RAINBOW RENTALS INC, 10-K, 1999-03-31

RAINBOW RENTALS INC
10-K, 1999-03-31
EQUIPMENT RENTAL & LEASING, NEC

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
------------------------------------
FORM 10-K
(Mark One)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934

For the Fiscal Year ended: December 31, 1998

[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934 (No Fee Required)

For the transition period from to .

Commission File No. 0-24333

RAINBOW RENTALS, INC.
(Exact name of Registrant as specified in its charter)

<TABLE>
<S> <C>
OHIO 34-1512520
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
</TABLE>

3711 STARR CENTRE DRIVE
CANFIELD, OHIO 44406
(Address of principal executive offices)
(Zip Code)

330-533-5363
(Registrant's telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:

<TABLE>
<S> <C>
TITLE OF EACH CLASS NAME OF EACH EXCHANGE ON WHICH REGISTERED
None Not Applicable
</TABLE>

Securities registered pursuant to Section 12(g) of the Act:

COMMON STOCK, NO PAR VALUE
(Title of Class)

Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or such shorter period that the registrant
was required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. [X] Yes [ ] No

Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of the registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [ ]

The aggregate market value of voting stock held by nonaffiliates of the
Registrant was approximately $25,203,750 at March 23, 1999. The number of common
shares outstanding at March 23, 1999 was 5,925,735.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the registrant's definitive Proxy Statement to be mailed to
shareholders in connection with the registrant's 1999 Annual Meeting of
Shareholders are incorporated by reference into Part III, Items 10-13.
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RAINBOW RENTALS, INC.
INDEX

<TABLE>
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PAGE
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<S> <C> <C>
PART I
Item 1. Business.................................................... 1
Item 2. Properties.................................................. 12
Item 3. Legal Proceedings........................................... 13
Item 4. Submission of Matters to a Vote of Security Holders......... 13
Item 4a. Directors and Executive Officers............................ 13

PART II
Item 5. Market for Registrant's Common Stock and Related Stockholder
Matters..................................................... 14
Item 6. Selected Financial Data..................................... 15
Item 7. Management's Discussion and Analysis of Financial Condition
and Results of Operations................................... 16
Item 8. Financial Statements and Supplementary Data................. 23
Item 9. Changes and Disagreements with Accountants on Accounting and
Financial Disclosure........................................ 23

PART III
Item 10. Directors and Executive Officers of the Company............. 23
Item 11. Executive Compensation...................................... 23
Item 12. Security Ownership of Certain Beneficial Owners and
Management.................................................. 23
Item 13. Certain Relationships and Related Transactions.............. 23

PART IV
Item 14. Exhibits, Financial Statement Schedules and Reports on Form
8-K......................................................... 23
</TABLE>

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PART I

ITEM 1. BUSINESS

GENERAL

The Company currently operates 84 rental-purchase stores under the Rainbow
Rentals trade name in Connecticut, Massachusetts, Michigan, New York, Ohio,
Pennsylvania, Rhode Island and Tennessee. The Company offers quality, name
brand, durable merchandise, including home electronics, furniture, appliances
and computers. Generally, rental-purchase merchandise is rented to individuals
under flexible agreements that allow customers to own the merchandise after
making a specified number of rental payments (ranging from 12 to 24 months).
Customers have the option to return the merchandise at any time without further
obligation and also have the option to purchase the merchandise at any time
during the rental term.

On June 5, 1998, the Company completed its initial public offering of
2,250,000 shares of common stock, without par value, at $10 per share. The net
proceeds of approximately $20.2 million were used to retire approximately $10.9
million of indebtedness due a former shareholder-officer and his affiliates. The
balance of the net proceeds was used to reduce borrowings with a lending
institution.

The Company completed 1998 with 70 stores, including eight stores opened
and one acquired during the year. On February 1, 1999, the Company completed the
purchase from Rental Mart of PA, Inc. ("Rental Mart") the assets of four stores
located in Ohio and Pennsylvania for approximately $1.3 million in cash. Rental
Mart had annual revenues of approximately $1.7 million in 1998. Immediately
following the acquisition, three of the stores were consolidated into existing
Company locations. During February the Company also opened a new store in a new
market in Chattanooga, Tennessee.

On March 1, 1999, the Company completed the purchase from Blue Ribbon
Rentals, Inc. and Blue Ribbon Rentals II, Inc. ("Blue Ribbon") the assets of 15
stores located in Ohio and Pennsylvania for approximately $10.4 million in cash.
Blue Ribbon had annual revenues of approximately $10.1 million in 1998.
Following the acquisition two stores were consolidated into existing Company
locations and the remaining store acquired in the Rental Mart acquisition was
consolidated into one of the newly acquired Blue Ribbon locations.

INDUSTRY OVERVIEW

The Association of Progressive Rental Organizations (APRO), the industry's
trade association, estimated that the rental-purchase industry generated $4.4
billion in revenues and that there were over 2.9 million customers in 1997. The
rental-purchase industry is highly fragmented. APRO estimated that there were
approximately 7,500 stores in operation at December 31, 1997 with a majority of
companies owning fewer than 20 stores and servicing small geographic areas.
Management believes the rental-purchase industry's potential market is under-
penetrated.

The industry continues to experience increased consolidation characterized
by multi-store companies gaining market share, primarily through acquisition
and, to a lesser extent, through internal growth, at the expense of smaller,
often highly leveraged, companies. In recent months the industry has seen a new
wave of consolidation among the large publicly traded consolidators. In two
recent transactions, four of the largest publicly traded companies in the
industry have combined to become the two largest companies in the industry
owning approximately 44% of the total rental-purchase stores in operation. The
Company believes that growth will be concentrated in those national or regional
chains that are well-capitalized, with access to bank or other institutional
lenders and, in some instances, the public capital markets. Management believes
the recent trend of consolidation will subside in the near future as the number
of acquisition targets declines, and as a result, industry growth will
predominately occur through new store openings.

The rental-purchase industry provides an alternative to traditional retail
installment sales, appealing to individuals with poor or limited credit
histories and to individuals with an aversion to debt. Rental-purchase programs
permit customers to have immediate possession of products without the assumption
of debt. In addition, the industry serves customers having short-term needs or
seeking to try products, like computers, before committing to purchase them.
Rental-purchase transactions generally include delivery and pick-up service and
a

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repair warranty for the rental term. Most rental-purchase transactions are made
on a week-to-week or month-to-month basis and provide customers with the
opportunity for outright ownership if the merchandise is rented for a continuous
term, generally 12 to 24 months. Customers may cancel agreements at any time
without further obligation by returning the merchandise or requesting its
pick-up by the store. Returned merchandise is held for re-rental or sale. Rental
renewal payments are generally made in person, in cash or by check, money order
or credit card.

Companies in the rental-purchase industry generally market to customers
with income at or below the median family income level. According to U.S. Census
Bureau data, the median family income in was approximately $34,000. Management
believes that the majority of rental-purchase customers are wage-earners.

OPERATING STRATEGY

The Company's operating strategy is to maintain a high Average Monthly
Rental Rate (AMRR) on its agreements, a high number of rental-purchase
agreements per store and a high level of customer referrals and repeat business,
all accompanied by a low level of delinquencies. The Company seeks to achieve
these objectives by applying the following operating techniques:

Store Environment. The Company believes it is essential that its
stores appeal to its customers and convey a sense of convenience, quality
and safety. Company stores are generally located on main arteries, near
residential or commercial areas and in strip shopping centers near national
discount retailers or grocery stores. The Company generally maintains a
uniform store size, color scheme, store layout and display signs. The
Company's parking areas and storefronts are well lighted. Stores are
intended to provide an appealing retail environment and are modeled to
resemble a quality electronics and furniture showroom. The Company believes
that the appearance and location of its stores are important factors in
attracting and retaining customers.

Quality Merchandise. The Company's merchandising strategy, "More,
Better, Different," is guided by its philosophy of providing its customers
with quality, name brand, durable merchandise. The Company believes this
type of merchandise attracts customers due to brand awareness and generates
excitement by providing customers the opportunity to rent nationally
recognized merchandise with popular features. Better quality merchandise
generally is more durable in the customers' homes, withstands multiple
pickups and deliveries and results in fewer service problems for the
Company. The Company's decision to rent quality, name brand, durable
merchandise has been instrumental in its ability to secure a high AMRR on
its agreements.

Customer Service. The Company's customer service policy is to treat
all customers with "Respect and Dignity." The Company strives to
distinguish itself from its competitors through its commitment to customer
service and professionalism at every stage of the rental process. Customers
are able to initiate transactions and obtain merchandise without visiting a
Company store by calling the Company's toll-free telephone number and
providing the necessary information over the telephone. The Company employs
bilingual associates in many of its stores who are able to facilitate
transactions in Spanish. Company associates deliver the merchandise to the
customers' homes. The Company imposes few fees in addition to the monthly
rental rate. As a result, its customers are able to afford higher quality
merchandise with additional features and benefits. The Company operates a
toll-free customer response line during business hours to address any
customer concerns. In addition, the Company operates product service
centers in most regions to service its products and strives to respond to
service requests the next business day after a call. The Company believes
its tactic of offering personal customer service minimizes delinquencies
and losses and maximizes its repeat and referral business.

Experienced Associates. The Company's operations and profitability
are largely dependent on the services of its executive officers, senior
management and store level personnel (collectively, the "associates"). The
Company's founding executive officers have worked in the rental-purchase
industry for an average of over 19 years and co-founded the Company in
1986. The Company's regional managers and store managers also have
extensive experience in the industry and have worked with the Company for
an average of approximately twelve years and seven years, respectively. The
Company has been able to attract and
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retain its quality associates through compensation and benefits that exceed
industry averages and through various ongoing proprietary training
programs. Management believes its associate development programs enhance
the Company's operations by ensuring conformity to established operating
standards, reducing associate turnover, enhancing associate productivity
and improving associate morale.

Decentralized Management. The Company's decentralized entrepreneurial
approach provides store managers with a significant degree of autonomy and
accountability. Within guidelines set by the Company, store managers are
responsible for: (i) managing the development of customer relationships,
the service and collection of accounts, store inventory and growth of
number of rental-purchase agreements in their store; and (ii) monitoring
store-level financial statements. Performance goals are established for
each store and each store manager's incentive compensation is tied to the
pre-tax operating earnings of the store (after certain corporate
allocations). Store managers, therefore, operate much as "owners" of their
own small businesses. Management believes this decentralized operational
structure results in better customer service, enhances personal knowledge
of local market conditions and improves collection rates because
collections are handled through direct contact with customers. The Company
supports its decentralized structure with strong management information
systems, internal audit procedures, operating guidelines and experienced
associates.

Management Information Systems. The Company utilizes a flexible,
proprietary, Windows NT-based management information system to support its
rental activities, to assist in compliance with applicable laws and
regulations and to monitor its decentralized store network. This system
provides store managers with relevant store-level financial and operating
data. In addition, this system provides individual profiles on each of the
stores' customers, enabling managers to focus their marketing efforts on a
localized and individualized basis. The Company's senior management has
immediate access to data from the management information systems that
provides them with the ability to analyze performance indicators at the
store and corporate level on a daily basis. Management believes the
Company's information system is scalable and will support the Company's
growth plan.

GROWTH STRATEGY

The Company's growth strategy is to continue to accelerate its new store
opening program and to increase comparable store revenue and profitability. In
addition, the Company will, to a lesser extent, make opportunistic acquisitions.

New Store Openings. Beginning with six stores in 1986, the Company
opened 60 additional stores through March 31, 1999 and has developed a
consistent, replicable model for opening new stores. The Company believes
the rental-purchase market is significantly under-penetrated and provides
substantial new store expansion potential. The Company currently plans to
continue opening new stores in current and new markets within the Midwest,
Mid-Atlantic and New England states. In investigating a new market, the
Company reviews demographic statistics, cost of advertising and the number
and nature of competitors. The Company believes its model for opening new
stores has resulted in more predictable growth and greater operational
control than is typically achieved through acquisitions. Because the
Company's growth strategy emphasizes internal growth primarily through new
store openings and, only to a lesser extent, through acquisitions,
management believes the state of the industry presents an opportunity for
the Company to capitalize on its demonstrated ability to open new stores.

Increase Comparable Store Revenue and Profitability. The Company
continually strives to increase revenue per store by enhancing individual
store operations and offering a new and different product selection. The
Company has demonstrated an ability to recognize increasing customer demand
for products and to provide such products. For example, the Company
recognized its customers' desire for computers and has developed an
effective strategy to meet this demand. Accordingly, computers have become
a significant percentage of the Company's overall revenues. In addition,
the Company is able to achieve increased profitability by leveraging its
stores' fixed costs, such as advertising and purchasing, over the higher
revenues generated by existing stores and by placing new stores in existing
markets.

