its 123 stores, compared to its current Enterprise Value of only $34m. Even if you went toward the lower end of comp transactions and gave them an 8X monthly revenue multiple, the stores would be good for $70m. This hasn’t gone unnoticed.

Aaron Rents (RNT), the final member of the big three, first purchased 5% of Rainbow in the open market for $4.70 a share in 10/02. Charles Loudermilk, Aaron’s CEO, said this about the Rainbow investment in Aaron’s most recent conference call:

“We've bought some Rainbow stock, as you probably know. I think 300,000 shares and we reported that a little over 5 percent. I've talked to the Chairman of the Rainbow; he has no interest in selling, so he says. And I think management controls almost 50 percent. So we have no idea of -- or thought of how to take over. We think that we would like to have a number of their stores. They operate somewhat like us two or three years ago. We went up and met with them with the idea of purchasing the company. So, we have an interest but I don't see us buying that company anytime soon, maybe never. But the stock that we've purchased it for 4.60 average or something like that. I think it's a good buy -- that the solution [sic] of that company would be worth certainly more than $4.60 a share. So, I just want to explain that there are a lot of questions of why we did it. I think we'll make some money on the stock, if nothing else happens.”

Then, on January 17, RNT bought another 175K shares (finding a seller that was willing to sell in bulk below market at $4.05) and increased its stake to 8%. Please see the amended 13D for stronger language indicating Aaron’s interest as a potential acquirer.

It seems straightforward that either Aaron or Rent-a-Center would be more than happy to pay at least 8X monthly revenues for Rainbow’s operations, which are well respected in the industry and represent by far the most attractive cluster of stores anybody could acquire in one shot. In fact, I would argue that Aaron would pay more than 8X monthly revenue, considering Loudermilk’s recent proclamations that his company will pass the much larger Rent-A-Center to become “number 1,” and RBOW's indications to me that RNT is not the only company that has expressed interest.

Of course, if a willing and capable buyer at a large premium were enough, we could all buy Crayfish and Zonagen and call it a day. But I have spoken with Mr. Russell and he is not currently interested in selling, and management controls the company. Although the apparent strategic value of Rainbow is neither a reliable near term catalyst nor an objective measure of intrinsic value, it’s also not irrelevant, in my view. At a minimum, it gives an idea of how industry insiders view the value of the business.

RBOW’s valuation also appears substantially cheaper than its peers using the industry-preferred acquisition metric. These are recent EV to sales valuations of the public US RTO companies:


Rent-A-Center 1.17
RentWay 0.58
Aaron Rents 0.84
BestWay 0.84
Average 0.86
Rainbow 0.34

Mind you, RentWay is significantly levered, losing money and faces potentially material class action liability from its prior restatements, plus a pending SEC investigation (and is selling off stores). Bestway is and has been unprofitable and has 69 stores doing some of the lowest volumes in the business. Meanwhile, Rainbow has vested management, some of the most productive stores in the industry, has never had an unprofitable year, has generated operating cash flow in excess of net income, is growing storecount organically by 10%, and had only $4m in net debt at 9/30/03.

Absolute Valuation

As I mentioned, understaffing starting in the second half of 2000 and two significant acquisitions of 20 total stores hurt Rainbow’s execution and have cost them customers, depressing results for the past two years. This is a business where mistakes take a bit longer to correct than in traditional retail, because customers tend to be stickier by the nature of the transaction. Operating income from 1997 to 2000 was $6.8m, $7.3m, $9.7m, and $8.2m. Operating income per store (this is not store contribution, it deducts G&A) from 1993 through 2001 has averaged $99K. And that number is after deducting the costs of opening news stores – which lose money for their first 12 months of operations – in a high growth period, and after deducting depreciation of PP&E that has exceeded maintenance capex by around $1m per year. Using the current 123 store base, that historical average would equate to $12.2m in operating income against an enterprise value of $34. Add back the excess depreciation over maintenance capex and you get an EV/EBIT of 2.5X, and again that’s including the initial losses from newly built stores.

In 2001, when comps fell 4.3%, operating income likewise fell precipitously to $3.1m, or approximately $28K per store, though after-tax operating cash flow was $5.4m. 2002 has also been difficult despite the 2% comp increase, but significant improvements over 2001 have been masked by the 12 new stores that are losing money. Store level operating margins in mature boxes, while still far below RBOW’s previously achieved and still expected 22% goal, have actually been approximately 14.3% as opposed to the reported contribution margins of 11.9%. Thus, excluding those new store losses and a small legal settlement charge in Q2, operating income for the first 9mos was (my estimate) ~$5.5m as opposed to the reported $2.9m. Although Rainbow has not provided guidance for seasonally strong Q4, this analysis suggests that even with a slow recovery, RBOW will produce ~$7-8m in operating income from mature stores this year, leaving an EV/EBIT of ~4.5 on (in my opinion) depressed earnings in a growing business.

Here’s a look at the upside. If Rainbow returns to its previously reached goal of $1m per store and 22% operating margins on 7% G&A, it would generating $150K per mature store (it has done this in the past but never in total because new store losses have always reduced the average). With 123 stores, that would equal $18.5m in operating income for a growing business with plenty of room to expand and a solid balance sheet against the current enterprise value of $34m.

Since the beginning of 1998, Rainbow has generated $26m in operating cash flow against its current equity cap of $29m. And that’s on a starting base of 62 stores and including the toughest two-year period in its sixteen-year history.

Risks

The biggest risk is that the cause for the Rainbow’s 00-01 struggles was more secular than it appears. It’s possible that RTO is more saturated than anyone thinks and RBOW was simply losing share and that profitability will be reduced permanently going forward, and that stores simply aren’t very profitable going forward. Recent improvements in operations, strong comps from competitors, RentWay’s reduced growth going forward, RBOWs ability to raise prices this year, and comp growth / margin improvement in 2002 make this seem somewhat unlikely.

Regulatory / Headline risk. RTO companies are permitted to charge mark-up rates that equate to imputed interest that exceed state usury ceilings because they are not treated like credit card companies in 47 of the 50 states. Consumer groups have argued that RTOs should be subject to consumer usury limits, and if this was ever legislated at the federal level, it would likely end the RTO business fairly quickly. However, that is extremely unlikely, and in fact the opposite sort of bill passed recently in House to mandate non-credit treatment for RTOs. The passage of that bill is not particularly important to Rainbow.

Also, for an example of some of the potential accounting concerns in the industry, please go to Off Wall Street’s website where they offer their old report on Rent-Way as a sample.

Disclosure

I own decent non-reporting position purchased fairly recently at around current prices. The trading in RBOW has been somewhat unusual in that bulk lots have been surprisingly available despite anemic exchange volume. I write this to both mitigate liquidity concerns, and to address any skepticism that might arise upon seeing large available blocks by stating plainly I am not the seller, and I have no intention of selling in the near future or at recent prices, although I can only promise to update my position ex post facto. I believe I know who the seller is, but I will not mention it publicly, except to say that I don’t believe it’s either an insider or Aaron Rents. The $5 price indicated above is slightly lower than the $5.24 listed close price because it is the price at which I believe (but obviously can’t promise) big lots can be purchased.

Catalyst

-Continued improvement in operating results as (and if) the company continues to recover from its 2000/2001 hiccup, leading to clearer indication of Rainbow's value relative to its price.

-Potential headline catalyst if Aaron Rents continues to purchase shares and becomes more vocal in its interest in Rainbow, although again I don't believe management is interested in selling the company at present.