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Executives

David E. Carpenter - Vice President of Investor Relations

Mark E. Speese - Chairman and Chief Executive Officer

Mitchell E. Fadel - President, Chief Operating Officer and Director

Robert D. Davis - Chief Financial Officer, Principal Accounting Officer, Executive Vice President of Finance and Treasurer

Analysts

Bradley B. Thomas - KeyBanc Capital Markets Inc., Research Division

Budd Bugatch - Raymond James & Associates, Inc., Research Division

Laura A. Champine - Canaccord Genuity, Research Division

Bruce M. Zessar - Advisory Research, Inc.

Brett Strauser - Sterne Agee & Leach Inc., Research Division

Jonathan P. Braatz - Kansas City Capital Associates

Carla Casella - JP Morgan Chase & Co, Research Division

Charles Ruff

Barry George Haimes - Sage Asset Management, LLC

Seth Damon Rosen - Eminence Capital, LLC

John A. Baugh - Stifel, Nicolaus & Co., Inc., Research Division

Rent-A-Center (RCII) Q3 2013 Earnings Call October 22, 2013 10:45 AM ET

Operator

Good morning, and thank you for holding. Welcome to Rent-A-Center's Third Quarter 2013 Earnings Release Conference Call. [Operator Instructions] As a reminder, this conference is being recorded, Tuesday, October 23 (sic) [22], 2013. Your speakers today are Mr. Mark Speese, Chairman and Chief Executive Officer of Rent-A-Center; Mr. Mitch Fadel, President and Chief Operating Officer; Mr. Robert Davis, Chief Financial Officer; and Mr. David Carpenter, Vice President of Investor Relations.

I would now like to turn the conference over to Mr. Carpenter. Please go ahead, sir.

David E. Carpenter

Thank you, Mo. Good morning, everyone, and thank you for joining us. You should have received a copy of the earnings release distributed after the market close yesterday that outlines our operational and financial results that were made in the third quarter. If for some reason you did not receive a copy of the release, you can download it from our website at investor.rentacenter.com.

In addition, certain financial and statistical information that will be discussed during the conference call will also be provided on the same website. Also in accordance with SEC rules concerning non-GAAP financial measures, a reconciliation of EBITDA is provided in our earnings press release under the statement of Earnings Highlights.

Finally, we must remind you that some of the statements made in this call such as forecast growth in revenues, earnings, operating margins, cash flow and profitability and other business or trend information are forward-looking statements. These matters are, of course, subject to many factors that could cause actual results to differ materially from our expectations reflected in the forward-looking statements. These factors are described in the earnings release issued yesterday, as well as our annual report on Form 10-K for the year ended December 31, 2012, and our quarterly reports on Form 10-Q for the quarters ended March 31, 2013, and June 30, 2013. Rent-A-Center undertakes no obligation to publicly update or revise any forward-looking statements.

I'd now like to turn the call over to Mark. Mark?

Mark E. Speese

Well, thank you, David. Good morning, everyone, and thank you for joining us this morning. Suffice it to say, I'm disappointed with our overall results, yet I remain enthused and optimistic about many of the trends that we are seeing, specifically in the Core U.S. business.

As for our results in the quarter, total revenue increased 2.1% year-over-year, with our RAC Acceptance and Mexico business units more than offsetting the decline in the core business.

Net earnings were down approximately $12 million year-over-year, again, primarily due to the operating profit decrease in the Core U.S. segment. That said, we continue to see positive, strong demand trends in the quarter.

Deliveries, the leading indicator for demand, were up again this quarter, increasing over 7% year-over-year that following the 6.6% increase in the second quarter. And in fact, as we predicted, our portfolio of agreements in the core, meaning the number of active agreements that we have, has now surpassed the prior year levels. However, the monthly average revenue per agreement or ticket is down, and as such, the value of the portfolio remains below the prior periods. That drop in the ticket, which is greater than we expected, has been caused by additional promotional activities to attract customers who remain under pressure, lower consumer spending and continued product deflation in electronics. While the overall retail environment remains challenging, we have been driving successful -- successfully driving more traffic and customers to our stores leading to the increase in deliveries and the larger portfolio size. That trend and the recent stabilization in the average ticket pricing gives us confidence in our long-term strategy of improving the results in the core.

Now regarding the growth initiatives, they continue to perform well. Our RAC Acceptance business added over 100 new kiosk locations during the quarter. Revenues were up approximately 48% to $124 million in the quarter, contributing over 16% of our total revenue and over 33% of our operating profit. We are very pleased with our results here.

In Mexico, we achieved our new store opening goal for the year and in the quarter with 150 locations. Net revenues grew over 91% in the quarter. And as previously stated, we remain on track to achieve the 4-wall breakeven by the end of 2013.