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Acquisitions. While the majority of the Company's growth is expected
to come from opening new stores, the Company also may make fill-in
acquisitions on an opportunistic basis and purchase agreements from
competitors exiting the business or a particular geographic area. During
the first quarter of 1999, the Company was in a position to capitalize on
the "opportunistic acquisition" segment of its growth strategy. With the
industry's two major consolidators focusing their attention on recently
completed transactions, combined with the Company's high capital
availability, the Company acquired the assets of nineteen rental-purchase
stores from two competitors in Ohio and Pennsylvania. The Company believes
it will continue to have the opportunity to consummate more acquisitions
due, in part, to potential store overlap among consolidating competitors.

STORES

Currently, the Company operated 84 stores in eight states, as set forth in
the following table.

<TABLE>
<CAPTION>
LOCATION NUMBER OF STORES
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<S> <C>
Pennsylvania.............................................. 23
Ohio...................................................... 26
Massachusetts............................................. 10
Tennessee................................................. 7
Michigan.................................................. 6
New York.................................................. 5
Connecticut............................................... 5
Rhode Island.............................................. 2
</TABLE>

The following table sets forth the number of stores opened, acquired and
consolidated or closed since the Company commenced operations in 1986. Several
stores have been enlarged or relocated.
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
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1986 1987 1988 1989 1990 1991 1992 1993 1994
---- ---- ---- ---- ---- ---- ---- ---- ----
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Stores open at beginning of period.... 0 6 15 20 24 28 36 38 42
Stores opened......................... 6 9 5 4 4 8 2 4 4
Stores acquired....................... 0 0 0 0 0 0 0 0 0
Stores consolidated/closed............ 0 0 0 0 0 0 0 0 0
--- --- --- --- --- --- --- --- ---
Stores open at end of period.......... 6 15 20 24 28 36 38 42 46
=== === === === === === === === ===

<CAPTION>
YEAR ENDED DECEMBER 31,
------------------------------- APRIL
1995 1996 1997 1998 1999
---- ---- ---- ---- -----
<S> <C> <C> <C> <C> <C>
Stores open at beginning of period.... 46 51 55 62 70
Stores opened......................... 0 4 7 8 1
Stores acquired....................... 7* 0 0 1 13**
Stores consolidated/closed............ 2 0 0 1 0
--- --- --- --- ---
Stores open at end of period.......... 51 55 62 70 84
=== === === === ===
</TABLE>

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* The Company acquired ten stores and immediately consolidated three into
existing Company stores.

** The Company acquired four Rental Mart stores and fifteen Blue Ribbon stores
and consolidated six into existing Company stores.

The Company focuses on internal growth by opening new stores. In
investigating a new market, the Company reviews demographic statistics, cost of
advertising and the number and nature of competitors. In addition, the Company
investigates the regulatory environment of the state in which the new market
exists. It is the Company's policy to operate only in those states where there
is an absence of unfavorable legislation regarding rental-purchase transactions.
The Company has developed a number of criteria that are reviewed prior to
choosing a new store location. These criteria include, among others: proximity
to national discount retailers or grocery stores, shopping patterns, traffic
patterns, accessibility, availability of personnel and proximity to the
Company's other stores. The Company seeks to locate its stores on main arteries
near residential or commercial areas in strip shopping centers containing
national discount retailers or grocery stores. In general, the strip shopping
centers in which the Company's stores are located contain large storefronts on
street level. This enables potential customers to view and recognize the
Company's stores from the street, which the Company believes, results in
increased recognition of the Company's name.

The most critical step in the selection of a new store location is a site
inspection by senior management. Once the Company's senior management selects a
market for a new store, a senior manager investigates a number

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of potential store locations. The Company's construction manager accompanies a
senior manager to several of the most promising store locations to evaluate the
construction cost of a particular location and to design the layout of the
store.

In order to enhance the early profitability of its new stores, the Company
employs a "new store" supervisor whose sole responsibility is to manage and
address issues inherent in new store operations. This supervisor assists new
store managers in developing customer relationships, monitoring store financial
statements and increasing the number of agreements. Generally, within two years
after a store is opened, the store formally joins its geographic region and the
regional manager of that particular geographic region assumes oversight of the
store.

The Company has developed a new store format that it utilizes in all new
stores. Existing stores are refurbished consistent with this new store format,
as necessary. Existing stores are typically remodeled every five years. With
this new store format, the Company has modified the store layout by placing the
counter near the center of the store to facilitate visibility of the
merchandise, by positioning computers close to the counter and ready for
customer use, by improving store lighting to enhance in-store viewing of the
merchandise and by adding interior graphics, including lithograph images,
containing the Company name and product categories. At December 31, 1998, the
Company's rental-purchase stores averaged approximately 4,300 square feet.

MERCHANDISE

The Company's merchandising strategy is to carry a wide variety of quality,
name brand, durable merchandise in four major categories, including home
electronics, furniture, appliances and computers. Store managers may order
merchandise from the Company's authorized product and vendor list, which
contains approximately 500 products, with a variety of models and styles.
Choices of merchandise reflect the Company's belief that customers want to rent
the same quality of merchandise that is available from more traditional
retailers, and that customers are willing to pay for value and quality. In
addition, by focusing on its manufacturers' mid-point and better range products,
the Company avoids frequent service problems associated with inferior products.
The Company purchases merchandise directly from the manufacturers and through
distributors generally through volume price discounts.

For the year ended December 31, 1998, revenues generated under
rental-purchase agreements for home electronics accounted for approximately
34.9%, furniture accounted for 29.8%, appliances accounted for 19.9%, and
computers accounted for 15.4% of the Company's rental revenues. Customers may
request either new merchandise or previously rented merchandise. Weekly rentals
currently range from $7.99 to $41.99 for home electronics, from $2.99 to $43.99
for furniture, from $5.99 to $28.99 for appliances and from $19.99 to $37.99 for
computers. Previously rented merchandise is typically offered at the same weekly
or monthly rental rate as is offered for new merchandise, but with an
opportunity to obtain ownership of the merchandise after fewer rental payments.

STORE OPERATIONS

A typical mature store has a store manager, an assistant manager, two or
three account managers, one or more full or part-time clerical staff associates
and may have a two-person delivery team. The store manager and assistant manager
are responsible for the operation of the store. Customers are assigned an
account manager who makes deliveries and monitors the accounts. The account
manager is responsible for securing timely rental renewal payments and will
pickup rental-purchase merchandise, as necessary. The clerical staff records
in-store and mail-in rental renewal payments, establishes and maintains customer
files and prepares reports as required by company operations. All stores are
open Monday through Saturday with evening hours on Friday.

Store managers are given the authority to make operating decisions and to
hire non-management store personnel. Most of a store's inventory is ordered by
the store's manager from the Company's authorized product and vendor list. Once
ordered, merchandise is drop-shipped directly to each store by the manufacturer
or distributor. The Company believes that the latitude granted to its store
managers is a key to individual store success. No approval by the Company's
senior management is required to order merchandise, except for non-stock items.
With respect to previously rented merchandise, individual store managers may
vary the number of months required for full ownership of such merchandise, but
generally not the rental rate. The Company has idle
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inventory standards that are closely monitored and designed to provide for
adequate display merchandise without building up excess inventory. In the case
of furniture, special delivery schedules have been obtained so that managers
have a designated delivery date. All of these factors help keep store inventory
as low as possible while maintaining sufficient quantities for store displays
and customer deliveries.

The Company believes open communication with store level management is
essential to understanding existing markets, increasing associate morale and
retaining associates. In order to facilitate open lines of communication, the
Company has formed a network of committees, a majority of whose members are
store managers. The Company currently has three committees to assist senior
management in areas of pricing, product selection, advertising and computer
operations. In addition, one committee, made up of top performing managers, acts
as a sounding board for new concepts and innovative operational and sales
techniques. Also, the Company holds store managers' meetings twice annually and
all store managers, regional managers, department heads and executive officers
are required to attend. Finally, to address regional-specific issues, senior
management regularly travels to the individual markets to meet with store
associates.

RECRUITING, RETENTION AND TRAINING OF ASSOCIATES

The rental-purchase industry is management intensive and the success of a
rental-purchase store is primarily the result of the store manager's
performance. In order to attract and retain quality personnel, the Company
endeavors to pay its associates more than the industry average and provides a
health benefits package paid entirely by the Company. The Company focuses on
promotions from within, and every Company associate has the opportunity to
advance due to the Company's growth. Excluding managers retained from acquired
stores, all current store managers began their careers with the Company as
account managers. The Company's managers (excluding managers from stores
acquired in 1999) have been employed by the Company for an average of
approximately seven years. In addition, the Company's five regional managers
have been employed by the Company for an average of approximately twelve years.
All associates are trained to provide a high level of personalized customer
service and to maintain a professional appearance. Because each customer has the
opportunity to terminate an agreement at any time, it is important that the
Company maintain a high degree of customer satisfaction.

In order to recruit quality personnel to staff existing and new stores, the
Company employs a personnel manager and several part-time associates whose
primary responsibility is to coordinate recruiting efforts within the Company's
markets. This individual gives presentations regarding Company career
opportunities at community colleges and other institutions, coordinates with the
career placement offices at the colleges and institutions, receives and reviews
resumes and conducts initial telephone interviews. If the personnel manager
believes a candidate is qualified for a position with the Company, the personnel
manager directs the candidate to the appropriate regional manager for additional
evaluation and interviews. This recruiting system has proven adequate to satisfy
the Company's on-going staffing requirements and has produced a sufficient
number of manager trainee candidates to staff the Company's planned growth.

The Company places great importance on training quality personnel. Store
manager candidates, all of whom are assistant managers who have worked for the
Company for at least six months, are nominated by their respective store
managers. In order to become a store manager, a candidate must be selected by
executive officers and senior management and must graduate from the management
training program conducted by executive officers and senior management. Classes
of candidates for store manager positions are generally comprised of 10 to 20
candidates, and the Company conducts two or three classes per year. The training
program is conducted over a six to twelve month period, during which time
candidates receive further experience as assistant managers and are frequently
tested on class materials. As manager opportunities arise, graduates of the
training program are assigned to their own stores.

After an associate becomes a store manager, the training continues. Twice
annually, the Company conducts a managers' meeting at a central location. All
store managers, regional managers, department heads and executive management of
the Company are required to attend. At such sessions, prior performance is
critiqued, operating procedures are reviewed and revised, new merchandise is
showcased and managers receive eight to 10 hours of classroom training in the
areas of financial management, product information, inventory management,
customer service, credit management and other areas of store operations.
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The Company's philosophy is to treat store managers much as "owners" of
their stores, and therefore the Company has always provided extensive
operational and financial information to store managers. At the end of each
year, store managers prepare projections for the upcoming year that must be
approved by executive officers and senior management. Each month actual results
are compared to projected results, and managers must be able to explain
significant discrepancies. Because nearly 50% of the compensation of the
managers of mature stores is based on profitability, store managers are
attentive to their store's financial statements and play an active role in the
analysis of store performance.

THE RENTAL PROCESS

MARKETING

The Company uses advertising to introduce and reinforce the benefits of its
rental-purchase program to existing and potential customers and to make such
customers aware of new products. The Company focuses on direct mail, radio and
television advertising that is designed to make existing and prospective
customers aware of special promotions and to encourage immediate customer
response. Substantially all of the design, production and placement of the
Company's advertising is performed by the Company's in-house advertising
department. The Company advertises in both English and Spanish, making the
Company's rental-purchase program and products accessible and understandable to
a wider range of customers. The Company currently operates in 22 different
advertising markets and seeks to cluster stores, where appropriate, to reach its
target markets efficiently. Many of the Company's vendors participate in a
co-operative advertising program and contribute a certain portion to the
Company's advertising costs.

Direct mail is used extensively because it allows the Company to target
specific zip codes near its stores' locations and those areas where potential
customers reside. The Company's advertising department creates color flyers to
use as direct mail, which show many products in a menu-like format. Television
and radio are used in more mature markets where the expense can be spread over a
number of stores. The Company's vehicles are adorned with the Company's
distinctive color decals, effectively becoming rolling billboards. In addition
to mass marketing, several direct marketing tools are employed to solicit the
Company's existing customer base. In addition, the Company has developed a
preferred customer program, directed at current and past customers. Under this
program, special promotions, including significant discounts and new product
offerings, are periodically run for these customers to encourage additional
rentals.

The Company attempts to remove as many obstacles as possible to the
completion of rental-purchase transactions. Customers are not required to visit
the store to initiate transactions. Most of the Company's advertisements,
whether direct mail, television or radio, encourage customers to "shop by phone"
and feature the Company's toll-free telephone number. When the toll-free number
is dialed, the call is automatically routed to the Company store closest to the
source of the call. Each product displayed in the Company's direct mailing piece
is numbered for easy reference during telephone orders. Store managers and sales
associates are trained to explain the rental-purchase program clearly and to
obtain orders over the telephone. Customers may give all information required by
the order form to a Company representative over the telephone, and once the
requisite approval is obtained, delivery is scheduled. The Company initiates a
significant number of its customer rental-purchase agreements over the
telephone.

