Description
INTRODUCTION
When first looking at Rent-A-Center (NYSE: RCII), some feel there's no way they can become interested in a company focused on a consumer segment notorious for not paying its bills. But when you look at RCII's consistent operating history, it's clear they've got this problem figured out. Looking closer, here's a company in a dominant market position (39% market share), with a business that generates good returns on capital, throwing off enough cash to grow its business, with enough free cash leftover for significant payouts to shareholders, and trading at only 11 times what I estimate to be a sustainable level of net income (market cap = $1.9B, sustainable net income = $175M).
I hope this chart comes through looking OK, but this info is readily available so it's more for convenience:
Year Sales EBIT NI ROA ROE
1994 $74M 12% 7% 15% 82%
1995 133 15 8 12 20
1996 238 13 8 11 16
1997 332 14 8 14 18
1998 810 13 3 2 14
1999 1,417 13 4 3 27
2000 1,602 15 6 6 36
2001 1,809 13 3 3 14
2002 2,010 17 8 10 26
2003 2,228 17 8 11 22
2004(e) 2,305 15 7 9 21
2005(e) 2,410 14 8 10 23
ACQUISITIONS
Rent-A-Center is an acquisition machine. Since 1993, they've increased the stores in number from 27 to 2,648. While they do open plenty of new stores, this growth came primarily through acquisitions. RCII's biggest acquisition was its acquisition of Thorn America in 1998-1999, wherein its store count went from 766 to 2,440.
The thing to worry about with an acquisition strategy is the price RCII pays. It's clear that it took them a few years to digest the 1998 acquisition. Nonetheless, I think RCII is good at acquiring stores at a reasonable price ... their return on assets has been in the 8-11% range. They've been acquiring stores long enough that if they were paying too much, it would have shown up in ROA by now.
COMPETITION
Rent-A-Center is in a dominant position (39% market share by store count) in an industry whose prospects for growth are respectable. They've been successful at buying competitors to minimize (1) the price competition for market share, and (2) the fixed-cost inefficiencies that occur when multiple competitive stores serve the same customer base. This strategy has enabled RCII to maintain EBIT margins in the 13%-18% range for the past decade, with margins in 2004 tracking for 14.7%.
A significant competitive advantage for RCII is its size, which has enabled it to operate more efficiently than competitors, to achieve lower costs of debt capital, and to have a purchasing advantage. With RCII's growth and acquisitions strategy, this competitive strength will be hard to mimic. And with the still-fragmented nature of the industry, despite RCII's size, its acquisition prospects continue to look plentiful (the 6 largest companies account for 4,800 of 8,300 stores, with most of the remaining 3,500 stores owned by companies with 20 stores or less).
As for the rent-to-own market itself, this concept has been validated by its own success, and looking forward, the industry should continue to perform well.
CAPITAL ALLOCATION & CASH FLOW
With a return on assets of around 9%, Rent-A-Center doesn't need an undue amount of leverage. After levering up significantly in the 1998 acquisition, it has brought debt/equity back down to about 1.4, which is enough to leverage its 9% ROA into a 20%+ ROE, but not so much that there is an undue amount of risk. S&P rates their debt BB+, one notch below investment grade, which I think reflects general pessimism about this unglamorous industry.
RCII is generating enough cash today that they have been able to throw off a significant amount to shareholders in the form of buybacks. It repurchased $270M worth of shares in 2003, and is tracking for another $190M this year. One thing that's helping RCII generate so much cash is that its store base is maturing. Net purchases of merchandise as a percentage of merchandise depreciation has declined from 130% in the 1990s to around 100% today (their stores are now at a maturity level where they need only to replenish existing inventory, as opposed to before when they needed to build up merchandise for a newer store base.) As a result, RCII has more cash available to make acquisitions or payout to shareholders.
In recent years the company has been generating about $320M in operating cash flow, of which it chooses to re-invest about $180M in the business through growth and acquisitions (money which they've historically gotten a good return on), leaving $140M in cash to pay to shareholders or debt-holders. That's a situation I would be very happy with as someone purchasing shares while the company's market value is $1.9B, less than 6 times operating cash flow.
FLAGS OR HERRINGS? ... THE RED.
Collections. The natural reservation with Rent-A-Center is an aversion to getting involved in a business perceived as collections-challenged. But on average only about 6% of accounts receivables are more than 7 days past due, and charges for stolen merchandise are consistently less than 3% of sales. This, coupled with their consistent (although a little lumpy) operating history, gives me confidence that the business is proven and they've got collections under control.
Depreciation. One thing to be wary of at a company like this is depreciation policy (I have visions of a case study on Blockbuster circa 1990 swimming in my head). You don't want to find out later that earnings were propped up by stretching depreciation out. I found that: (1) the only recent change in depreciation policy was to accelerate the rate at which they depreciate computers, and (2) merchandise depreciation as a percent of rental revenue was 21.6% in 2003, comfortably in the middle of the 20.5% to 23.0% range over the past decade.
