Aaron’s (AAN)

couch

Key Statistics

Enterprise Value = $3.25 billion

Operating Income = $405 million

EV/Operating Income = 8.02x

Price/Revenue = .94x

Earnings Yield = 9%

Debt/Equity = 20.42%

The Company

Aaron’s is in the furniture and equipment leasing business. They lease items like furniture, tablets, computers, mattresses, dryers, refrigerators. They service a mostly low-income clientele who cannot afford to buy items upfront and typically have limited access to credit. The typical customer has a job but isn’t making much money, doesn’t have savings, and wants to furnish or buy appliances for their apartment or home.

Sentiment

The business that Aaron’s is engaged in generates a fair degree of “ick” reactions from investors. They’re engaged in subprime credit and working with customers who can’t afford to buy furniture which is unappetizing for many investors. Nonetheless, it is a solid business that generates a nice stream of free cash flow and they maintain a safe level of debt.

My take

It looks like we’re in the late stages of this economic cycle. It’s not until the last few years of a boom that lower income groups begin to feel the effects of an economic recovery. Looking at the yield curve, this stage of the cycle looks a lot like 1998 or 2006. Things are good, the recovery is entering its manic stage, and the Fed is tightening and setting the stage for a recession at some point in the next few years. For now, the 2 to 10-year spread is still positive and a recession does not appear to be imminent.

With unemployment at historic lows and wage pressures growing, lower income groups are finally feeling the recovery. As a result, they’re becoming more optimistic. They’re feeling better about their jobs and their wages are increasing but they are lacking in savings. They want a new washer or dryer, a more comfortable mattress, a new couch, etc. They lack the credit to simply put it on a credit card and they lack the savings to buy it outright. Enter Aaron’s as a temporary solution.

Aaron’s should perform well in this environment. This is a cyclical pick. Revenues, earnings, and cash flow have gradually picked up steam with each passing year of the economic recovery. On a simple P/E basis, Aaron’s currently trades at 11 times earnings. The 5-year average is 18, meaning multiple expansion alone could send the stock up by 63%. I think the stock’s valuation remains depressed solely due to the ugliness of the business that it is engaged in.

It’s also worth noting that the company recently announced a $500 million share buyback. This is solidly in the “high conviction” buyback zone, as it is 15% of the existing market capitalization.

The risk is that the economy enters a recession and Aaron’s customers have difficulty making their payments. On the other hand, a recession would likely increase the appetite for Aaron’s business. In the grips of a recession, customers would likely turn to Aaron’s as a way to buy essential household items. Aaron’s actually increased 54% during 2008. This move was bolstered by a sale of their office furniture business to Berkshire Hathaway at the time. Even with that taken into consideration, their model looks like it offers some protection even if the cycle turned ugly. I doubt it would repeat its stellar 2008 performance during the next recession, but it at least calms my nerves that the downside risk is limited even if I’m wrong about where we are in the economic cycle.

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