Discover more from Ben’s Substack
Aaron’s Company, Inc. (AAN)
AAN has fallen 14% this week on news that it will be removed from the SmallCap 600. This forced selling has created an excellent opportunity for investors. At its current market cap, the stock trades at ~57% of its book value, excluding goodwill and the book value of its intangible assets. This material discount is completely unjustified, given the company’s profitability: their projected free cash flow this year alone ($89-$95 million) is roughly 30% of their market cap (~$313 million). Moreover, the company is counter cyclical, and should materially benefit from tightening credit standards or an economic downturn.
The Aaron’s Company is a lease-to-own retailer that was founded in 1955. Until November 2020, the company was one of three businesses owned by Aaron’s Holdings Company, Inc. The other two businesses were Progressive Leasing and Vive Financial. In November 2020, Aaron’s Holdings Company, Inc. changed its name to PROG Holdings, Inc. and spun-off the Aaron’s Company to its shareholders. The Aaron’s Company is currently owned by the Aaron’s Company, Inc. (AAN).
In April 2022, AAN acquired BrandsMart U.S.A.—a discount retailer that sells a wide selection of brand-name consumer electronics. AAN paid ~$266.7 million in connection with the transaction.
AAN has two segments: the Aaron’s Business segment and the BrandsMart segment. The Aaron’s Business segment’s business model is lease-to-own (LTO). The company’s most recent 10-K describes the LTO model as follows: “[i]n a standard LTO transaction, the customer has the option to acquire ownership of merchandise through a renewable LTO plan, usually 12 to 24 months, typically by making weekly, semi-monthly, or monthly lease renewal payments.” The filing also says that the company’s “core customer base is principally comprised of overlooked and underserved consumers in the U.S. and Canada with limited access to traditional credit sources.”
As of June 30, 2023, the company owns and operates 1,026 Aaron’s stores in the United States and has 230 franchised locations. However, the company is currently in the process of restructuring its stores to implement a “hub” and “showroom” model. Under that model, certain stores will become “showrooms” that focus on sales activities, and other stores will become “hubs” that focus on product delivery and customer support. So far, the restructuring has materially reduced the Aaron’s Business segment’s operating costs by centralizing certain activities in the “hubs” and removing redundancies that exist in the stores that have become “showrooms.” Management expects that the company will complete the restructuring in 2025.
BrandsMart is a discount electronics retailer that operates in Florida and Georgia. As of June 30, 2023, the company owns 10 BrandsMart stores (8 in Florida and 2 in Georgia). Management has repeatedly stated that they view BrandsMart as a growth opportunity for the company and that they plan to open one or two BrandsMart locations a year.
The most attractive aspect of AAN is its balance sheet. Currently, the company’s stock is trading at a mere ~57% of its book value, excluding goodwill and the book value of its intangible assets. That number falls to ~44% if you include both goodwill and intangible assets.
The vast majority of the company’s book value is attributed to its lease merchandise ($636.6 million, net of accumulated depreciation and allowances) and merchandise inventories ($92.8 million, net of depreciation). Of that lease merchandise, ~$408 million is currently on lease to customers. When a piece of merchandise is leased to a customer, the company starts depreciating the product the second it is leased and depreciates the entire cost of the product over the course of the lease agreement period. At the same time, the company collects payments bi-weekly or monthly from the customers to whom lease those products. This dynamic essentially means that the ~$408 million in inventory that is currently on lease is effectively a guaranteed revenue stream over the next 12-24 months where the cost of the revenue has already been paid for and the gross profit margin for the revenue is ~66.6% (based on recent and historical results).
On the liabilities side, the company has a manageable debt load. Currently, AAN has $147.7 million in net debt (~$186 in debt and ~$38.3 million in cash). That debt is almost entirely attributable to the company’s purchase of BrandsMart in 2022, at which time it took out $291.7 million in debt. Management has aggressively paid off the debt over the past year using the company’s excess free cash flows, and has been able to reduce AAN’s debt from ~$310.3 million in June 2022 to ~$186 million in June 2023. Management will likely continue to aggressively pay down debt, given that the current interest rate on their debt is around 7%.
