Conn's is a retailer. They sell electronics, furniture, and appliances to the thousands of sub-prime borrowers who walk into their store. About 80% of their sales are financed.
Goal of the analysis: Determine if Conn's is overvalued and a timely short
Amazon is decimating brick and mortar retailers. As expected, the stocks of Best Buy (BBY) and hhgregg (HGG) have been punished and appear to be value traps. I believe that Conn's should be valued similarly, if not worse than those two companies. While analysts will argue that the company is growing quicker than rivals and has an advantage by extending credit to those who can't afford it I think there are problems.
Is CONN growing enough to deserve a premium?
The charts below show revenue and store growth is non-existent at CONN. HGG and BBY have been growing store count and along with that, overall revenue. Conn's store count has dropped from 76 in 2009 down to 65. It does seem that these were less active stores as revenue/store has risen from $9.59M in 2010 to $10.05M in 2012(~2% per year).
HHG is argued to be snapping up old Circuit City stores. This rumor seems believable based on their store count numbers quickly expanding since 2008. BBY is growing stores and revenue is starting to flatten out, in their 10K they mention that comparable store sales have declined by ~1.7% per year the past two years.
Regardless, CONN is the only one of the bunch that is neither growing store count nor revenue. While they have eliminated stores that are less active (based on Rev/store number) the growth within existing stores is hardly inspiring. Yet this growth commands a 13X forward multiple based on guidance of $1.30 EPS.
This high multiple for a sector in decline seems odd when you consider BBY has a forward multiple of ~6X with guidance for GAAP EPS of $2.85-$3.25. HHG is guiding for GAAP EPS of $0.90-$1.05 for a multiple of ~6.6X. So why would CONN be valued 2X as high as rivals who may be in a secular decline, but are still quite profitable, growing revenue and store count?
Regardless, CONN is the only one of the bunch that is neither growing store count nor revenue. While they have eliminated stores that are less active (based on Rev/store number) the growth within existing stores is hardly inspiring. Yet this growth commands a 13X forward multiple based on guidance of $1.30 EPS.
This high multiple for a sector in decline seems odd when you consider BBY has a forward multiple of ~6X with guidance for GAAP EPS of $2.85-$3.25. HHG is guiding for GAAP EPS of $0.90-$1.05 for a multiple of ~6.6X. So why would CONN be valued 2X as high as rivals who may be in a secular decline, but are still quite profitable, growing revenue and store count?
Does Conn's have a better business model?
Maybe CONN is doing something better than their rivals. Perhaps they sell different products, don't have as many contractual obligations, or get much higher returns through their financing arm.
Besides the subprime financing, BBY and HHG sell cell phones while CONN does not. In FY2012 BBY had 40% of their sales come from "Computing and Mobile phones." Besides appliances (comparable store growth up 10.6% from 2012 to 2011) it's been the only growing segment up 6.0% compared to 2011 in comparable stores.
For HHG 9% of sales came from computing and mobile phones and comparable store sales grew 52.9% YoY. Appliances grew 3.0% YoY in comparable stores. Besides that, all other segments declined but they did mention that mattresses had "strong double digit growth.''(pg 37 2012 10K)
So appliances are growing between 3-10% at the two other retailers. At CONN recent conference calls have emphasized increased furniture and mattress sales. This segment increased 35.2% YoY (pg 8 2012 10K) but only makes up 16.7% of their product sales. The thought is that they can generate higher margins by growing this segment. Retail gross margin has improved 2.2% YoY thanks to an emphasis on furniture and mattresses. I think the obvious thing is that cell phones should not be focused on(see Radioshack).
So there are some differences in the business model. So much in fact, that for 2013 management expects retail gross margin to jump up to 33%, largely thanks to product mix. I still believe that's a lofty goal considering a well established company like La-Z-Boy has 30% gross margins currently and 10 year gross margin average of 26.5%(LZB filings).
Total contractual obligations are always big for retailers as operating leases can be hidden. BBY has total contractual liabilities of $14.2B (pg 54 2012 10K) for a total capitalization (MC+total contractual liabilities-cash) of $19.1B. With a low end earnings of $2.85 and 366.3M total shares net income will be $1.043B. So BBY has a total capitalization to earnings ratio of 18.3X.
