Aaron’s, Inc (NYSE: AAN)

December 2, 2019

With the S&P 500 and DJIA at an all-time high, most investors find it hard to find bargain securities at depressed prices. Stocks are rising despite a lack of corresponding real performance in earnings or production; coupled with the trade war and a changing yield curve, investors anticipate a dip looming, but no one truly knows when.

Lease to own, virtual leasing, and retail companies have benefited from this boom. However, the lease-to-own industry is changing to an online business model, and as consumers get more financially savvy, they may opt for credit cards instead. Important industry metrics for lease-to-own goods are comparable store sales, invoices grown, and invoices per active door count.

Aaron’s has taken advantage of this boom by buying up Progressive’s product leasing division for approximately $700million in 2014. Aaron’s higher operating margins are due to Progressive’s cooperation with large enterprise accounts vs purchasing store owned merchandise. Progressive Leasing acts as a lease to ownership facilitator— Progressive partners with different retailers to provide customers with poorer FICO (600-700) or credit ratings with lease-to-own agreements for products outside of Aaron's coverage. 

In 2019, Progressive partnered with BestBuy in February and Wayfair in October. Despite these positive partnerships, the nature of the lease-to-own retail industry is that it will experience cyclical downturns especially with Aaron’s heavy product range in appliances and furniture. Before the Progressive acquisition, Aaron’s legacy business’ operating margins were still in single digits.

John Robinson, Aaron’s current CEO, previously ran an auto-title lender called TitleMax, growing the company from approximately 100 stores to more than 750 stores. Robinson and has team have now solidified Aaron’s position as the US lease-to-own market leader with a capitalization of 4 billion with 1689 stores and operating margins of 13.8% as of December 2018. Competitor Rent-A-Center has a capitalization of 1.4 billion, has 2561 stores, but almost half the operating margins at 6.2%. Both companies are benefiting with E-commerce, with Rent-A-Center generating 80% of its new customers online, while Aaron’s saw a 68% increase in e-commerce lease-to-own revenues in 2019.

Progressive now carries the weight for Aaron’s future prospects, since its legacy leasing and brick and mortar business is deteriorating. Invoice numbers are an excellent predictor of revenue performance, while other figures come with a trade-off. Since acquisition, Progressive has grown customer leasing invoice volume from 471 million in 2014 to 1.49 billion in 2019, with 2.46 billion of lease agreements in effect.

Progressive’s leasing business uses proprietary algorithms to determine whether customers meet leasing qualifications with the ability to turn on and off different pools of opportunity and approval rates. Progressive’s system is really agile, while on the other hand, there are many problems with Aaron's legacy retail business–their old technology makes them non-competitive. Progressive has been helping Aaron’s make a transition, by having 40-50 trial stores with new technology and trained staff, but whether this strategy proves successful and well executed poses a risk to shareholders.

Most of Progressive’s transactions are completed online or through a point of sale integration with retail partners. Contractual payments are usually based on a customer's pay frequency and are typically processed through automated clearing house payments. If the payment is unsuccessful, collections are managed in-house through a call center, customer service hubs, and a proprietary lease management system. The call center contacts customers within a few days after the due date to encourage them to pay on time. If the customer chooses to return the merchandise, arrangements are made to receive the merchandise through retail partners, or Aaron's operated stores.

Despite Progressive’s complex algorithms to screen candidates for credit-worthiness, their rapid and aggressive expansion always makes me consider whether there are conservative factors embedded in screening candidates.

Progressive calculates, at the end of each period, the allowance for loan losses based on actual delinquency balances. Delinquent loans receivable are those that are 30 days or more past due based on their contractual billing dates. Progressive then evaluates the historical average loss for the prior eight quarters on loans receivable by aging category.

Aaron’s places loans receivable on nonaccrual status when they are greater than 90 days past due or upon notification of client bankruptcy, death or fraud. For loans in nonaccrual status, Aaron’s discontinues accruing interest and fees. The allowance for loan losses is maintained at an adequate level to cover probable losses of principal, interest and fees in the loans receivable portfolio.

Loans receivable are removed from nonaccrual status when payments resume, the loan becomes 90 days or less past due and collection of outstanding amounts is deemed probable. Payments received on nonaccrual loans are allocated according to the same payment ranking system applied to loans accruing interest. Loans receivable 120 days past due are charged off at the end of the month following the billing cycle.