APPROVAL

Although the Company does not conduct a formal credit review, the Company's
order approval process provides a mechanism for qualifying a customer. This
process is designed to verify a customer's stability in his or her community and
serves as a successful method of loss prevention. The Company's customer
qualification process consists of obtaining the customer's name, address,
landlord or mortgage holder, source of income and four personal references, two
of whom generally must be family members. Information is verified over the
telephone by store associates contacting the personal references and other
sources. Generally, the Company will verify employment and residence status.
Since merchandise is rented rather than purchased, the Company focuses on a
customer's credibility, not the customer's credit history. If a customer does
not pay promptly, the rental-purchase merchandise is simply returned or picked
up. The approval process is designed to take less than one hour.
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<PAGE> 10

THE RENTAL-PURCHASE AGREEMENT

The Company strives to make the rental-purchase transaction as simple and
as accessible as possible for the customer. This includes providing a complete
explanation of the entire rental-purchase program prior to delivery of the
rental merchandise. An agreement is intended to be straightforward and
understandable by a customer and includes the total amount required to be paid
for ownership of the merchandise, as well as all other required disclosures. The
Company's flexible rental payment program allows a customer to choose weekly,
biweekly, semi-monthly or monthly rentals. To facilitate timely renewal
payments, the Company attempts to match a customer's renewal payment schedule
with his or her wage or other income schedule. At the end of each rental period,
a customer will renew the agreement, terminate the agreement or purchase the
merchandise. If a customer elects to continue to rent the merchandise, the
customer pays the next period's rental. If a customer elects to terminate an
agreement, the Company will pick up the merchandise or the merchandise will be
returned by the customer and in either case, will be held by the Company for
re-rental. If a customer terminates a rental, but subsequently elects to re-rent
the same item or a similar item within a designated period of time, the customer
generally will be granted a reinstatement of the previously terminated
agreement. A customer may purchase a rented product at any time for a price
based on a predetermined formula.

During the term of an agreement, all service and repair is provided by the
Company or an authorized manufacturer's service representative at no additional
cost to the customer, unless damage is caused by the customer's misuse or abuse.
Most products are covered by manufacturers' warranties for varying periods. The
Company also provides service and repair for 90 days after the merchandise is
purchased by a customer.

The Company seeks to establish long-term relationships with its customers.
Accordingly, the Company does not require an application fee, nor does it charge
for delivery and set-up. The Company does not sell credit life, disability,
unemployment, or damage-waiver insurance. The Company charges only two fees: a
reinstatement fee if an agreement is terminated and then reinstated and a fee if
a Company associate is required to visit the customer's residence to collect a
rental renewal payment. By limiting the add-on fees charged, the Company enables
its customers to spend more of their rental renewal payment on the merchandise,
which, the Company believes, directly results in higher customer retention and
repeat and referral business. Rental income represented approximately 95% of the
Company's total revenues in 1998.

DELIVERY AND INSTALLATION

After an order is approved, it is assigned to an account manager. The
Company requires that, before merchandise is placed in a customer's residence,
the account manager or delivery team must ensure that the customer understands
all aspects of the agreement. Accordingly, the forms are explained in detail and
each section is initialed by a customer prior to his or her execution of the
rental-purchase agreement. The Company believes that a thorough understanding by
a customer of all the terms of the agreement is the first step of a successful
rental-purchase program. Merchandise is generally delivered by an account
manager or a delivery team on the same day that the order is approved, which is
generally the same day that the order is received. Deliveries are made in
vehicles that are leased new and regularly cleaned and maintained. All vehicles
have the Company's logo on the side in order to enhance name recognition in
local markets. Vehicles are generally retained for a period of not more than 36
months.

A delivery of home electronics, appliances or computers includes
installation by a Company associate enabling the customer to immediately enjoy
the benefits of the product. Account managers and delivery associates receive
extensive training on many aspects of the rental-purchase transaction, including
delivery and installation of products, explanation of agreements and customer
service throughout the rental term. Along with two weeks of on-the-job training,
all account managers and delivery associates are given a detailed "Customer
Management Manual" that they are expected to learn and refer to in the
performance of their duties. In addition, both account managers and store
managers are instructed to follow up with customers after delivery to ensure
they are satisfied with the merchandise and installation.

10
<PAGE> 11

CUSTOMER MANAGEMENT

Once a customer accepts delivery of merchandise, the next priority is
ensuring that the customer continues renting and makes all rental renewal
payments in a timely manner. The goal is to treat each customer with respect and
dignity because it is the Company's philosophy that "customers will pay you
because they want to, not because they have to." Most customers make rental
renewal payments in person. This affords the Company an opportunity to enhance
the customer relationship, while displaying merchandise for future rentals. A
customer pays in cash or by check, money order, or credit card.

A significant portion of all rental renewal payments are made without any
collection efforts by the Company. If rental renewal payments are not made on or
before the agreement renewal date, an account manager first contacts the
customer by telephone. If the initial telephone contact does not lead to renewal
or return of the merchandise, then the account manager makes a personal visit to
the customer. Company procedures require that all customer management efforts be
performed in a professional and courteous manner. Account managers receive
extensive training, and are expected to learn and refer to the "Customer
Management Manual" in the performance of their duties. In cases where the
customer chooses not to renew the agreement, the merchandise is returned to the
store and reconditioned for a subsequent re-rental. In cases where the customer
refuses to return the merchandise, the Company uses various legal methods to
recover the merchandise, including enlisting the personal references which were
obtained on the original order form.

MANAGEMENT INFORMATION SYSTEMS AND CONTROLS

The Company's proprietary computer software programs continue to be
upgraded and rewritten by the Company on an ongoing basis in order to meet the
Company's information needs and to conform with the Company's philosophy of
decentralization and customer management. The Windows NT operating system and
Company-wide Intranet provide management with timely operational and financial
information and flexibility. The Company's corporate headquarters operates under
a client-server platform, utilizes a proprietary Windows NT-based enterprise
software system and licenses its accounting software. In 1997, the Company
installed a Company-wide intranet which enables e-mail communication from the
corporate headquarters to the stores and between stores. The intranet also
allows for a fast and cost effective transfer of data from the stores to the
corporate headquarters on a daily basis. The Company believes that both its
store and corporate information systems will be able to meet its growth plans.

The Company's computer system maintains all standard agreements, and all
agreements are printed off the system on an as-needed basis at each store. The
Company has formatted all documents, including standard agreements, sales
material and collection material, to contain "customer-friendly" terminology. In
addition, when there is a change in state law, the Company can make timely
modifications on its system to the standard agreements in that particular state
and, since the Company does not pre-order its agreements but rather prints them
on an as-needed basis, the Company incurs minimal expense as a result of such
modification.

Customer renewal payments are made at or mailed to the individual stores.
Such payments are deposited nightly. A record of each transaction is transmitted
overnight to the corporate headquarters. Critical data, such as outstanding
agreements, idle inventory, revenue, expired agreements percentage and cash
receipts are available to management the following day on a store-by-store,
regional and an aggregate basis. Also, regional managers have remote access to
this data each morning by utilizing the Company's intranet.

On a daily, weekly and monthly basis, reports are generated that provide
critical information for each of the Company's products, a detailed accounting
of total rent due and collected and customer information. On a monthly basis,
store operating results are compared to each other and ranked on 10 critical
operating statistics and eight key financial indicators. Operational and profit
"Rating Sheets" are generated each month and year to date, store managers are
rated and annual awards are given to the top rated stores for each year. In
addition, stores are grouped by size and compared to their own group by nine
operational and financial statistics.

11
<PAGE> 12

COMPETITION

The Company competes with other national and regional rental-purchase
businesses, as well as rental stores that do not offer their customers a
purchase option. With respect to customers desiring to purchase merchandise for
cash or on credit, the Company competes with department stores, consumer
electronic stores and discount stores. Competition is based primarily on product
selection and availability, customer service and rental rates and terms. The
Company's three largest competitors, Rent-A-Center, Inc., Rent-Way, Inc., and
Aaron Rents, Inc., have significantly greater financial and operating resources
and name recognition than the Company.

PERSONNEL

As of March 31, 1999, the Company had approximately 750 associates,
including 510 full-time associates. Approximately 35 associates are located at
the Company's corporate headquarters in Canfield, Ohio. None of the Company's
associates is represented by a labor union. Management believes its relations
with its associates are good.

GOVERNMENT REGULATION

There are currently 46 states that have legislation regulating
rental-purchase transactions, all of which require operators to provide certain
disclosure to customers regarding the terms of rental-purchase transactions. Two
states (Minnesota and Wisconsin) regulate rental-purchase transactions as credit
sales subject to interest rate limitations and other consumer lending
restrictions. In addition, recent court decisions in New Jersey have created a
legal environment in that state which is prohibitive to rental-purchase
transactions. The Company does not operate in, nor does the Company intend to
operate in, any of these three states. All of the eight states in which the
Company operates impose certain contractual and advertising disclosure
requirements concerning the nature of rental-purchase transactions and also
provide varying levels of substantive consumer protection.

With some variations in individual states, most state legislation requires
the lessor to make prescribed disclosures to customers about agreements and
rental-purchase transactions. Such legislation also prescribes grace periods for
nonpayment and time periods during which customers may reinstate agreements,
prohibits or limits certain types of collection or other practices and, in some
instances, limits certain fees that may be charged. Some states, including
Michigan and Ohio, limit the total rental payments that can be charged. If the
Company opens or acquires new stores in states in which it does not currently
operate, the Company will become subject to the rental-purchase laws of such
states, if any. The Company operates its stores only in states that have enacted
laws specifically regulating rental-purchase transactions. This policy provides
the Company with a measure of certainty regarding its legal obligations to its
customers. There can be no assurance against the enactment of new or revised
rental-purchase laws that would have a material adverse effect on the Company.
No federal legislation has been enacted regulating or otherwise governing
rental-purchase transactions. The Company instructs its managers in procedures
required by applicable law through training seminars and policy manuals and
believes that it has operated in compliance with the requirements of applicable
law in all material respects. In addition, the Company provides its customers
with a toll-free number to telephone corporate headquarters to report any
irregularities in service or misconduct by its associates.

SERVICE MARKS

The Company owns the federally registered service marks "Rainbow Rentals"
and "Spectrum Rents." The Company believes that the Rainbow Rentals mark has
acquired significant market recognition and goodwill in the communities in which
its stores are located.

ITEM 2. PROPERTIES

The Company leases all of its stores under operating leases that expire at
various times through 2007. Store leases generally provide for fixed monthly
rental payments, plus payment for real estate taxes, insurance and common area
maintenance. Most of these leases contain renewal options for additional periods
ranging from three to five years at rates generally adjusted for increases in
the cost of living. There is no assurance that the Company can renew the leases
that do not contain renewal options, or that if it can renew them, that the
terms
12
<PAGE> 13

will be favorable to the Company. Store sizes range from approximately 2,450 to
6,200 square feet, and average approximately 4,300 square feet. Management
believes that suitable store space is generally available for lease and that the
Company would be able to relocate any of its stores without significant
difficulty should it be unable or unwilling to renew a particular lease.
Management also believes that additional store space is available to meet the
requirements of its new store opening program. The Company leases its corporate
office located at 3711 Starr Centre Drive, Canfield, Ohio from a company owned
by three of its executive officers (See "Related Party Transactions"). The
corporate office consists of approximately 10,000 square feet and is leased
through January 31, 2006. In 1998, the rental amount was $98,000. The Company
believes the rental is at market rate and the other provisions of the lease are
on terms no less favorable to the Company than could be obtained from unrelated
parties.

ITEM 3. LEGAL PROCEEDINGS

The Company is also subject to various legal proceedings and claims that
arise in the ordinary course of business. The Company believes that the amount
of any ultimate liability with respect to these actions will not have a material
adverse effect on the Company's liquidity or results of operations.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

None

ITEM 4A. DIRECTORS AND EXECUTIVE OFFICERS

The executive officers and directors of the Company and their ages as of
March 31, 1999 are as follows:

<TABLE>
<CAPTION>
NAME AGE POSITION
- ---- --- --------
<S> <C> <C>
Wayland J. Russell................... 47 Chairman of the Board of Directors and Chief Executive
Officer
Lawrence J. Hendricks................ 41 Chief Operating Officer and Director
Michael J. Viveiros.................. 43 President and Director
Michael A. Pecchia................... 38 Chief Financial Officer and Secretary
Brian L. Burton...................... 58 Director
Ivan J. Winfield..................... 64 Director
</TABLE>

WAYLAND J. RUSSELL, Chairman of the Board and Chief Executive Officer since
February 1997, having previously served as the Company's President since its
inception in 1986. Mr. Russell has served as a director of the Company since its
inception in 1986.

LAWRENCE S. HENDRICKS, Chief Operating Officer since February 1997, having
previously served as Vice President for Store Operations since the Company's
inception in 1986. Mr. Hendricks has served as a director of the Company since
its inception in 1986.

MICHAEL J. VIVEIROS, President since February 1997, having previously
served as Vice President since the Company's inception in 1986. Mr. Viveiros has
served as a director of the Company since its inception in 1986.

MICHAEL A. PECCHIA, Chief Financial Officer of the Company since February
1997, having previously served as the Company's Controller from 1991 -- 1996 and
Treasurer and Secretary since 1991. Mr. Pecchia also served as a director of the
Company from February 1997 to June 5, 1998.