We remain very excited about the long-term opportunities that we have in Mexico. Also as mentioned in the press release, we've embarked on another initiative, our wholly-owned ColorTyme -- subsidiary ColorTyme, a franchise or rental stores operating under the trade name of ColorTyme, has changed its name to Rent-A-Center Franchising International in connection with an offer to the current franchisees of the opportunity to convert their ColorTyme store to the Rent-A-Center brand. And we are currently in the midst of discussions with our ColorTyme franchisees regarding this offer. During the fourth quarter, we expect to complete a variety of buy-sell transactions with certain franchisees to facilitate their conversion to the Rent-A-Center brand. In addition, we will pay certain signage and related reimaging costs for those franchisees electing to rebrand. As such, we expect to record a charge in the fourth quarter related to the rebranding initiative in the range of $1 million to $3 million.

Now while I'm unable to provide a number today, it is our expectation that the majority will rebrand to the Rent-A-Center name. We believe that a unified network of both company-owned and franchise stores operating under the Rent-A-Center name creates a stronger service offering for our customers and leverages our growth efforts to reach more customers. We expect to be able to provide more specifics surrounding the conversion counts, geographies and so forth during our next quarterly call.

In terms of guidance for the remainder of 2/3 -- 2013, Robert will provide more specifics. But again, as was noted in the earnings release last night, given our third quarter results and the impact of pricing on the core portfolio, our expectations for EPS is now a range of $2.80 to $2.85. While disappointed in the quarter, the current trends remain positive. Our growth initiatives continue to perform well, and financially, we remain solid.

As always, I want to thank all of our coworkers for their continued hard work and contributions, and of course, we appreciate your support as well.

With that, let me ask Mitch to provide a more in-depth detail on the operating results of the various segments.

Mitchell E. Fadel

Thanks, Mark, and good morning, everyone. As Mark mentioned, we are pleased with our results in building our portfolio of agreements in our core business, as we surpassed prior year levels of agreements in the quarter. Overall, our same-store sales declined 0.8%, this was an improvement of 0.8% from our second quarter results, and this improvement was primarily the result of the core segment, which was down 5.1% versus being down 5.9% last quarter. Same-store sales in the Core segment has improved each quarter this year, albeit not as fast as we would like. The 7.3% improvement in year-over-year delivery shows continued strength in the model and in our ability to gain market share. However, the average revenue per agreement or the ticket component remains under pressure and has us still in a negative revenue position for now.

While we now have more agreements on rent than a year ago, there are 2 primary reasons for negative comps in the core, one is the ticket that we've already talked about. More specifically, this is being caused by electronics deflation and aggressive promoting to gain market share. The other one is our early purchase option, our sales income is running significantly lower than last year. This is primarily due to changes we made at the beginning of the year to our early buyout programs. While seeing less -- lower margin early purchase options as not necessarily a bad thing, it does affect year-over-year revenue counts. In fact, although the fourth quarter overall core total revenue count will be negative again, we estimate our rental and fee comp in the core to be about flat. And this positive trend also shows up in the core's gross profit margin improving by 30 basis points year-over-year.

So very good news on deliveries and overall portfolio of agreement results. The headwinds are ticket and fewer revenues from early purchase options. But again, Q4 looks like rental and fee revenue year-over-year in the core should be about flat, which is a very good trend, and we believe a very positive sign of things to come.

On the collection side, our losses ran a little high at 3.2%. Summer quarter is usually our worst loss quarter of the year, and 3.2% is at the higher end of our historic summer range. Our operations team will continue its focus here and we expect this to not be an issue going forward.

On the inventory front, we're in good shape. You can see the positive delivery in portfolio of agreement performance just by looking at our inventory numbers. The Held for Rent inventory dollars in the core are flat year-over-year, yet the on-rent inventory in the core segment is up about $40 million. This gives us the Held for Rent percentage of 26.4%, a 120 basis point improvement from last summer.

Regarding RAC Acceptance, we remain very pleased, as Mark said, with things in that segment. For the quarter, revenues of about $124 million, profit of about $19 million and a positive comp over 29%. We've opened 320 through the first 3 quarters, 100 more than last year. And all of our operating metrics in this segment are staying consistent and in line with expectations. RAC Acceptance results are tracking to their new store economic model as demand remains strong. Overall, RAC Acceptance is a very successful growth vehicle for us, and it's helping us grow the overall U.S. market, which for most retailers is not an easy thing to do right now.

In fact, when you think about our core and RAC Acceptance segments together, it's one U.S. business model. Our revenues in the U.S. are up about 2%. Another sign and another area that points to the fact we are growing our United States market share.

In Mexico, we opened 22 in the quarter, and we have now met our new store goal there for the year. We wanted to get them all opened before the fourth quarter, and we did just that. Mexico's revenues, as Mark mentioned, grew over 91% in the third quarter with a positive comp of over 36%, and we remain excited about this additional growth vehicle as we remain on track to achieve 4-wall breakeven in Mexico for the first time in December.

Overall, the core is improving from a market share standpoint with rental and fee revenue getting back to about flat in the fourth quarter, while RAC Acceptance provides a very strong near-term and long-term growth strategy, and Mexico continues to grow towards a meaningful growth strategy for us for many years to come.

