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Two retail stocks for a recession

In hard times, rent-to-own chains are already built for customers who are short on cash.

By Eugenia Levenson, writer-reporter
Last Updated: January 20, 2009: 10:05 AM ET

NEW YORK (Fortune) -- From mall mainstays to luxury department stores, retailers are reeling as consumers put away their credit cards and curb household spending. But there is one corner of the industry that's less vulnerable to the slowdown: rent-to-own chains.

For one, these stores - which lease furniture, electronics, and appliances through weekly or monthly contracts - are already in the business of catering to consumers who are tight on cash.

"The customer base they serve doesn't really boom and bust like the general economy," says Stifel Nicolaus analyst John Baugh. "This customer lives in a constant recession."

And thanks to their recession-friendly policies - no credit checks and flexible, short-term transactions - chain operators like Aaron Rents (RNT) and Rent-a-Center (RCII) can expect to see that customer base grow in downturns. Consumers with ruined credit or those on a tightening budget can still pick up a high-definition television or sofa set for a fraction of the price, then return it if they are short on cash the next pay period.

That flexibility turns out to have another advantage: Rent-to-own chains have relatively low rates of late and non-payment. And when credit is tight, these stores become an increasingly attractive alternative to the big box retailers.

"In tougher times, the market for rent-to-own expands," says analyst Arvind Bhatia at Sterne Agee & Leach. "People can rent these products with no obligation at all. When your life is uncertain, when your job is uncertain, this gives you the option to rent something on a short-term basis."

The market hasn't missed this advantage. Over the last year, Aaron's stock returned 77%, while Rent-a-Center gained 30%. Still, analysts say Rent-A-Center, which is the industry's biggest operator with over 3,000 locations, remains undervalued at about eight times 2009 projected earnings.

"Rent-a-Center is trading at a 20% discount to the market, whereas Aaron's is trading at a 40% premium," says Bhatia, who recently downgraded Aaron to a "hold" but maintains a "buy" rating on Rent-A-Center with a $17 price target.

With a smaller footprint of about 1,500 stores, Aaron serves a slightly more affluent customer base that prefers monthly rentals to weekly contracts. Bhatia points out that Rent-A-Center's customers are more sensitive to spikes in fuel costs, one of the reasons the chain lagged its competitor last year but should benefit in 2009 if low gas prices persist.

"They ran into some headwinds because of gasoline, and lower-end consumers dropped off faster then they gained upper-end consumers," he says. "That trend seems to have stemmed, and we think it's likely that over the next three to six months, Rent-A-Center will start to catch up."

Fund manager Neil Hennessy bought Rent-A-Center roughly six months ago when the stock was trading in the low $20s, as part of an annual rebalance for his Hennessy Focus 30 fund.

The fund, which has thirty holdings, screens 10,000 mid-cap U.S. stocks for the best combination of value and momentum. Since the stock has dropped in the last few months, it wouldn't pass Hennessy's momentum screen today - but he says it's still a great bargain.

"We don't pay more than $1.50 for a $1 in sales, and today you can buy Rent-A-Center for $0.37 for a $1 in revenue," says Hennessy. "We're in a slow economy, but people still watch TV - they might just have to rent it."

Not that Rent-A-Center is completely impervious to a deeper recession. Even if gas prices stay low, a sharp spike in unemployment remains a looming threat.

"While this customer doesn't need a credit score to get merchandise, they do need a source of income," says Stifel Nicolaus's Bough, who rates the stock a "buy" with a $19 price target. "I always describe this industry as recession-resistant, not recession-proof." To top of page

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