It has been some time since I took a look at Aaron's (NYSE:AAN), a company that was once was a part of my own portfolio. I had picked up shares at $27.78/share late in 2014 on what I felt was a fairly compelling story at face value. After all, this was a company that had rebuked multiple takeover bids (PE fund Vintage Capital, Rent-A-Center (NASDAQ:RCII)) at a modest premium to the current share price; new management was in place; the recently acquired Progressive business seemed healthy enough; and the company was trading at a historically fair valuation. After enjoying a healthy run (30% in six months), however, I penned a research note here on Seeking Alpha that Aaron's was likely to find some hefty resistance heading into the remainder of 2015 and was near fair value. I sold my shares and moved on to greener pastures.
Every once in a while you dodge a bullet, and this was definitely the case for me with Aaron's. The eve of Q3 2015 results likely marked a peak in the company's stock for years to come, with the stock nearly cut in half overnight. Weak results led to a sharp decline in share price, and a meaningful rally has not yet taken place, despite some otherwise positive news like a new Wal-Mart partnership. We're now back well below the price at which I made my initial purchase, so is now the time to rebuy?
Why I Can't Own Aaron's Long Term
The short answer is no. My initial investment in Aaron's was one primarily driven by catalysts and momentum, not the underlying fundamentals. I never intended to be in the company for the long haul. At times, it can be the right play to own a mediocre company with slowly deteriorating fundamentals in order to play market sentiment, and Aaron's was that company early in 2015. That has now changed, and at this point, being an Aaron shareholder means believing the long-term picture.
So why the lack of faith in the business model? Aaron's, at its core, is a simple business. It buys things consumers want but can't afford outright, and then leases those same items back to them, pocketing a spread. Over time, Aaron's revenue has become more concentrated on this core leasing business, rather than ancillary revenue. This ancillary revenue primarily consists of non-retail sales, in which the company buys and subsequently sells leasable products to franchisees. Such sales are flat over the 2011-2015period, despite a moderate uptick (5%) in franchisees. To blame for this is the fact that franchisees, dealing with falling y/y same store sales, are simply carrying less inventory. Click to enlarge
At first glance, nothing seems awry. After all, this is what Aaron's is supposed to be doing - leasing goods to consumers. Total Revenue is up handsomely over the 2011-2015 timeframe. So what is the big deal? That answer lies in the continuing growing cost of its leased merchandise:
Aaron's has spent $6.4B on acquiring merchandise over the past five years. That is a lot of money by itself to maintain operations, and this number has grown by an average of 14.7%/year since 2011. Yes, this spending has outpaced revenue growth marginally. However, despite that spending spree, the carried value of these assets on the balance sheet remains only $1.1B at the end of 2015, growing only half that amount (7.2%) annually.
The cause of this weakness on the balance sheet is rapidly accelerating depreciation. Annual depreciation as a % of lease revenue now runs 45%, up from 36% in 2011, despite lease revenue constituting a larger portion of the revenue pie. Higher depreciation has been driven not by a change in accounting policies, but due to a shift in the mix of goods leased (higher percentage of furniture on lease and a shift towards shorter-lived electronics), primarily within the Progressive business, which has to-date been focused on goods like furniture and mobile phones that depreciate rapidly.
Beyond the obvious impact to income per share that the higher depreciation expenses mean (which led me to being a touch too high on my EPS estimates in 2015 and too low on my free cash flow estimates), rapidly depreciating products increase risk in the overall loan business, and it is a twofold story. For one, customers must bear higher lease rates to offset the faster depreciation, which likely increases both chances of default and decreases motivation by customers to undertake the loan in the first place due to cost. For two, if the consumer does stop making payments, by the time the item is eventually written off (120+ days late) and the asset is recovered, potentially little value remains for resale. Asset recovery is always a nice backstop to have on companies like this. If I'm a bank and I foreclose on a house, that home has likely held substantially all of its value - or potentially appreciated - since I made that loan. A lease on a couch? It is likely worth 30% of what the price was new after just a year.
With higher rates and higher defaults, it isn't a surprise to see higher loss provisions, which are reflected in the company's results. Aaron's wrote off $155.6M in 2015, compared to just $34.7M in 2013. That is massive growth in write-offs, and definitely reflective of the higher risk leasing the company is now engaged in more often.
Given the focus on the Progressive business, unless the company onboards new partners, this mix is unlikely to change. Could Wal-Mart lead to such a shift? I'd deem that somewhat unlikely; given the relatively low cost of many of the company's goods, they are likely to be quickly depreciating goods as well.
Despite relatively costly lease rates (a common target for consumer advocacy groups), it still simply doesn't pay well to be in this business. Aaron's assets like furniture and electronics tend to rapidly depreciate, and over time , Aaron's has shifted towards more and more products with shorter lives, pressuring the company's financials.
Despite the risks, there is no doubt that Aaron's trades cheaper today on a forward earnings valuation than it has some time. While the company has missed expectations, misses were slight and were punished broadly. There is likely still some value to the name, but it is worth waiting for a change in overall sentiment before taking a position in this one. The more I look at this one, the more I lean towards a "wait-and-see" approach.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.