Description

Here is a company perceived as a retailer/lender to subprime consumers.  But their customer doesn’t own a home – 90% of them live in an apartment, which means they don’t have a subprime mortgage. 

Dominant #1 in its business and the stock can be bought for 8.5x earnings.

If you look at a chart of the stock you’ll see a big drop in August which was when we started buying.  We would argue that that was not a drop on fundamentals – that was a drop because a lot of speculative investors owned the stock looking for an LBO and all rushed for the exit at once.  Remember what everybody was thinking in July?  RCII was an LBO story with a $30-32 ribbon on it then.

Rent-a-Center is the dominant leader in the rental business for furniture/TVs/appliances for households.  They just got more dominant as they ate their largest competitor in two bites over the last several years. 

Their customer is the low income worker and Wall Street is terrified of that customer now because the other word for them is “subprime”.  Ick.  Eeew.

Very profitable and surprisingly predictable business if you get collections right, and they always have in our experience through some scary times like after 9/11, in 2002,  and after Katrina.  We have great respect for management of Rent-A-Center after watching them for six years and owning them for much of that time.

The stock has always been more volatile than the business, which has presented big opportunities to buy and sell and is presenting another one now.

This may be a baby in the bathwater just like it was other times investors panicked about subprime borrowers (fall of 2001, fall of 2005). 

1) They are not a subprime lender because they don’t lend, they rent.  The credit card company doesn’t come the week after you’re late on your payment with a truck to repo your furniture and TV.  They do.

2) Their customer doesn’t have a risky mortgage because they’re not a homeowner.  90% of customers rent their dwelling.  Let me repeat that.  Their customer doesn’t have an adjustable rate mortgage.

3) RCII’s customer is somebody who can’t get credit.  Are there going to be more of those or less of those in the next 12 months?  (Let’s think about the subprime borrower  who DOES have an adjustable rate mortgage.  Is that a future RCII customer?)  We could see Rent-a-Center’s business being a beneficiary of the subprime crunch, but for the moment they are being treated as a casualty of it.

If you’re looking at RCII for the first time the accounting and the business will be scary.  We have gained a lot of comfort with management - particularly CEO Mark Speiss - over the years, and the accounting short case is always out there but has always been mistaken in our experience.  Their accounting is not GAAP but it matches the economics of the business and free cash flow has matched or exceeded earnings for as long as we’ve watched this company and what would have happened if the short case on the accounting was right has never happened. 

A recession doesn’t scare me a lot here - things always suck for their customer no matter how good the economy is.  Their customer is a consumer who has a job, but doesn’t have credit.  Credit has been very loose, no?  If credit to the working poor tightens, that could wind up being good for this business.  An environment where you can’t get credit by presenting a drivers licence and fogging a mirror might wind up being very good for RCII.

What we are dealing with now is a sudden slowdown in their business in July and August (and no reason to believe it got better in September) due to high gas prices and an economic slowdown.  High gas prices mean a lot to their customer who lives paycheck to paycheck.  We have seen this before, and often at this time of the year.  Its not like they’re losing money – it was a routine earnings miss.

We believe the reason the stock broke so sharply in August on an unsurprising earnings “surprise” is that there were a lot of investors in the stock who didn’t know the business but were looking for a $32 LBO.  This company has been LBOed by Apollo before and looked like a sitting duck, though we were not in the stock then.  Didn’t happen and now the window is shut.  All it took was an earnings miss and all those “investors” sold at once and took the stock to a very cheap price which now fundamental investors are justifying based on the macro environment.  Sometimes a cigar is just a cigar and sometimes a cheap stock is just a cheap stock and you don’t need to overthink it.

Valuation:

OK, lets put some numbers on this.  Its pretty simple to us, so we’re not going to make it complicated.

If you look at the last six years, earnings power looks like a very solid $2.00 per share and earnings have been far less volatile than the stock price.  Free cash flow in our experience has always matched or even exceeded earnings.  8.5x earnings for a decent business, dominantly #1 at what they do, with very solid cash flow.  Management has behaved like owners in the past buying back shares very aggressively when the stock is cheap.

RCII is not rocket science – just a cheap stock.  We think its worth 26-30 and we expect to see that price within a year.  It is tough to see this stock trading below 15 for any length of time given the earnings history and the resilience of the business.

Catalysts:

1)      They acquired the remainder of Rentway late ’06.  Those stores have been out of comps since the acquisition and will go back into comps in ’08.  That could boost comps and that could be what gets the stock going.

2)      If you read the VIC post on RCII from late ’05 the last time it was this cheap (we owned it then too and sold it in between), the catalyst was rolling out their new initiative of pay day loans and check cashing.  Just seem like a natural fit for their stores.  They’ve been very slow and methodical in doing it and Wall Street has completely forgotten about that story because they didn’t get instant gratification..  They are still rolling it out though and if CEO Mark Spiess goes on the 3Q conference call and says they are very comfortable here and are going to accelerate the rollout the stock goes to 22 that day.  Not a prediction, but a possibility.  Regardless of timing, that was a 2-3 year now a 1-2 year catalyst increasing profitability of their stores with very little incremental investment.

3)      Big screen TVs are moving into their kill zone of below $1000 price point.  $2000 items are risky for them, but as big screen TV prices come down it gets a big category of merchandise into a less risky price point for their model.

Catalyst