BRIAN L. BURTON, President of Vertical Merchandising Systems, Inc., a
distributor of impulse merchandising systems to supermarkets, for over five
years. Mr. Burton has served as a director of the Company since June 1998. From
1987 to 1991 Mr. Burton was a private retail consultant. Prior thereto, Mr.
Burton was Chief Operating and Financial Officer of Fabri-Centers of America,
Inc., a publicly traded fabric and craft retailer.

IVAN J. WINFIELD. Mr. Winfield has served since September 1995 as an
Associate Professor at Baldwin-Wallace College, Cleveland, Ohio, and as a
business consultant. Prior thereto, Mr. Winfield was a Managing Partner of
Coopers & Lybrand from 1978 to 1994. He is a director of Boykin Lodging Co., HMI
Industries, Inc., International Total Services, Inc. and OfficeMax, Inc. Mr.
Winfield has served as a director of the Company since June 1998.
13
<PAGE> 14

PART II

ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS

The Company's common shares trade on the National Market of the Nasdaq
Stock Market, Inc. under the symbol "RBOW". The following table shows the high
and low closing sale prices of the common shares since the common shares began
trading publicly on June 5, 1998, as reported through December 31, 1998. The
price to the public in the initial public offering, which occurred on June 5,
1998, was $10.00 per share.

<TABLE>
<CAPTION>
COMMON SHARES
----------------
HIGH LOW
------ ------
<S> <C> <C>
Quarter ended June 30, 1998 (From June 5, 1998)............. 10.625 10.063
Quarter ended September 30, 1998............................ 10.875 9.125
Quarter ended December 31, 1998............................. 10.375 8.750
</TABLE>

As of March 23, 1999, the Company believed there were approximately 300
beneficial owners of the Company's common shares.

DIVIDEND POLICY

The Company has never paid cash dividends on its shares of common stock.
The Company currently intends to retain all earnings from its operations to
finance the growth and development of its business and, consequently, does not
expect to pay dividends on its shares of common stock in the foreseeable future.
The payment of future dividends will be at the sole discretion of the Company's
Board of Directors and will depend on, among other things, future earnings,
capital requirements, the general financial condition of the Company and general
business conditions. In addition, the payment of dividends by the Company is
limited by certain covenants in the Company's Credit Facility. See "Management's
Discussion and Analysis of Financial Condition and Results of
Operations -- Liquidity and Capital Resources."

14
<PAGE> 15

ITEM 6. SELECTED FINANCIAL DATA

The selected financial data presented below under the captions "Statement
of Income Data" and "Balance Sheet Data" for, and as of the end of, each of the
years in the five-year period ended December 31, 1998, are derived from the
consolidated financial statements of the Company. Effective as of the close of
business on December 31, 1994, the Company changed its method of depreciating
rental-purchase merchandise from the straight-line basis to the units of
activity method. Therefore, the financial information presented for 1994
reflects the Company's use of the straight-line basis and has not been restated
because such restatement was deemed impractical. As a result, certain financial
information for 1994 may not be comparable to later periods. The data presented
below should be read in conjunction with Management's Discussion and Analysis of
Financial Condition and Results of Operations, and the Consolidated Financial
Statements and the related notes thereto included elsewhere in this annual
report.

<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
-------------------------------------------------------------------
1998 1997 1996 1995 1994
----------- ----------- ----------- ----------- -----------
(DOLLARS IN THOUSANDS, EXCEPT SHARE AMOUNTS, PER SHARE AMOUNTS AND
OPERATING DATA)
<S> <C> <C> <C> <C> <C>
STATEMENT OF INCOME DATA:
Revenues
Rental revenue..................... $ 59,932 $ 52,153 $ 43,815 $ 39,721 $ 33,700
Fees............................... 1,959 1,588 1,284 1,151 957
Merchandise sales.................. 1,588 1,587 1,461 1,687 1,626
---------- ---------- ---------- ---------- ----------
Total revenues................ 63,479 55,328 46,560 42,559 36,283
Operating expenses
Merchandise costs.................. 21,765 19,145 17,003 16,235 13,156
Store expenses
Salaries and related............ 13,943 11,809 9,655 9,136 7,020
Occupancy....................... 4,671 4,068 3,416 3,092 2,567
Advertising..................... 3,500 3,283 2,837 2,576 2,280
Other expenses.................. 7,686 6,127 5,437 4,746 3,980
---------- ---------- ---------- ---------- ----------
Total store expenses.......... 29,800 25,287 21,345 19,550 15,847
---------- ---------- ---------- ---------- ----------
Total merchandise costs and
store expenses............. 51,565 44,432 38,348 35,785 29,003
General and administrative
expenses........................ 4,607 4,096 3,934 3,216 2,662
---------- ---------- ---------- ---------- ----------
Total operating expenses...... 56,172 48,528 42,282 39,001 31,665
---------- ---------- ---------- ---------- ----------
Operating income.............. 7,307 6,800 4,278 3,558 4,618
Interest expense..................... 918 1,822 834 898 726
Other expense, net................... 109 329 453 183 52
---------- ---------- ---------- ---------- ----------
Income before income taxes.... 6,280 4,649 2,991 2,477 3,840
Income taxes......................... 2,662 1,968 972 1,253 1,642
---------- ---------- ---------- ---------- ----------
Net income.................... 3,618 2,681 2,019 1,224 2,198
========== ========== ========== ========== ==========
Basic and diluted earnings per
common share.................... $ 0.73 $ 0.59 $ 0.32 $ 0.19 $ 0.34
========== ========== ========== ========== ==========
Weighted average common shares
outstanding..................... 4,970,256 4,509,406 6,392,610 6,392,610 6,392,610
OPERATING DATA:
Stores Open at end of period....... 70 62 55 51 46
Comparable store revenue
growth(1)....................... 3.8% 9.9% 2.0% 8.0% 6.7%
</TABLE>

15
<PAGE> 16

<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
---------------------------------------------------
1998 1997 1996 1995 1994
------- ------- ------- ------- -------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C>
BALANCE SHEET DATA:
Rental-purchase merchandise, net..... $25,246 $23,411 $19,740 $15,676 $13,378(2)
Total assets......................... 33,068 31,293 25,401 20,932 17,097(2)
Total debt........................... 190(4) 23,203(3) 9,850 8,651 6,843
Total liabilities.................... 6,230(4) 28,240(3) 13,934 11,484 8,873
Shareholders' equity................. 26,838(4) 3,053(3) 11,467 9,448 8,224(2)
</TABLE>

- ---------------

(1) Comparable store revenue growth is the percentage increase in revenue from
the same number of stores over a two year period. Only stores that have
been open 12 months in both periods are included in the comparison.

(2) Includes the effect of the change in the method of depreciating
rental-purchase merchandise from the straight- line basis to the units of
activity method of $1.6 million at December 31, 1994.

(3) Includes the effect of the redemption of shares from a prior
shareholder-officer.

(4) Includes the effect of the Company's initial public offering and subsequent
elimination of debt.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS

The following discussion is intended to assist in the understanding of the
Company's financial position and results of operations for each of the years
ended December 31, 1998, 1997 and 1996. This discussion should be read in
conjunction with the Company's consolidated financial statements and notes
thereto included herein.

GENERAL

At December 31, 1998, the Company operated 70 rental-purchase stores in
eight states. During the year ended December 31, 1998, the Company opened eight
new stores and acquired two stores, one of which was immediately consolidated
into an existing Company location. All nine stores added during 1998 were
located in existing markets.

On June 5, 1998, the Company completed its initial public offering
consisting of 2,250,000 shares of common stock at $10.00 per share. Proceeds
from the offering after deducting underwriters' discounts and offering expenses
totaled $20.2 million. The proceeds were used to repay substantially all
outstanding debt.

On February 1, 1999, the Company completed the purchase from Rental Mart of
PA, Inc. ("Rental Mart") the assets of four stores located in Ohio and
Pennsylvania for approximately $1.3 million in cash. Rental Mart had annual
revenues of approximately $1.7 million in 1998. Immediately following the
acquisition, three of the stores were consolidated into existing Company
locations. During February the Company also opened a new store in a new market
in Chattanooga, Tennessee.

COMPONENTS OF INCOME AND EXPENSES

Revenues. The Company collects rental renewal payments in advance,
generally on a weekly or monthly basis. This rental revenue is recognized when
collected. Fees include fees for reinstatement of expired agreements and fees
for in-home collection. These fees are recognized when collected.
Rental-purchase agreements generally include an early purchase option.
Merchandise sales include amounts received upon sales of merchandise

16
<PAGE> 17

pursuant to such options and upon the sale of previously rented merchandise.
These amounts are recognized as revenue when the merchandise is sold.

Merchandise Costs. Merchandise costs include depreciation of
rental-purchase merchandise under the units of activity depreciation method.
Rental-purchase merchandise is depreciated as revenue is collected. Rental-
purchase merchandise is not depreciated during periods when it is not on rent
and therefore not generating rental revenue. Merchandise costs also include the
remaining book value of merchandise sold or otherwise disposed, the cost of
replacement parts and accessories and other miscellaneous merchandise costs.

Salaries and Related. Salaries and related includes all salaries and wages
paid to store level associates, related benefits, taxes and workers'
compensation premiums.

Occupancy. Occupancy includes rent, repairs and maintenance of the
physical store locations, utility costs and depreciation of store leasehold
improvement. The Company has no leases that include percentage rent provisions.

Advertising. Advertising includes television, radio and print media costs
as well as the expenses (including payroll) of the Company's internal
advertising department.

Other Expenses. Other expenses include delivery expenses, insurance, costs
associated with maintaining rental-purchase merchandise, telephone expenses,
store computer and office expenses and personal property taxes, among other
items.

General and Administrative Expenses. General and administrative expenses
include all personnel, occupancy and other operating expenses associated with
maintaining the Company's corporate-level departments. In addition, all costs
associated with the Company's annual and semi-annual manager meetings and
committee meetings, as well as charitable contributions and state taxes not
based on income, are included.

For several years, the Company has made significant contributions to
charitable organizations, including organizations for which directors and
officers serve or have served as trustees or officers. The aggregate amount of
charitable contributions was approximately $230 thousand, $208 thousand and $243
thousand in 1998, 1997, and 1996, respectively, and the amount of contributions
for 1999 will be approximately $360 thousand. For subsequent years, the Board of
Directors has determined to limit charitable contributions to an amount not to
exceed 10% of the prior year's net income.

Income Tax Expense. Income tax expense includes the combined effect of all
federal, state and local income taxes imposed upon the Company by various taxing
jurisdictions.

17
<PAGE> 18

RESULTS OF OPERATIONS

The following table sets forth, for the periods indicated, certain
Statements of Income data as a percentage of total revenues.

<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
-----------------------
1998 1997 1996
----- ----- -----
<S> <C> <C> <C>
STATEMENT OF INCOME DATA:
Revenues
Rental revenue............................................ 94.4% 94.3% 94.1%
Fees...................................................... 3.1 2.9 2.8
Merchandise sales......................................... 2.5 2.8 3.1
----- ----- -----
Total revenues....................................... 100.0 100.0 100.0
Operating expenses
Merchandise costs......................................... 34.3 34.6 36.5
Store expenses
Salaries and related................................... 21.9 21.3 20.7
Occupancy.............................................. 7.4 7.4 7.3
Advertising............................................ 5.5 5.9 6.1
Other expense.......................................... 12.1 11.1 11.7
----- ----- -----
Total store expenses................................. 46.9 45.7 45.8
----- ----- -----
Total merchandise costs and store expenses........... 81.2 80.3 82.3
General and administrative expenses......................... 7.3 7.4 8.4
----- ----- -----
Total operating expenses............................. 88.5 87.7 90.7
----- ----- -----
Operating income..................................... 11.5 12.3 9.3
Interest expense............................................ 1.4 3.3 1.8
Other expense, net.......................................... 0.2 0.6 1.0
----- ----- -----
Income before income taxes................................ 9.9 8.4 6.5
Income taxes................................................ 4.2 3.6 2.1
----- ----- -----
Net income................................................ 5.7% 4.8% 4.4%
===== ===== =====
</TABLE>

COMPARISON OF YEARS ENDED DECEMBER 31, 1998 AND 1997

For the year ended December 31, 1998, total revenues increased to $63.5
million from $55.3 million, an increase of 14.7% over the prior year. The
increase was due to the inclusion of a full year's results for stores opened in
1997, revenue from the nine stores opened and acquired in 1998 and an increase
in comparable store revenue. The increase in revenue of stores opened in 1997
accounted for $3.7 million, or 45.3% of the increase, newly opened and acquired
stores accounted for $2.5 million or 29.8% of the increase, and the increase in
comparable store revenue accounted for $2.0 million or 24.9% of the increase.

For the year ended December 31, 1998, merchandise costs increased to $21.8
million from $19.1 million, an increase of 13.7% over the prior year, but
decreased to 34.3% from 34.6% of total revenues due to an increase in rental
rates and a shift in the Company's product mix towards lower cost and higher
margin products.