I'd like to thank our 20,000-plus coworkers for all their efforts as we continue to improve the quality of life for our customers. Robert?

Robert D. Davis

Thank you, Mitch. I want to spend a few moments updating you on our financial results during the quarter, and then review our 2013 revised annual guidance, and then we'll open the call for questions. As outlined in the press release, our total revenues were $754.8 million during the third quarter of 2013, an increase of $15.5 million or 2.1% as compared to the third quarter of last year. Our net earnings in the quarter were $27.6 million, while diluted earnings per share equated to $0.51, a decrease of approximately 24% quarter-over-quarter.

These results include about a $0.09 drag on earnings in the third quarter due to the continued investment and ramp-up of our international growth initiatives.

Operating margins in the quarter declined 170 basis points, primarily due to the negative same-store sales results in the core RTO segment. Similarly, our third quarter EBITDA margin declined 190 basis points to 10.1%. Going into our seasonally strongest quarter of the year, from a growth perspective, we do expect that both operating profit and EBITDA margins will increase approximately 200 basis points sequentially from the third quarter. We generated positive operating cash flow of $57.4 million during the third quarter. And year-to-date, we have generated approximately $173 million in operating cash flow.

During the quarter, the company reduced indebtedness by over $39 million, while continuing to invest in new stores, new channels and new markets. In fact, our overall location count has increased approximately 10% from the prior year, and 2.6% since June 30. Since quarter end, we have reduced indebtedness a further $19 million, while our $200 million accelerated share buyback continues to be executed in the market. Dividends continue to play a vital role in our total shareholder return, and we did make an $11 million dividend payment in the quarter and anticipate making our 14th consecutive quarterly cash dividend payment later this week.

We believe we've taken a fair and balanced approach to total shareholder return. We ended the quarter with roughly $53 million in cash on hand, and our leverage ratio at the end of the third quarter remained essentially flat at 2.17x, well below the floor on our covenant requirement of 3.25 turns. We continue to believe our balance sheet remains strong, and as such, we believe we remain well-positioned to continue to execute on our growth initiatives.

Now in terms of guidance, with just 1 quarter remaining, we have revised our annual 2013 guidance as follows: We are now expecting diluted EPS to range between $2.80 and $2.85, this includes an approximate net $0.30 drag on EPS relating to our international growth initiatives; we previously expected a $0.25 drag from international but are updating this to reflect 2 recent development. The first is a new lower share count due to the ASR impacting the dilution, and the other being that given our continued confidence in Mexico, we have decided to increase our investment there in preparations for entering Mexico City in the first quarter of 2014; in terms of revenues, we now expect total revenues to increase approximately 1%, with same-store sales declining approximately 1.5%; in terms of EBITDA and free cash flow, the company now estimates EBITDA will approximate $370 million, with free cash flow expected to be roughly $90 million; for 2013, we expect both our consolidated operating and EBITDA margins to decline approximately 100 basis points, due to the continued investment in our growth initiatives, as well as the impact of the negative same-store sales in the Core U.S. segment. However, given the agreement count in our Core U.S. segment has now surpassed prior year levels, we do believe 2013 will be a valley in regards to our profit results and margins, and we look forward to reporting back next quarter with our fourth quarter results and the initiation of our 2014 annual guidance.

Now this 2013 guidance does not include the potential impact of any repurchases of covenant stock the company may make, changes to future dividends, material changes to indebtedness or the potential impact of acquisitions, dispositions or store closures that may be completed or occur after the date of this press release.

That concludes our prepared comments. Mo, would you now open the call for questions?

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes from the line of Brad Thomas with KeyBanc Capital Markets.

[Technical Difficulty]

Bradley B. Thomas - KeyBanc Capital Markets Inc., Research Division

Sorry about that, something was not working technically. I wanted to just first ask about what you guys are seeing from a competitive standpoint, we get asked about that a lot. Obviously, when we look at your results here and see the traffic increase and the account growth, it would seem that you're picking up customers and gaining market share. But do you think it's perhaps competition that's maybe nipping away a little bit at the ticket?

Mitchell E. Fadel

I think -- Brad, this is Mitch. You put it in whatever order you want, really, right, if you get more aggressive to get -- to gain market share, it shows up negatively in the ticket, but we are gaining the market share. We talk in the press release and in our prepared comments also about the electronics deflation continuing. In a lot of ways, our promotional activity just reflects the deflation in electronics. Our whole ticket problem is in electronics, whether you consider promotional activity or everyday pricing, the 5% we're down, we've crossed the line on agreements, so it's not -- the agreements aren't down year-over-year, so if we're down 5% in the comp, it's all in ticket. And we can tell you, it's all in electronics, and that's about half of our business. So you can calculate that, that the electronics is down probably closer to 10% year-over-year. But that's what you're seeing out there, if you go back 15 months on electronics, they're down. We've always talked about -- and by the way, it continues, the product deflation, the next TV technology coming out in the future, they continue to deflate the current one. We've always talked about how we have a lot of different levers we can pull, Brad. We can lower rate or we can lower term. And obviously, in the last -- so far, this year, we've done a lot more rate than term to be more competitive, and it's showing up in the traffic and in our delivery count, but it's coming at the expense of ticket. Had we just lowered term to make up for the deflation, it would keep our margins in line and give the customer about the same overall margin, but it wouldn't be as competitive if we just did it all for terms. So you're always trying to balance those levers. So I think -- so the short answer is competition is always probably what we look out at for pricing, we feel like we're doing pretty well against our competition based on the way we're growing the market share and growing deliveries and the agreements are now higher than they were last year, even though we -- remember, we started the year with a major deficit in our agreement count. We've made that up and now crossed the line. It's showing up unfortunately on the ticket side, and it will be another couple of quarters before we have enough agreements to make up for the ticket and then have a positive same-store sales sometime in 2014.