HHG has $715M of contractual obligations, no debt and cash of $59M. With a market cap of $227M they have a total capitalization of roughly $880M. Net income will come in at $36M if EPS is $0.95/share. So my calculated total capitalization to earnings ratio for HHG is 24X.
Finally, CONN has $458M of total contractual cash obligations (pg 59 2012 10K), a market cap of $578M and cash of $6M (which isn't excess but I'll just subtract it for simplicity) for a total capitalization of $1030M. With net income of $1.30/share and 32.9M diluted shares (a 1M increase from the quarter before!), my calculated total capitalization to expected earnings ratio is 24.1X.
I could calculate ratio after ratio and paint a million different pictures. At the very least I'm convinced that HHG isn't that cheap due to contractual obligations and neither is CONN. Yet all three are in the same ballpark. What I can try to determine now is the quality of Conn's earnings. Are they avoiding the secular decline in brick and mortar stores from their financing arm?
Conn's Financing and Overall Valuation
This credit segment first caught my eye and still mystifies me. Somehow this company charges 18% interest rates and has net charge-offs of 8.5% on a $634M portfolio balance(pg 23 Q1 2013 10Q). Therefore the maximum amount of money they'll get is 18% of $634M ($114.1M). They also have 3rd party financing that makes ~$25M. Total financing revenue is $138.6M.
If we back out the expected 8.5% net charge-offs ($53.89M), $24.5M of interest expense (guided to on their Q1 2013 earnings call) and Credit Segment SG&A of $57.8M (pg 42 10K 2012 41.7% of revenues), we have total costs for the portfolio of $136.2M. Adding back the provision for bad debts of $53.6M and the $634M portfolio makes $56M or 8.8%.
What I find amazing, stunning actually, is that their loss rates are so low. They re-age their loans and currently 11.6% of their loans are re-aged. CONN has figured out something that Visa, MasterCard, Bank of America, Citi, JP Morgan, etc have not figured out. Giving a group of people with an average weighted score of 601 more chances at paying back debt drops charge offs to rates seen in prime borrowers.
According to Lending Club's white paper, FICO bands of 600 or lower will see >19% charge offs. Hmmm, if we add 11.6% plus 8.5% we get 20.1%. I would argue that re-aging simply pushes out the charge-off date. I believe this is confirmed even with secured debt. On home loans with LTV's over 90% (the average down payment for Conn's is 4.5%) foreclosure rates average 25% for FICO 580-599 and 19.5% for 600-619. It's simply amazing that CONN has such low rates of default and in reality, they probably don't.
FY 2012 Valuation
So let's revisit the business again and see if it's making money. The information below is from the 2012 10K and simply reproducing their numbers to fit what I see as free cash flow.
The retail section is pretty straightforward. Retail gross profit for FY 2012 was $191.6M ($653.6M-$455.5M-$6.5M). Total SG&A was $237.9M(I'll assume all SG&A is in retail, by my calculations Credit SG&A minus provision for losses is only about $3-4M). Therefore operating profit for this segment was -$46.3M.
Credit had total revenue of $138.6M, net charge offs of $46.9M, and borrowing costs of $22.5M. Profit for the credit segment was $69.2M.
Other non-operating charges included $7M for store closings and $2M for impairment. These are added back to operating cash flow on the cash flow statement but I believe that to be a mistake. Opening and closing stores, even if they are not operating, still cost a business money. Leases have to be paid and that payment is usually in cash, meaning it's a real cost.
From there I've assumed that a real investor would see D&A ($12.8M), stock comp ($2.3M), and loss from early extinguishment of debt ($11.0M) for total non-cash provisions of $26.1M. Back out $4.3M in CapEx and the company generated $35.7M in what I believe is free cash flow.
With today's market cap right around $578M the investor today gets a FCF yield of 6.1%.
FY 2013 Valuation
But perhaps next year will get better. The stock market is after all, future looking. They hope to open 5-7 more stores in FY 2013. Let's say 6 stores are opened and for simplicity sake, they make 1/2 the revenue that established stores make (50% of 10M).
