|Shares Out. (in M):||36||P/E||14||13.5|
|Market Cap (in $M):||701||P/FCF||0.0x||0.0x|
|Net Debt (in $M):||0||EBIT||0||0|
1 + 1 = 3: that is a business-school definition of synergy. Two companies join forces, and the quality and profitability of the combined entity improves more than arithmetical result of sum of the parts. However, when you combine two awful businesses you get the inverse synergy: -1 + (-1) = -3. The combining of two dysfunctional companies results in an even more dysfunctional sum (think of a hypothetical GM and Chrysler merger circa 2007).
We expected to see inverse synergy at Conn’s when we started analyzing it; after all, it consists of two pretty awful businesses – a retailer of electronics, furniture, and appliances and a subprime lender. However, we discovered the opposite phenomenon in the course of our analysis, and we are now proud to reveal Conn’s Paradox: the (positive) synergy of awful.
Conn’s brick and mortar retail business – especially in electronics – has very few competitive advantages; it sells commodities and is therefore fighting for its life with competitors that are much larger and thus have greater buying power (think Wal-Mart and Best Buy), often have more efficient distribution systems (think Amazon), and therefore have structural cost advantages. Conn’s subprime lending business is not any better: just a few years sub-prime lending was the culprit that almost bombed the US into a depression.
Conn’s paradox is that the severe unattractiveness of each business in isolation opened a unique niche for a combined business and allowed the company to build a competitive advantage by dis-aligning it against its perceived competition – the Best Buys, the Wal-Marts, and the Amazons of the world. All of the aforementioned retailers sell some or even all the products that Conn’s sells, but Conn’s customers don’t have the means – the credit – to buy them from the other guys; therefore they are only Conn’s competitors in theory, not in practice.
Conn’s, despite being an unknown quantity to most of our clients and readers, has been around for a long time. The company started about 60 years ago in Texas, where it still has its largest number of stores. Though it does sell electronics, it has been deemphasizing that category for a while, taking it down from 40% of sales a few years ago to only a quarter of sales today. In fact, if you visit a Conn’s store it looks a lot more like a furniture, mattresses, and appliances store than an electronics store. Conn’s customers are underbanked consumers – and this country has 30 million of those. They usually have poor credit (low FICO scores) and don’t have access to bank or plain vanilla credit and thus cannot actualize their constitutionally granted right to pursue happiness, which in the modern American dream version means watching Netflix on a 60-inch TV.
Thirty million people is a large number – it’s only a few million shy of the total population of Canada – but from Best Buy’s or Wal-Mart’s perspective, the rest of the country – 300 million Americans – represents much-lower-hanging fruit. The upper 90% of consumers have far higher buying power than the lowest 10%; and while Best Buy would love to sell a 60-inch TV to anyone who comes into its stores, it will not get into the subprime lending businesses to go after 10% of the market (I’d argue that it’s more like 5% of spendable dollars) to sell an extra TV.
Under its new CEO, Conn’s has modified its retailing strategy: it has slowly moved away from electronics and focused on improving margins in its retail business by NOT trying to offer the lowest prices, and it stopped carrying category losers – products that by their nature have low or no margins. For instance a $300 TV has only a 10% gross margin, so the company makes only $30 on that sale and generates little financing income. But a $2,000 top-of-the-line TV has a 28% margin and brings almost $900 of gross profit to the company along with plenty of finance income.
This change in strategy makes a lot of sense: this way Conn’s doesn’t have to fight with Amazon or Best Buy for a sale on which it would make very little profit and where Conn’s ability to finance the purchase would have much lower value to the customer. This strategy has proved to be very successful, as the company’s operating margins have improved significantly in recent years and retail business has become a significant profit center for the company.
Conn’s ability to lend profitably to subprime customers is an important skill that requires a laser-like focus on that relatively small niche, which Conn’s mass-retail brethren don’t have.
The question comes to mind, why wouldn’t Best Buy team up with another subprime lender to compete against Conn’s?
One of the biggest obstacles is that the lending partner would have to overcome significant losses in the initial years. When Conn’s opens stores in new areas, it loses money on new loans (we estimate that credit losses peak at 15%). The new stores remain profitable only because credit losses are subsidized by the profit generated by the retail side of the business. Only a competitor that does both retail and subprime financing can do that, and Conn’s has no such competitors.
