Rent-A-Center (RCII) – Expected Acquisition – 60% upside

Current Price – $8.10

Buyout Offer - $13.00

Upside – 60%

Expiration Date – TBD

Non-binding Offer Announcement

 

This is a merger arbitrage, turn-around and activist proxy fight situation in one. Market seems to have given up on a year long activists’ efforts to sell the company despite interest from a number of parties. Rent-A-Center is a rent-to-own operator in US with c. 2500 owned shops and a financing arm. Recently the business has been struggling and significantly under-performed it’s main competitors. Shares trade at all time lows (at least since 2000).

For background on the company and industry I recommend this VIC write-up. Here is a brief timeline of events leading to current situation.

  • Jan-Feb 2017 – Activist investor Engaged Capital acquired 13% stake in the company and launched proxy fight (read letters here and here) arguing for the sale of the company. Activists’ valuation was $16/share (or 90% premium at the time).
  • Mar 2017 – Engaged Capital increases stake in RCII to 17%, and seems to have upped the stake later to 20.5%.
  • Apr 2017 – Another activist investor discloses 5% stake in the company and joins Engaged in proxy fight.
  • Jun 2017 – Activists win the proxy fight and get 3 board seats (out of 7). Founder of RCII is stripped of his chairman role but remains as company’s CEO.
  • Jun 2017 – Despite winning the proxy fight Engaged Capital does not seem to have control of the company as newly appointed chairman (previously incumbent director) leaves for 2 month vacation and is unwilling to call board meeting.
  • Jul 2017 – Vintage Capital is offering to buy out RCII for $15 share and the offer is not disclosed to shareholders. Board of directors reject the offer on the basis of it being too low. As it turned out, Engaged Capital was not aware or involved in this decision and apparently multiple other acquisition interest have been turned down.
  • Oct 2017 – Board of Directors initiate strategic review process and chairman resigns.
  • Nov 2017 – Vintage Capital offers $13/share for RCII in a non-binding proposal.
  • Jan 2018 – CEO (and Founder) of the company resigns. BoD nominee of Engaged Capital and previous COO of RCII is appointed as new CEO.
  • Jan 2018 – Vintage Capital and RCII enter into confidentiality and non-disclosure agreement regarding acquisition proposal.
  • Feb 2018 – Engaged Capital gets another board seat nomination in the upcoming 2018 annual shareholder meeting. So after the meeting Engaged will have 4 out of 6 seats.
  • Feb 2018 – RCII shares drop to $8/share amid lackluster Q4 results as well as announcement of restructuring plan rather than any updates on the strategic review process.

So we are currently in the position where activist investor with 17% ownership has full control of the board and is seeking the sale of the company. Non-binding offer at 60% premium still stands (at least there have been no official announcements regarding it) and strategic review process is still ongoing. Additionally, new CEO (with 30 years experience in RCII) was appointed and significant cost saving initiatives launched with 2/3 of the benefits expected to be realized already in 2018. Management expects to generate $130m of FCF in the current year, which compares to $1150m in EV – i.e. 11% FCF yield. Also despite declining sales (note: SSS have somewhat stabilized during the last year) operations are still cashflow positive. The obvious question is why the company has not yet been sold to Vintage Capital if the offer still stands? Two possibilities:

  1. Engaged Capital sees easily achievable cost saving measures, believes it can improve operations quickly and then sell the company at a higher price than what Vintage is currently offering;
  2. Discussions with Vintage Capital are not progressing well (offer was conditional, so not clear what else was in there) and the bidder is no longer interested in RCII at $13/share.

Most likely it is the mixture of both. CEO tried to clarify this during the latest conference call:

“I want to provide some clarification regarding certain details from yesterday’s press release. I believe there is some confusion as to why the Board hired consultants to work on a restructuring plan? Well, the company is in the midst of a strategic and financial alternative review process.

Some have mistakenly taken our announcement of a significant cost savings plan as evidence that the strategic and financial alternatives process has concluded. I’m here to tell you that’s not the case. The Board made a decision to hire AlixPartners in December, because it believed that a major cost savings opportunity existed inside the company. This belief was clearly validated based on the substantial savings target we’ve outlined and we will discuss today.