In FY 2013 if sales grow by 2%(what I've calculated rev/store growth to be over 2 years) and an extra $30M is made 2013 revenues will be $696M. Maybe they become a furniture store for people with credit scores under 605, if so they could see 30% gross profit (in line with La-Z-Boy). So gross profit would be $208.8M. SG&A should rise ~5% due to 10% more stores for half a year so SG&A of $249.8M. So operating profit should come in around -$41M.
The financing segment is tough to predict but lets assume that it too increases by ~10% and the average total outstanding balance gets to $700M, roughly what it was for FY 2011. At 18% interest they'll make $126M plus another $28M (a 10% increase from 2012) from third parties. Total Financing revenue of $154M. Subtracting out 7.5% net charge-offs (7.5%*$700=$52.5M), $24.5M interest (guided on their Q1 2013 call) the financing segment should see operating profit of $77M.
If we add back non-cash of $26.1M to the two segments operating profit of $36M ($77M-$41M) and back out CapEx for the year of $18M (pg 58 10K 2012) FCF for the year is $44.1M. So forward looking an investor today can get a business with a 7.6% FCF yield. I did not subtract impairment or store closing costs as was the case in 2012.
While maintenance CapEx will be less than $18M even if it goes to zero the company makes $62.1M, giving the investor in CONN a 10.7% FCF yield. Definitely not a long but is it really a short? That clue may lie in an assessment of management.
Management
For all that I tried I couldn't find anything terrible on management. They have over-reserved provisions for bad debts in the past five years. Perhaps they use this to massage earnings, I don't know. It still shows conservative accounting for bad debts, which based on their use of re-aging is probably necessary.
If they are massaging earnings (again I don't know if they are) it would be under the direction of a new CEO, Theodore Wright. Theo was previously CFO at Sonic Automotive and left for personal reasons. It certainly wasn't the salary, as his base salary in 2000 was almost the same as his salary now($450,000). He owns over 175K shares and his only open market purchase was April 4, 2011 when the company was trading for $4.83 a share. With the benefit of hindsight it was a well timed purchase.
His compensation is tied to adjusted operating profit and ignores costs for store closings and severance agreements. Grand total he made $2.9M in 2012. While it certainly would be nice to find something far more devious, I see nothing that's really out of line. It's rare to see a CEO actually really own a significant chunk of shares, especially at a small-cap so I can't really hold it against him. I don't think most executives understand how the market works anyways, but that's a topic for another time.
Why this stays in the "Too Hard" pile
I found myself going down rabbit hole after rabbit hole with this analysis. While the company is not cheap, there is nothing caustic here. I believe there is some flexibility being applied to their accounts receivable portfolio but it seems a stretch to say that anything is materially wrong. Since they no longer have the off balance sheet vehicle it is considerably harder to hide bad loans.
Also, just because CONN is offering credit to lower quality borrowers does not mean they are a ticking time bomb. Payday lenders are incredibly profitable and as long as there aren't interest rate restrictions I believe they will continue to make money. Whether or not 18% is enough to charge is the question. If you forced me to make a call I'd say the portfolio is break even at best over a 10 year cycle. That is just a gut level assumption.
The rise in promotional receivables and decreased down payment could lead to trouble down the road and let's be honest: the brick and mortar store is not profitable. Until I can find something more definitive I will stay on the sidelines. I am often wrong and could be here. No position.
Maybe CONN is doing something better than their rivals. Perhaps they sell different products, don't have as many contractual obligations, or get much higher returns through their financing arm.
Besides the subprime financing, BBY and HHG sell cell phones while CONN does not. In FY2012 BBY had 40% of their sales come from "Computing and Mobile phones." Besides appliances (comparable store growth up 10.6% from 2012 to 2011) it's been the only growing segment up 6.0% compared to 2011 in comparable stores.
For HHG 9% of sales came from computing and mobile phones and comparable store sales grew 52.9% YoY. Appliances grew 3.0% YoY in comparable stores. Besides that, all other segments declined but they did mention that mattresses had "strong double digit growth.''(pg 37 2012 10K)
So appliances are growing between 3-10% at the two other retailers. At CONN recent conference calls have emphasized increased furniture and mattress sales. This segment increased 35.2% YoY (pg 8 2012 10K) but only makes up 16.7% of their product sales. The thought is that they can generate higher margins by growing this segment. Retail gross margin has improved 2.2% YoY thanks to an emphasis on furniture and mattresses. I think the obvious thing is that cell phones should not be focused on(see Radioshack).