For the year ended December 31, 1998, total store expenses increased to
$29.8 million from $25.3 million, an increase of 17.8% over the prior year, and
as a percentage of total revenues increased to 46.9% from 45.7%. The increase
was due to expenses associated with stores opened and acquired in 1998, the
inclusion of a full year of expenses from the stores opened in 1997, and an
increase in comparable store expenses necessitated by the increase in
rental-purchase agreements in 1997. Salaries and related increased to $13.9
million from $11.8 million, an increase of 18.1% over the prior year and as a
percentage of total revenues increased to 21.9% from 21.3%. The increase was due
to additional personnel associated with stores opened and acquired in 1998,
additional personnel at comparable stores necessitated by the increase in
rental-purchase agreements in 1997 and the inclusion of a full year of salaries
and related expenses from stores opened in 1997. Occupancy increased to $4.7
million from $4.1 million, an increase of 14.8% over the prior year due to
stores opened and acquired in 1998 and the inclusion of a full year of occupancy
expenses from stores opened in 1997. As a percentage of total revenues,
occupancy remained relatively constant at 7.4%. Advertising increased slightly
to $3.5 million from

18
<PAGE> 19

$3.3 million, an increase of 6.6% over the prior year due to stores opened and
acquired in 1998 offset by a decrease in advertising expenses of comparable
stores. As a percentage of total revenues, advertising decreased to 5.5% from
5.9%. Other expenses increased to $7.7 million from $6.1 million, an increase of
25.5% over the prior year and as a percentage of total revenues increased to
12.1% from 11.1%. The increase was due to an increase in comparable store
expenses necessitated by the increase in rental-purchase agreements in 1997,
stores opened and acquired in 1998 and the inclusion of a full year of expenses
from stores opened in 1997.

For the year ended December 31, 1998, general and administrative expenses
increased to $4.6 million from $4.1 million, an increase of 12.5% over the prior
year. The increase was due to the addition of a regional manager, an increase in
costs associated with the Company's training programs and additional support
personnel, all of which were necessitated by the Company's current and
anticipated growth. Expenses associated with being a public company and an
increase in pension costs also contributed to the increase in general and
administrative expenses. As a percentage of total revenues, general and
administrative expenses decreased to 7.3% from 7.4%.

For the year ended December 31, 1998, operating income increased to $7.3
million from $6.8 million, an increase of 7.5% over the prior year. The increase
is due to the growth of stores opened in 1997 and an increase in operating
income of comparable stores, offset by operating losses associated with new
store openings. As a percentage of total revenues, operating income decreased to
11.5% from 12.3%. The decrease in operating margin was mainly due to newly
opened and acquired stores operating at revenue levels below those of core
stores and other factors discussed above.

For the year ended December 31, 1998, interest expense decreased to $0.9
million from $1.8 million, a decrease of 49.6% from the prior year, and as a
percentage of total revenues decreased to 1.4% from 3.3%. The decrease is
attributable to the retirement of substantially all outstanding debt with the
proceeds received from the Company's initial public offering in June 1998.

For the year ended December 31, 1998, other expense decreased to $0.1
million from $0.3 million, a decrease of 66.9% over the prior year mainly due to
a one-time refund of workers' compensation premiums of $0.2 million received
from the State of Ohio. The Company's effective tax rate for 1998 of 42.4%
remained relatively consistent with the 1997 rate of 42.3%.

For the year ended December 31, 1998, net income increased to $3.6 million
from $2.7 million, an increase of 34.9% over the prior year, and increased to
5.7% from 4.8% of total revenues as a result of all of the factors discussed
above.

COMPARISON OF YEARS ENDED DECEMBER 31, 1997 AND 1996

For the year ended December 31, 1997, total revenues increased to $55.3
million from $46.6 million, an increase of 18.8% over the prior year. The
increase was due to an increase in comparable store revenue, the inclusion of a
full year's results for stores opened in 1996, and new store openings. An
increase in comparable store revenue accounted for $4.5 million, or 51.7%, of
the increase, stores opened in 1996 accounted for $2.4 million, or 27.6% of the
increase, and new store openings accounted for $1.8 million, or 20.7%, of the
increase.

For the year ended December 31, 1997, merchandise costs increased to $19.1
million from $17.0 million, an increase of 12.6% over the prior year and as a
percentage of total revenues decreased to 34.6% from 36.5% due to improved
margins and a decrease in amortization associated with the DTO acquisition.

For the year ended December 31, 1997, total store expenses increased to
$25.3 million from $21.3 million, an increase of 18.5% over the prior year. The
increase was primarily due to new stores opened in 1997 and expenses associated
with the increase in the number of rental-purchase agreements at existing
stores. As a percentage of total revenues, store expenses remained relatively
constant at 45.7%. Salaries and related increased to $11.8 million from $9.7
million, an increase of 22.3% over the prior year. The increase was due to
additional personnel associated with new store openings and an increase in
rental-purchase agreements at existing stores. As a percentage of total
revenues, salaries and related increased slightly to 21.3% from 20.7%. Occupancy
increased to $4.1 million from $3.4 million, an increase of 19.1% over the prior
year. The increase was due primarily to rent increases in existing stores and
new store openings. As a percentage of total revenues, occupancy remained
19
<PAGE> 20

relatively constant at 7.4%. Advertising increased to $3.3 million from $2.8
million, an increase of 15.7% over the prior year, due to new store openings. As
a percentage of total revenues, advertising decreased slightly to 5.9% from
6.1%. Other expenses increased to $6.1 million from $5.4 million, an increase of
12.7% over the prior year. The increase was due primarily to the increased
number of stores opened, as well as the increased number of rental-purchase
agreements at existing stores. As a percentage of total revenues, other expenses
decreased to 11.1% from 11.7%.

For the year ended December 31, 1997, general and administrative expenses
increased to $4.1 million from $3.9 million, an increase of 4.1% over the prior
year, but as a percentage of total revenues, decreased to 7.4% from 8.4% in
1996. The increased costs associated with the addition of a fourth regional
manager, professional services and additional support service personnel were
offset by a decrease in executive expenses.

For the year ended December 31, 1997, operating income increased to $6.8
million from $4.3 million, an increase of 59.0% over the prior year, and
increased to 12.3% from 9.3% of total revenues. The $2.5 million increase in
operating income and the 3.0% increase in operating margins were due primarily
to the improved performance of the DTO stores, the maturation of stores opened
in 1996, growth of rental-purchase agreements in core stores and the
stabilization of corporate expenses, partially offset by operating losses
associated with new store openings.

For the year ended December 31, 1997, interest expense increased to $1.8
million from $0.8 million, an increase of 118.5% over the prior year, and as a
percentage of total revenues increased to 3.3% from 1.8%. The increase was
attributable to the increased indebtedness associated with the redemption of
stock owned by a former shareholder-officer of the Company.

For the year ended December 31, 1997, other expense decreased to $0.3
million from $0.5 million, a decrease of 27.4% over the prior year. During 1997,
the amortization of non-compete and consulting agreements executed in connection
with the redemption of stock owned by a former shareholder-officer of the
Company, was offset by gains from the sale of delivery vehicles. In 1996, the
Company recognized a one time charge for the loss of a lawsuit brought by a
former associate as well as a charge associated with the upgrade of the
Company's management information systems and remodeling of the Company's
corporate headquarters.

For the year ended December 31, 1997, income tax expense increased to $2.0
million from $1.0 million, an increase of 102.5% over the prior year. The
increase was due to increased income before taxes in 1997 as well as a higher
effective tax rate in 1997 as compared to 1996 caused by prior year refunds of
state taxes recognized during 1996.

For the year ended December 31, 1997, net income increased to $2.7 million
increased from $2.0 million, an increase of 32.8% over the prior year, and
increased to 4.8% from 4.4% of total revenues, as a result of all of the factors
discussed above.

LIQUIDITY AND CAPITAL RESOURCES

The Company's primary requirements for capital consist of purchasing
additional and replacement rental-purchase merchandise, expenditures related to
new store openings, acquisitions and working capital requirements for new and
existing stores. For the years ended December 31, 1998 and 1997 purchases of
rental merchandise (excluding acquisitions) amounted to $22.9 million and $22.7
million, respectively. During the year ended December 31, 1998, the Company
acquired the assets of two rental-purchase stores in the aggregate amount of
$1.6 million while its investment in new store openings including store
operating losses amounted to approximately $3.4 million.

For the year ended December 31, 1998, cash provided by operating activities
increased to $5.5 million from $0.7 million for the prior year. The increase was
due to a reduction in the purchase of rental merchandise in comparable stores
and increases in net income and trade accounts payable. Cash used in investing
activities increased to $2.7 million from $0.9 million due primarily to the
acquisition of two rental-purchase stores in Ohio and Massachusetts. Cash used
in financing activities increased to $2.9 million from $0.3 million due to the
reduction of substantially all of the Company's debt with proceeds from its
initial public offering and cash provided by operating activities.
20
<PAGE> 21

On June 5, 1998, the Company completed its initial public offering of
2,250,000 shares of common stock, without par value, at $10 per share. The
offering generated net proceeds of approximately $20.2 million after deducting
underwriters' fees and offering expenses. The net proceeds were used to retire
approximately $10.9 million of indebtedness due a former shareholder-officer of
the Company and his affiliates. The balance of the net proceeds was used to
reduce borrowings under the Credit Facility.

Prior to the Company's initial public offering, the Company's growth was
financed through cash flow from operations, borrowings under a revolving loan
agreement with a lending institution (the "Credit Facility") and trade credit.
As a result of the offering, the Company reduced its Credit Facility to $10.0
million. Borrowings under the Credit Facility bear interest at a variable rate
equal to prime or the Interbank Offering Rate ("IBOR") plus 200 basis points. In
conjunction with the Company's acquisition of the assets of 15 Blue Ribbon
stores on March 1, 1999, the Company increased its Credit Facility to $16.0
million and extended the maturity date to March 1, 2002. The Credit Facility
includes certain cash flow, net worth and idle inventory requirements, as well
as covenants which limit the ability of the Company to incur additional
indebtedness, grant liens, transfer assets outside the ordinary course of
business, pay dividends, engage in acquisition transactions and make capital
expenditures (excluding the purchase of rental merchandise) in excess of a
specified amount. Availability under the Company's Credit Facility as of March
29, 1999 was approximately $6.0 million.

The Company currently plans to increase the number of new store openings in
1999 and 2000 respectively, from the eight new stores opened in 1998. The
Company further believes that it will continue to have the opportunity to
increase its number of stores and rental-purchase agreements through selective
acquisitions. Potential acquisitions may vary in size and the Company may
consider larger acquisitions that could be material to the Company. To provide
any additional funds necessary for the continued pursuit of its growth
strategies, the Company may use cash flow from operations, borrow additional
amounts under its Credit Facility, seek to obtain additional debt or equity
financing, or use its equity securities, the availability of which will depend
upon market and other conditions. There can be no assurance that such additional
financing will be available on terms acceptable to the Company.

INFLATION

During the years ended December 31, 1998, 1997 and 1996, the cost of
rental-purchase merchandise, lease expense and salaries and wages have increased
modestly. The increases have not had a significant effect on the Company's
results of operations because the Company has been able to charge commensurately
higher rental rates for its rental-purchase merchandise.

MARKET RISK

The Company does not have significant exposure to changing interest rates.
The Company does not undertake any specific actions to cover its exposure to
interest rate risk and the Company is not party to any interest rate risk
management transactions. A 10% change in interest rates would not have a
material effect on the Company's pretax earnings for the next fiscal year.

The Company does not purchase or hold any derivative financial instruments.

FORWARD-LOOKING STATEMENTS

Forward-looking statements in this report are made pursuant to the safe
harbor provisions of the Private Securities Litigation Reform Act of 1995. Such
forward-looking statements are subject to certain risks and uncertainties that
could cause actual results to differ materially from those projected. Readers
are cautioned not to place undue reliance on these forward-looking statements
which speak only as of the date hereof. Such risks and uncertainties include,
but are not limited to, (i) the ability of the Company to execute effectively
its expansion program and (ii) changes in the government's regulation of the
industry. The Company undertakes no obligation to publicly update or revise any
of these forward-looking statements, whether as a result of new information,
future events or circumstances, or otherwise. There can be no assurance that the
events described in these forward-looking statements will occur. For further
information, please refer to the Company's filings with the

21
<PAGE> 22

Securities and Exchange Commission, including specifically the Risk Factors
contained in the Company's prospectus dated June 4, 1998.

ACCOUNTING PRONOUNCEMENTS

During 1998, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 133, "Accounting for Derivative Instruments
and Hedging Activities," which establishes accounting and reporting standards
for derivative instruments and for hedging activities. This Statement is
effective for all quarters of fiscal years beginning after June 15, 1999. While
the Company has not yet determined the effects the Statement will have on its
financial position or results of its operations, it does not anticipate a
material impact.