The Board also recognized that the completion of this analysis using competent outside experts would benefit our shareholders where the company have sold its result to the strategic and financial alternatives process or remained an independent company.

As was stated in the press release, the alternatives process, strategic and financial alternatives process does remain ongoing and the Board plan to provide an update to investors once this work has concluded. So I hope this helps to clarify the situation for those of you who may have been confused, but the strategic and financial alternatives process has not been concluded.”

Worth noting that operations have not deteriorated since Vintage offer – the downward sales trend has softened and now  the announced cost saving initiatives are painting path towards profitability. Vintage knows the rent-to-own business well through the ownership of Buddy’s Home Furnishings, a privately run rent-to-own operator. There are easily identifiable synergies in combining the two together. Thus I do not see any reasons for Vintage to loose interest in RCII yet.

 

Couple valuation reference points

Aaron’s – largest industry player – has revenues of $3.4bn and trades at EV/Revenue = 1. Company has 1,726 owned/franchised stores and 27,000 locations of its Progressive Leasing arm. RCII has similar revenues of $2.7bn, and similar store base of 2,500 owned stores + 1,300 Acceptance Now locations, but trades at EV/Revenues = 0.4. Profitability margins are obviously very different, revenue composition also varies (Aaron’s generates half of earnings from its financing division and RCII only 30%), but this still shows that RCII is vastly undervalued if it can achieve profitability levels similar to Aaron’s.

At 7.5% operating profit margin (in line with Aaron’s), RCII would be generating $2.8 per share in EBT. Even taking more conservative profitability improvements, the $13-$15/share acquisition does not look like a stretch.

Another valuation reference – in July 2017 Aaron acquired it’s largest franchisee, paying $1.34m per store. This compares to current $0.45m per store valuation for RCII (fully ignoring value of Acceptance Now locations). This is a difference of 3x. I do not believe such a large difference in valuations per store are justifiable for similar businesses where store re-branding can be easily done without significant loss of customers (Aaron’s acquisition of RCII was rumored in April 2017).

 

Bottom Line 

I like the setup here. New experienced management is in place, board’s interests are fully aligned with shareholders, acquisition offer at 60% premium still seems to be standing and significant cost saving initiatives are underway. Comparison to similarly sized competitor clearly identifies RCII undervaluation if new management is able to stop revenue decline and bring company back to profitability. My expectation is that company will be sold as soon as cost saving initiatives start bearing fruit and any acquisition offer fairly reflects this expected improvement.

The risk here is that management fails to deliver on FCF guidance and potential acquirers walk away. But I think current share price already reflects this negative scenario giving little consideration for the potential upside.

Industry wide risks (consumers leaving B&M location for online) as well as relative valuation risks can be easily hedged by shorting Aaron (short thesis outlined in this VIC write-up).

44 COMMENTS

  1. Alex1511

    Thank you for sharing your RCII idea. Do you think that new management is waiting for the sale after a short squeeze?
    Capital Iq says there are 27mm shares sold short. Which alone justifies a big Upside.

  2. dt

    Yes, I forgot to mention large short interest. More than 50% of all shares are sold short (and 80% of the float). So market is very skeptical on business prospects to say the least and as you suggest any positive developments are likely to cause a short squeeze. At the same time this clearly tells that I might be very wrong regarding takeover speculation – so size this accordingly.

    Short interest increased over the last few months, likely with expectation of large losses due to hurricane activity. This turned out to be a correct expectation as company lost $25m in cash flow from operations during the last quarter (vs $135 generated in 9M 2017). Management also removed undisclosed number of hurricane affected stores from SSS calculations – which opens doors for gaming SSS figures.

    During conference call management that said Q4 performance was an exception and that 2018 will be more like 2017 overall rather than Q4 alone. Company has new CEO who will gain nothing by over-promising and failing to deliver.