AAN is not just an asset play: its Aaron’s Business segment is highly profitable. Last year, the Aaron’s Business segment brought in roughly $1.7 billion in revenue and had an EBIT of roughly $122 million. Through two quarters, management currently expects the Aaron’s business segment to bring in between $1.5 and $1.57 billion in revenue in 2023 and have an EBIT of somewhere between $101 and $110 million. Although I typically do not trust management’s projections, these particular projections include six months of actual results, and the LTO business model allows management to make short-term predictions with a fair amount of precision.
Although the Aaron’s Business segment’s revenue has fallen over the past two years, the decline does not appear portend a permanently deteriorating business. The Aaron’s Business segment primarily serves low-income individuals—a group that pulled forward demand in 2021 when they received stimulus and that has been particularly hit hard by inflation. The segment has also reduced their store-count by about 3% over the past two years to remove underperforming stores, which has had the impact of lowering revenue but potentially increasing the company’s profits.
The BrandsMart segment has been a disaster for AAN since it purchased the business in 2022. After the April 1, 2022 acquisition, the BrandsMart segment brought in roughly $552 million in revenue in 2022 and had an EBIT of roughly negative $11 million—driven primarily by a one-time $23.1 million non-cash charge for a fair-value adjustment to the company’s acquired merchandise inventories. Management currently expects the BrandsMart segment to breakeven this year. Despite these disappointing results, the valuation of AAN is so low that I view BrandsMart as essentially a free option for investors that could pay off when demand for electronics returns.
Overall, management expects the entire consolidated company to generate between $85 and $95 million this year in free cash flow (after capex spending). A material portion of that free cash flow is from working down merchandise levels. But the level is largely consistent with the Aaron’s segment’s typical pre-COVID cash flows—back when it was owned by Aaron’s Holdings Company, Inc.
As for net earnings, management projects earnings to be between $16.8 and $25.5 million this year. That earnings projection includes ~$20 million in expenses related to the restructuring (which management expects to complete by 2025), ~$14 million in interest expenses (for debt that management is aggressively paying off), and ~$3 million in costs related to the 2022 acquisition of BrandsMart. Once the company’s debt is paid off and the restructuring is complete, the company’s net earnings could double or triple without any material improvement in the company’s underlying performance.
The Aaron’s Business segment is one of the rare businesses that should benefit materially from tightening credit standards (which recently started to occur) or an economic downturn (which many predict to occur). As explained in the company’s most recent 10-K says: “Historically, during economic downturns, [Aaron’s] customer base expands due to tightened credit underwriting by banks and credit card issuers, as well as employment-related factors which may impact customers’ ability to otherwise purchase products from traditional retailers using cash or traditional financing sources.” A perfect example is the company’s performance during 2008 and 2009, where the Aaron’s Business segment’s revenue increased 14% and 10% respectively.
The reason that the Aaron’s Business segment benefits from tighter credit is that LTO is an alternative to purchasing with credit. The difference is that instead of buying the product now and owing some credit provider on some pre-defined schedule, at Aaron’s you take possession of the product now and own it after you make a certain number of payments to Aaron’s. Thus, if the cost of credit increases or the availability of credit shrinks, some subset of customers who would have otherwise preferred credit will turn to LTO providers like Aaron’s.
AAN has not yet seen an increase in revenue due to the recent credit tightening. But their CEO remarked in early August that they “are seeing a slightly higher quality customer coming into Aaron’s.” In other words, they are starting to see customers come into their store who have higher scores than their typical customer the past few years, and who may have previously relied on credit to purchase products.
As mentioned above, the acquisition of BrandsMart in 2022 has been a complete disaster. It seems likely to me that one of the reasons that AAN trades a such a substantial discount to its intrinsic value is that investors don’t trust AAN’s management to steward the company’s capital. While management almost certainly made a mistake buying BrandsMart, I don’t think that mistake warrants such a steep discount.
Since the acquisition, management has focused primarily on using the company’s free cash flow to pay off debt and to pay dividends to shareholders (the yield is currently ~4.9%). It has then used the remaining cash flows to repurchase stock. I would prefer more aggressive buybacks given how substantial the discount is to AAN’s intrinsic value, but the general point here is that management has been aggressively returning capital to shareholders. We’ll see what happens when the company is eventually debt free. But for now, the risk of capital mismanagement is low given their aggressive focus on debt repayments and dividends.