Elevated Consumer Discretionary Risk

Rent-A-Center (RCII), a market leading rent-to-own retailer, preannounced very poor operating results today. The company expects same store sales at its core U.S. stores to decline -12% in Q3. Management blamed the “implementation of our new point-of-sale system.” Rent-A-Center has been reporting weak consumer trends for the past several quarters. How much of the sharp decline in comps in Q3 is due to a struggling consumer versus issues with their point-of-sale system? Based on recent results of other consumer businesses, I’m not convinced the point-of-sale system is the sole driver of poor results. We’ll learn more about the health of Rent-A-Center’s customer base when they, along with Aaron’s (AAN), report earnings later this month.

Rent-A-Center also announced it amended its credit agreement and reduced its minimum coverage ratio from 1.75x to 1.5x. Rent-A-Center had $724 million in debt and $88 million in cash as of June 30, 2016. The company generated $150 million in free cash flow in fiscal 2015. Similar to many companies this cycle, Rent-A-Center has aggressively allocated capital to dividends and buybacks. Over the past three years, the company repurchased $217 million in stock and distributed $147 million in dividends. As a result of shareholder friendly capital allocation decisions, the balance sheet continues to hold considerable debt, limiting flexibility. As the profit recession continues, it will be interesting to see how many other companies that aggressively bought back stock and provided generous dividends will end up in a similar financial bind. As many businesses have learned the hard way, capital and liquidity have a way of becoming scarce when they are needed most. This is especially true for cyclical companies.

I consider many consumer discretionary businesses to be cyclical. As such, I attempt to avoid extrapolating near-term results too far into the future and normalize cash flows for valuation purposes. Furthermore, as with most cyclical businesses, I require a strong balance sheet to ensure the company can survive the uncertain swings in its profit cycle. I believe the sharp decline in Rent-A-Center’s stock today was partially balance sheet related. With over $700 million in debt and declining profits, I believe investors’ are becoming increasingly concerned about the firm’s financial risk. Rent-A-Center’s bond holders also appear concerned as the company’s 4 ¾% coupon bonds maturing 2021 declined $5 today to $74.75 and are now yielding 12%.

As I’ve stated in past posts, combining operating and financial risk is something I attempt to avoid. In fact, it’s one of the main reasons I did not purchase Rent-A-Center’s stock despite its seemingly inexpensive valuation. Prior to today’s announcement, Rent-A-Center was trading near 7x earnings. Although this is an extremely attractive valuation in today’s market, before I could consider Rent-A-Center for purchase it had to pass my financial risk test. Because I view their business as cyclical (above average operating risk), it is necessary that they have a strong balance sheet and an acceptable leverage ratio (debt to free cash flow of 3x or less). Based on my free cash flow estimate, Rent-A-Center did not pass my financial risk test and as a result, I was restricted from purchasing its stock.

If my theory on a weakening consumer holds, I believe more consumer discretionary businesses will report challenging operating results in Q3. If I was forced to play the game and had to be invested, I’d be extra careful owning seemingly inexpensive consumer discretionary companies with questionable balance sheets. There are no free lunches at this stage of the market cycle. If it looks cheap, it’s most likely cheap for a reason. There are thousands of desperate investors currently scavenging for any crumb of value they can find. If you think it’s been overlooked, I suggest reconsidering that assumption. Thankfully I’m not forced to play the game and I’m not required to own stocks I don’t want to own. I feel very fortunate I can remain disciplined in a market stripped of opportunity and filled with risk.

It seems every other post I’m revisiting the topic of risk. After an eight year bull market, I know I may sound like a fuddy-duddy or overly conservative. However, when I see business results like Rent-A-Center’s and weakening fundamentals overall, I can’t help but be surprised by the lack of concern for what seems very obvious to me – asset prices are not properly discounting risks. As I’ve illustrated with many examples in past posts, risks to future cash flows are alive and well. Furthermore, I’m not expecting operating risks to recede in the near-future as Q3 earnings reports will most likely confirm business trends remain sluggish and outlooks uncertain.

On a final note, I thought it was interesting that the top three holders of Rent-A-Center’s stock are passive funds, which combined own 28% of the company. As I discussed in my post Small Cap Police, I believe the popular trend of indexing carries risk. As investors flock into passive funds to save on fees, the number of investors that are price insensitive grows. In investing, price and risk are joined at the hip. If price is being ignored what does that say about risk? I continue to look forward to the day when passive fund flows reverse and the major holders attempt to sell to one another at once. If you’re wondering what that will look like (when the bid disappears), I suggest pulling up a chart of Rent-A-Center’s stock, which declined 29% today.