GLG News by Ben Bost

Implications: We’ve heard this story before. Two years ago when store performance was suffering, it was fuel cost. Here we go again. Demand drops and energy costs are to blame. Does anyone wonder what the real story is here? Could there be more to it than higher prices at the pump? Besides, gas is only a few percentage points higher right now than it was last summer.

Analysis: I have an idea that customers just don’t like what Rent A Center is selling. The stores are small, there’s a high percentage of used product in them, and the prices are too high. Demand seems just fine to me. Yes, July was a relatively weak month, but the calendar set up poorly and anyone who’s been in rent to own for any amount of time knows about seasonal weakness and the importance of the calendar, and would have easily predicted what kind of month July would be. August and September look good. There’s more going on here than gas.

Implications: Investors sold shares of Aaron Rents (RNT) yesterday in response to its Q2 earnings release and conference call. Aaron’s lowered FY 2007 guidance, reported lower than normal same store sales growth for the quarter, and discussed struggles in its new store openings initiative, all of which led to a 12% sell-off in shares of RNT. The market overreacted to the report, as the store-level fundamentals are stronger than ever.

Analysis: Aaron’s management cited new store opening costs as the main factor in lowering earnings guidance. Last year, when they announced a goal of opening 350 stores in the 18 months ending December 2007, many outside observers questioned the rationale of such an aggressive mark. After opening 165 stores in the first 12 months of the initiative, they say they can open 185 in the last 6 months of this year. Franchise and company-owned stores were originally planned to contribute equally to the 350 openings, but the mix first changed to 60% corporate/40% franchise, and now appears more likely to be 70% corporate and 30% franchise. While the company has awarded record numbers of stores to franchisees in recent quarters, those franchisees won’t likely open stores this year. The trend shift from leased in-line stores to free-standing, franchisee owned stores has contributed to the lag in franchise opening timelines.

The market’s reaction to the report was overdone. The Q2 earnings decline was mainly due to the sale of stores in Puerto Rico last year that skewed the comparison. Weak results in the rent to rent division also hurt Q2 earnings, and had to compare against Katrina windfall last year. Earnings for the first half of 2007 were still up 16%. Same store sales more accurately increased by 8%, looking solely at lease revenue of the stores, while net revenue comps were weaker due to an increase in retail prices which led to a decrease in retail sales and early payout revenue. Even if the new store openings goal is not met, the core leasing business in the Sales and Lease Ownership division is strong, and it continues to bring new customers in the door and take market share from Rent A Center (RCII). Revenue from franchise royalties and sales of merchandise to franchisees will continue to increase as the pipeline of franchise stores awarded starts to materialize into actual store openings. Rent A Center’s Q2 earnings report next week will give investors a clearer view of the overall rent to own environment.

Implications: Last year, management at Aaron Rents committed to open 350 new stores by the end of 2007.  In its Q4 earnings call, RNT addressed questions about the purposes and logistics of the new opening timetable and announced that the expansion is on track, with plans to open 250 stores in 2007. 

Analysis: Revenue and earnings keep growing at Aaron Rents and management hopes to continue the trend by opening 250 new stores in 2007.  Since committing in the middle of 2006 to add 350 stores in 18 months, RNT has opened roughly 100 new stores.  However, they only added a net of 146 stores in all of 2006, which begs the question of whether they can substantially exceed that effort this year.  And, most important, why the rush?

While Aaron's has aggressively increased its store count over the past 10 years (with only 350 stores open in 1997), management seems to think that Rent-A-Center's acquisition of RentWay late last year has created the opportunity to open stores at an even brisker pace.  Some have speculated that RNT wanted the RentWay deal and felt pressure to respond when it lost a bidding war to RAC.

In another interesting twist, management said that it hopes franchisees will open about 50% of the remaining 250 stores.  Previously, RNT has said that 2/3 of the new stores would be company-owned, with the remaining 1/3 being franchise stores.  Chairman and CEO Charlie Lowdermilk noted that RNT headquarters has been full of prospective new franchisees recently, likely a result of added franchise sales personnel and a strengthening track record of successful franchisees.

