Rent-A-Center Gets 'Engaged' On Valentine's Day

| About: Rent-A-Center Inc. (RCII)

Summary

Shares of RCII have collapsed by almost 80% in two years. The company has been plagued by poor management, unappealing offerings, failed technology, and rising delinquencies.

Management has a plan to turn things around, but an activist investor with less patience believes RCII can quickly fetch $16 per share in the private markets.

After conducting a conservative discounted cash flow analysis, I agree that RCII is grossly undervalued. I derive an intrinsic value closer to $20 per share.

I'm not convinced, however, that a quick sale in the private markets is superior to management's plan.

Talk about a collapse! Just two years ago, shares of Rent-A-Center, Inc. (NASDAQ:RCII) were selling in the mid-$30s. Now they are struggling to stay above $8. This is a company that has been managed by Murphy's Law. (Anything that could go wrong, did go wrong.)

The latest bad news came out on the eve of Valentine's Day. RCII released financial results for Q4 2016. Because the company had previously warned investors that the results would be horrendous, there wasn't much to be surprised about. Besides, the stock had already plunged about 20% in mid-January when that warning was issued.

The problems at RCII have been accumulating for years, but they basically boil down to a few key points. First, the company has been offering goods that customers aren't crazy about. Second, RCII introduced technology that didn't work properly. Its point-of-sale (POS) system suffered numerous outages. Fortunately, it seems to be working fine now. Third, delinquency rates have risen, meaning that many customers have simply stopped paying what they owe. Fourth, the company embarked in a largely unsuccessful attempt to make money by renting smartphones to customers.

The good news, if there is any, is that RCII seems to have finally hit rock bottom. The CFO was fired in December, supposedly by the CEO, who himself resigned in January. The company has now written off all of its accounting goodwill in the Core U.S. segment. And the Chairman of the Board, Mark Speese, who is also a co-founder of the company, has stepped in as the acting CEO while the company searches for a permanent replacement.

During the conference call that followed the release of Q4 results, Mr. Speese outlined several steps he plans to take that hopefully will hasten RCII's turnaround. Most notably, he wants to improve the company's product offerings. He stressed that RCII had traditionally offered more aspirational (and more profitable) furniture and televisions to its customers, but that in recent years, the mix of products migrated toward cheaper and less profitable stuff.

He also wants to make changes to the labor force. In recent periods, RCII tried to save money by reducing the number of full-time employees in favor of part-timers. The unfortunate result was an increase in turnover and a poor experience for customers. Mr. Speese hopes to reverse this trend in favor of full-timers again, yet he plans to cut labor costs overall by eliminating jobs at the corporate level.

Interestingly, Mr. Speese said he also plans to increase transparency by providing more detailed information about how the business is doing. Most importantly, RCII will begin providing data on same-store sales and delinquencies on a monthly basis for both the Core U.S. and Acceptance Now segments. However, the company will no longer provide revenue or earnings guidance.

According to management, the most recent evidence suggests that things are already improving as evidenced by a reduction in delinquencies over the past 30 days and an increase in same-store sales in January.

As usual, analysts had plenty of questions for management. But the elephant in the room was ignored. That elephant is Engaged Capital, an activist investor that has taken close to a 13% stake in RCII and is agitating aggressively for change. Mr. Speese made it clear that he would not discuss this matter during the Q&A.

Glenn Welling of Engaged Capital had sent RCII's board of directors a strongly worded but cordial letter on December 7, expressing dismay that the CFO, Guy Constant, was dismissed. Mr. Welling believes that Mr. Constant was highly respected by the investment community and added credibility to RCII.

However, the real point of the letter was to stress that a major turnaround was sorely needed and that the only question was whether this should occur in the private or the public markets. Engaged Capital made a case for taking the company private. Mr. Welling expressed confidence that "a number of qualified buyers would emerge" if RCII chose this path and suggested that RCII could be sold for $16 per share.

Engaged Capital sent a second letter on February 14. I suppose if you're going to get a proposal from an investor named "Engaged," it might as well arrive on Valentine's Day. This letter was much less cordial than the first. It accused the board of directors of "foot dragging," being "asleep at the wheel," and paying only "lip service" to Engaged Capital's proposals.

It accused the board of being loyal to Mr. Speese rather than to the shareholders and it accused Mr. Speese of having conflicts of interest that prevented him from acting as a fiduciary to shareholders. Engaged Capital again stressed its belief that RCII must be sold in its entirety, preferably in the private markets.

I conducted a conservative discounted cash flow analysis on RCII and I too conclude that the stock is grossly undervalued. The company reported revenues of $2.9 billion for 2016, but in my analysis, I assumed that revenues would plunge by 8% per year for the next five years before stabilizing at just $1.9 billion per year and never rising from that level. Realistically, I don't expect anything this dire to happen. Even so, with any decline in sales, we should also see improved profit margins as underperforming stores are eliminated.

Just a couple of year ago, RCII's operating profit margin on a GAAP basis was approximately 7%. However, I applied an operating margin of just 1.5% for 2017. I also assumed that the margin would gradually increase and top out at only 3.5% after five years. I discounted the estimated cash flows at 11%, which I believe is significantly higher than what the company's actual weighted average cost of capital is likely to be. Yet despite these conservative assumptions, I conclude that RCII is worth close to $20 per share.

While I agree with Engaged Capital that this is a grossly undervalued stock, I am not convinced that it would be better to sell the company quickly in the private market. Shareholders may actually realize a higher value in the public market if management is successful in turning the company around. That course, however, will require some patience. As Engaged Capital has so aptly pointed out, many shareholders have already lost patience and voted with their feet. In the two months through December 7, more than 115% of the company's outstanding shares traded hands. No doubt that figure has doubled by now.

Disclosure: I am/we are long RCII.

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.

Additional disclosure: RCII is held in portfolios managed by Vahan Janjigian, including his own.

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