In the first quarter of 1998, the American Institute of Certified Public
Accountants issued Statement of Position (SOP) No. 98-5, "Reporting on the Costs
of Startup Activities," which requires that the cost of startup activities be
expensed as incurred. The Statement will be effective for fiscal years beginning
after December 15, 1998. The Company is currently assessing the effect of this
Statement, but does not anticipate a material impact.

In the first quarter of 1998, the American Institute of Certified Public
Accountants issued SOP No. 98-1, "Accounting for Costs of Computer Software
Development or Obtained for Internal Use," which requires that certain internal
and external costs to develop or obtain software for internal use be expensed or
capitalized as incurred. Generally, costs incurred during the preliminary
project stage and post-implementation/operation stages must be expensed. The
Statement will be effective for fiscal years beginning after December 15, 1998.
The Company is currently assessing the effect of this Statement, but does not
anticipate a material impact.

YEAR 2000

The Company utilizes information technology and non-information technology
throughout its operations and has third-party relationships with vendors who may
be affected by Year 2000 issues. During 1998 the Company began to assess its
Year 2000 readiness and has already begun to implement plans to ensure that its
systems are or will be Year 2000 compliant. The Company anticipates completing
its implementation plan by the third quarter of 1999. All of the Company's
remote locations operate on an internally developed point-of-sale system which
has been tested and determined to be Year 2000 compliant. In addition, all
hardware utilized to run both its remote locations and corporate offices are
believed to be Year 2000 compliant. The company's proprietary Windows NT-based
software system utilized by its corporate office, updated in 1999, and its
licensed accounting software are Year 2000 compliant. The company has developed
questionnaires and contacted key suppliers of its rental-purchase merchandise as
well as other vendors regarding their Year 2000 compliance to determine any
impact on its operations. In general, the Company's key suppliers and vendors
have developed or are in the process of developing plans to address their Year
2000 issues. Based on the vendors' responses to date, the Company does not
anticipate that it will experience a material amount of merchandise returns due
to Year 2000 issues. The Company will continue to monitor and evaluate the
progress of its third-party relationships on this critical matter. The Company
is also reviewing its non-information technology systems to determine the extent
of any changes that may be necessary and believes there will be minimal changes
required for compliance.

The Company has spent to date a de minimus amount to implement its Year
2000 readiness plan, including amounts to update its Windows NT-based software
utilized at its corporate office. The Company has not yet estimated additional
costs to bring its operations into Year 2000 compliance, however, it believes
that such costs will be immaterial to its results of operations and financial
condition.

Based on the progress the Company has made in addressing its Year 2000
issues and the Company's plan and timeline to complete its compliance program,
the Company does not foresee significant risks associated with its Year 2000
compliance. The Company realizes however, that in spite of its Year 2000
compliance efforts, factors beyond its control may have an adverse effect on its
operations. Therefore, the Company has begun to develop a contingency plan which
may include operating its store locations under the previously utilized manual
point-of-sale system and increasing the amount of rental-purchase merchandise
available for rent prior to the year 2000. Though not yet complete, the Company
believes the plan will be available in the unlikely event the Company's
operations are materially adversely affected by the Year 2000 issues.
22
<PAGE> 23

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

Reference is made to Part IV, Item 14 of this Form 10-K for the information
required by Item 8.

ITEM 9. CHANGES AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL
DISCLOSURE

None.

PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE COMPANY

The information required by this Item (other than the information regarding
executive officers set forth at the end of Item 4A of Part I of this Form 10-K)
will be contained in the Company's definitive Proxy Statement for its 1999
Annual Meeting of Shareholders, and is incorporated herein by reference.

ITEM 11. EXECUTIVE COMPENSATION

The information required by this Item will be contained in the Company's
definitive Proxy Statement for its 1999 Annual Meeting of Shareholders, and is
incorporated herein by reference.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

The information required by this Item will be contained in the Company's
definitive Proxy Statement for its 1999 Annual Meeting of Shareholders, and is
incorporated herein by reference.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

The information required by this Item will be contained in the Company's
definitive Proxy Statement for its 1999 Annual Meeting of Shareholders, and is
incorporated herein by reference.

PART IV

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K

<TABLE>
<CAPTION>
PAGE
-------
<C> <S> <C>
(a)(1) Financial Statements:
Independent Auditors' Report................................ 24
Consolidated Balance Sheets as of December 31, 1998 and
1997........................................................ 25
Consolidated Statements of Income for the Years Ended
December 31, 1998, 1997 and 1996............................ 26
Consolidated Statements of Shareholders' Equity for the
Years Ended December 31, 1998, 1997 and 1996................ 27
Consolidated Statements of Cash Flows for the Years Ended
December 31, 1998, 1997 and 1996............................ 28
Notes to Consolidated Financial Statements.................. 29-37
(a)(2) Financial Statement Schedules:
All financial statement schedules have been omitted because
they are not applicable or because required information is
included in the Company's financial statements and notes
thereto.
(a)(3) Exhibits
See the Index to Exhibits included on page 39.
(b) Reports on Form 8-K:
(1) On March 16, 1999, the Company filed a Current Report on
Form 8-K, disclosing the completion of its acquisition of
the assets of 15 stores from Blue Ribbon Rentals, Inc. and
Blue Ribbon Rentals II, Inc.
</TABLE>

23
<PAGE> 24

INDEPENDENT AUDITORS' REPORT

The Shareholders and Board of Directors
Rainbow Rentals, Inc.

We have audited the accompanying consolidated balance sheets of Rainbow
Rentals, Inc. and subsidiary (Company) as of December 31, 1998 and 1997, and the
related consolidated statements of income, shareholders' equity, and cash flows
for each of the years in the three-year period ended December 31, 1998. These
consolidated financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these consolidated
financial statements based on our audits.

We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining on a test basis, evidence supporting
the amounts and disclosures on the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of Rainbow
Rentals, Inc. and subsidiary as of December 31, 1998 and 1997, and the results
of their operations and their cash flows for each of the years in the three-year
period ended December 31, 1998, in conformity with generally accepted accounting
principles.

KPMG, LLP
Cleveland, Ohio
February 10, 1999

24
<PAGE> 25

RAINBOW RENTALS, INC. AND SUBSIDIARY

CONSOLIDATED BALANCE SHEETS
(DOLLARS IN THOUSANDS, EXCEPT SHARE AMOUNTS)

<TABLE>
<CAPTION>
DECEMBER 31,
--------------------
1998 1997
-------- --------
<S> <C> <C>
ASSETS
Current assets
Cash...................................................... $ -- $ 77
Rental-purchase merchandise, net.......................... 25,246 23,411
Prepaid expenses and other current assets................. 706 824
Income tax receivable..................................... -- 399
-------- --------
Total current assets................................. 25,952 24,711
Property and equipment, net................................. 3,394 3,441
Deferred income taxes....................................... 1,058 1,041
Goodwill, net............................................... 910 --
Other assets, net........................................... 1,754 2,100
-------- --------
Total assets......................................... $ 33,068 $ 31,293
======== ========
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities
Current installments of obligations under capital
leases................................................. $ 80 $ 80
Accounts payable.......................................... 1,242 1,000
Accrued income taxes...................................... 290 129
Accrued compensation and related costs.................... 1,429 1,091
Other liabilities and accrued expenses.................... 1,166 1,616
Deferred income taxes..................................... 1,913 1,201
-------- --------
Total current liabilities............................ 6,120 5,117
Long-term debt.............................................. -- 12,464
Notes payable............................................... -- 10,488
Obligations under capital leases, excluding current
installments.............................................. 110 171
-------- --------
Total liabilities.................................... 6,230 28,240
Shareholders' equity
Serial preferred stock, no par value, 2,000,000 shares
authorized, none issued................................ -- --
Common stock, no par value; 10,000,000 shares authorized,
5,925,735 and 3,675,735 issued and outstanding at
December 31, 1998 and 1997, respectively............... 11,039 60
Retained earnings......................................... 17,706 14,088
Treasury stock, 466,875 and 2,716,875 common shares at
December 31, 1998 and 1997, respectively, at cost...... (1,907) (11,095)
-------- --------
Total shareholders' equity........................... 26,838 3,053
-------- --------
Total liabilities and shareholders' equity........... $ 33,068 $ 31,293
======== ========
</TABLE>

See accompanying notes to consolidated financial statements.

25
<PAGE> 26

RAINBOW RENTALS, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF INCOME
(DOLLARS IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)

<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
--------------------------------------
1998 1997 1996
---------- ---------- ----------
<S> <C> <C> <C>
Revenues
Rental revenue..................................... $ 59,932 $ 52,153 $ 43,815
Fees............................................... 1,959 1,588 1,284
Merchandise sales.................................. 1,588 1,587 1,461
---------- ---------- ----------
Total revenues................................ 63,479 55,328 46,560
Operating expenses
Merchandise costs.................................. 21,765 19,145 17,003
Store expenses
Salaries and related............................ 13,943 11,809 9,655
Occupancy....................................... 4,671 4,068 3,416
Advertising..................................... 3,500 3,283 2,837
Other expenses.................................. 7,686 6,127 5,437
---------- ---------- ----------
Total store expenses.......................... 29,800 25,287 21,345
---------- ---------- ----------
Total merchandise costs and store expenses.... 51,565 44,432 38,348
General and administrative expenses................ 4,607 4,096 3,934
---------- ---------- ----------
Total operating expenses...................... 56,172 48,528 42,282
---------- ---------- ----------
Operating income.............................. 7,307 6,800 4,278
Interest expense..................................... 918 1,822 834
Other expense, net................................... 109 329 453
---------- ---------- ----------
Income before income taxes.................... 6,280 4,649 2,991
Income taxes......................................... 2,662 1,968 972
---------- ---------- ----------
Net income.................................... $ 3,618 $ 2,681 $ 2,019
========== ========== ==========
EARNINGS PER COMMON SHARE:
Basic and diluted earnings per common share........ $ 0.73 $ 0.59 $ 0.32
========== ========== ==========
WEIGHTED AVERAGE COMMON SHARES OUTSTANDING:
Basic and diluted.................................. 4,970,256 4,509,406 6,392,610
========== ========== ==========
</TABLE>

See accompanying notes to consolidated financial statements.

26
<PAGE> 27

RAINBOW RENTALS, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
(DOLLARS IN THOUSANDS, EXCEPT SHARE AMOUNTS)

<TABLE>
<CAPTION>
COMMON STOCK TOTAL
-------------------- RETAINED TREASURY SHAREHOLDERS'
NUMBER COST EARNINGS STOCK EQUITY
---------- ------- -------- -------- -------------
<S> <C> <C> <C> <C> <C>
Balance at December 31, 1995................ 6,392,610 $ 60 $ 9,388 $ -- $ 9,448
Net income................................ -- -- 2,019 -- 2,019
---------- ------- ------- -------- -------
Balance at December 31, 1996................ 6,392,610 60 11,407 -- 11,467
Net income................................ -- -- 2,681 -- 2,681
Acquisition of common shares.............. (2,716,875) -- -- (11,095) (11,095)
---------- ------- ------- -------- -------
Balance at December 31, 1997................ 3,675,735 60 14,088 (11,095) 3,053
Net income................................ 3,618 3,618
Issuance of common shares................. 2,250,000 10,979 -- 9,188 20,167
---------- ------- ------- -------- -------
Balance at December 31, 1998................ 5,925,735 $11,039 $17,706 $ (1,907) $26,838
========== ======= ======= ======== =======
</TABLE>

See accompanying notes to consolidated financial statements.

27
<PAGE> 28

RAINBOW RENTALS, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CASH FLOWS
(DOLLARS IN THOUSANDS)

<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
------------------------------
1998 1997 1996
-------- -------- --------
<S> <C> <C> <C>
Cash flows from operating activities
Net income................................................ $ 3,618 $ 2,681 $ 2,019
Reconciliation of net income to net cash provided by
operating activities
Depreciation of property and equipment and amortization
of intangibles....................................... 1,931 1,989 2,024
Depreciation of rental-purchase merchandise............ 19,607 16,994 14,475
Deferred income taxes.................................. 695 993 (335)
(Gain) loss on disposal of property and equipment...... (229) (182) 120
Purchases of rental-purchase merchandise............... (22,903) (22,707) (20,546)
Rental-purchase merchandise disposed, net.............. 1,939 1,929 2,092
(Increase) decrease in
Short-term investments............................... -- 27 (2)
Prepaid expenses and other current assets............ 118 (330) 179
Income tax receivable................................ 399 (399) 314
Increase (decrease) in
Accounts payable..................................... 242 (917) 571
Accrued income taxes................................. 161 (103) 232
Accrued compensation and related costs............... 338 149 298
Other liabilities and accrued expenses............... (450) 623 150
-------- -------- --------
Net cash provided by operating activities......... 5,466 747 1,591
-------- -------- --------
Cash flows from investing activities
Purchase of property and equipment, net................... (1,422) (1,120) (2,371)
Proceeds on the sale of property and equipment............ 333 250 3
Acquisitions.............................................. (1,580) -- --
Other..................................................... -- -- (30)
-------- -------- --------
Net cash used in investing activities............. (2,669) (870) (2,398)
-------- -------- --------
Cash flows from financing activities
Proceeds from long-term debt borrowings................... 43,385 63,827 53,644
Current installments and repayments of long-term debt..... (55,849) (60,922) (52,379)
Proceeds from stock offering, net of related expenses..... 20,167 -- --
Decrease in notes payable................................. (10,488) (291) (66)
Loan origination fees paid................................ (28) (147) (63)
Payment in connection with Redemption Agreement........... -- (2,700) --
Principal payments under capital lease obligations........ (61) (39) --
-------- -------- --------
Net cash (used in) provided by financing
activities...................................... (2,874) (272) 1,136
-------- -------- --------
Net (decrease) increase in cash............................. (77) (395) 329
Cash at beginning of year................................... 77 472 143
-------- -------- --------
Cash at end of year......................................... $ -- $ 77 $ 472
======== ======== ========
Supplemental cash flow information:
Net cash paid during the period for
Interest............................................... $ 1,556 $ 1,060 $ 795
Income taxes........................................... 1,529 1,577 884
</TABLE>

See accompanying notes to consolidated financial statements.

