Description

Rentway (RWY) is a turnaround story that should appreciate 80% to my 12 month price target of $16 per share. My downside case supports the current price of the stock and the upside case supports a price of $22 - $25 per share. I think the risk reward ratio more favorable than other ideas available in today's markets.

Recent results at RWY are showing a return to market share growth following a dark three years that focused on accounting issues. Comps were a positive 6.9% for the last reported quarter (March), up sequentially from 6.6% in the December quarter. For the next two quarters, the company faces relatively easy y/y comp comparisons. As part of its refocus, RWY has announced a return to opening new stores, identifying 15-30 locations to be opened over the next 12-18 months. On a FCF basis, the company can currently easily open 30 units per year. This growth exemplifies the company’s refocus on operations.

Valuation: Currently, the stock trades at 8.2x F04 EBITDA. Carrying this multiple out to my mid-point F05 EBITDA estimate yields a price above my $16 target price, and appreciation of 80%+ from today’s level. Comparable companies, RNT and RCII, trade at 8.2x and 6.1x, respectively. RCII is currently suffering from weak same-store sales, which were down 1.3% for the March quarter. In my opinion, RWY, while enjoying a current year valuation in line with its peers, is not benefiting, valuation wise, from normalized (ie having a focus on operations versus the SEC) earnings that should reappear in 2005 numbers. Thus, with little valuation expansion, and results indicative of a normal business cycle, I expect the stock to perform well with little downside risk. The table below outlines expected values based on EBITDA generated at our low-end and management’s higher estimates.

Valuation Matrix

2005E EBITDA (mil)
Low Mid High
$77 $86 $96
EBITDA 6 8.83 10.63 12.62
Mult 8 13.96 16.35 19.02
10 19.09 22.08 25.41


Company Description: As a rent-to-own retailer, RWY is a financial company disguised as a traditional retailer. The company “rents” out merchandise (through its footprint of 753 retail stores) under contracted weekly (85%) or monthly (15%) payments. These agreements can be cancelled by the customer at any time, with the merchandise returning to the store floor for another rental term.

The customer base is made up of lower income people with limited credit availability. Thus, RWY is often the only viable alternative to secure higher end electronic, computer and/or furniture components; items otherwise often unavailable to this consumer. Customers frequently enter into repeat transactions for new or additional goods. Internal growth can be tracked by number of agreements by store and average contract size. The March quarter is generally the strongest as agreements signed during the Christmas selling season, and the benefit of tax refunds, hit for the quarter.

The average customer rents the merchandise for 16 weeks and 75% of items are returned before the agreement ends. An item is generally rented to 3-5 consumers in its 20-24 month life span. Target ROI is 4x product cost. Largest product categories - -Furniture 38%, Electronics, 23% and Appliances 22%. Store merchandise is branded product, including Sony, Maytag, GE, and Ashley Furniture.

In 2000, the company became the subject of a SEC investigation, which is now completed and is well behind the company, with the offending management sentenced by the courts and separated from RWY. The charges were about asset and expense account manipulation that inflated operating income. Revenue was not affected. Therefore, I expect no further implications from the closed investigation, and believe the scrutiny placed on RWY during the SEC investigation, has left the company’s books scrubbed clean, with a duplicative outsourced internal audit in place, in addition to the company’s normal external auditor.

During the 3 year SEC investigation, the company was operating in a cost containment mode, shuttering stores on Wednesdays to save overhead. Further, cash for inventory build was sparse, rendering inventory available for sale depleted and lean. Today, the company has reopened stores on Wednesdays and refurbished stores with attractive merchandise. Furthermore, approximately 295 of the company’s lower return stores were sold off to RCII, leaving RWY with 753 higher return stores.

Market Overview. The rent-to-own industry is estimated to be a $6 billion market. Three public competitors, Rent-a-center (RCII), $2.2 bil in revenues, Aaron Rents (RNT), $766 in revenues, and Rent-way, $518 in revenues, are the major players. Approximately 50% of the industry is controlled by mom-and-pop operators. The industry is consolidating. RCII has recently purchased Rainbow Rentals(sold in 2/04 for 12x average monthly revenue), Rent Rite (sold in 5/04 for 12.75x average monthly revenue), and 295 RWY stores (sold in 12/02 for $101 million with $10.1 million in associated monthly revenues, roughly 10x monthly revenues). We anticipate continued market share gains from the industry competitors as they displace mom-and-pop operators, through both acquisition and cannibalization.


Long Term Financial Targets: High single digit revenue growth will come from the combination of store expansion and 3-5% comps. Expected operating profit margins of 12%-14% will provide EBITDA growth of over 20% for the next 3-5years. This margin growth stems from operational efficiencies and sales leverage.

Model: Sept 03A Sept 04 Sept 05
Revs $518 508 533
Op Mgn 7.3% 8.3% 10.9% ( company target 12-14%)
EBITDA $ 59 59 77
Stores 753 761 775
Shares Out 25.7 29.0 30.0

In ’96 and ’97, RWY was able to achieve operating margins within the 12-14% target range. In the just reported March quarter, the company increased this margin to 11.3%, ahead of schedule in our opinion, but indicative of the earnings power in the economic model. Further, RCII has consistently had operating margins in the low double digits for the past decade and operates a similar store format.

If RWY were to achieve a 14% operating margin based on my F05 revenue projection, EBITDA would increase to $96 million, versus $77 million at my target of 10.9% margin.

FCF = NI+D&A-Capex : In 2003, FCF was approximately negative $16 million, which includes a $14 million lawsuit settlement and a $16 million loss from discontinued operations. Adjusted for these two items, FCF for 2003 would have been a positive $14 million. For 2004, I estimate FCF of $7.6 million. In 2005, my estimate is for FCF of $25.8 Million.

EPS- Preferred Warrants: Given a non-cash adjustment ( mark to market) on the vehicle, there will be a variable charge/gain on the issue, impacting EPS based on stock price performance. When the stock goes up, the non-cash charge is greater, thus hurting GAAP EPS, but not Cash EPS. Given this, it is more meaningful to focus on cash flow measures to value the company.

The balance sheet is relatively clean except for the $205 million senior secured notes which were issued in 2003 and bear interest at 11.875%. Of note, RWY’s debt has been coming down over the past few years, as the company has right-sized its capital structure for the longer-term. LTD is down from $277 million at the end of F02.

Sept 03A Mar ‘04A
Debt $214 $226.8
Cash $ 3 $4.8

When analyzing the company’s financials, I believe it important to understand the operational difficulties encountered through the SEC investigation that hampered the company from 2000-2003. Now with the investigation behind the company, RWY can refocus on operations enabling margin growth and cash flow expansion. Thus, when I view this investment opportunity, I focus my valuation on the September ’05 earnings potential, which I believe is the first year of normal operational practices, relating to marketing activities and store growth.

Catalyst

Strong sales and earnings results
Increased investor awareness
Improving economy
Potential buyout by competitor