Rent-A-Center Reiterated at Neutral

Rent-A-Center Inc. (RCII - Analyst Report), the largest rent-to-own operator in the U.S, leverages an extensive network of stores to effectively penetrate into its target markets, which in turn facilitates it to generate healthy sales and gain competitive advantage over its rivals, Aaron’s Inc. (AAN - Snapshot Report) and Advance America.

Moreover, the company has been taking prudent steps to optimize rental merchandise levels in accordance with sales trends. Rent-A-Center implemented a centralized inventory management system, including automated merchandise replenishment. Moreover, a new centralized purchasing system allows better management of rental merchandise.

In order to enhance consumers’ shopping experience, the company has developed a new business model called RAC Acceptance. When the consumer is denied credit financing for a particular product from the retailer, Rent-A-Center under its RAC Acceptance program acquires that product from the retailer and offers it to the consumer under a rental-purchase transaction.

Despite sluggish recovery in the economy, Rent-A-Center is witnessing healthy demand for its product and services, as evident from its third-quarter 2012 results. Rent-A-Center posted third-quarter 2012 earnings of 67 cents a share that came in line with the Zacks Consensus Estimate, and rose 11.7% from the prior-year quarter, aided by top-line growth. Total revenue climbed 5% to $739.3 million on the back of higher RAC Acceptance segment revenue. However, total revenue fell short of the Zacks Consensus Estimate of $757 million.

The company projects top-line growth for 2012 between 7% and 8.5%, attributable to a low single-digit jump in Core U.S. segment and a contribution worth more than $325 million from the RAC Acceptance business. Management expects comparable-store sales growth of 2% for the fourth quarter and 2012. Management envisions 2012 earnings in the band of $3.05 – $3.15 per share.

However, we observe that higher cost of revenues kept the margins under pressure during the last reported quarter. Rent-A-Center’s gross profit margin shrunk 160 basis points to 70.2%. Cost of rentals and fees rose 11.2%, whereas cost of merchandise sold grew 10%. Operating profit margin also contracted 10 basis points to 9.2%.

Going forward, the sluggish economic recovery and a fragile job market may make customers reluctant to enter new rental-purchase deals. Moreover, Rent-A-Center’s business is seasonal in nature and typically generates stronger sales during the first quarter characterized by federal income tax refunds, which are used by the company’s customers to exercise early purchase option on existing rental agreements.

As a result, we have maintained our Neutral recommendation on the stock with a target price of $36.00. Moreover, Rent-A-Center holds a Zacks #3 Rank that translates into a short-term ‘Hold’ rating.