28
<PAGE> 29

RAINBOW RENTALS, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(DOLLARS IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)

(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

The significant accounting policies of Rainbow Rentals, Inc. and subsidiary
(Company), which are summarized below, are consistent with generally accepted
accounting principles and reflect practices appropriate to the industry in which
the Company operates.

(a) Reporting Entity and Principles of Consolidation

The Company is engaged in the rental and sale of home electronics,
furniture, appliances, and computers to the general public. At December 31,
1998, the Company operated 70 stores in eight states: Connecticut,
Massachusetts, Michigan, New York, Ohio, Pennsylvania, Rhode Island, and
Tennessee. The Company's corporate headquarters is located in Canfield, Ohio.

The consolidated financial statements include the accounts of Rainbow
Rentals, Inc. and its wholly owned subsidiary, Rainbow Advertising, Inc. All
significant intercompany profits, transactions, and balances have been
eliminated in consolidation.

(b) Financial Instruments

The carrying amount of financial instruments including cash, trade
receivables and accounts payable approximated fair value as of December 31, 1998
and 1997, because of the relatively short maturity of these instruments.

Rental-purchase merchandise consists of merchandise rented to customers or
in the stores available for rent or sale. Merchandise is rented to customers
pursuant to rental agreements which generally provide for either weekly or
monthly rental terms with rental renewal payments collected in advance. The
rental agreements may be terminated at any time by the customers, if terminated,
the merchandise is returned to the Company.

Rental-purchase merchandise is stated at the lower of cost or market. The
Company depreciates inventory using the units of activity method. Under the
units of activity method, merchandise held for rent is not depreciated, and
merchandise on rent is depreciated in the proportion of rents received to total
expected rents provided over the rental contract term. The Company believes the
units of activity method more accurately matches the recognition of depreciation
expense with the estimated timing of revenue receipts over the rental-purchase
agreement period. The units of activity method is recognized in the
rental-purchase industry and does not consider salvage value.

(d) Property and Equipment

Property and equipment are recorded at cost. Depreciation is computed on
the straight-line method over the estimated useful lives of the respective
assets which range from three to five years. Leasehold improvements and vehicles
held under capital lease arrangements are amortized over the shorter of the term
of the applicable leases or useful life of the improvement.

(e) Goodwill

The excess of cost over fair value of net assets of businesses acquired is
amortized on a straight line basis over periods ranging from 18 to 20 years. The
Company periodically monitors the value of goodwill for possible impairment by
utilizing the undiscounted cash flow method. Measurement of an impairment loss
is determined by reducing the carrying value of the related assets to fair
value.

29
<PAGE> 30
RAINBOW RENTALS, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONT'D)

(f) Other Assets

Other assets consist primarily of noncompete and consulting agreements
which arose in connection with the share repurchase from a former officer of the
Company, (see notes 11 and 12). These costs are amortized over the agreement
lives of seven years and three years, respectively.

(g) Rental Revenue

Merchandise is rented to customers pursuant to rental-purchase agreements
which generally provide for weekly or monthly rental terms with nonrefundable
rental payments. Rental income is recognized as collected, because at the time
of collection the merchandise has been placed in service and costs of
installation and delivery have been incurred. A customer may elect to renew the
rental-purchase agreement for a specified number of continuous terms and has the
right to acquire title either through payment of all required rentals or through
a purchase option. Amounts received from such sales, as well as sales of new and
used merchandise available for rent in the stores, are included in merchandise
sales.

(h) Stock-Based Compensation

The Company applies Accounting Principles Board Opinion No. 25, "Accounting
for Stock Issued to Employees" (APB 25), and related Interpretations in
accounting for its stock-based compensation. The Financial Accounting Standards
Board issued Statement No. 123, "Accounting for Stock-Based Compensation" (FAS
123), which was effective in 1996. FAS 123 provides the option of accounting for
stock-based compensation using the provisions of APB 25 or the fair value method
of accounting. The Company elected to account for stock-based compensation using
the provisions of APB 25. The fair value disclosures required under FAS 123 are
contained in note 14 to the consolidated financial statements.

(i) Advertising Expenses

Costs incurred for producing and communicating advertising are charged to
expense as incurred.

(j) Income Taxes

Income taxes are accounted for under the asset and liability method.
Deferred tax assets and liabilities are recognized for the future tax
consequences attributable to differences between the financial statement
carrying amounts of existing assets and liabilities and their respective tax
bases and operating loss and tax credit carryforwards. Deferred tax assets and
liabilities are measured using enacted tax rates expected to apply to taxable
income in the years in which those temporary differences are expected to be
recovered or settled. The effect on deferred tax assets and liabilities of a
change in tax rates is recognized in income in the period that includes the
enactment date.

(k) Basic and Diluted Earnings per Common Share

Basic and diluted earnings per common share are based on the weighted
average number of common shares outstanding during each year. Average shares
used in the calculations were 4,970,256, 4,509,406 and 6,392,610 in 1998, 1997
and 1996, respectively. For the periods presented, stock options would have had
an anti-dilutive effect on earnings per share. Therefore, there is no difference
between basic and diluted earnings per share.

(l) Use of Estimates

The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.
30
<PAGE> 31
RAINBOW RENTALS, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONT'D)

(m) New Accounting Pronouncements

Statement of Financial Accounting Standards (FAS) No. 130, "Reporting
Comprehensive Income", issued in June 1997, established standards for reporting
and display of comprehensive income and its components. This standard currently
does not apply to these financial statements because the Company has no items of
other comprehensive income in any period presented.

The Company adopted FAS No. 131, "Disclosures about Segments of an
Enterprise and Related Information", on January 1, 1998. This statement provides
accounting and reporting standards for the way public enterprises are to report
information about operating segments in annual financial statements and requires
those enterprises to report selected information about operating segments in
interim financial reports issued to shareholders. It also established standards
for related disclosures about products and services, geographic areas, and major
customers. The Company has determined that the adoption of FAS No. 131 has no
effect on its consolidated financial statements as the Company has a single
operating segment.

(n) Reclassification

Certain amounts in the 1997 and 1996 consolidated financial statements have
been reclassified to conform with the 1998 presentation.

(2) PUBLIC OFFERING OF STOCK

On June 5, 1998, the Company completed its initial public offering of
2,250,000 shares of common stock, without par value, at $10 per share. The net
proceeds of approximately $20.2 million, after deducting underwriters' discounts
and offering expenses, were used to retire approximately $10.9 million of
indebtedness due a former shareholder-officer of the Company. The balance of the
net proceeds were used to reduce borrowings with a lending institution.

(3) ACQUISITIONS

On August 1, 1998, the Company acquired certain assets of Choice Rental of
Massachusetts, Inc., a Massachusetts competitor, for approximately $1.1 million
in cash. The acquisition was accounted for using the purchase method of
accounting. Accordingly, all identifiable assets were recorded at their
estimated fair value at the date of acquisition. The excess of the acquisition
cost over the estimated fair value of the net assets acquired ("goodwill" of
$0.7 million), is being amortized on a straight-line basis over twenty years.
Assets acquired, other than goodwill, consisted primarily of rental-purchase
merchandise and a non-compete agreement.

On July 1, 1998, the Company acquired certain assets of Eppy's Furniture,
Inc., a store located in Lorain, Ohio, for approximately, $0.5 million in cash.
The acquisition was accounted for using the purchase method of accounting.
Accordingly, all identifiable assets were recorded at their estimated fair value
at the date of the acquisition. The excess of the acquisition cost over the
estimated fair value of the net assets acquired ("goodwill" of $0.2 million), is
being amortized on a straight-line basis over eighteen years. Assets acquired,
other than goodwill, consisted primarily of rental-purchase merchandise and a
non-compete agreement.

31
<PAGE> 32
RAINBOW RENTALS, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONT'D)

(4) RENTAL-PURCHASE MERCHANDISE

Following is a summary of rental-purchase merchandise:

<TABLE>
<CAPTION>
DECEMBER 31,
--------------------
1998 1997
-------- --------
<S> <C> <C>
Rental purchase merchandise, at original cost............... $ 44,517 $ 39,926
Less: accumulated depreciation.............................. (19,271) (16,515)
-------- --------
$ 25,246 $ 23,411
======== ========
</TABLE>

(5) PROPERTY AND EQUIPMENT, NET

Property and equipment consist of the following:

<TABLE>
<CAPTION>
DECEMBER 31,
--------------------
1998 1997
-------- --------
<S> <C> <C>
Vehicles.................................................... $ 1,241 $ 2,142
Leasehold improvements...................................... 4,025 3,286
Computer equipment.......................................... 761 688
Office equipment............................................ 1,490 1,133
Vehicles held under capital lease........................... 290 290
-------- --------
7,807 7,539
Less accumulated depreciation and amortization.............. 4,413 4,098
-------- --------
$ 3,394 $ 3,441
======== ========
</TABLE>

(6) LONG-TERM DEBT AND NOTES PAYABLE

The Company has a revolving loan agreement with a lending institution; the
maximum revolving loan amount under this agreement at December 31, 1998 was
$10.0 million. The loan agreement expires July 15, 2001, at which time any
outstanding balance will be payable in full. Interest is charged on the
outstanding loan balance at prime, or 8.00% at December 31, 1998. The Company
can request to have portions of the outstanding principal designated as "IBOR
Portions," which under the terms of the loan agreement would bear interest at
the Interbank Offering Rate (IBOR Rate), plus 200 basis points. The IBOR Rate at
December 31, 1998 was 5.625%. At December 31, 1998 no part of the outstanding
principal is designated as an "IBOR Portion."

The loan agreement is secured by substantially all assets, contract rights,
documents, and all rental agreements of the Company. The loan agreement contains
various covenants, with which the Company was in compliance at December 31, 1998
and 1997. The loan agreement calls for a nonuse fee equal to 0.315% per annum on
the daily average amount by which the maximum revolving amount exceeds the
outstanding loan balance. Bank borrowings under the loan agreement at December
31, 1998 and 1997 were $-0- and $12,464 respectively.

In April 1997, the Company entered into a Stock Redemption Agreement
(Redemption Agreement) with a former shareholder-officer of the Company. The
Redemption Agreement required the Company to repurchase all 2,716,875 shares of
stock owned by the former shareholder-officer and affiliates. The Company
entered into note
payable agreements (Redemption Debt) with the shareholder-officer and certain
affiliates of the shareholder-officer amounting to $10,488. The Redemption Debt,
which accrued interest at a rate of 8.0%, was paid in full during June, 1998
with proceeds received from the Company's initial public offering of common
stock.

32
<PAGE> 33
RAINBOW RENTALS, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONT'D)

(7) RELATED PARTY TRANSACTIONS

The building which serves as the Company's corporate headquarters is leased
from a company, owned by the Company's three majority shareholders. The Company
entered into a 10-year building lease agreement, expiring January 2006, with the
company at a rental rate which approximates market rates. Total rent paid to the
partnership in 1998, 1997, and 1996 was approximately $98, $103, and $100,
respectively.