Bradley B. Thomas - KeyBanc Capital Markets Inc., Research Division

That's helpful. And if I could just ask a follow-up on RAC Acceptance, which continues to really be a bright spot for you all. If we could just get an update on how that keep rate is trending. And then, perhaps, how you feel about the pipeline for additional stores as we look ahead to 2014?

Mitchell E. Fadel

The metrics remain consistent, both in collections and in keep rate, and we feel real good about the pipeline. We'll give guidance, I'll remind everyone, we'll give guidance in January for 2014, when we do our January earnings call, but the pipeline is strong. The pipeline is strong. Like I said, we've opened 100 more through 3 quarters than we did last year through 3 quarters, and the pipeline remains strong. So very excited about RAC Acceptance. And overall, as I pointed out in my prepared comments, if you add the 2 together, we're growing the U.S. market share. Now we're not happy with where the quarter is, don't misunderstand that comment, but we are growing the U.S. market share when you add the 2 together, and they're all in -- they're in the U.S., and it's a pretty similar customer base. So in some ways, you have to add them together to see what's happening in our business. It doesn't mean we're not working our butts off to get the core back in the positive territory on its own though.

Operator

Your next question comes from the line of Budd Bugatch with Raymond James.

Budd Bugatch - Raymond James & Associates, Inc., Research Division

Yes, I wanted to -- you've answered -- I guess, my first question was on electronics deflation because it's not new. And what is new is the fact that you're changing more price than term. Is that what I understand?

Mitchell E. Fadel

That's right, Budd. We go back to the beginning, maybe late spring, and you're exactly right, product deflation is not new, but to be more competitive and drive market share, we are doing more on the rate than term. And you've got it.

Budd Bugatch - Raymond James & Associates, Inc., Research Division

Okay. And the operating expense in the core also went up by $7 million or so, was that -- how does that -- is that more promotional expense or what caused that?

Robert D. Davis

Budd, some of that is the byproduct of -- in Mitch's prepared comments, losses as a percent of revenue came in higher than our historical ranges. So a few million of that increase was related to losses and the rest is primarily utilities in the summer with air conditioning and the overtime hours were a little higher in the third quarter than the prior quarter, just given vacations and time off.

Mitchell E. Fadel

And then, the loss number, Budd, is a couple million higher than last year, and that is part of that $7 million. It's not -- we have been at 3.2% before in the third quarter. We weren't last year. Last year was on the historically low side, when we look at a range of -- the way the third quarter runs, run between 2.7% and 3.2% of revenue. This is on the high side of 3.2% I mentioned. We've been at 3.2% before though, so I don't want anybody to panic about being at 3.2% before. We have been there before. We just weren't there last year, and that's a few million of the $7 million that Robert was talking about.

Budd Bugatch - Raymond James & Associates, Inc., Research Division

Okay. Just 2 other quicker questions, I hope. One, on the change in the franchise agreement. What's the economics change and how will we see it in reported results? Will there be a change in franchise fees or how will that work?

Mitchell E. Fadel

Yes, we'll put up -- will give a lot more color on this when we'll have more numbers come January in that call. But yes, the franchise Rent-A-Center will cost franchises more than ColorTyme. So there will be increases in fee revenue with the franchisees. The product markup stays about the same, so that won't change much on that side, but the royalties and fees to open stores do go up using the Rent-A-Center name versus the ColorTyme name. We'll know and give some color in January on how many stores converted over, how many are still left ColorTyme, there will be some left ColorTyme, although as Mark said, the majority, we believe, will end up Rent-A-Center.

Budd Bugatch - Raymond James & Associates, Inc., Research Division

And do you want to give us any feeling of what your thought is on how much it goes up or quantification of that?

Mark E. Speese

Not at this time.

Budd Bugatch - Raymond James & Associates, Inc., Research Division

Okay. And my last question is regarding Mexico. You said, I think, you're on track to do 4-wall profit breakeven by the end of the year. What about overall segment breakeven? When do we look for that to occur?

Mitchell E. Fadel

Let me go back to your last question because I might have misunderstood it. We're not giving any color. We don't know where the store count is going to end up. But if you're looking for how much the fees go up, that I could tell you because that's public information already. It's -- the ColorTyme royalty rate is between 2% and 4%, depending on their volume. The Rent-A-Center royalty rate will be between 4% and 6%. So basically, it goes up 2 points.

