Current Price – $8.10
Buyout Offer - $13.00
Upside – 60%
Expiration Date – TBD
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.
- 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:
- 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;
- 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).
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).