(8) INCOME TAXES

The provision for income taxes consisted of the following components:

<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
--------------------------
1998 1997 1996
------ ------ ------
<S> <C> <C> <C>
Current
Federal................................................... $1,660 $ 738 $1,203
State and Local........................................... 307 237 104
------ ------ ------
1,967 975 1,307
Deferred
Federal................................................... 485 837 (284)
State and Local........................................... 210 156 (51)
------ ------ ------
695 993 (335)
------ ------ ------
$2,662 $1,968 $ 972
====== ====== ======
</TABLE>

A reconciliation between income tax expense reported and income tax expense
computed by applying the federal statutory rate is as follows:

<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
--------------------------
1998 1997 1996
------ ------ ------
<S> <C> <C> <C>
Income before income taxes.................................. $6,280 $4,649 $2,991
Federal statutory tax rate.................................. 34% 34% 34%
------ ------ ------
2,135 1,581 1,017
State and local income taxes, net of federal income tax
benefit................................................... 345 262 37
Meals and entertainment and officers' life insurance
premiums.................................................. 50 33 20
------ ------ ------
Other, net.................................................. 132 92 (102)
------ ------ ------
$2,662 $1,968 $ 972
====== ====== ======
</TABLE>

The following deferred tax assets (liabilities) are reflected in the
consolidated balance sheets as follows:

<TABLE>
<CAPTION>
DECEMBER
------------------
1998 1997
------- -------
<S> <C> <C>
Rental-purchase merchandise................................. $(2,110) $(1,324)
Property and equipment...................................... 735 703
Intangibles................................................. 323 326
Other....................................................... 197 135
------- -------
Net deferred tax liability................................ $ (855) $ (160)
======= =======
</TABLE>

33
<PAGE> 34
RAINBOW RENTALS, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONT'D)

The net amount of current and non-current deferred tax liabilities was $855
as of December 31, 1998 and $160 as of December 31, 1997, representing deferred
tax assets and deferred tax liabilities of $1,255 and $2,110, respectively, at
December 31, 1998 and $1,163 and $1,324, respectively, at December 31, 1997. No
valuation allowance was required for the deferred tax assets.

(9) LEASES

The Company entered into a capital lease arrangement in 1997 for the
financing of new vans. The gross amount of vehicles and the related accumulated
amortization are recorded in property and equipment, net.

The Company operates its retail stores and offices under noncancelable
operating leases with terms extending to 2007 and additional option periods
renewable at the request of the Company. Additionally, the Company leases a
number of delivery and general use vehicles under operating lease arrangements.
Rental expense charged to operations totaled $4,144, $3,266 and $2,495 for the
years ended December 31, 1998, 1997, and 1996, respectively. Future minimum
lease payments under noncancelable operating leases (with initial or remaining
lease terms in excess of one year) and future minimum capital lease payments as
of December 31, 1998 are as follows:

<TABLE>
<CAPTION>
CAPITAL OPERATING
YEAR ENDING DECEMBER 31, LEASES LEASES
- ------------------------ ------- ---------
<S> <C> <C>
1999........................................................ $ 84 $ 4,497
2000........................................................ 127 3,968
2001........................................................ -- 2,900
2002........................................................ -- 1,790
2003........................................................ -- 1,154
Thereafter.................................................. -- 543
---- -------
Total minimum lease payments................................ 211 $14,852
=======
Less amount representing interest........................... 21
----
Present value of net minimum capital lease payments......... 190
Less current installments of obligations under capital
leases.................................................... 80
----
Obligations under capital leases, excluding current
installments........................................... $110
====
</TABLE>

(10) RETIREMENT PLAN

The Company maintains a qualified defined contribution retirement plan
under Section 401(k) of the Internal Revenue Code. The plan, which covers
substantially all employees, provides for the Company to make discretionary
contributions based on salaries of eligible employees plus additional
contributions based upon voluntary employee salary deferrals. Payments upon
retirement or termination of employment are based on vested amounts credited to
individual accounts. In 1998 and 1997, the Company contributed $49 and $25,
respectively. No retirement plan expenses were incurred in 1996.

34
<PAGE> 35
RAINBOW RENTALS, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONT'D)

(11) OTHER ASSETS

Following is a summary of other assets:

<TABLE>
<CAPTION>
DECEMBER 31,
----------------
1998 1997
------ ------
<S> <C> <C>
Noncompete and consulting agreements........................ $2,221 $2,093
Loan origination fees and other............................. 438 425
------ ------
2,659 2,518
Less accumulated amortization............................... 905 418
------ ------
$1,754 $2,100
====== ======
</TABLE>

(12) SHAREHOLDER TRANSACTIONS

In connection with the Redemption Agreement (note 6), the Company entered
into noncompete, consulting, and severance agreements with the former
shareholder-officer (see notes 6 and 11), and agreed to pay a total of $13,436
(cash payment of $2,948 and notes payable of $10,488), allocated as follows:

<TABLE>
<S> <C>
Stock repurchase............................................ $11,095
Noncompete and consulting agreements........................ 2,093
Severance agreement......................................... 248
-------
$13,436
=======
</TABLE>

The full amount paid for the acquisition of shares was recorded as treasury
stock. As indicated in note 11, the amount allocated to the noncompete and
consulting agreements was recorded in other assets. The severance payment was
charged fully to general and administrative expense in 1997.

(13) SHAREHOLDERS' EQUITY

On March 23, 1998, the Company's Board of Directors (Board) approved an
increase in the number of authorized shares and the conversion of all
outstanding shares of common nonvoting stock for an equal number of common
voting stock. Additionally, the Board authorized 2,000,000 shares of Serial
Preferred Stock (consisting of 1,000,000 Voting Preferred Shares and 1,000,000
Non-Voting Preferred Shares). The conversion of nonvoting shares has been
reflected retroactively, by removing reference to common nonvoting shares from
shareholders' equity and calculating earnings per share based on the weighted
average number of common shares outstanding after considering the conversion.

Also, on March 23, 1998, the Board approved a 10,500 for one stock split
distributed in the form of a stock dividend. As a result of this action, an
additional 3,675,385 shares of common stock were issued on June 5, 1998, the
date of the Company's initial public offering, to shareholders of record on
March 23, 1998. All references throughout these consolidated financial
statements and notes thereto to number of shares and per share amounts of the
Company's common stock have been restated to reflect the stock split.

(14) STOCK OPTION PLAN

The Company's Stock Option Plan ("Plan") offers employees the opportunity
to acquire shares of common stock by the grant of stock options, including both
incentive stock options ("ISOs") and nonqualified stock options ("NQSOs"). A
total of 400,000 shares of common stock have been reserved for issuance upon
exercise of stock options under the Plan. The purchase price of a share of
common stock pursuant to an ISO shall not be

35
<PAGE> 36
RAINBOW RENTALS, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONT'D)

less than the fair market value of a share of common stock at the grant date.
The purchase price of a share of common stock pursuant to a NQSO may be less
than the fair market value of a share of common stock.

On June 5, 1998, the Company granted 306,000 stock options under the Plan.
Because all stock options were granted with an exercise price equal to the
market price on the date of grant, no compensation expense has been recognized,
consistent with the provisions of APB 25. Stock options granted become
exercisable over a three-year or four-year vesting period and expire ten years
from the date of grant.

Pro forma information for net income and basic and diluted earnings per
common share is required by FAS 123 and has been determined as if the Company
had accounted for it stock options under the fair value method of that
statement. The fair value for these stock options was estimated at the date of
grant using a Black-Scholes option pricing model with the following weighted
average assumptions for 1998: risk free interest rate of 5.4%; dividend yield of
- -0-%; volatility factor of the expected market price of the Company's common
stock of 30.0%; and an expected life of the stock options of seven years. The
weighted average grant date fair value of stock options granted during the year
was $4.43 per stock option.

Had compensation cost for the stock options been determined based on the
fair value at the grant date, the Company's net income and basic and diluted
earnings per common share would have been reduced. For purposes of pro forma
disclosures, the estimated fair value of the stock options is amortized to
expense over the stock options' vesting period. The pro forma amounts for the
year ending December 31, 1998 are indicated below. No amounts are provided for
the years ended December 31, 1997 and 1996 since there were no options granted
until the Company's initial public offering on June 5, 1998.

<TABLE>
<CAPTION>
1998
------
<S> <C>
Net income:
As reported............................................... $3,618
Pro forma................................................. 3,506
Basic and diluted earnings per common share:
As reported............................................... .73
Pro forma................................................. .71
</TABLE>

A summary of the Company's stock option activity and related information
for the year ended December 31, 1998 is as follows:

<TABLE>
<CAPTION>
NUMBER OF WEIGHTED
STOCK OPTIONS AVERAGE
1998 EXERCISE PRICE
------------- --------------
<S> <C> <C>
Outstanding at beginning of year............................ --
Granted..................................................... 306,000 $10
Exercised................................................... --
Forfeited................................................... (11,100) $10
-------
Outstanding at end of year.................................. 294,900 $10
=======
Exercisable at end of year.................................. --
</TABLE>

36
<PAGE> 37
RAINBOW RENTALS, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONT'D)

(15) SUBSEQUENT EVENTS (UNAUDITED)

On February 1, 1999, the Company acquired certain assets of Rental Mart of
PA, Inc. for approximately $1.3 million in cash. The acquisition will be
accounted for using the purchase method of accounting.

On March 1, 1999, the Company acquired certain assets of Blue Ribbon
Rentals, Inc. and Blue Ribbon Rentals II, Inc. for approximately $10.4 million
in cash. The acquisition will be accounted for using the purchase method of
accounting. In conjunction with this acquisition, the Company amended the terms
of its revolving loan agreement on March 1, 1999. The amendment increased the
maximum revolving loan amount to $16.0 million and extended the loan agreement
to March 1, 2002.

37
<PAGE> 38

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.

RAINBOW RENTALS, INC.

By: /s/ WAYLAND J. RUSSELL

------------------------------------
Wayland J. Russell
Chairman and Chief Executive Officer

Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
registrant and in the capacities and on March 29, 1999.

<TABLE>
<CAPTION>
SIGNATURE TITLE
--------- -----
<C> <S>
/s/ WAYLAND J. RUSSELL Chairman and Chief Executive Officer
- ---------------------------------------------
Wayland J. Russell

/s/ LAWRENCE S. HENDRICKS Chief Operating Officer and Director
- ---------------------------------------------
Lawrence S. Hendricks

/s/ MICHAEL J. VIVEIROS President and Director
- ---------------------------------------------
Michael J. Viveiros

/s/ MICHAEL A. PECCHIA Chief Financial Officer
- ---------------------------------------------
Michael A. Pecchia

/s/ BRIAN L. BURTON Director
- ---------------------------------------------
Brian L. Burton

/s/ IVAN J. WINFIELD Director
- ---------------------------------------------
Ivan J. Winfield
</TABLE>

38
<PAGE> 39

EXHIBIT INDEX

<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION OF DOCUMENT
- ------- -----------------------
<C> <S>
2.1(1) Amended and Restated Asset Purchase Agreement dated March 1,
1999 by and among the company, Blue Ribbon Rentals, Inc.,
Blue Ribbons Rentals II, Inc. and William Wendell.
3.1(2) Amended and Restated Articles of Incorporation
3.2(2) Amended and Restated By-Laws and Code of Regulations
4.1(2) Loan and Security Agreement dated as of October 5, 1992, by
and between the Company and Bank of America National Trust
and Savings Association (formerly Bank of America, Illinois,
formerly Continental Bank, Illinois, formerly Continental
Bank, NA), as amended.
Consent and Amendment No. 10 and Third Amended and Restated
4.2(3) Supplement A to Loan and Security Agreement between the
Company and Bank of America National Trust and Savings
Association, dated July 15, 1998.
Consent and Amendment No. 11 and Fourth Amended and Restated
4.3(1) Supplement A to Loan and Security Agreement between the
Company and Bank of America National Trust and Savings
Association, dated March 1, 1999.
4.4(2) Collateral Trademark Security Agreement dated as of October
5, 1992 by and between the Company and Bank of America
National Trust and Savings Association. Information
concerning certain of the Company's other long-term debt is
set forth in Note 6 of the consolidated financial
statements. The Company hereby agrees to furnish copies of
such instruments to the Commission upon request.
10.1(2) 1998 Stock Option Plan
10.2(2) Lease by and between the Company and Rainbow Properties,
Ltd. dated January 1, 1996 for the Company's principal
executive offices.
21(2) List of subsidiaries
27.1(*) Financial Data Schedule
</TABLE>

- ---------------

* Filed Herewith

(1) Previously filed, as of March 16, 1998, pursuant to the Company's report on
Form 8-K.

(2) Previously filed, as of June 5, 1998, pursuant to the Company's
Registration Statement on Form S-1.

(3) Previously filed, as of August 13, 1998, pursuant to the Company's report
on Form 10-Q.

<ARTICLE> 5
<CIK> 0001058441
<NAME> NONE
<MULTIPLIER> 1,000

<S> <C>
<PERIOD-TYPE> YEAR
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> JAN-01-1998
<PERIOD-END> DEC-31-1998
<CASH> 0
<SECURITIES> 0
<RECEIVABLES> 0
<ALLOWANCES> 0
<INVENTORY> 25,246
<CURRENT-ASSETS> 25,952
<PP&E> 7,807
<DEPRECIATION> 4,413
<TOTAL-ASSETS> 33,068
<CURRENT-LIABILITIES> 6,120
<BONDS> 0
<COMMON> 11,039
0
0
<OTHER-SE> 15,799
<TOTAL-LIABILITY-AND-EQUITY> 33,068
<SALES> 1,588
<TOTAL-REVENUES> 63,479
<CGS> 0
<TOTAL-COSTS> 21,765
<OTHER-EXPENSES> 34,516
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 918
<INCOME-PRETAX> 6,280
<INCOME-TAX> 2,662
<INCOME-CONTINUING> 3,618
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 3,618
<EPS-PRIMARY> .73
<EPS-DILUTED> .73

</TABLE>