When you undertake the journey of purchasing furniture or household appliances for a new area, it can be easy to get caught up in the moment and forget that this process is incredibly expensive and out-of-reach for many consumers. Especially for those with low credit and thus no access to adequate financing. This is where Rent-A-Center (Ticker: RCII) comes in, they offer Lease-to-own (LTO) financing options that provide flexible payment options for consumers. The program works as follows:
RCII operates thousands of physical retail locations across the country
When you walk in the store, you can either buy it outright, or the more common option of entering a lease contract with the company for a piece or group of furniture
If the company approves your application you walk out with the furniture you ordered and start making rental payments
Once you’re in the ecosystem, if you want to purchase the furniture during your lease and keep it you make a final payment and you’re done
If however, you can no longer afford the rent, or simply don’t want to anymore, you can return the furniture at no cost, with no hit on your credit
Rent-A-Center Business Success
Why is this business model so lucrative? Well, to start, if you buy the furniture with no rental plan, they make a profit from their gross margin just like any retailer. However, the real money comes from clients that enter their facilitation ecosystem. Their client base is traditionally poor credit types and they are very willing to pay very high interest rates - but here’s where their magic starts, they don’t frame the deal as a loan and thus “evade” the protective laws associated with maximum interest rates. The company is able to get away with charging their clients effectively 100% APR and get to keep the asset. Any way the game goes, they are sure to make a ton of money. If clients make a few payments and then buy out the furniture (which is only the case for about 6% of renters), the company got good ROI for the time rented and a buyout amount far above retail. In the meantime, if clients keep their products for a long time/permanently, well it is easy to see how profitable that is. If clients return the furniture, the company gets paid their “interest” and now gets to start the cycle all over again, though with a used item… The only real way they lose money is if the clients steal the property at which point the company has a lot of options to get their stuff back - rates they forecast to be around 3% in the Rent-a-Center business, including when clients need a skip payment to afford the property. Rcii is doing phenomenally, being one of the only retailers that are consistently expanding their store count to reach even more locations. Part of this is from their advantageous demographic targeting, they tend to locate themselves in rural areas in the USA. Customers in these locales are much less focused on the online environment and so make attractive retail targets - they also have very low credit penetration…
Acima Acquisition
This isn’t to say that they don’t have an excellent online presence too. Rcii recently purchased Acima, a digital LTO provider for third parties. Essentially, traditional or online retailers who want to sell more products can offer Acima solutions to their underserved credit-needing customers. Acima provides approvals with no minimum credit score and based primarily on income. This simple model based around a Lease Pay card, facilitated through Mastercard means that retailers can sell more products, while Acima can benefit from the rent. This acquisition was incredibly savvy, since it meant that Rcii could leverage Acima to expand its business very quickly, while also using their own physical stores to take on any returned inventory from third-party retailers… They have been incredibly successful with the adoption of the service, with over 30,000 independent stores using Acima products, and big wins including massive East coast retailer P.C Richard & Son. Acima also provides repeated access to customers digitally and allows for a ton of remarketing opportunities and is a big part of why clients in the Rent-A-Center ecosystem have been seeing consistent increases in the amount of leases per individual. Unfortunately, Acima does have much higher skip/stolen losses at around 8.7%.
Business Growth
This brings me to the growth of the business over time, and why now is the time when it is seeing critical mass. From 2006 to 2019, Rent-a-Center’s business has been essentially flat… This might initially seem like a doomsday prediction for the company, but from 2020 to 2021, the company grew 50% in sales… This excellent growth came since Rcii is a cyclical business, where a strong consumer pocketbook, but other problems tighten up credit policies - making Covid a perfect storm for the company, with stimulus programs and scared financial institutions leaving the company in a dream position. Additionally, through their purchase of Acima they were able to quickly grow their footprint and cement all their new sellers. Theoretically, this new ecosystem of sellers and renters should remain in the future and make growth continue, instead of the perpetual roller coaster we saw for the past 15 years. Most of this growth however did still come from the Acima business acquisition - Acima grew around 19% last year, and of course, the acquisition added Acima’s revenues to Rcii's. Rent-a-Center’s primary business had same store sales growth of around 14%, and has recently hit 23% of the business being processed online.