So there are some differences in the business model. So much in fact, that for 2013 management expects retail gross margin to jump up to 33%, largely thanks to product mix. I still believe that's a lofty goal considering a well established company like La-Z-Boy has 30% gross margins currently and 10 year gross margin average of 26.5%(LZB filings).
Total contractual obligations are always big for retailers as operating leases can be hidden. BBY has total contractual liabilities of $14.2B (pg 54 2012 10K) for a total capitalization (MC+total contractual liabilities-cash) of $19.1B. With a low end earnings of $2.85 and 366.3M total shares net income will be $1.043B. So BBY has a total capitalization to earnings ratio of 18.3X.
HHG has $715M of contractual obligations, no debt and cash of $59M. With a market cap of $227M they have a total capitalization of roughly $880M. Net income will come in at $36M if EPS is $0.95/share. So my calculated total capitalization to earnings ratio for HHG is 24X.
Finally, CONN has $458M of total contractual cash obligations (pg 59 2012 10K), a market cap of $578M and cash of $6M (which isn't excess but I'll just subtract it for simplicity) for a total capitalization of $1030M. With net income of $1.30/share and 32.9M diluted shares (a 1M increase from the quarter before!), my calculated total capitalization to expected earnings ratio is 24.1X.
I could calculate ratio after ratio and paint a million different pictures. At the very least I'm convinced that HHG isn't that cheap due to contractual obligations and neither is CONN. Yet all three are in the same ballpark. What I can try to determine now is the quality of Conn's earnings. Are they avoiding the secular decline in brick and mortar stores from their financing arm?
Conn's Financing and Overall Valuation
This credit segment first caught my eye and still mystifies me. Somehow this company charges 18% interest rates and has net charge-offs of 8.5% on a $634M portfolio balance(pg 23 Q1 2013 10Q). Therefore the maximum amount of money they'll get is 18% of $634M ($114.1M). They also have 3rd party financing that makes ~$25M. Total financing revenue is $138.6M.
If we back out the expected 8.5% net charge-offs ($53.89M), $24.5M of interest expense (guided to on their Q1 2013 earnings call) and Credit Segment SG&A of $57.8M (pg 42 10K 2012 41.7% of revenues), we have total costs for the portfolio of $136.2M. Adding back the provision for bad debts of $53.6M and the $634M portfolio makes $56M or 8.8%.
What I find amazing, stunning actually, is that their loss rates are so low. They re-age their loans and currently 11.6% of their loans are re-aged. CONN has figured out something that Visa, MasterCard, Bank of America, Citi, JP Morgan, etc have not figured out. Giving a group of people with an average weighted score of 601 more chances at paying back debt drops charge offs to rates seen in prime borrowers.
According to Lending Club's white paper, FICO bands of 600 or lower will see >19% charge offs. Hmmm, if we add 11.6% plus 8.5% we get 20.1%. I would argue that re-aging simply pushes out the charge-off date. I believe this is confirmed even with secured debt. On home loans with LTV's over 90% (the average down payment for Conn's is 4.5%) foreclosure rates average 25% for FICO 580-599 and 19.5% for 600-619. It's simply amazing that CONN has such low rates of default and in reality, they probably don't.
FY 2012 Valuation
So let's revisit the business again and see if it's making money. The information below is from the 2012 10K and simply reproducing their numbers to fit what I see as free cash flow.
The retail section is pretty straightforward. Retail gross profit for FY 2012 was $191.6M ($653.6M-$455.5M-$6.5M). Total SG&A was $237.9M(I'll assume all SG&A is in retail, by my calculations Credit SG&A minus provision for losses is only about $3-4M). Therefore operating profit for this segment was -$46.3M.
Credit had total revenue of $138.6M, net charge offs of $46.9M, and borrowing costs of $22.5M. Profit for the credit segment was $69.2M.
