Description

Rent-a-Center (trades under the ticker RCII) has been in my own portfolio for over 6 months, and the more research I do the more I like the stock. In Buffettology, Rent-a-Center is an attractive GARP investment, a growth company selling at a reasonable price. RCII is a quality growth story that is priced at a significant discount to its peers, the S&P and intrinsic value with several catalysts that should unlock further value. RCII is the dominant player within an interesting and stable industry that has been successful at growing its top line with maintaining strict control of operating costs, with healthy and stable operating margins. RCII is a cash generative retail story with less cyclical risk that you would get with other retailers.

RCII is the largest rent-to-own operator in the US with 30% of the market (it has 2,552 company owned stores and 320 franchised stores). The rent-to-own industry (“RTO”) is a healthy, growing and profitable space in the retail sector and has grown at a CAGR of 6.2% from 1995-2001, reaching $5.6b in 2001 (growing 5.7% in 2001, despite a recession!). Over cycles, the RTO industry is amazingly recession resistant. Despite negative comps from the retail sector during Q3 2001, one of the bleakest quarters, RCII’s same store comps increased by 4.5%. This is largely due to the type of customer that the industry targets.

RCII targets low-income customers and sells electronic and home appliances and furniture under flexible agreements that allow the customer to take ownership of the item at the end of the lease term or to return the item to the store and cancel the contract after a minimum period. This sector performs well in depressed cycles given the nature of the product (more needs based) and the customer it targets (in a downturn, the size of the target market naturally increases). The brands are of high quality, the same as those found in traditional retailers. Rent-to-own contracts typically call for weekly or monthly payments.

A REASONABLE PRICED GROWTH STORY

RCII has been able to grow its topline faster than the broader retailer sector, while maintaining strong internal control over costs (stellar management and excellent Wal-Mart-like systems) and customer delinquencies. M&A has played an important role in the Company’s growth. RCII’s most significant acquisitions include Thorn Americas in August 1998 (1,409 company owned stores plus 65 franchised stores for $900mm in cash) and Rent-a-Way recently in February 2003 (295 stores for $100mm in cash). RCII went public in 1995 and has since grown gross margins from 22% to 27% and operating margins from 14.9% to 17.5%

The RTO business requires operators to have tight control over store costs and customer delinquencies. RCII has the highest operating margin in the sector and has been successful at controlling costs, expanding the offering of upscale, higher margin products (many of which it has exclusive distribution arrangements with suppliers, such as Whirlpool) and using a sophisticated information system and a proven incentive plan to monitor store level performance and motivate employees to attain results.

The CEO (Mark Speese) has a disproportionate share of his incentive tied to the stock performance ($550,000 salary plus 209,000 options with a strike price of approximately $30, only 25% of which have vested). At current prices, Speese’s options are worth $5 million (net of exercise).

RCII has the highest average monthly revenue per square foot, ROA and ROE compared with its competition. RCII’s size allows it to negotiate more advantages and often exclusive arrangements with suppliers, carry on a national campaign to build its brand (currently invests 4% of sales) and to continually invest in information systems to improve store profitability and minimize customer delinquencies. RCII is increasing its leadership in the industry as it consolidates smaller firms (most recently acquired 4th largest player Rent-a-Way), as competitors go bankrupt and as smaller businesses realize they don’t have the capital necessary to run a profitable and growing rent-to-own business.

RCII is conservatively financed. It has funded acquisitions by paying cash and has consistently paid down its debt using internal funds. It has more than adequate capacity to cover debt and lease commitments over the next few years. RCII’s goals of 6% delinquency rate of payments that are seven days past due is one of the tightest in the industry. S&P raised RCII’s corporate credit rating to BB (stable outlook) from BB- (negative outlook) in August 2002 after the company converted its Series A preferred stock to common equity.

With $537mm in net debt as of 6/30/2003, the company has an enterprise value of $3.0bn. RCII earned $4.82 (14x current P/E) in 2002 and is expected to earn $5.869/share in 2003 (11x forward P/E). RCII’s forward P/E compares favorably to peers (2003E P/E of RNT and RBOW of 17x and 23x, respectively) with smaller footprints. RCII’s current trailing P/E of 14x trades at a 20% discount to its 8yr average of 18x. On an EV/EBITDA basis, RCII trades at a discount to RNT’s (5.5x vs. 6.7x) despite RCII’s competitive strengths. RCII’s cash flow of $268mm in 1H 2003 (EBITDA – WC – normalized capex) equates to FCF yield of 17%. On a DCF basis, the current share price implies a negative terminal growth rate! Assuming no growth from acquisitions and a 2% terminal growth rate, DCF value/share is $120/share. Over the long term, RCII’s price should approach the discounted sum of its cash flows.


CATALYSTS

-In February 2003, RCII closed its acquisition of 295 Rent-a-Way stores. The transaction should be modestly accretive to 2003’s earnings but RCII should exceed analyst estimates based on their proven track record to integrate acquisitions and drive margins.
-Potential regulation (Bill HR 1701) opening up three US states to RTO transactions.
-RCII just announced a 5 for 2 stock split (record date Aug 15 will receive 1.5 shares for each share held). -Recent stock buyback signals management’s bullish view on its share price (recent dutch auction of 2.6mm shares). At current share prices, company will likely continue to buy back its stock.
-Continued expansion: plans to open 80 stores by year end and an additional 100 in 2004. Stores open one year. Good cost control despite strong growth, with operating margins stead at 17.6% as of Q2.


RISKS

Accounting – RCII has been accused of aggressive depreciation policies. I have studied the issue and believe RCII’s policies are appropriate and consistent with its business realit
Insider sales – Apollo has been selling stock, which is a technical reason in my opinion for the share price weakness. If you subscribe for Ben Graham’s concept of value and price converging over the long term (market is a long term weighing machine) than this effect should be muted over the medium/long term.

Catalyst

-Potentially favorable regulation
-External growth (successful track record)
-Stock split and buybacks
-Synergies from prior acquisitions