Aaron’s 2016 annual report is titled “Saying “Yes” to more Customers” as if taking on additional risk by adding credit constrained customers, portraying its Progressive financing arm as the magic elixir, and paying a premium for traditional rent to own stores as the path to creating value. AAN’s earnings come from a very tricky game which makes it hard to understand the effectiveness of their lending activities. Put simply, AAN is in the business of loaning inventory and expecting a payback over time, IF at all. Below we lay out a series of scenarios that could cause multiple contraction and should also put some doubt in the 11x EBITDA valuation at which the company currently trades.

After following AAN’s for a handful of years, the recent M&A of traditional RTO stores piqued our interests into, what is really going on at AAN. This acquisition doesn’t gel with the stated strategy of less traditional RTO and more virtual marketplace as the way of the future.

AAN’s Operating Segments

AAN’s has five operating segments.

• Sales and Lease Ownership: employs a monthly payment model to provide household goods and consumer electronics (which face a new bought of deflation quarterly) through AAN’s stores. The customer base is comprised of customers with limited access to traditional credit sources and the average store is approximately 8,000 square feet, which is absurd in today’s retail environment much less the future. Each store usually maintains at least two at least two trucks for delivery, service and return of product and generally offer same or next day. AAN’s also locates their stores close to retailers who have similar customer demographics, which also may conveniently use the Progressive platform to capture customers and cannibalizing the high fixed cost store structure.

• Franchise: AAN’s franchise stores are in markets where they have no immediate plans to enter via brick and mortar, Progressive has stealthy entered these markets and is seen as a competitor (see CONN/Progressive example below).  Historically, this high margin franchise royalty stream was viewed as a “crown jewel” of the AAN’s story, but now it may come into question the future of this segment.

• Woodhaven: AAN’s manufacturing segment that was established in 1982 and makes them the largest lease-to-own company in the US that manufactures its own furniture. This segment wreaks of legacy issues with a dash of antiquation.

• Progressive: established in 1999 and acquired by AAN’s in 2014 to thwart an unsolicited bid, which was more or less a poison pill. Regardless, Progressive partners with retailers, primarily in the furniture and bedding, mobile phones, consumer electronics and jewelry industries to offer a lease-purchase option for customers to acquire goods they might not otherwise have been able to obtain. Sound familiar? In a nutshell, Progressive is financing customers at retailers that otherwise would have been using traditional rent-to-own stores. Progressive offers a technology-based application and approval process (algorithms) that does not require a Progressive employee to be staffed in a store. Once a customer is approved, Progressive purchases the merchandise from the retailer and enters into a lease-to-own agreement with the customer. Progressive has retail partners in 46 states and operates under state specific regulations in those areas. So much for franchising stores “where they have no immediate plans to enter.”

Is Progressive Funding A Direct Competitor?

April 3, 2017 Conn’s a specialty retailer of furniture and mattresses, home appliances, consumer electronics and home office products and a provider of consumer credit, announced a partnership with Progressive Leasing, to provide “lease-to-own” payment solutions to consumers who do not qualify for Conn’s proprietary credit offering.

• Conn’s: 116 stores in traditional rent-to-own territories: TX, AL, AZ, CO, GA, LA, MS, NV, NM, OK, NC, SC, TN and VA

• CONN’s financed approximately 71% of customer transactions through its in-house financing program during Q1 FY18; refers the customers that would have resorted to traditional RTO to Progressive’s algorithm based customer approval process

• Lease to own solution 8% of Q1 18 sales;  and CONN’s cannot afford to lose 8% of their sales and stay in business

Recent M&A

On July 28, 2017 AAN announced they acquired their largest franchises SEI for $140MM in cash for 104 stores, which equates to a per store valuation of $1.34MM, which we believe is a premium on any metric, but since SEI is private we can only safely speculate. Of course the press release paints this in the most favorable and glowing light and is littered with “excitement” and “synergies” as expected.  But the real question is “WHY” AAN was compelled to buy their largest and oldest franchisee at premium, when they are closing corporate stores at warp speed.  AAN’s closed 212 stores from 2015 to 2017…ending with 1,093 in 2017 only to turnaround and pay a premium for a franchisee just strikes us as odd at a bare minimum.  Especially, since AAN’s recently sold their 82 company operated HomeSmart stores in May of 2016. The addition seems to contradict the rapid of corporate stores and the divestiture of the weekly pay model stores.

There have been grumblings in the AAN’s franchise system for quite some time, which is not an anomaly in the franchise world. However, two major franchisees joined Orlando based Vintage Capital Management’s activist campaign in March of 2014 by being two of five nominees to replace the sitting AAN’s board of directors, which is a rare occurrence.  And this unhappiness was prior to AAN’s purchase of Progressive Finance Holdings in April 2014, which is a competitor to traditional RTO stores, regardless of the omnichannel spin. Historically, credit constrained customers that could not afford higher ticket items at Big Lots or Conn’s would venture over to their local mom and pop RTO or national RTO chain, but now has the option of “winning” on Progressive’s algorithm and “virtually” eliminating the RTO option.

One has to ask the question is Progressive’s competition with traditional RTO stores, including their own a form of “virtual” franchise encroachment and therefore affording the balance of the 680 franchisees to request the SEI treatment? Could there be a run on the bank and what could it possibly look like? And does Progressive potentially violate the franchise agreement?  And will the franchisor be forced to buy back all their stores? I do not know if this is the case but it certainly warrants further investigation because if it were the case it could possible require $1B in capital to buy back the other franchisees.

Hurricane Harvey:

Although it is hard to quantify the effects of Harvey and they may be viewed as non-recurring or one time, it is possible that Harvey affected 40 stores and a distribution center in the greater Houston area.  In addition, the stores in which Progressive has partnered such as Conn’s, Big Lots, and Mattress Firm will be affected as well.  If AAN is self-insured, the effects to bottom line could be quite significant since Progressive has a much larger footprint than just the 40 or so stores in the area.  Keep in mind that when Katrina hit Louisiana, it affected approximately 15 AAN stores which cost the company around $4 million or so.

Conclusion:

All of these unknowns don’t warrant a premium valuation and believe as AAN’s is forced to deal with the “melting ice cube” reality of traditional brick and mortar rent-to-own the equity will contract from 11x EBITDA.