Budd Bugatch - Raymond James & Associates, Inc., Research Division

That was what I was looking for on that. And then, on international, I'm looking for when we might get to breakeven for the segment in Mexico?

Robert D. Davis

Yes, the 4-wall breakeven is at the store level does not include overhead. And then, given our ramp-up in new stores that we expect to continue throughout next year and beyond, it will be sometime out before there is segment breakeven. If we stopped opening stores, that segment breakeven would accelerate much sooner. But just given the outlook and the positive framework in that country, we intend to continue to open stores. And as you know, new store economics, there's a drag in earnings when you open new stores.

Mitchell E. Fadel

And we would expect to be accretive every year relative to last year.

Robert D. Davis

Yes, there'll be less dilution each year going forward, but just overall profit is a few years out.

Budd Bugatch - Raymond James & Associates, Inc., Research Division

And the positive sign will occur in '15 or '16? Or do we -- is it longer than that?

Robert D. Davis

We haven't given that specific direction because it depends on store count and we're -- we'll continue to evaluate the new store opportunity each year. We do expect the increase from 60 this year to a larger number next year, but we'll provide more guidance for that in the first quarter in January.

Mark E. Speese

Budd, just you may know that we are planning an Investor Day in February. That will be another 5-year look, and I suspect, at that point, there will obviously be some assumptions in terms of the number of openings and so forth, but we'll create a waterfall that will answer the question you're asking. But we're going to wait and do that in the Investor Day presentation in February, when we provide a full 5-year look on all the various businesses.

Operator

Your next question comes from the line of Laura Champine with Canaccord.

Laura A. Champine - Canaccord Genuity, Research Division

The deliveries are moving up faster than dollar sales. We're seeing some pressure on the salary and other expense line is going to extend into 2014. Can you comment on how long it will take before you start to see leverage on that line again and what kind of a comp you would need to do that?

Robert D. Davis

Laura, we didn't hear the very beginning of your question. You came on late. Would you mind repeating it, please? Sorry about that.

Laura A. Champine - Canaccord Genuity, Research Division

Sure. Because deliveries are growing faster than sales and the charge-off rate is higher too, we're just assuming that there'll be continued pressure on margins next year on the salary and other line as you collect from those contracts. Can you comment on what kind of a comp you would need to see, to see margins flat? And do you also think that you'll see pressure on that expense line in 2014?

Robert D. Davis

We don't expect pressure on that line by increased deliveries. Obviously, there's additional cost associated with more deliveries, so to speak, but not materially in regards to leverage, if you will. We've always talked about needing a 1% or 2% comp in regards to needing -- to leverage our fixed cost business model, if you will. So we're not anticipating increased pressure on that line item going into next year.

Mitchell E. Fadel

And sequentially, as you pointed out, Robert, the EBITDA margins you'd expect it sequentially in the fourth quarter to be up 200 basis points.

Robert D. Davis

Right, right.

Operator

Your next question comes from the line of Bruce Zessar with Advisory Research.

Bruce M. Zessar - Advisory Research, Inc.

I had a question regarding RAC Acceptance versus the core business. You've said in the past that you haven't seen much in the way of cannibalization as RAC Acceptance has grown relative to the core unit. But with the results in the third quarter, is there any evidence that may be undercutting that thesis that in fact, as RAC Acceptance is growing more that, that is cutting into the core business?

Mitchell E. Fadel

Bruce, this is Mitch. There's a couple of reasons why we don't think it is, certainly not materially. One, our deliveries are higher and we've got more agreements on rent. And we don't see a way that it would actually be affecting the promotional activity or -- which is generally being [indiscernible] in a lot of ways by product deflation and electronics. So that's really not the reason why the ticket is down and we're up in customers. The other thing we do, Bruce, is we've got names of all of our customers. So we can look at overlap whether the customer ever was with us before. And if they're with RAC Acceptance now, have they ever done business with Rent-A-Center and vice versa, and it's very, very de minimis the overlap there. Now what we can't track is opportunity, right? When somebody leaves an Ashley furniture store, had they gotten turned down for credit and RAC Acceptance wasn't in there, would they have gone to a Rent-A-Center. So we can't -- it's hard to track the opportunity cost or opportunity potential there. But by name, there's very little overlap. And again, just based on the way we're doing more deliveries, when it's a ticket problem, we wouldn't relate that to RAC Acceptance.

Operator

Your next question comes from the line of Arvind Bhatia with Sterne Agee.

Brett Strauser - Sterne Agee & Leach Inc., Research Division

This is Brett Strauser in for Arvind. A couple of questions here. I'm wondering if you could talk about how much the gross margin in your core business benefited from the lower level of EPOs.

Mitchell E. Fadel

About 30 basis points year-over-year we're up.

Robert D. Davis

And it is reflective of the mix in -- sales mix change because merchandise sales are less of the overall revenues than they were before. So as you know, those are lower margin revenues. And so, yes, there is some pick up in the overall gross margin due to less sales.