Other non-operating charges included $7M for store closings and $2M for impairment. These are added back to operating cash flow on the cash flow statement but I believe that to be a mistake. Opening and closing stores, even if they are not operating, still cost a business money. Leases have to be paid and that payment is usually in cash, meaning it's a real cost.
From there I've assumed that a real investor would see D&A ($12.8M), stock comp ($2.3M), and loss from early extinguishment of debt ($11.0M) for total non-cash provisions of $26.1M. Back out $4.3M in CapEx and the company generated $35.7M in what I believe is free cash flow.
With today's market cap right around $578M the investor today gets a FCF yield of 6.1%.
FY 2013 Valuation
But perhaps next year will get better. The stock market is after all, future looking. They hope to open 5-7 more stores in FY 2013. Let's say 6 stores are opened and for simplicity sake, they make 1/2 the revenue that established stores make (50% of 10M).
In FY 2013 if sales grow by 2%(what I've calculated rev/store growth to be over 2 years) and an extra $30M is made 2013 revenues will be $696M. Maybe they become a furniture store for people with credit scores under 605, if so they could see 30% gross profit (in line with La-Z-Boy). So gross profit would be $208.8M. SG&A should rise ~5% due to 10% more stores for half a year so SG&A of $249.8M. So operating profit should come in around -$41M.
The financing segment is tough to predict but lets assume that it too increases by ~10% and the average total outstanding balance gets to $700M, roughly what it was for FY 2011. At 18% interest they'll make $126M plus another $28M (a 10% increase from 2012) from third parties. Total Financing revenue of $154M. Subtracting out 7.5% net charge-offs (7.5%*$700=$52.5M), $24.5M interest (guided on their Q1 2013 call) the financing segment should see operating profit of $77M.
If we add back non-cash of $26.1M to the two segments operating profit of $36M ($77M-$41M) and back out CapEx for the year of $18M (pg 58 10K 2012) FCF for the year is $44.1M. So forward looking an investor today can get a business with a 7.6% FCF yield. I did not subtract impairment or store closing costs as was the case in 2012.
While maintenance CapEx will be less than $18M even if it goes to zero the company makes $62.1M, giving the investor in CONN a 10.7% FCF yield. Definitely not a long but is it really a short? That clue may lie in an assessment of management.
Management
For all that I tried I couldn't find anything terrible on management. They have over-reserved provisions for bad debts in the past five years. Perhaps they use this to massage earnings, I don't know. It still shows conservative accounting for bad debts, which based on their use of re-aging is probably necessary.
If they are massaging earnings (again I don't know if they are) it would be under the direction of a new CEO, Theodore Wright. Theo was previously CFO at Sonic Automotive and left for personal reasons. It certainly wasn't the salary, as his base salary in 2000 was almost the same as his salary now($450,000). He owns over 175K shares and his only open market purchase was April 4, 2011 when the company was trading for $4.83 a share. With the benefit of hindsight it was a well timed purchase.
His compensation is tied to adjusted operating profit and ignores costs for store closings and severance agreements. Grand total he made $2.9M in 2012. While it certainly would be nice to find something far more devious, I see nothing that's really out of line. It's rare to see a CEO actually really own a significant chunk of shares, especially at a small-cap so I can't really hold it against him. I don't think most executives understand how the market works anyways, but that's a topic for another time.
Why this stays in the "Too Hard" pile
I found myself going down rabbit hole after rabbit hole with this analysis. While the company is not cheap, there is nothing caustic here. I believe there is some flexibility being applied to their accounts receivable portfolio but it seems a stretch to say that anything is materially wrong. Since they no longer have the off balance sheet vehicle it is considerably harder to hide bad loans.
Also, just because CONN is offering credit to lower quality borrowers does not mean they are a ticking time bomb. Payday lenders are incredibly profitable and as long as there aren't interest rate restrictions I believe they will continue to make money. Whether or not 18% is enough to charge is the question. If you forced me to make a call I'd say the portfolio is break even at best over a 10 year cycle. That is just a gut level assumption.
The rise in promotional receivables and decreased down payment could lead to trouble down the road and let's be honest: the brick and mortar store is not profitable. Until I can find something more definitive I will stay on the sidelines. I am often wrong and could be here. No position.
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