Concerns
There seem to be two primary concerns surrounding the company at this moment: delinquencies and buy now pay later. The second, is in fact relatively easy to explain away; detractors are worried that alternative payment solutions like BNPL which are direct competitors to Acima in many ways will overtake their business and cause them problems. However, they seem to forget that in Acima’s core vertical, the LTO model is a lot more effective, especially on the profitability side - which is why tons of BNPL companies burn cash, while Rcii has an EBITDA margin in the mid-teens. Additionally, as the CEO recently explained, BNPL in fact increases adoption of alternative financing options, but doesn't have the same effectiveness with customers since they have credit requirements and also don’t have an integrated experience for appliances.
In terms of delinquencies, managing skip/stolen loss rates is crucial for maintaining good margins - and the company did have a concerning trend in the recent quarterly report, suggesting what we knew all along, that as stimulus wares off, and especially during the Christmas quarter, delinquencies would rise above recent levels. However, there were a lot of promising trends in October according to management, who said that as collection staff were ramped so too did delinquencies stabilize - and if that is true then the market overreacted substantially (plunging the stock almost 30% on the news since the report). Interestingly, the margin question was somewhat impacted as well by rising interest rates, which will bad in the short-term, but good for adoption of its services over the long term as tightened credit moves clients down the funnel to alternative financing.
Valuation
Now that we’ve established that the company is likely to continue relatively good growth, most likely in the double digits over the next few years and why they have a great business model, it is important to explore their valuation, dividend, competitors and balance sheet. Starting with their valuation:
The company currently trades for around 5.7 times forward earnings, and is expecting growth of 14% next year
Meanwhile, its only real competitor, a much smaller company Aaron’s trades for 7.6 times forward earnings
This illustrates two things, first, of course, that its cheap compared to its almost non-existent direct competition - but also that they are just a cheap company, virtually any industry would consider a growing company very cheap at 5.7 times earnings, showing the level of pessimism around the company
Dividend Yield & Share Repurchases
Moving onto shareholder value, the company pays a 3.3% yield at current prices, at a payout of 43%. This level of payout vs. yield is relatively high and suggests that the company is not generating as much relative cash to its yield as much as other companies in the financial services sector, though part of that variance comes from the fact that they use a lot of their generated cash for inventory tie-ups which hides the general business performance. In general though, the company has an above average yield compared to the financial services industry in absolute terms (industry average is 2.5%). Additionally, the company recently announced a 500 million dollar share repurchase program. Keep in mind that the total market cap at current prices is about 2.75 Billion. That means that the company has plans put in place to return over 20% in capital to shareholders between the dividend and share repurchase program.
Balance Sheet
Let’s also take a look at the balance sheet:
The company has about 82% of their long term debt in cash or cash equivalents & a debt/EBITDA ratio of under 0.33. This suggests an exceptionally good generation of cash and ability for the company to maintain its capital position. Essentially, the company can almost pay off all its debt with cash, and its net income is virtually equal to their debt - not to mention their EBITDA. This level of financial stability is excellent and is how they are financing such generous shareholder return policies.
Free Cash Flow Model
To end it off, let’s evaluate the company on the gold standard of the Discounted Free Cash Flow Model (DCF Model):
If we take their forward eps of 7.1 and give them a conservative 10% growth rate over the next 5 years, which isn’t crazy considering they’re expecting over 14% next year - along with a perpetual growth rate of 2%, which matches inflation, taking a required rate of return of 11% a year, you get a fair value of $116/share, suggesting almost 3x from current prices
However, it gets even crazier when you take unrealistically conservative estimates. Assuming that the company only manages to stay flat from next year’s earnings, meaning 0% growth forever, at a 15% required rate of return, the suggested fair value of the company is 47.33. This suggests a 14% margin of safety, at an 18.3% rate of return annually, with 0 growth for a company expecting double digit growth…
Decision
At the end of the day, Rent-a-Center is too cheap to ignore, a company that trades for such a cheap price, with a great business model and with a proven track record of management’s success with acquisitions, investors are clearly poised to realize above market returns with an above 3% yield paying them to wait until the market realizes the undervaluation of the company & rewards shareholders accordingly.
By: Mateo Gjinali
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