    Also worth nothing that short interest figures are as of Jan 2018 when RCII has trading 50% higher – I would assume Feb end figures will be much lower.

  3. exponential

    hi dt-

    RCII down 5%. Any news or just normal volatility? I couldn’t find anything so far. Thanks in advance!

  4. makarid makarid

    Hello dt,

    thanks for this excellent idea! Do you believe that the whole situation will be done in 2018?Thanks

  5. Alex1511

    Rent-A-Center (NASDAQ:RCII) had its target price lowered by equities research analysts at Stifel Nicolaus from $10.50 to $9.00 in a research note issued on Tuesday

  6. Rick Sanchez

    COO just stepped down, is that a positive for the prospect of a sale?

    *Co. announces the retirement of COO Joel Mussat
    *The company also says that it’s eliminating the position of chief operating officer in a cost-cutting move

    Form 8-K: https://seekingalpha.com/filing/3908829

    1. dt

      Without knowing the real reasons for his retirement – we cannot tell:
      - Maybe he is running from the sinking boat. Previous chairman and CEO resignations could be viewed in the same way.
      - Maybe it is a genuine cost cutting scheme and elimination of previous execs who have under-performed.
      - Also current CEO acted as COO of Rent-A-Center earlier in his career, so maybe he wants to have things done his way and therefore had to let go Mussat.

      1. Rick Sanchez

        good point dt. I was thinking too optimistically that since the deal is likely (Vintage to buy and roll up with Buddy’s), they’re jettisoning redundant C-suite executives. Counting chickens before they’re hatched is never a good strategy! I took a smallish position yesterday and added some more today.

  7. M

    @dt given the material upside do you think the way to play this is with Jan 19 CALL options rather than direct equity exposure?

    1. dt

      This would definitely be an interesting way to play it, but option liquidity is very low and spreads are wide.
      Till 2019 it should already be clear whether this is a bust (think SEARS) or whether situation is turning around and share price should reflect that accordingly.

  8. slow

    Rent-A-Center +10% after announcing layoffs, evaluating potential sale

    1. dt

      Market reaction is puzzling as always – there was nothing in the press release that was not discussed with Q4 results. In any case good to see things moving in the right direction.

  9. Rick Sanchez

    For my own benefit, can you share the calc behind how you get 30% of earnings from the financing division?
    “Aaron’s generates half of earnings from its financing division and RCII only 30%”

  10. Rick Sanchez

    fyi, per theStreet.com on 4/3/18,
    “Buyout shop Vintage Capital Management LLC and other bidders are reviewing activist-targeted Rent-A-Center’s (RCII – Get Report) books, and a sale of the rent-to-own retailer is likely to be announced in a month or two, people familiar with the situation said.

    Rent-A-Center has received multiple bids to acquire the whole rent-to-own company, which is in active discussions with potential bidders, they said.”

  11. Rick Sanchez

    Buyout firm Cerberus Capital Management LP is among the companies entering the final round of bidding to buy activist-targeted Rent-A-Center (RCII – Get Report) , according to a person familiar with the situation.

  12. Alex15

    It’s quite interesting to me that the shorts are not covering their positions. They must either expect no deal at all or a deal at a much lower price on very high volume. The second option seems unlikely and the first very unlikely.

    1. dt

      This actually worries me quite a bit – to be short a stock that is rumored to be sold one has to be quite certain that your indicated scenarios will turn out to be true. Short sellers are usually smart hedge funds that have done extensive due diligence and have connections to sense where the deal is going. So I would not discount your two scenarios as unlikely – it seems that few investors (i.e. short sellers) know more than has been announced to the public. I would actually be quite surprised if a deal at something like $13/share materializes.

      I have closed out 3/4 of the position at 25% gain and intend to keep the rest till the announcement.

  13. Ben

    I don’t know if it’s true but a large fund manager once told me the short amount reported can be wildly inaccurate. He said his own position was once larger than the entire amount reported for the stock. Meaning I don’t know how much one should or should not read into that value.

  14. Alex15

    I agree that one can’t be certain of the accuracy of the short interest.