Brett Strauser - Sterne Agee & Leach Inc., Research Division

All right. And as you rebrand these franchisees, does this mean that -- will there be any opportunity for them to participate in RAC Acceptance in terms of handling any product returns?

Mitchell E. Fadel

That's not the plan right now. We haven't gotten that far as far as any how RAC Acceptance might relate to franchisees in the future. This is not something we've addressed at this point. So right now, the answer is no. Obviously, it could in the future end up tying in to our franchise business, but right now, we don't have it tying in to the franchise business.

Brett Strauser - Sterne Agee & Leach Inc., Research Division

Okay. And one last one for me. Last quarter, you talked about a virtual kiosk or an online business model that may be in the works and I'm wondering if you could provide any update there?

Mitchell E. Fadel

We are working on that. We continue to work on it. We don't have any specific updates. I think, by the January call, certainly in the Investor Day that Mark was referring to earlier, we'll have an update on that business model for the next 5 years and how a virtual model will play into that model. For right now, we would just tell you we'll continue to work on it, seriously work on it and we'll have more of an update in January and February.

Operator

Your next question comes from the line of John Braatz of Kansas City Capital.

Jonathan P. Braatz - Kansas City Capital Associates

One question. Given the weakness in the core operations and maybe an uncertainty about when your customers are going to return again. Are there more stores maybe failing to meet the hurdle rate? And could we see some additional store closing beyond maybe what we've seen before closings or mergers with other stores? Could we see that pick up a little bit going forward?

Mark E. Speese

We're not anticipating it right now, John, and I -- your point is a good one. Having said that, we're actually -- the individual stores are handling more traffic and more customers, which actually goes the other way, right? Albeit pricing is down, and so we're not leveraging the fixed cost as much as we would've otherwise. The fact is we're actually handling more transactions and serving more customers today than the stores that we have. So as we said here today, the answer is no. And again, we think there's an opportunity to grow further into this, given the traffic that we've been seeing and the stabilization in pricing and so forth. And I think that goes maybe to the question that Laura was asking a while ago about leveraging the fixed cost, and I think, as Robert said, going into our seasonally strongest fourth quarter, as I sit here today, I would tell you the quarter we just come out of would be the low watermark, if you will, and we expect it to improve from here.

Mitchell E. Fadel

In my prepared comments, we expect 2013 to be the valley in terms of margins and profit.

Mark E. Speese

We continue to evaluate individual stores and their performance. And we, as you've seen, we've done handfuls, if you will, each quarter. I don't expect that to change, but I would not suggest that you think about a larger consolidation plan or something. No.

Operator

Your next question comes from the line of Carla Casella with JPMorgan.

Carla Casella - JP Morgan Chase & Co, Research Division

Questions have been answered. But did you say how long you expect the ColorTyme transition to take, the buy-sell transactions?

Robert D. Davis

I don't think we did, Carla, it should be done by the end of the year. There may be a few rollover into early next year, so by the January call, we'll have real good handle on the exact numbers on how many converted and so forth. So by the January call, it will be -- if not 100% percent done, then the 90% range of being done.

Carla Casella - JP Morgan Chase & Co, Research Division

Okay. And then, the cost to, I guess, convert on a per store basis?

Robert D. Davis

We're picking up a lot of that rebranding, and that's why we see the potential for a $1 million to $3 million restructuring charge in the fourth quarter.

Carla Casella - JP Morgan Chase & Co, Research Division

Okay. So it sounds like that would run through SG&A then, instead of just CapEx, is there any capital expenditures needed?

Mark E. Speese

Yes, there'll be some additional capital as well, in a similar range of $1 million maybe.

Operator

Your next question comes from the line of Chuck Ruff with Insight Investments.

Charles Ruff

In Mexico, revenues were obviously up a whole lot, operating profit or operating loss did not improve a whole lot. Is it strictly because of the large number of openings this year? Or is there anything else going on there?

Mitchell E. Fadel

It is because of the large number openings. Our stores, as they're maturing, are running, generally speaking anyhow, on the model, so we're -- they're improving and stores get profitable as they age. So yes, it's because of the openings. And as I mentioned earlier, we front-loaded them more so than last year. And by getting all 60 opened this year, before the fourth quarter, so they were opened by the best time of year. So that's what you're seeing there, is the opening schedule being pretty heavy.

Charles Ruff

Okay. And if we could just step back a little bit and take a little longer view. I look back to 2010 when the economy was also very, very weak, and yet the core business had much higher operating profit than this year. Are there some reasons beyond what you've already talked about going on this year? Are there any systemic issues that you're aware of?

Mitchell E. Fadel

No. I think, the product deflation is the biggest one. We did lose -- go back to the beginning of this year, when we talked about starting out the year quite behind on our agreement portfolio quite a bit. So this started really last year as far as -- we just lost ground last year and because of the recurring revenue nature of our business, it rolled into this year. Now we've crossed that line as far as now we have more agreements than last year. And though we had to do it with lower pricing by lowering rate rather than just lowering terms with this deflation. So I think it really started last year, Chuck, in that we lost agreements last year, started this year behind the eight ball. We've made up the agreements, but we haven't made up the revenue just yet, and that will come. And obviously, we need even more agreements to make up for lower ticket.