Progressive Leasing had 953,000 customers at September 30, 2019, a 17.9% increase from September 30, 2018. Despite sales are growing about 30% year on year, Aaron’s quickly depreciating merchandise (Progressive and Aarons has roughly half of its leasing in furniture, a quarter in appliances, and a quarter in electronics) and poor same store sales growth (-7% in 2017 and -1.5% in 2018) in an attempt to restructure its legacy business makes investing in Aaron’s fraught with risk. Aaron's lease ownership requires significant levels of merchandise inventory available for lease in order to ensure timely delivery of products for store-based and e-commerce operations. Therefore, Aaron's most significant working capital asset is merchandise inventory on lease.

Aaron’s has 1312 stores which are wholly owned, and 377 franchised stores. Aaron’s also has its own furniture brand called Woodhaven. About a third of Aaron’s stores are franchisees, and that number is shrinking. In 2017, Aaron’s largest franchisee, SEI, was acquired in an all cash transaction for 140 million which included coverage of 11 states and 90,000 customers mainly in the North East.

Company-operated Aaron’s stores had 963,000 customers in September 30, 2019, a 2.6% decrease from September 30, 2018. This transition turns Aaron's Business segment into a more capital-intensive business model due to real estate and additional costs associated instead of collecting a franchise fee.

When Aaron’s enters into franchise agreements, they govern the opening and operations of franchised stores. Under the standard agreement, Aaron’s receives a franchise fee for a term of ten years, with one ten-year renewal option from $15,000 to $50,000 per store depending upon market size. Franchisees are also obligated to remit to royalty payments of 6% of the weekly cash revenue collections from their stores.

Same-store revenues for franchised stores increased 1.7% and same-store customer counts declined 3.7% for the third quarter of 2019 compared with the same 3^rd quarter in 2018. Franchised stores had 241,000 customers at the end of the third quarter of 2019.

Aaron’s tried to minimize expenses after acquisition of SEI by shutting down 155 stores in 2019. To a certain extent, gaining ownership of retail franchise stores is a liability rather than an asset. The good news is, in Aaron’s recent conference call, directors claim— “We do not have any material franchise acquisitions planned at this time. However, we would certainly evaluate the right opportunity were it to present itself.”

Another risk with from significant increase in deliveries results in insufficient labor to handle the workload in stores. Aaron’s provides durable household goods such as furniture on monthly, semi-monthly, and weekly installments. Aaron’s also guarantees same or next day delivery for customers ten miles from the store. This labor shortage hampers collections performance, which had an unfavorable impact on lease revenues and write-offs.

Aaron’s also experienced a decrease in active door count primarily due to a reduction in locations in mattress and mobile phone segments. Q3 2019 active door count was approximately 19,900, down 1.6% from the third quarter of 2018. In terms of active doors, a metric for Progressive’s virtual lease to own transactions there were 24,198 in 2018 and 21,840 in 2016.

Management and Aaron’s CEO John Robinson believes that invoices per active door count has become less predictive as a leading indicator of future revenue growth, particularly as overall mix shifts towards larger footprint locations and e-commerce transactions (virtual leasing) or larger footprint type doors. A new influx of invoices can come in without necessarily moving the door metric as seen in the past.

Should a recession scenario occur, Aaron’s might gain more customers, due to customers with poorer credit ratings seeking to purchase goods. But there is also a chance the legacy business might fail weather the storm. Factors to consider are with Aaron’s being more lenient in accepting leasing for goods—will there be increasing defaults? Will the business model become obsolete as customers get more responsible?

Aaron’s customers are non-sophisticated customers with limited access to traditional credit based bank financing, installment credit cards. This is bad since the majority of Americans are in the upper tiers of the FICO scoring distribution—nearly 57% of Americans have a FICO score of 700 or higher. This has historically been the case, but in the last eight or ten years of steady economic growth since the 2008 financial crisis most American consumer’s credit profiles have improved significantly. As Americans become more responsible and credit worthy, they would gradually make the switch to credit cards and traditional bank financing.

Another factor to consider is – with electronics and mobile phones depreciating at a quick rate and since only a certain amount of consumer durables are considered a necessity, would people stop buying and leasing certain goods in a recession? Progressive’s average lease life is 7 months and has superior analytics and faster collection compared to Aaron’s legacy business. Despite Aaron’s being able to buy at better rates due to relationships with large electronics manufacturers like Samsung, too many goods in electronics and appliances become obsolete within a year.

