TEXT-S&P raises Rent-A-Center to 'BB+'
Overview -- North American rent-to-own retailer Rent-A-Center has demonstrated the willingness and ability to maintain credit ratios within levels indicative of an "intermediate" financial risk profile. -- We are raising the corporate credit rating to 'BB+' following our upward revision of the company's financial risk profile to intermediate from "significant." -- The stable outlook reflects our expectation for the company to maintain credit ratios indicative of an intermediate financial risk profile and for the company's business risk profile to remain "fair" for at least the next two years. Rating Action On Oct. 11, 2012, Standard & Poor's Ratings Services raised its corporate credit rating on Plano, Texas-based rent-to-own retailer Rent-A-Center Inc. to 'BB+' from 'BB'. The outlook is stable. At the same time, we raised our issue-level rating on the company's $300 million 6.625% senior notes to 'BB' (one notch below the corporate credit rating) from 'BB-'. The recovery rating remains '5', indicating our expectation of modest (10% to 30%) recovery for noteholders in the event of a payment default or bankruptcy. Rationale The rating action reflects Standard & Poor's expectation that the company has both the willingness and ability to maintain credit ratios indicative of an intermediate financial risk profile. We continue to view the company's business risk profile as fair. The ratings on Rent-A-Center reflect Standard & Poor's analysis that the company's business risk profile will remain fair for at least the next two years, based on the company's meaningful presence in the U.S., ongoing geographic expansion in Mexico, and recent channel expansion with RAC Acceptance. We believe the company continues to lack a meaningful international presence and it remains vulnerable to potentially increasing consumer finance protection regulations in the U.S. We have revised the company's financial risk profile upward to intermediate from significant, principally because we forecast the company can sustain credit ratios within the range indicative of an intermediate financial risk profile. A key aspect of our forecast includes the assumption that financial policies will remain moderate, meaning dividends, share repurchases, and potential acquisitions will be funded with internally generated cash flows. Our forecast for key credit ratios through the end of 2013 is as follows: -- Lease-adjusted debt to EBITDA reaching 2.7x by the end of 2012 and 2.6x by the end of 2013. As of June 30, 2012, we calculate leverage was 2.8x. -- Funds from operations (FFO) to total debt reaching 39% by the end of 2012 and 41% by the end of 2013. As of June 30, 2012, we calculate FFO to total debt was 37%. -- Debt to capital remaining at 46% at the end of 2012 and reaching 44% by the end of 2013. As of June 30, 2012, we calculate adjusted debt to capital was 46%. Financial ratios indicative of an intermediate financial risk profile include leverage between 2x and 3x, FFO to total debt between 30% and 45%, and debt to capital between 35% and 45%. Standard & Poor's economists believe the risk of another U.S. recession during the next 12 months is between 20% and 25%. We expect GDP growth of just 2.2% this year and only 1.8% in 2013, consumer spending growth of between 2.0% and 2.3% per year through 2013, and the unemployment rate remaining at or above 8% through late 2013 (see "U.S. Economic Forecast: He's Buying A Stairway To Heaven," published Sept. 21, 2012, on RatingsDirect). Considering these economic forecast items, our base-case forecast for the company's operating performance over the next two years is as follows: -- Revenue growth in the high-single digit percent area, supported by RAC Acceptance kiosk growth and international expansion in Mexico and, to a lesser extent, Canada. -- Gross margin (excluding depreciation and amortization) declines by about 50 basis points (bps) to about 17.5%, as the company further grows its lower-margin RAC Acceptance business and new stores in Mexico take time to reach their full potential. -- Selling, general, and administrative (SG&A) expense growth no longer outpaces revenue growth. This trend began in early 2012 and we expect it to continue, largely because the RAC Acceptance business requires less SG&A. -- EBITDA margin declines versus the prior year and settles between 14% and 15%. -- Debt reduction is limited to the contractual amortization of $25 million per year under the term loan. We view the company's financial risk policies as moderate. Significant debt reduction has occurred since 2006, though the rate of decline has slowed since 2009 and we believe accelerated debt reduction is unlikely to resume for the foreseeable future. The company instituted a regular cash dividend during the third quarter of 2010; we forecast cash dividends of about $40 million per year. We believe the company will fund dividends, share repurchases, and potential acquisitions with discretionary cash flows. The company's primary focus on rent-to-own