As stores mature, bad borrowers naturally filter out by not paying (if you don’t pay for your TV, Conn’s will not lend you money to buy a couch), and underwriting losses settle at somewhere around 5%. During the financial crisis Conn’s had a very mature store base and held underwriting losses below 5%. That’s a good number for any lender and an incredibly low number for a subprime lender, especially at a time of severe economic distress. For example, American Express, which lends to the very high-end tier of the market, had losses around 8% during the crisis.
One of the keys to Conn’s underwriting success is the recurrence of revenues from existing customers. Conn’s provides great customer services, its prices are reasonable (not the best but fair), and most importantly, Conn’s offers one of the few avenues for its customers to get financing at reasonable rates. Thus customers keep coming back to its stores and buying from Conn’s, which explains the low default rates.
A current opportunity in Conn’s has been created thanks to the company’s aggressive expansion strategy. Conn’s went into new markets and almost doubled it store base in five years. As we discussed above, new stores bring higher underwriting losses, at least initially. The extent of credit losses was magnified by the fact that Conn’s opened stores in new markets where it had no or few existing stores. Management was as surprised by the severity of the losses as investors were. The company’s CFO and the stock paid the price: the CFO was fired and the stock collapsed.
Management vowed to be less promiscuous with lending in new stores. They kept their promise, as delinquency have been on a steady decline over the last two quarters. It is easy to hate a subprime lender that in theory competes with Best Buy and Amazon, especially when the delinquency rate on its loans is going through the roof; but once you understand that higher delinquency is a natural byproduct of the company opening new stores, it stops being a surprise and in fact can be treated as part of the company’s competitive advantage. In fact, if the company stopped opening new stores today, then in a few years, as stores it has opened over last few years matured, it would generate about $5 of earnings. But as the company continues to open new stores, the initial underwriting losses mask significant (eventual) earnings power. Today Conn’s has only 120 stores, but it has the potential to have 500. At current prices you have an opportunity to buy a company with a significant growth runway ahead of it at a bargain basement price.
|Subject||What's it worth?|
|Entry||04/22/2015 06:25 PM|
I kind of get the "big picture" thoughts on the post / msg, but what do you think the security is worth? What's your valuation scenario?
|Subject||Re: What's it worth?|
|Entry||04/22/2015 07:18 PM|
We get $5 of no growth EPS (if the stopped opening new stores) - you put 12x - $60?.
|Entry||04/22/2015 10:40 PM|
Aren't the credit metrics about to materially degrade since the significant majority of Conn's credit book is in Texas? Texas has an outsized exposure to oil and although the state hasn't felt a slowdown yet, I find it difficult to believe that Conn's customers won't feel pinched as the year goes on. CONN's stock price seems highly correlated to credit metrics - how do you get comfortable that their Texas customers will keep making their payments after their April tax refunds fade?
|Subject||Copperfield's short thesis|
|Entry||05/27/2015 12:04 PM|
|Entry||06/03/2015 09:43 AM|
Note the following language in the earnings release:
“The Board of Directors may also determine that a refinancing transaction or no transaction is in the best interests of stockholders. As a result, we have determined that the loan portfolio does not meet the criteria for treatment as an asset held for sale, which would require recording at the lower of cost, net of allowances, or fair value. Because the fair value will be based on the expected return on the loan portfolio over its expected life whereas a significant portion of our allowances are based on expected charge-offs over the next twelve months, the fair value of the loan portfolio could be less than the amount currently recorded.”
If the bulls are so certain that the loan portfolio will be sold immediately because there are so many bidders, why wouldn’t CONN treat it as asset held for sale? My guess is: (a) CONN is having trouble selling this portfolio due to low bids and potential CFPB regulation; and (b) marking the portfolio at fair value would cause CONN to violate debt covenants.
|Subject||Largest holder Luxor selling|
|Entry||06/04/2015 10:07 AM|
Amended 13D filed today. Ownership down from 7.6m shares to 6.6m shares after selling this week. Still owns 18%.