    The strategic review seems to be ongoing. The fact that the nomination was “delayed” provides some confidence that a sale will be reached soon. https://www.sec.gov/Archives/edgar/data/933036/000092189518001825/sc13da1109455023_05252018.htm

    In my opinion, it feels like the more days pass (without a sale) the more likely it becomes that management comes up with a standalone strategy. The short interest has also increased (5/15/2018 28,960,388 vs.4/30/2018
    26,846,210).

    1. dt

      Should be interesting trading today. Guidance update is definitely a huge positive, SSS also improved. But there is no sale which probably quite a few investors expected at this stage. I am just wondering whether:
      - no sale = no buyers at current (or +20%-30%) prices, or;
      - no sale = business is improving so fast that BoD wanted much higher valuation.

    1. dt

      Not 10% but 16% spread. Market mostly likely does not expect the deal to be accepted.

      Interesting situation. RCII management did not reveal any numbers and then Vintage simply made their offer public to add pressure.

      https://www.sec.gov/Archives/edgar/data/933036/000114420418033839/tv496322_ex99-3.htm

      Apparently Vintage $13/share offer was always on the table and this was not good enough for the board. Now Vintage is offering $14/share. If the board rejects this proposal (keep in mind board is controlled by Engaged Capital appointees) it should be taken as a pretty strong sign that insiders are very confident on operational improvements and higher company valuation in the future.

      So either way it would seem such a large spread should not exist.

      1. makarid makarid

        That is exactly what i was thinking. If the deal stands then you get the spread.If the deal breaks,maybe you will have some down pressure for the stock,but fundamentals are the same.So it is a win-win here.I will consider to take a position here

  15. greg lia

    My impression from yesterday was that this $14 offer was rejected because it was not accompanied by letters of credit or other showing of financial backing to accomplish the deal. That was at least my read of it

    1. dt

      My guess is that board will need to issue further clarification. Vintage Capital has been in discussions to acquire the company for almost a year. Previous proposals have been non-binding, but the latest seems to be ready to be signed and seems to contradict what RCII is saying. From Vintage letter:

      “At this time, RCII is in possession of all requested documentation concerning our proposal, including (1) a draft merger agreement that we are prepared to sign; and (2) an equity commitment letter and ample supporting documentation to evidence our ability to complete an acquisition of RCII.”

  16. makarid makarid

    Is it possible, Engaged Capital to just spread rumors about the new guidance in order to pump the price and sell his share?Maybe they have found that they cannot turn around or sell the company at their desired price.Is that possible or legal in US?

  17. dt

    As expected:

    “Vintage filed a Schedule 13D amendment this morning containing a letter to the Rent-A-Center Board of Directors offering to acquire the Company for $14.00 per share in cash. Subsequently, Vintage provided Rent-A-Center with an equity commitment letter and other necessary supporting documentation related to its bid. Consistent with its fiduciary duties, the Rent-A-Center Board is reviewing Vintage’s latest offer”

    http://investor.rentacenter.com/phoenix.zhtml?c=90764&p=irol-newsArticle&ID=2354323

    1. FM W

      Then why is there still a $2 huge spread exists? What are the potential risks here? Thank you.

      1. dt

        The risk is that management reject Vintage offer and stock tanks. And then after this happens management’s optimism does not materialize in actual business improvement in the upcoming quarters.

  18. greg lia

    Assuming the stock reacting to this

    * RENT-A-CENTER SAYS TO SUSPEND CURRENT TRADING BLACKOUT PERIOD APPLICABLE TO CO’S DIRECTORS, EXECUTIVE OFFICERS, AMONG OTHERS – SEC FILING

    1. dt

      I think you are referring to a press release few days old. Vintage offer expired yesterday, so market probably thinks management passed on it.

  19. Rick Sanchez

    dt, thanks a lot for this idea; it is my biggest winner for the year!

  20. Kevin Chang

    Is everybody closing out on the news? Thoughts on it hitting +15 because of the high short interest?

  21. bill

    Thanks for this…your thoughts pushed me over the edge…nice trade!

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