transactions is a key ratings risk factor, especially with nearly all of its stores in the U.S. and the potential for U.S. regulation to hurt the rent-to-own retail business model. Current U.S. regulation focuses on strengthening consumer finance protection regulations. Increased consumer finance protection regulations on rental purchase transactions could require the company to alter its business practices in a manner that impairs performance. For example, regulatory changes could involve areas such as customer disclosure, rental terms, grace periods, and pricing caps. At this time, it is difficult to quantify the potential negative impact, though the lingering issue will constrain the business risk profile for the foreseeable future. We believe the company's RAC Acceptance business and international expansion will be key growth drivers. Management estimates the company's RAC Acceptance kiosks will increase to 950 by the end of 2012. As of June 30, 2012, there were 811 RAC Acceptance kiosks in service, up from 750 at the beginning of the year. International expansion is likely to accelerate, in part because growth prospects in the U.S. rent-to-own industry are becoming more limited as the industry matures. The company is focusing on Mexico--with 67 stores open as of June 30, 2012--and, to a lesser extent Canada, with 32 stores open as of June 30, 2012. Establishing a meaningful presence outside the U.S. could be one catalyst for a higher business risk profile, because it would reduce the company's vulnerability to changes in U.S. regulations and it would increase the company's long-term growth prospects. We believe it will take considerable time for the company to build a meaningful presence outside the U.S., given the rent-to-own industry's limited existence in most international markets. Liquidity We view the company's liquidity as "adequate." We expect the company's cash sources to exceed its cash uses over the next 24 months. Our assessment of the company's liquidity profile includes the following expectations, assumptions, and factors: -- We forecast cash sources will exceed cash uses by more than 1.2x over the next 12 months and will remain positive over the next 24 months. -- We forecast net sources would remain positive, even if EBITDA were to decline 15%. -- We forecast covenant cushion should remain sufficient. -- Contractual debt amortization is manageable, at $25 million per year. -- Debt maturities are favorable, with the revolving credit facility and term loan due in 2016 and the senior notes due in 2020. As of June 30, 2012, we calculate total liquidity was about $360 million, which included revolver availability of about $260 million. Over the past eight quarters, average revolver availability was near $237 million, and fluctuated between $180 million and $280 million during this time. We expect this pattern to continue. We forecast free cash flow of about $100 million in 2012 and about $130 million in 2013, which incorporates our expectation for capital expenditures to remain near $100 million per year. We assume share repurchases, dividends, and potential acquisitions consume the majority of discretionary cash flow. Recovery analysis For the complete recovery analysis, please see the recovery report on Rent-A-Center Inc., to be published on RatingsDirect following this report. Outlook The outlook is stable, reflecting our expectation for the company to maintain credit ratios indicative of an intermediate financial risk profile and for the company's business risk profile to remain fair for at least the next two years. We could lower our ratings if the company is unable, through weaker operating performance, or unwilling, through debt-financed share repurchases or dividends, to maintain credit ratios indicative of an intermediate financial risk profile, which includes leverage sustained below 3x. Based on second-quarter financial results, an EBITDA decline of between 7% and 7.5% or a debt increase of nearly $100 million would cause leverage to increase to 3.0x. It is unlikely we will raise our ratings within the next two years, because we believe the company's business risk profile will remain fair for that time. The company's ability to replicate the success of its U.S.-based business model in other countries would improve its geographic diversity, which could be a catalyst for a higher business risk profile. We believe it will take a considerable amount of time for the company to build similar scale in an international market. Related Criteria And Research -- Business Risk/Financial Risk Matrix Expanded, Sept. 18, 2012 -- Liquidity Descriptors For Global Corporate Issuers, Sept. 28, 2011 -- 2008 Corporate Criteria: Analytical Methodology, April 15, 2008 -- 2008 Corporate Ratings Criteria: Ratios And Adjustments, April 15, 2008 Ratings List Ratings Raised; Recovery Rating Unchanged To From Rent-A-Center Inc. Corporate Credit Rating BB+/Stable/-- BB/Stable/-- Senior Unsecured BB BB- Recovery Rating 5 5
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