From 2017-2019, the write-offs for damaged, lost or unsaleable merchandise ranged from 5-8% of gross revenues. There was a slight increase in writes-offs due to a reduction in collections from the implementation and adoption of new sales programs, and store closures. Bad debt ranged from 10-13%. Performance differed due to restructuring of legacy stores and an increasing mix of virtual leasing added to the revenue stream.

For Aaron’s you can expect annual capital expenditures to continue to be in the 100-130 million dollar range. With 60-70 million for maintenance capital expenditures and the rest for expansion. Expansion or growth capital expenditures is focused in 3 areas—

1.      Due to the change in lease accounting, Aaron’s reevaluated their vehicle acquisition strategy and plans to purchase trucks in the Aaron's Business instead of leasing them going forward. The incremental capital expenditures for trucks should be approximately $15 million for 2019.

2.      Another $15 million relates to both hardware and software to complete the rollout of rapid customer onboarding, centralized processing, and IT based customer support for Aaron's Business.

3.      Finally, the new store concept and the restructuring of stores is being implemented. The improvements include an increase in deliveries in excess of 30%. Aaron’s has increased their sample set by 40 to 50 locations during 2019. We expect to spend approximately $30 million for these real estate-related improvements.

Aaron’s management deems it prudent to confirm results of these 40-50 locations before deciding on a possible broader rollout.

During Q2 2019 Aaron’s returned approximately $27 million to shareholders through buybacks repurchased approximately 243,000 shares, returning approximately $17 million to shareholders. In Q3 2019, with 150 million in cash, Aaron’s repurchased 399,424 shares for 25 million at an average price of 62 dollars per share. Despite buybacks and dividends, one negative sign suggesting management may not be aligned and incentivized in the same interests as shareholders is that the board of directors and executive team own less than 2% of Aaron’s. Aaron’s has had one 3-for-2 stock split in 2011 and hasn’t had any splits since.

Aaron's, Inc. directors raise quarterly cash dividends by 14.3% from $0.04 per share from $0.035, and declared the first such dividend payable January 6, 2020 to shareholders of record as of the close of business on December 19, 2019.

Aaron’s dividend has been raised for 17 consecutive intervals and has not been omitted.

Credit and appliance rentals a 20-25 billion market in the US. With approximately 40% of the US population carrying a FICO score under 700, there is still a large enough addressable market that the business can continue growing. Of the whole market, if Aaron’s targets the 40% within its FICO range, this mean 8-12 billion of Aaron’s customers are untapped. Being conservative, if the market doesn’t grow, due to an inability to partner with enterprises or consumers becoming wiser and not leasing goods to own them later; at most, there is room for Aaron’s market capitalization to double or maybe, very remotely, triple. I don’t foresee Aaron’s expanding internationally soon.  

One positive sign is that Aaron’s return on capital has been continuously increasing, and is now at 14%. Days-payable has decreased from 68 days in 2014 to 15 days in 2019, which warrants further investigation. Tangible book value has more than doubled since 2014, from 360 million to 933 million in 2019.

Debt to equity has decreased from 50% in 2014 to 38% in 2019. Aaron’s amended its revolving credit facility and term loan agreement to increase its term loan by $137.5 million, to $225 million. Aaron’s also amended its franchise loan facility to reduce the total commitment amount from $85 million to $55 million and extend the maturity to October 22, 2019.

Will Aaron's be able to turn its legacy business around? Will the 40-50 trial stores work out and be rolled out nation-wide? Or will this legacy business cancel out benefits accrued from Progressive? Despite partnerships with Bestbuy and Wayfair, will bigger players like Walmart and Amazon disrupt this field?

At a present price of about 4.5 billion inclusive of debt, and a predicted consistent earning power of 300 million a year, 15 times earnings seems to be a bit too expensive despite Aaron’s growth potential should it fix its traditional business and expand further. While Aaron’s is by no means very cheap at 8.4x enterprise value to operating earnings, it is cheaper than its peers which are near 15-16x earnings.

I would wait until there’s a dip of 50-70% so enterprise value is closer to 2 billion or not buy at all. Even if I were to own this business, I don’t see it as a great business model over the next decade.