RealMoney Silver - Rent-A-Center Could Get a Boost From Credit Squeeze

Rent-A-Center Could Get a Boost From Credit Squeeze
By Bill Trent
RealMoney.com Contributor
5/12/2008 11:00 AM EDT

The current tightening of consumer credit and spending could not only spur a shift to discount stores such as BJ's Wholesale (BJ) , it could also influence the way goods are purchased.

One manifestation of this could be a shift from buying on credit toward the rent-to-own market. If so, the way to play the trend is most likely Rent-A-Center (RCII) .

With more than 3,000 stores and a 36% market share, Rent-A-Center is the largest rent-to-own operator in the U.S. Historically, rent-to-own stores have primarily served customers who have household income of less than $50,000 a year. However, a generally tighter credit market could expand that base into slightly higher income categories.

Background on a Bargain

Beginning in 1993, Rent-A-Center expanded dramatically, primarily by acquisition. The industry remains highly fragmented, aside from the two largest operators, and additional acquisitions are likely. However, the rapid expansion caused some markets to become oversaturated.

In early 2007 the stock peaked at $31 a share before a legal settlement and the saturation issues took the wind out of its sails. Later in 2007, the company closed 369 of its stores, and the stock now appears to be getting its mojo back, recovering from a low near $12 earlier this year.

The current $21 share price is just 9.4 times the consensus current-year earnings expectations and 8.9 times the estimate for 2009 earnings. Sometimes multiples that low indicate a belief that the estimates will fall. However, the consensus estimates for Rent-A-Center have been doing exactly the opposite. Over the last 90 days, the 2008 estimate has been revised upward by 3 cents and the 2009 estimate by 2 cents. The earnings appear to be relatively high quality, as the accrual ratio indicates a difference of less than 4% between cash earnings and accounting earnings.

Tightening the Ship

On the company's year-end conference call, President Mitchell Fadel said that Rent-A-Center is responding to the economic slowdown by focusing on the things they can control: "execution of our consolidation plan; controlling our delinquencies which are now back where they need to be; controlling of our inventory levels which is clearly in the right direction."

To that end, the company has been putting its solid free cash flow ($193 million over the last 12 months) to work cleaning up the balance sheet. The company has reduced its debt by more than $100 million, and it has used another $50 million to repurchase stock. The free cash flow yield is a very impressive 13.6% of the company's current market capitalization, which to me would be supportive of an investment, whether or not the company can grow. (In fact, I'd even be willing to accept modest shrinkage.)

Rent-A-Center's price-to-book multiple of 1.4 puts it smack in the middle of peers United Rentals (URI) and Aaron Rents (RNT) , whose multiples are 0.8 and 1.9, respectively.

Yet over the last five years, Rent-A-Center has enjoyed consistently higher profit margins, and its return on equity has averaged more than 19%, compared with 13% to 14% for its peers. Although analysts expect the company to grow at a slower rate than its peers over the next several years, its higher ROE justifies exactly the opposite outcome.

If Rent-A-Center were to receive the same price-to-book multiple as Aaron Rents, it could trade above $28 per share today. While I don't believe that will happen overnight, over the next five years Rent-A-Center could see high-single-digit earnings per share growth and also expand its price-to-book multiple to the 1.9 level. The combination of earnings growth and valuation expansion could generate annual returns averaging 15% or more.