A Consumer-Fueled Rebound Stock with Downside Protection
July 5, 2010By: Frederick M. SteierArticles RSS feedPrintPrint

Americans are a materialistic people. We like our home theatres, our furniture and our appliances. Unfortunately, not everyone can afford a new refrigerator or television, so they choose to rent instead of buy.

The great news for investors is that this turns out to be an extremely lucrative business, because those renters end up spending more to rent than if they'd just bought.

At first glance, the home rental business might not seem appealing to investors. It's capital-intensive because the company must buy all the appliances, have a delivery infrastructure, a lot of rental and labor overhead

and deal with repossession. However, since most customers have weak credit, the company can charge monthly rental fees that are reasonable to the customer but offset operational costs. Once those costs are offset, every month's payment thereafter is pure profit.

Among companies in this space, I like Rent-A-Center (Nasdaq: RCII).

The thing Rent-A-Center has going for it is that it's been in this business so long -- since 1986. The company has its operations down to a science. It's also the biggest player in the field. The company owns 3,000 stores, representing a 35% market share in the United States. Only Aaron's (NYSE: AAN) comes close in size, but is still far behind with 1,700 stores.

Rent-A-Center helps pad revenue by offering financial services products like short-term secured and unsecured loans, debit cards, check cashing, tax preparation and money transfer services in about 10% of its stores. This puts Rent-a-Center in slight competition with the likes of Advance America (NYSE: AEA), Cash America (NYSE: CSH), and Dollar Financial (Nasdaq: DLLR). But while the payday loan sector is mature, Rent-A-Center has the advantage of having these services in-store as an adjunct, so it's incremental revenue.

The state of the economy raises an interesting issue with Rent-a-Center. Would investors expect earnings to soar as people turn to rentals instead of purchases, or would sales lag because nobody is spending money? It turns out the latter has proven to be more the case. And yet, revenues for full-year 2008 and 2009 were $2.9 billion and $2.8 billion, respectively. Profit was $140 million in 2008 and $168 million in 2009.

What attracts me to Rent-A-Center is that even in these worst of times, it still generated a profit and revenues were still almost three billion dollars.

Before getting sucked in, however, it's important to examine cash flow, debt service and capital management. In these departments, Rent-A-Center is making all the right moves.

The company generated about $261 million in free cash flow during the past year, so interest expense is well covered. The company also realized its debt load was too great and began paying it down. Now, interest expense has declined year-over-year to $27 million from $66 million. In addition, the company managed to trim more than $100 million in overhead, which is why net income rose in 2009 even though same-store sales were down -3.5%.

Those same-store sales numbers shouldn't be too much of a concern. As mentioned, that's simply what happens when the economy is bad. The company says it expects same store sales to increase by a modest +1% this year, however.

Analyst consensus targets $2.45 a share in earnings this year, which is down from last year. But analysts expect that figure to leap to $2.68 in 2011, a +10% increase over 2010. This equates to a P/E of 7.6, which is slightly below its growth estimate for next year.

Action to Take --> Rent-A-Center makes money. It's a healthy business with little regulatory concern.
With the stock -20% off its April high, I see a chance to jump into this stock, but prudent investors may want to open a half-position now and wait for a possible -10% to -15% pullback to complete the position, just to be on the safe side.

When the economy improves, people will be dying to have new appliances again, and I expect Rent-A-Center to lead the way.

Frederick M. Steier
Contributor, StreetAuthority.com
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