Looking at inventory, merchandise inventory on rent and merchandise inventory held for rent have been consistently in the area of $210,000 and $55,000 per store in the past 5 years. Furthermore, RCII's efficiency has increased in recent years, generating $3.20 in revenue for every $1 in inventory in 2003, compared with $2.90 on average in the 1990s.
Litigation & Charges. Lawyers have an infatuation with Rent-A-Center. This is partly due to the laws for rental contracts, which differ state by state and so make compliance a challenge. It appears that these types of lawsuits benefit lawyers and few others. The other half of lawsuits are for alleged labor violations such as unpaid overtime and sexual discrimination. RCII seems to manage its lawsuits ok, often settling claims which it doesn't get a judge to throw out, and voluntarily adjusting its business practices to make sure they are as above reproach as possible.
In addition to litigation charges, RCII takes finance charges every once in a while. These seem a little high if you ask me, but -- for example -- the debt service savings they achieved last year by refinancing their 11% notes with 7% notes created plenty of value, even after considering the charge. My estimate of $175M in sustainable net income factors in $15M a year for legal settlements and finance charges, which should be plenty.
Stock Options. Net of cancellations, about one million options are granted each year, which represents about 1% of the outstanding shares. In figuring out the $175M I think is sustainable for Net Income, I increased management's calculation of stock option expense by 50%, to $20M a year. I think that's a decent margin of safety.
Major Shareholder. Apollo Advisors (started by Leon Black of Drexel Burnham fame) has been a major owner around since 1998 when RCII acquired Thorn America. In addition to common stock, they hold the only 2 shares of Series C preferred stock, which lets them choose 2 directors. They have been selling their stake over the past couple years. Their ownership percentage is down from 34% to what appears to be 9.5% after their most recent filing. I don't know whether Apollo has sold because they had somewhere else to put their money or because they saw something they didn't like. The good news is that there was a buyer on the other side of each sale.
Same-Store Sales. If you had to write this idea in one sentence, it would be: "Rent-A-Center is a good business that is currently struggling with same-store sales growth, for which it has been pummeled by the market, trading at 11 times earnings vs. 24 for the rest of the industry."
The company is certainly facing some headwinds. Despite its hopes to continue to grow its store count by 5-10% per year, growth forges its own anchor. Even with flat same-store sales, they're still generating $120,000 in EBIT per store. Times a few thousand stores ... nothing to complain about. But same-store sales are a concern. You can pretty much make your investment decision based on whether you think same-store sales will rebound or not.
VALUATION
Here's what I think is a sustainable baseline for Rent-A-Center
Revenue $2,310M
Depreciation $450M
Salaries $1,260M
Other $260M
Net Interest $35M
Taxes $95M
"Nonrecurring" $15M
Stock Options $20M
Net Income $175M
Of course the actual performance of RCII will bounce all around, but I think they have a viable business, are in a great market position, and over time their average performance will be at this level, if not higher. I also think that the maturing business will continue to throw off plenty of cash which can be used advantageously for either acquisitions at reasonable prices or buybacks (especially at the current stock price).
So what is the stock worth? RCII trades for about $25 a share, which equates to a market capitalization of about $1.9 billion, just 11 times my estimate of sustainable earnings of $175 million. I think the margin of safety in my estimate is adequate because of adjustments for increased salary expense, "nonrecurring" charges, and stock option expenses, as well as the growth potential which remains for this company.
With a 10% required rate and a 4% expected growth rate, I think RCII is worth $2.98B (17 times earnings), about 60% higher than the current market price.
Even if RCII's net income is flat, by buying back $100M in stock per year, the stock will need to appreciate by 5.3% a year just so the P/E is stable. If RCII is really worth 17 times earnings, then for every dollar the company uses to buyback shares at 11 times earnings, investors receive $1.54 in value. That's a scenario I like very much.
Taking a look at the rest of the industry, you can't help but reach the conclusion that either RCII is undervalued or the industry is overvalued. RCII's biggest competitor, Aaron Rents (NYSE: RNT), trades for 25 times earnings with a market cap of $1.2B (about 65% of RCII's market cap), while RCII's earnings are almost quadruple RNT's. Now, I agree that growth has a big effect on value, but not this big.
The Rental & Leasing industry as a whole trades for 24 times earnings. And here is the dominant player in the industry, with great earning power and decent growth prospects, who is struggling a little with same-store sales growth ... and the stock is bid down to 11 times earnings? This seems a bit extreme to me. I'm glad the company is buying back stock to multiply my return.
Catalyst
Cash flow & buybacks. Whereas before the market could value RCII however it pleased, now RCII is buying shares at that price. Continued buybacks will eventually force Mr. Market to recognize that he's giving his shares of RCII away for far less than they're worth. In the meantime, every dollar used for buybacks creates more than a dollar in value for remaining shareholders.