Why Aaron's Is a Survival Stock

Unfortunately, as we collectively face challenging times during this pandemic, certain business models thrive and benefit in this kind of environment. One of the main beneficiaries of the coronavirus crisis, in my opinion, would have to be Aaron's Inc. (AAN, Financial).

Aaron's offers lease-purchase solutions primarily to an undeserved, credit-challenged segment of the population who tend to have a FICO score between 500-700. A lease-purchase solution is a written agreement between a seller and buyer giving the buyer an option to purchase the property when they have made lease payments until the full price is paid up.

Consumers with lease-purchase solutions usually have early buyout options, low up-front payments, and flexible payment options. These agreements exist for a variety of products, including furniture, appliances, electronics, jewelry, and accessories. A typical contract may be for 12, 18, or 24 months.

I believe in the short term, the company is well-positioned to benefit from where the current economy is heading, but in the long term, they still face some challenges.

Cash conversion cycle

Let's take a look at the cash conversion cycles of Aaron's and some well-known companies. This metric serves as an indicator of how long it takes to convert investments in inventory and other resources into cash flows from sales.

At first glance, this seems like a terrible sign. Rent-a-center, a direct competitor to Aaron's, has a cash-conversion cycle 10 times faster than Aaron's. Although it is typical for a rental company to have a cash conversion cycle over 1000, even by that standard, Aaron's is way off.

The cash conversion cycle consists of three components: days of inventory outstanding (DIO), days sales outstanding (DSO), and days payables outstanding (DPO). The formula is calculated as DIO+DSO−DPO. From these three components, I've noticed that the DIO of Aaron's is unusually high at 3660. DIO can be calculated as average inventory divided by the cost of goods sold (COGS), multiplied by 365 (days in a year). So for DIO to be that high, the inventory has to be unusually high, and/or the COGS must be unusually low.

Not surprisingly, we found out that inventory was rising while COGS was decreasing, having a magnified effect on days of inventory outstanding.

Having a high level of inventory is part of the business model for the rental business. So there's nothing unusual about the inventory level as it seems to be growing in line with the revenue growth. But if you look at finished goods inventory and compare it against the inventory level, the answer becomes clear. The level of the finished goods is much higher than the actual inventory and the difference becomes inventory adjustment allowance or the inventory write-off. It has happened twice at Aaron's in the last 10 years, while Rent-A-Center has zero at the same time. This shows how aggressively management is pursuing a growth strategy.

COGS, on the other hand, is calculated as beginning inventory minus ending inventory plus purchases. This definition is helpful for manufacturing and mining companies, but for service and software companies, this can lead to a false sense of low COGS and high gross profit since COGS only applies to those costs directly related to producing goods intended for sale. This is exactly the case with Aaron's, as they are transitioning their business model from a brick-and-mortar rental company to a virtual rental company. As part of the plan to reshape the business model to focus on an e-commerce platform, the company acquired Progressive Leasing for $700 million in 2014 to gain “an entry point” to the fast-growing online lease-to-own market. Since then, this segment of the business has become the main revenue driver for the overall company.

What makes Progressive Leasing so successful is that it offers virtually a risk-free solution for the vendors by bearing the risk for customers who may not be otherwise qualified to buy an item with a regular financing option. By doing so, they don't just approve of anyone. They use analytical methods to carefully select the customers who they think are capable of following through on their commitments.

Whatever is being leased at Progressive Leasing is not coming out on COGS; rather, it appears on the balance sheet as a depreciation cost. As a result, in this case, I think it is deceptive to rely on Gross Profit to gauge the profitability of the company. Instead, to get a more complete picture, we should add depreciation on top of COGS.

Economic value added

I believe the economic value added (EVA) is useful to analyze the “true” level of value created by the management over a long term horizon. EVA is defined as the value generated from the funds invested in the business. I don't want to bore readers with the details of this complicated calculation, but feel free to comment or message me if you want to know more. Below are my calculated EVA values for the past four years of operations at Aaron's:

EVA had an overall positive trend, except for 2019. That is because of a one-time payment settlement with the Federal Trade Commission about business misconduct.

Let's focus on business misconduct a little bit. According to the complaint, Aaron's had prior knowledge that some of its franchisees were using software that has invasive features, but went ahead and allowed them to use it without telling customers. Aaron’s also stored data collected by the software for its franchisees and served as the go-between to transmit messages between them. Thus, the complaint alleges that Aaron’s knowingly played a direct and vital role in the franchisees’ actions challenged as illegal in the earlier lawsuits. In the latest conference call, the company management kept avoiding the FTC investigation subject.

In the big picture, I don't think the problem here is about ethics. Rather, it shows more about the weakness of corporate governance.

Final thoughts

Despite the recent setback with misconduct allegations, I believe that as a company that operates on a lease-to-buy model, Aaron's has tremendous potential to survive and even benefit from a recessionary economy due to an increase in consumers who are unable or unwilling to foot the full cost of goods upfront.

Moreover, I see enormous expansion potential for Progressive Leasing, as many retailers are just beginning to learn about it and become more familiar with the platform.

On the other hand, I also think the company needs to enforce stricter and more conservative business management and ethical practices while addressing the inventory management issue better. If left unresolved, these issues could hurt the company in the long term.

Disclosure: I don't own any of the stocks mentioned and do not have the intention to own in the near future.