Mark E. Speese

Also a little bit of the way our business model works, 2009 actually was a pretty good year for us. The results of 2009 showed up in 2010 because you have to build that portfolio of accounts and so forth. We had a pretty rough '08. We actually had a quite good '09 from a portfolio standpoint, and then it showed itself in '10's results just because of how our business works building that annuity, if you will, the recurring revenue off the portfolio.

Charles Ruff

Okay. And lastly, you've mentioned twice that you expect this year to be the valley in earnings and margin, but to be honest with you, I'm not real clear on why next year is going to be better. So, I'm afraid I'm going to ask you to quickly run through that one more time.

Mark E. Speese

We'll obviously provide more color in January. But given the fact that our agreement count has now passed last year and the price has stabilized more recently from a trend perspective, going into the fourth quarter, our seasonally best quarter, we will grow our overall portfolio. And that will allow us to have a shot in the arm, so to speak, in the core business going into '14. Coupled with the RAC Acceptance business maturing, continuing to mature and the flow through on the incremental revenue from RAC Acceptance are 2 of the big primary reasons that 2014 will be an improvement over 2013. But again, we'll provide additional color, more specifically in January.

Mitchell E. Fadel

And remember, Chuck, we talked earlier about the sales number being down because of the early purchase options running behind. In the fourth quarter, we're going to be pretty -- we're going to be right around flat with rental and fee revenue in the core. So if you get back to flat and you seasonally add all the customers and the agreements that Robert was just referring to, in our best quarter, the fourth quarter, gives you momentum going into next year. We're going to be back to about flat anyhow. And now, with those extra agreements, you can see how next year would be positive sales numbers without any changes, any material changes to the expense base, that's why this year is going to be a valley.

Charles Ruff

Okay. And Mexico is expected to lose less money next year?

Mark E. Speese

That is correct.

Mitchell E. Fadel

Right.

Operator

[Operator Instructions] Your next question comes from the line of Barry Haimes with Sage Asset Management.

Barry George Haimes - Sage Asset Management, LLC

I have 2 questions, I guess. One, so with the extra -- with the pressure on term and rate that you talked about in terms of promotions, that could be 2 issues: One, more supply, so greatest growth -- footage growth in the industry could be putting the pressure on; and then, the second, of course, is pressure on the core customer. So I wonder if you could talk a little bit about where you think that pressure is coming from. And then, my second question was just to get a feel for the age of inventory in the stores. Is it skewing a little older as people give back more goods? Or is it sort of in the range of normal?

Robert D. Davis

Sure, Barry. I think, the answer to your first part of your question is primarily the pressure is on our core customer. The square footage in the industry hasn't changed materially over the last couple of years. There's a few new stores that -- we bought stores, too. So -- and merge the accounts into ours. So overall, it's not so much the supply or a lot more places to go shop a rent-to-own store it's mostly the pressure on the core customer. And on the inventory, it's about the same. We're not -- you could see the overall inventory numbers are a whole lot better than they were a year ago and from -- would be idle inventory, the Held for Rent inventory staying the same as last year, yet $40 million more on renting the core, which certainly speaks to that portfolio being up, right? But from an age standpoint, there's nothing -- there's no material changes in the age of the inventory either.

Mitchell E. Fadel

And I was just going to add, going back a couple of years anyways, we talked earlier about deflation being mainly through rate and term, and historically, have been primarily focused on term. Our average age of inventory in the system today is less than it was a few years ago as we were reducing term primarily. And so the overall fleet of inventory, if you will, is cycling through the stores faster, which speaks to, I guess, the inverse of your assumption there about age of inventory being old.

Operator

Your next question comes from the line of Seth Rosen with Eminence Capital.

Seth Damon Rosen - Eminence Capital, LLC

Just in reference to the comment that the impact on discounting has more been on rate rather than term. Can you just explain how that manifests itself through the P&L? So what I mean by that is if we've only been more promotional for 3 months or so, does it take a full 18 months or the average duration of the contract to cycle through the impact? Or is the nature of the promotions more of the kind where you give the first month free, so it's all impacted in the current quarter?

Mitchell E. Fadel

In the pricing, it's -- I mean, the product deflation has been around longer than just this quarter. So it goes back a ways before this quarter. When we've started lowering rate more than lowering term goes back to about April 1, and with our average life of an agreement running in the 4.5 months range in our system, that's why we're seeing leveling off of that ticket now that Robert mentioned earlier. So we've probably been lowering more rate on electronics. Lowering rate more than term now for about 6 months, and we've cycled through that, which is why we're seeing the leveling off that Robert referred to.

