Neither Wall Street nor Main Street like home furnishings lessor Rent-a-Center (Nasdaq: RCII ) very much. And it's not hard to figure out why. From Wall Street's perspective, it seems that whenever Rent-a-Center does well, it means the economy's tanking and stocks are in freefall. That's bad for business. Conversely, when everything's going gangbusters on the Street, Rent-a-Center tends to lag -- much as it's been doing lately. Not much to love there, either.
Meanwhile, over on Main Street, furniture, home appliance, and consumer electronics renters like Rent-a-Center and its rivals Aaron Rents (NYSE: RNT ) and Rent-Way (NYSE: RWY ) walk around cloaked in a pall of gloom, a whiff of poverty, and the inability to afford the good things in life. They're even, to put it bluntly, accused of being in the business of exploiting the working poor.
All of those are bad raps. Tough to overcome, and reasons why, over the past year, Rent-a-Center has underperformed the S&P average by more than 20%. But they're also clues that should set off alarm bells in the mind of a hunter of hidden gems. It's been in large part due to our courage to invest in these kinds of unloved, underappreciated, and abused companies that Motley Fool Hidden Gems has been able to achieve its enviable record of trouncing the broader market's returns by a four-to-one margin, generating annualized profits of 25% for our members over the past two years.
Investing with Peter Lynch
In his stellar tutorial on stock picking for the common man, One Up on Wall Street, investing guru Peter Lynch laid out 13 attributes that he looks for in a stock, suggesting that the company could be underpriced and ripe for the picking. Rent-a-Center hits on several of those points, but I want to focus on just one today -- Rule No. 7 for finding "the perfect stock": "There's Something Depressing About It."
What, pray tell, could be more depressing than a business that's very existence confirms that there are Americans living among us who cannot afford to buy their TVs at Best Buy (NYSE: BBY ) or Circuit City (NYSE: CC ) ? Or perhaps worse, who are those people so shortsighted that they choose to not buy a TV they can afford -- but rather to rent one that they cannot afford to buy? Whichever demographic Rent-a-Center and its competitors are pulling their customers from, you have to find it vaguely depressing that there are any customers to be had at all.
In a way, investing in Rent-a-Center is like investing in Altria (NYSE: MO ) , which makes addictive cigarettes we'd rather not be made. Or Service Corporation International (NYSE: SCI ) , which buries people we wish had not died. Gloomy, gloomy, gloomy.
The end result of all this gloom, however, is to create opportunity for Fools who are realistic enough to see profits where others see only depressing facts of life. As evidence of that, let's take a quick stroll through Rent-a-Center's financials, and see what can happen to depress a fine business's valuation when no one's looking -- or when no one wants to look.
7 steps to finding Hidden Gems
In a pair of recent articles, "Panning for Gold" and "7 Steps to Finding Hidden Gems," I laid out the process by which I generate a quick (five minutes, tops) snapshot of a company's financial health and prospects as an investment. In reviewing Rent-a-Center, we'll again focus on the following metrics:
- Market cap
- Enterprise value-to-free cash flow (EV/FCF)
- Historical and projected earnings growth
- Return on equity (ROE)
- Insider ownership
- Share dilution
With a market cap under $2 billion, Rent-a-Center qualifies as a small-cap company with plenty of room to run.
Take Rent-a-Center's $1.9 billion market cap, subtract its $60 million in cash, and add its $710 million in long-term debt, and Rent-a-Center has an enterprise value of $2.55 billion.
Free cash flow
Rent-a-Center has not published its 2004 cash flow statement yet, but by using the run rate on capital expenditures, combined with the company's published statement that it generated $331 million in cash from operations last year, it appears likely that free cash flow came in at nearly $260 million for the year. Although Rent-a-Center expects to generate just over half that number in 2005, as it builds out its store base, "maintenance free cash flow" (the cash necessary to maintain the status quo) is still probably pretty close to $260 million.
Enterprise value-to-free cash flow
Thus, the company's $2.55 billion enterprise value (EV), divided by $260 million in free cash flow (FCF), gives Rent-a-Center an EV/FCF ratio of just under 10, which makes the grade for a small-cap value stock.
Historical and projected earnings growth
Over the past five years, Rent-a-Center has grown its net profits at an average rate of 25% per year; the consensus of the nine analysts following the company is that over the next five years, the company should be able to grow earnings by an average of 11% per year.
Divide the EV/FCF of 10 by the more conservative of the two growth rates (i.e., 11), and Rent a-Center scores less than 1.0, again falling within our targeted range for small-cap value stocks.
Return on equity
To quality-check the growth number, I like to run a second comparison: EV/FCF over the company's recent operational performance, as measured by its return on equity. Rent-a-Center boasts a strong return on equity of 20%, giving it an EV/FCF/ROE of 0.5. That, too, is a passing grade.
Management owns a significant stake in Rent-a-Center, with insiders owning 13%. That kind of stake should help to align management's interests with those of outside shareholders.
Over the past year, Rent-a-Center has been buying back its shares at a swift pace, dropping the weighted average diluted share count from 83.5 million to 76.4 million shares in just 12 months. That's not only a strong vote of confidence in the share value by management. For existing shareholders, it's been a bonus 8.5% increase in the value of their ownership stake over the past year. The fact that the company expressed an intent to continue the share buybacks in the coming year promises more of the same, on both counts.
With a bargain basement price, decent prospects for future growth, and management whose ownership stakes in the company align their interests with those of outside shareholders, Rent-a-Center makes the grade -- as a possible hidden gem.
That does not necessarily mean that it is a true gem of an investment. While I use these "7 Steps" to get a quick idea of whether a company deserves further study, head Hidden Gems analyst Tom Gardner runs each of his finds through a much more rigorous and exhaustive evaluation before choosing his top two recommendations each month.
Want to learn what Tom himself looks for in a gem? Take a free, one-month trial of Motley FoolHidden Gemsand you'll receive access to all of his advice on the subject from the past 20 issues, and see his 40 winning picks as well. If you don't like the service, there's no obligation to remain a member. You may unsubscribe at any time and we'll refund the entire amount of your unused subscription, no questions asked.
Fool contributorRich Smithhas no position in any of the companies mentioned in this article. The Motley Fool's full disclosure policy can be read rent-free.