Implications: An analyst listening to the recent RNT earnings call asked a simple question: "Why were retail sales down in Q4?" The answer is equally simple, and has some interesting implications.  Aaron's management commented on the decline in retail sales, the corresponding margin increase on customer payouts, and the reason cash prices increased in the first place.

Analysis:

An analyst listening to the recent RNT earnings call asked a simple question:  "Why were retail sales down in Q4?"  The answer is equally simple, and has some interesting implications. 

The company increased retail prices in the second half of 2006.  Retail pricing at Aaron's is tied to the 12-month lease rate of the product.  Take the 12-month lease rate, multiply it by 8, and you had the cash price - until a recent decision by the New Jersey Supreme Court.

A Rent-A-Center customer in New Jersey got a judgment against RAC on the basis that its pricing violated state usury laws.  In order to comply with usury laws, rent to own operators increased their cash prices.  RNT increased the multiple of its 12-month lease rate from 8 times to 9.5 times in order to protect the existence of its 12 NJ stores (6 company-operated, 6 franchisee-operated).  It could have left pricing in its other 1300+ stores alone.  Instead, it increased the multiple company-wide (excluding New Jersey) to 9 times.  The bad news?  Retail sales go down when pricing is less competitive.  The good news?  Retail sales are a small portion of a rent to own store's revenue.  The even better news?  An increase in retail prices leads to a corresponding increase in margins on all agreements paid out early, including 90 days same-as-cash.

Early payouts at RNT have trended up consistently over the past few years.  Q1 is tax refund time, and customers are paying out agreements left and right, and earlier than ever, with instant-refund places sprouting up on every corner.  This is time of year when RNT will reap benefits from its retail pricing increases.

Implications: Rent-A-Center management will focus in 2007 on completing the integration of 786 acquired Rentway stores into the Rent-A-Center system and continuing to add financial services in their stores.  These points of emphasis make it clear that the core rent-to-own business of RAC has matured to the point that new store openings are no longer a priority.

Analysis: Rent-A-Center recently made its first earnings announcement since the closing of its acquisition of Rentway in November 2006.  RAC has closed approximately 20% of the 786 Rentway stores, moving the accounts from those stores to nearby RAC stores.  In these situations, a rent-to-own operator will typically lose 50% or more of the acquired accounts over a 6-8 month period.  Management's strategy is to try to keep as many of the transferred accounts as possible, while focusing primarily on rebranding the remaining stores and growing them to a revenue level close to the RAC store average of $70K per month.

RAC plans to add financial services products in 200-250 stores this year, building on the 150 locations with financial services at the end of 2006.  States with the most favorable legislation enabling payday loan transactions will be the first targets for these additions.  RAC has previously stated a goal of 1000 financial services locations by 2010 and appears on track to get there.  Payday loans are a good fit for rent to own stores, and it will be interesting to see whether or not Aaron Rents, the second largest RTO company, follows RAC's lead in this area. 

Implications: The nomination of Rep. Carolyn Maloney (D-NY) to lead the Financial Institutions and Consumer Credit subcommittee of the House Financial Services Committee could be bad news for the Rent to Own industry. Rep. Maloney previously co-sponsored a bill that would have characterized the RTO transaction as a credit sale, and thus subject to state usury laws.

Analysis:

The Rent to Own Industry has seen a recent flurry of legislative activity at the state and federal levels, most of which has aimed to put caps on the total cost of an RTO transaction.  Texas and New York legislators have proposed such caps, and Senator Charles Schumer (D-NY) has introduced a federal bill with the same intent.   

The House Subcommittee on Financial Services and Consumer Credit is the key subcommittee for any future Rent to Own legislation.  In 2001, Rep. Maloney was one of only 13 co-sponsors of the Rent to Own Reform Act, which would have redefined rental purchase transactions as credit sales.  That bill was authored by Rep. Maxine Waters (D-CA), who one year later introduced the Consumer Rental Purchase Act, which passed the House and was supported by the RTO industry.

This year, as in years past, Rent-A-Center, Aaron Rents and the RTO industry trade association will lobby for federal legislation that defines a rental purchase transaction as a lease.  The IRS and 46 states agree that it is a lease, and not a credit/installment sale, since the customer may return the product at any time without any further obligation.  Other services offered in the typical RTO transaction that are not offered in a typical credit/installment sale include free delivery and setup, free relocation, free service of the merchandise during the term of the agreement, and credit checks.

