Hedge Funds Seem to Love Aaron’s, Inc. (AAN)

Buying stocks alongside activist investors can be a profitable strategy. Hedge funds with an activist bent attempt to build large stakes in cheap companies that are mismanaged, have excessive cost structures or are otherwise not earning to their full potential, in order to gain a seat on the board of directors. The ultimate goal of these investors is to affect change at the company that will lead to a higher stock price. As these changes are implemented, passive investors can participate in the upside.

Aaron’s, Inc. (NYSE:AAN) was a popular pick among hedge fund managers during the fourth quarter of 2013, with Ric Dillon of Diamond Hill Capital, Mario Gabelli of GAMCO Investors and Robert Rodriguez and Steven Romick of First Pacific Advisors LLC increasing their holdings. Other shareholders of the retailer include Mark Travis Intrepid Capital Management, Thomas Claugus‘ GMT Capital and Citadel Investment Group, managed by Ken Griffin.

CITADEL INVESTMENT GROUP

Aaron’s, Inc. (NYSE:AAN) is a $2.3 billion market cap company that engages in the lease ownership, lease and retail sale of consumer electronics, computers, residential furniture, household appliances and accessories. It has more than 2,000 company-operated and franchised stores in 48 U.S. states and Canada. The company also manufactures the majority of the furniture it leases and sells. Aaron’s customer base is mainly low-to-middle income consumers, who are struggling in a difficult economic environment.

The stock has had a rollercoaster ride recently, as disappointing fourth quarter results and 2014 guidance in mid-January 2014 caused a 7% price decline. In February, Aaron’s, Inc. (NYSE:AAN) received a $2.3 billion unsolicited bid (or $30.50 per share) for the entire company from private equity firm Vintage Capital Management LLC - its second largest shareholder with a 9.5% stake. The stock recovered all of its prior month losses and continued to rally through March, when Vintage disclosed the possibility of a high bid as well as plans to nominate five candidates to the rent-to-own retailer’s board, which currently has nine members (this is on top of four candidates nominated by activist investor Jeffrey Smith of Starboard Value LP). At the same time, Aaron’s announced it would conduct a broad review of potential options for the company, including Vintage’s bid.

Since its trough in January, the stock has appreciated by 18% in two months. Despite this impressive performance, Aaron’s, Inc. (NYSE:AAN)’s valuation is not too demanding, trading at forward P/E and EV/EBITDA multiples of 16.9X and 7.7X, respectively, in line with its peer group. From an earnings standpoint, recent results were not pretty and growth has been below average but the retailer’s margins are in-line with peers. In addition, Aaron’s has a healthy balance sheet and superior free cash flow generation, a portion of which it returns to shareholders regularly through dividends and share repurchases.

With the shares trading above Vintage’s initial bid of $30.50, the market is expecting a higher bid to emerge, either from Vintage or another party (among competitors, a possible suitor could be Rent-A-Center Inc. (NASDAQ:RCII), who operates a similar rent-to-own business model). Given the speed in which recent events transpired with Vintage, along with the presence of another activist investor, Starboard, there is a high likelihood that some sort of deal gets consummated in the near future.

Disclosure: none

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