The Long Road to Aaron’s (NYSE:AAN)

Storefront

Recently for an Investment Club project, we (first-year MBA students) were tasked with pitching one long stock from the retail sector, with a market capitalization over $500M. Now retail is NOT my bread and butter. The P/E ratios right now are astronomical. Price/Book and Price/Cash Flows are almost as bad. Consumers are fickle, and tastes change constantly. My wife will even tell you that I am a terrible shopper. So I was definitely concerned about what sort of horrors I would find. We ended up with a list of 254 stocks. I went through and removed the companies with what I felt were bad business models or extremely high valuations. That left me with about 150 stocks. From there I screened for various criteria (P/E, P/B, P/S, P/CF, PEG, etc). I looked for stocks which were running below their five-year averages in two or more categories, and which were also undervalued compared to their competitors.

To make the research process more interesting, I committed myself to putting a small amount of money into whichever stock I end up recommending. I believe it is very important to have some skin in the game. It certainly kept me honest. I spent 12 straight hours looking hard at Francesca’s (NASDAQ:FRAN). I loved the growth potential there, but found some disturbing stuff in the end.

Essentially, FRAN follows the Uniqlo business model, but tweaks the end-user experience with customizable boutiques designed to make the shopping experience unique. The margins were high. And it was only after significant time and effort that I discovered FRAN was a short favorite (something like 14M shares shorted), due to questionable subsidiary/founder relations. I thought long and hard about whether I should recommend the stock to my school fund. What kept me honest was asking myself “Am I still willing to put my own money into FRAN?” The answer was a resounding no.

After that I looked at Corner Shop Brands (NYSE:CST), a recent Valero spinoff. CST looks like it might go places, and I am still interested. There simply wasn’t enough data to support or reject a growth thesis there.  I even asked for, and received, supplementary materials from CST’s investor relations. At the same time, valuations are too high to support a deep value thesis. I agonized over this one for a while too, but ultimately I had to reject the stock for now.

Aaron’s (NYSE:AAN) on the other hand, was a very interesting prospect.

With a market cap of $2.1B, and 2012 sales revenue of $2.25B, Aaron’s is a serious contender to Rent-A-Center (NASDAQ:RCII). 46% of Aaron’s rental agreements go to ownership, far more than the industry average (29%).The company operated 1,854 stores as of FY 2012, with 125 new stores planned for 2013, and has averaged a 5% store growth rate over the past 5 years.
AAN has three fully owned subsidiaries: HomeSmart, Rimshop, and Woodhaven Furniture. HomeSmart uses the same model but bases payments week-by-week. Rimshop sells custom car rims. Woodhaven Furniture manufactures most of the furniture Aaron’s sells, which helps Aaron’s keep costs low and quality high. Aaron’s is also a 10% stakeholder in a British rent-to-own company.

Segments

First let’s talk about the macroeconomic environment. Aaron’s customer base is primarily working class. What does this income inequality graph indicate about Aaron’s growth potential?

income_distribution_over_time

Walmart has been wondering where the customer’s wallets are this year, and it is highly likely that Aaron’s has been suffering from the same tax increase issues. This is whacking estimates way out of line of the underlying business. Ultimately, the long-term customer prospects for both Aaron’s and Walmart are strong. In the meantime, the company generates tons of cash flow and has almost no debt. It could pay off all its long-term debt tomorrow.

Sales Revenue

Now this is not growth for growth’s sake. Note the equivalent growth in Tangible Book Value.

Tangible Book Value Per Share

Now a quick comparison of some key figures.

Comparables

Aaron’s doesn’t need leverage to grow, and is therefore independent of rates rising or falling. At the same time, the company stands to benefit if consumers cannot obtain credit to buy durable goods outright. It is clearly operating its business better than the competition, and is doing a great job stealing market share.

Google Trends

Indeed.com ratings support the thesis that Aaron’s maintains a better relationship with its clients than Rent-A-Center or Conn’s. The company has built up a loyal user-base and has not had to go into serious debt to do so. The big question revolving around Aaron’s right now is the cash.

Use of Cash

Bear Case

  • Founding CEO retired in 2012. We can’t say for sure that the new CEO will continue the same policies.
  • Management salaries have doubled each year for the past several, resulting in SGA increases of ≈ 1%/year. Sales growth is still strong enough to support this but SGA needs to stabilize.
  • Though it has a progressive dividend policy, current yield is a meager 0.25%.
  • Management stated shareholders will see increased dividends and buybacks “soon” but that was two quarters ago and some investors are becoming restless.
  • Sears is making a small effort in rent-to-own. I’m not sure I consider this a serious threat since Sears has been promising everyone the moon and stars lately. Really, the best option for Sears would be to acquire Aaron’s.

Share Price

Analysts are predicting a retraction for Aaron’s in the near-term followed by continued growth. We can’t predict the future, and we don’t know the company as well as management does. What we can do is look at past earnings/growth ratios. Since our thesis is growth-based, PEG seems to be the appropriate measure by which we will judge the stock.

PEG Calculations

A fair value price with five-year growth rates to consider should be $27.87.

The economics of the business are sound, and management is doing a better job than its competitors. My one reservation with this company is a big one. Management is not rewarding shareholders. The current CEO owns very little stock and has been accepting cash pay raises. The dividend is paltry and so far, a share buyback has not been announced. That should lead to some serious thought. The business prospects are great. Shareholder prospects are not. From an investor standpoint, what is the point of all this cash flow if none of it is going to the owners?

I really enjoyed the mental exercise here. Retail is a hard sector to be in right now. The P/Es suck and you can’t patent a fashion style or a retail business model. I looked for the safest stock I could find which offered growth opportunities at a reasonable price. Aaron’s fits that bill from a business model perspective. The market is anticipating lower revenues for 2013, and that may be the case. But in the long-term the market does not understand the business model. Aaron’s is like a bank in the sense that it will benefit from a rate rise, as much or more than it loses. Analysts are only seeing a reduction in rental interest revenues, but remember that 46% of product which goes to ownership? Aaron’s is in very little danger here. Additionally, the macro-economic trends are in its favor.

While I believe Aaron’s is going places, I’m not sure it is going to take shareholders along for the ride. Until I can be sure of adequate returns I cannot advocate a stock purchase. One thing I will be keeping a close eye on is whether or not the new CEO takes a large stake in his business. So far that has not happened. Which leads me to a much more conservative price point, call it a lack-of-ownership penalty – $18.50. That would put it under a P/E of 10. At which point, I will be willing to take the risk.The founder pictured below still owns more stock than the new CEO. That needs to change to make Aaron’s a resounding Buy. loudermilk.0417_BH024

Advertisements

Author: secondhandstocks

The genesis for this blog stems from a Marine buddy and I came back from Afghanistan with more money than knowledge, and heedlessly tossed our hats into the stock market ring. A few months later, I remember discovering the classic book The Intelligent Investor by Graham and Dodd, and ravenously devouring my first introduction to value investing. That framework - with some generous additions by Seth Klarman, and Joel Greenblatt among others - guides my investment philosophy. I spent five years working in the intelligence field, both in the Marine Corps and then for a government agency after that. I speak Arabic and Pashto, have programming and analysis experience, and enjoy investing in technology companies as a hobby. I also spent a year on Wall Street working on a #1 Ranked Institutional Investor team, before deciding that that the Sell-Side was not for me.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s