Implications: New York lawmakers at the local, state, and federal levels continue to publicly bash the Rent to Own industry for what they call “exorbitant prices” and other predatory practices. While the evidence they site is vague at best, the New York Legislature has introduced a bill that could bring an end to RTO in the state, and Senator Charles Schumer is attempting the same thing on Capitol Hill.

Analysis:

Picking up the baton where the New Jersey Supreme Court recently left off, some lawmakers in New York are supporting a bill that, if passed, could effectively end Rent to Own in the state. The bill limits the total amount paid under any RTO agreement to the cash price of the merchandise plus 25% per year, and is another example of lawmakers mistakenly characterizing the RTO transaction as a credit/installment sale instead of a lease. Since the customer in an RTO transaction has the right to return the merchandise at any time with no further obligation, the IRS and almost every other state, including New York, have deemed the transaction a lease, and thus not subject to state usury laws.

Recently, the New Jersey Supreme Court ruled that an RTO transaction is an installment sale and is subject to the New Jersey usury limit of 30% per year. RTO operators responded by increasing their cash prices and tweaking their lease rates and early payout formulas to comply with the 30% cap. The proposed New York legislation defines “cash price” as the price as the price charged “by a reasonable number of merchants in the trade area during the sixty days prior to the date of the rental-purchase agreement.” It is unclear how many merchants constitutes a “reasonable number” and what constitutes a “trade area.” This vague standard would make pricing much more difficult for New York RTO operators.

New York Senator Charles Schumer has proposed similar legislation at the federal level in what he calls the Rent to Own Protection Act, which would subject RTO operators in every state to that state’s own usury laws. If passed, the Act would trump state laws that specifically define the RTO transaction as a lease.

The “investigative report” referred to in the NY Times article was compiled by a consumer advocacy group called the Neighborhood Economic Development Advocacy Project. The report alleges, among other things, that RTO charges too much and targets low-income consumers, specifically minorities. Rent-A-Center’s General Counsel recently testified before the New York Assembly that the mix of RTO customers is nearly identical to the overall US population mix in terms of race. Rent-A-Center, the largest RTO operator in the country, has over 120 stores in New York. Aaron Rents, the second largest, operates 30 Aaron’s Sales and Lease stores in the state.

Implications: Traditionally a hotbed of Rent to Own activity, Texas would potentially shut down its hundreds of RTO stores if state legislators pass this bill, which limits the total cost of an RTO transaction to the cash price of the merchandise plus 15%.  RTO operators in the state will be watching closely to see whether the bill defines "cash price" in a way that eliminates a work-around that has been effective to date in New Jersey.

Analysis: As home to Rent-A-Center's headquarters, a strong state rental dealers' association, and some of the best-performing RTO stores in the country, Texas seems an unlikely place for state lawmakers to pass legislation that would potentially kill the RTO industry.  The bill introduced by Harold Dutton would seemingly render RTO stores helpless to remain profitable.  Operators can't offer all of the services of an RTO transaction for a total return of only 15% over the cash price of the merchandise, can they? 

Actually, that depends on how you define "cash price."  Recently, the New Jersey Supreme Court said that RTO transactions are really just installment sales, and thus are subject to state usury laws.  How can a transaction in which the customer has no obligation to continue making payments and, can turn in the merchandise at any time without negative consequences be considered an installment sale, you might ask?  That's a question for another day, and a question that almost every other state in the union has answered differently than the New Jersey judicial branch.  Nevertheless, New Jersey operators responded to the ruling by increasing their cash prices so that the spread between total cost of ownership and the cash price was in compliance with the 30% interest rate cap in that state. 

In the unlikely event that Rep. Dutton's bill gains enough support to become state law, Texas operators would respond just like their New Jersey counterparts did.  By raising their cash prices, they might lose some of the retail business they are used to, but they would be able to continue to offer the valuable services of RTO and remain profitable.  Since retail sales typically account for only a small percentage of an RTO dealer's revenue, this work-around would be relatively painless.