Aaron's: I Believe My Thesis Was Correct - Moving On To Q1 2023

Summary

• Aaron's is a market leader in the lease-to-own segment, specifically in furniture, electronics, appliances, and other home goods, and this is the second time I review it.
• The company has solid gross margins, operating margins, and ROCE, ROE, and ROIC trends, but is currently overvalued and faces risks if the economic downturn lasts longer than expected.
• I'm currently maintaining a "hold" rating on AAN, with a price target of $10/share, as the risk/reward is unfavorable at its current price.
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Dear readers/followers,

In this article, I'll be updating my thesis on Aaron's (NYSE:AAN). This is an interesting company because it's market-leading in an appealing segment - namely the lease-to-own segment, and specifically in the categories of furniture, electronics, appliances, and other home goods.

While I personally prefer to own the goods around me, be it furniture, cars or other things, I realize that I am in the minority as far as certain segments go. We haven't seen this model really take off in most European markets yet, but in the USA, the market is certainly booming. This is something that can be easily seen judging from the company's 60+ year history since its founding and headquarters in beautiful Atlanta, GA.

Let me update my thesis on the company and show you why this is a good investment prospect.

Aaron's: Small, but interesting - just not at any price

So first off, remember that I was negative about the company, to begin with. There was a very good reason for this. The company was, and in many ways still is overvalued for what it is. Because of that, even though we've recovered quite a bit, we're actually down double-digits since my first article, which called this company a firm "hold".

Seeking Alpha Aaron's (Seeking Alpha)

We also want to remember that the company has actually been through a significant number of restructurings over the past 2 decades, leading to its current iteration, with over 1,200 combined franchised and company stores in both the USA and Canada.

So, the company focuses on leasing, or LTO of these aforementioned products. The core arguments for using AAN for the customers lie in excellent customer service, good value, competitive monthly payments as opposed to a large one-time payment, good cost of ownership, good approval rates, and flexibility on the leasing. Your business can grow faster if you use a larger amount of OPM, or other people's money. If you can do so cheaply and can use mostly other people's money while still making a good profit, that is an attractive business. And this company is part at least in theory, of enabling this.

Aaron's is without a doubt, in many ways, a profitable market leader. It has solid Gross Margins, excellent and 83rd percentile operating margins in the sector of industrial products/services, and solid ROCE, ROE, and ROIC trends. Looking at ROIC net of WACC, the company has been in a better position prior, but it's still making a good amount of money.

AAN ROIC/WACC (GuruFocus)

The company hasn't been listed in its current iteration for a very long time. That in conjunction with some relatively volatile trends has seen the share price experienced similar volatility. The current market cap has dropped to below $400M, the company is 50%+ in debt in terms of LT debt to cap, and it pays a decently-covered dividend of around 4% at this particular time.

Over the past few years, the company has seen its operating margin expand, though it has also become a company that relies more on debt (as you can see above). The big news for 2022 was the BrandsMart acquisitions. On February 23, 2022, the Company entered into a definitive agreement to acquire 100% ownership of Interbond Corporation of America, doing business as BrandsMart U.S.A, and this is now ongoing. For 2023, the first set of results is decent enough.

AAN IR (AAN IR)

Revenue increased by over 21.5% due to BrandsMart. Earnings, however, were in line with expectations. They decreased by 40%, or 25.5% on a Non-GAAP basis, with a 20.7% decrease in EBITDA on an adjusted basis.

At the same time, the company increased its 2023E expectation and outlook as well as adjusted free cash flow on a forward basis. Positives here from the company included consolidated results well ahead of earnings expectations, despite both a softer tax season and continued economic pressure. When the macro isn't doing well, a company that lives off leasing these sorts of assets also is not doing well.

Profitability enhancements are first and foremost on the company's target list. While these earnings may initially look bad, they were actually ahead on an internal basis. Other positives included actually reducing debt well ahead of schedule, by almost $37M on a quarterly basis due to strong cash from an operational basis. The company is already, also, working hard to reduce OpEx by cutting personnel costs and other general OpEx. E-commerce is on the rise with a 12.3% increase and now represents close to 18% of leasing for Aaron's business.

For BrandsMart specifically, the newest M&A, results here exceeded internal expectations for the company despite lower revenues due to continued pressure on overall customer demand.

Why the massive net earnings decline?

Lower revenue and fees, and loss before income taxes generated by expenses due to the BrandsMart inclusion in consolidated results, offset in turn by lower personnel costs at Aaron's, and the income tax benefit described above.

The company isn't in any sort of dire straits. Much of this was expected. In fact, it was expected by me - that is part of the reason I did not give much credence to the company's valuation in my last article, or to the many positive articles on Aaron's at this particular price. It was simply too expensive for my taste - and I believe at least for the past few months, I have been proven correct in that assumption.

The company is expecting a significant dip in demand for its services. For the full year, earnings on an adjusted basis are expected to dip by 41%. That's on top of a 45% adjusted EPS dip already materializing in 2022, as the pressure really started mounting on the company. While this will no doubt revert, and likely as early as 2024, once BrandsMart really starts materializing some of the currently forecasted earnings increases, this will nonetheless be a process - and it's a process in a relatively small company with less than half a billion in market cap. This still puts the company in what is known as a small-cap range, not a micro-cap yet, but it's sliding toward that barrier of $250M as time goes on - though to be clear, I don't believe it will actually go down to that level.