Robert D. Davis

And the way it sort of manifests itself through the P&L is strictly through revenue, and to some extent, margin. And if we were focused more on term, that might impact working capital and cash flow a little differently, but given the fact that the inventory is really being managed through rate and not terms, it's primarily through the revenue line, as opposed to working capital on the balance sheet.

Mitchell E. Fadel

In effect, you could still make your normal percentage margin on product. Well, when they're deflating, the dollars are lower. And when we take them off the monthly rate, that's where the revenue per month is down about 5% on the ticket.

Seth Damon Rosen - Eminence Capital, LLC

Okay. And in your guidance for the fourth quarter that the margins would be up 200 bps, the EBITDA margins in the core, so that's down 200 bps year-over-year, up 200 bps sequentially. Should we expect a similar profile to this third quarter that gross margins are up but the EBIT margins are down or will the makeup be different?

Robert D. Davis

Well, the prepared comments of the 200 basis points up sequentially was consolidated, not focused on the core, but we would expect that the core margins to expand in the fourth quarter over the third as well.

Seth Damon Rosen - Eminence Capital, LLC

Okay. And the same dynamic with gross margins being up but de-levering on SG&A?

Robert D. Davis

Yes.

Operator

Your next question comes from the line of John Baugh with Stifel.

John A. Baugh - Stifel, Nicolaus & Co., Inc., Research Division

So I just wanted to hone in on the core again and discuss the margin and your confidence that '14 will be up. So it sounds like the -- because the portfolio is being rebuilt to some degree, you're going to back off of the discounting on the rate like soon or in the fourth quarter? That's the first question. And then, secondly, do you not, as RAC continues to grow, absorb on the returns that you're seeing from RAC with increasing losses, to some degree, that get funneled to the core business on that returned merchandise?

Mitchell E. Fadel

Yes. First, John, on the pricing. As we said, it's leveled off already from when we started lowering rate rather than only lowering term on this electronic deflation issue. So we've already seen that level off, and that's what gives us confidence going forward as well. As we rebuild the portfolio now that we've leveled off for a number of weeks, it stayed about the same. On RAC Acceptance, yes, as they grow, we get more products. Fortunately, their metrics have stayed very similar in that the returns are very low. And we haven't had a problem putting the product in our stores, re-running it. It's still in the 30 to 40 basis point range as far as the impact it has on the core business depreciation, when we look at that, with it all coming back in. It does -- we can rent it. It goes out at a higher margin because we paid more for it, as you know. But it's in that 30 to 40 basis point range is all the overall effect it is on the core business, so not much of an effect there. Obviously, not when you calculate the overall profit. If you take that range of 30 to 40 basis points on the core business and then figure out what RAC Acceptance is making, it's still a great model for getting rid of the product. And only when we calculate the profit of RAC Acceptance, what it does to the margin in the core, that 30, 40 basis points obviously isn't -- the 30, 40 basis points doesn't calculate very much against all the profit the RAC Acceptance make in the first place.

Robert D. Davis

And in fact, Mitch, John, the gross profit margin in the core has actually increased each quarter this year. So even with that impact from the RAC merchandise, gross profit margins are improving in the core.

John A. Baugh - Stifel, Nicolaus & Co., Inc., Research Division

Great. And then, just secondly, anything going on, on the regulatory front, either or within Rent-A-Center dealing with the various entities or industry-wide?

Mark E. Speese

No, there's not. And from a legislative standpoint, there's nothing unusual or abnormal or significant for that matter going on as we speak. So no, things are pretty quiet, pretty good shape.

Operator

And at this time, there are no further questions. I would like to hand the call to Mr. Mark Speese for summary comments.

Mark E. Speese

Thank you, Mo. Well, ladies and gentlemen, thank you again for joining us this morning. As I started my comments, we're disappointed with our results in the third quarter, yet at the same time, we are enthused, we are excited about what we're seeing. We are successfully driving traffic into our stores. The portfolio is larger than it has been previously, pricing has been the issue, and we've seen a fair amount of stabilization there, recognize we've got work to do in the core, but I think we're in a good position to continue driving traffic work. And the next line that we have to cross, if you will, is the value of that portfolio. So the size is now bigger and when we make the value of it bigger, that's when it's going to show up in a very positive way and we believe we're on a path of doing that. It's just going to take another quarter or 2 to do so. The emerging businesses, a lot of enthusiasm, a lot of excitement, a lot of good things going on there. You heard Mitch say, clearly, RAC Acceptance performing well, the demand pipeline remains strong. So we're optimistic about what we can continue to do there. In Mexico, again, different story, but an exciting one also. Performing generally in line with our expectation. We're getting ready to go into Mexico City in the first of the year. And we'll be breaking even at the 4-walls later this year. So again, we feel excited about the long-term prospects there. So as always, we appreciate your interest. We appreciate your support, and we look forward to reporting back to you at the end of the year with our fiscal results, and hopefully, an opportunity to see all of you in February at our Investor Day, and we'll have more information coming on then. So thanks, again, and we'll talk to you next quarter.

Operator

And ladies and gentlemen, with this, we conclude today's presentation. We thank you for joining. You may now disconnect.

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