As we'll see in the valuation segment, Aaron's typically sticks fairly close to a 6-8x P/E ratio and that's where we seem likely to go as we go forward here.

Risks are fairly simple. The downturn could last longer than is forecasted. If the macro stays down for longer, Aaron's will likely stay in trouble for longer as well.

Positives include that the company actually outperformed on credit, despite lower tax rate funds. Delinquencies are a KPI to really keep an eye on here, and we'll want to keep an eye on the 30+ day delinquencies to spot any major issues here. But these numbers are actually dropping. The 32+ day delinquencies are actually down over the past 12 months to less than 1.7% - so as far as fundamental issues for the company go, I really do think these are few.

The company's business model is intact, and I foresee future appeal for Aaron's - at a good price, at least.

Here's the company's current outlook for the 2023 period.

AAN IR (AAN IR)

Aaron's valuation

And that time certainly isn't now. The company is still well above the level where I would want to be buying it. In my last article, I went for a share price target of $10/share. As you can see, we're still far off from that target, and a double-digit PT would be even better.

Remember, Aaron's has very few peers. Even though I put it in industrial services and products, that's really mostly for show to have something to compare it to. Leggett & Platt (LEG) would be a stretch given the mix and volume of that business and the way they operate. So peers are a no-go here.

We have some forecasts - both mine and other analysts' - and the forecasts given here continue to be a non-trivial problem insofar as potential RoR goes. We do have double digits on a forward basis now, but really only if we expect a 70%+ normalization in 2025E. this might happen, but it also might not. Analyst accuracy has too little history to be anything near to reliable here.

AAN IR (AAN IR)

What else can we look at? Other analysts aren't exactly climbing the walls with joy here either. 6 analysts follow the company, and only 1 has a "BUY", and that is despite an average PT of $13.55 from a range starting in the double digits at $9.3 and going up to $18.

I'd be more interested in the $9.3 target, because, at that price, I could really see myself getting excited about the company's overall prospects. At this price today, not so much.

For that reason, I'm not changing my thesis here. I'm also not shifting my price target for Aaron's, but doubling down on it. This company, at this time, is not worth more than barely $10/share. Anything above that, and the risk/reward is extremely unfavorable. Heck, even at double digits at $10/share, I would say that the company's risk/reward is tolerable at best, at least if we see it in the context of the bigger picture.

This leads me to the following thesis for Aaron's.

Thesis

• Aaron's is a company with a very attractive business model, but still with only limited data following the split and recent merger. Because it has a market cap of less than $500M and no credit rating, it goes into the relatively risky category regardless. Still, it's a storied business with decades worth of tradition - and that can make it potentially interesting.
• I would consider the company attractive at multi-year low or conservative multiples, around a 6.5x P/E, or a $10/share price target, which is significantly below the $12.8 we're at today.
• Because of this, I would view AAN to be a "hold" here, and I can't change my rating even after these last few months.

Remember, I'm all about:

1. Buying undervalued - even if that undervaluation is slight, and not mind-numbingly massive - companies at a discount, allowing them to normalize over time and harvesting capital gains and dividends in the meantime.

2. If the company goes well beyond normalization and goes into overvaluation, I harvest gains and rotate my position into other undervalued stocks, repeating #1.

3. If the company doesn't go into overvaluation, but hovers within a fair value, or goes back down to undervaluation, I buy more as time allows.

4. I reinvest proceeds from dividends, savings from work, or other cash inflows as specified in #1.

Here are my criteria and how the company fulfills them (italicized).

• This company is overall qualitative.
• This company is fundamentally safe/conservative and well-run.
• This company pays a well-covered dividend.
• This company is currently cheap.
• This company has a realistic upside based on earnings growth or multiple expansion/reversion.

This company lacks the valuation-specific upside I look for in my investments - I say "hold".

Analyst’s Disclosure: I/we have a beneficial long position in the shares of AAN either through stock ownership, options, or other derivatives. 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.

While this article may sound like financial advice, please observe that the author is not a CFA or in any way licensed to give financial advice. It may be structured as such, but it is not financial advice. Investors are required and expected to do their own due diligence and research prior to any investment. Short-term trading, options trading/investment and futures trading are potentially extremely risky investment styles. They generally are not appropriate for someone with limited capital, limited investment experience, or a lack of understanding for the necessary risk tolerance involved. I own the European/Scandinavian tickers (not the ADRs) of all European/Scandinavian companies listed in my articles. I own the Canadian tickers of all Canadian stocks I write about. Please note that investing in European/Non-US stocks comes with withholding tax risks specific to the company's domicile as well as your personal situation. Investors should always consult a tax professional as to the overall impact of dividend withholding taxes and ways to mitigate these.

Comments

[Nicholas Sherr]

Here we are at 10. I like the risk reward, but why the huge discount to Book? Thanks for your work.

[alexalekhine]

I'm not sure how you could miss Upbound (UPBD) as a direct competitor that is, I believe, 2x the size of AAN in revenue. UPBD was formerly known as Rent-a-Center (RCII).

[Spanishmoss]

@Wolf Report thank you for reminding me about AAN… I’ve never owned it, but I love the business model! I’m adding it to my watch list and hoping to start a position if it falls into the range you suggested.