Seeking Alpha
Long/short equity, value, special situations, contrarian
Profile| Send Message|
( followers)  

Conn's (CONN) is a fast growing retailer that is taking advantage of the propensity of most Americans to give in to the instant gratification of purchasing things before they can really afford them. Instead of saving up for a luxury item, or god forbid actually living without it like our parents did, many people in today's society seem to believe that they deserve everything that others are more inclined to work and save for.

This behavior manifested itself recently in the housing boom, when everyone with a pulse, although not necessarily an income, felt they deserved to be handed the keys to the American Dream of a McMansion. All it took was a negative amortizing, adjustable rate loan with no money down but a balloon payment sometime in the future, which could easily be refinanced forever as long as home prices kept going up.

Greedy bankers soon found they could package these loans and sell them as fast as they could make them. Actually, once they got the AAA rubber stamp of approval from the inept or possibly complicit ratings agencies, they could sell them even faster than they could make the actual loans, which led to an even further deterioration in loan quality, not to mention the creation of synthetic derivatives like CDOs.

But enough with the history lesson, this reckless era is obviously safely behind us, with a five year bull market showing no signs of abating anytime soon. Back to the subject of this article, Conn's has ridden this recovery with strong revenue and earnings growth by providing financing for cash strapped consumers to make the big purchases they deferred during the financial crisis and resulting recession.

The company sells mostly furniture and electronics, usually financed by their own consumer loans or rent-to-own payment plans. According to the latest quarterly report, 80 percent of the store's retail sales were purchased using the company's in-house financing program. Conn's uses the euphemistic and alliterative phrase "credit constrained consumers" to describe their target customers, which are typically less credit worthy individuals with credit scores between 550 and 650.

These shoppers' reliance on financing allows Conn's to charge higher retail prices than competing discount stores like Wal-Mart (WMT) or Target (TGT). Indeed, the company enjoys gross margins of 40%, which would make these stores or even Amazon (AMZN) envious. The company explains the increase in gross margins to this level as the result of "continued focus on higher price-point, higher margin products". Selling higher priced products to higher risk borrowers, what could possibly go wrong?

Luckily, the company claims to have a contingency plan in place to deal with this increased risk, in the form of a "provision for bad debt". However, given recent trends, this provision seems to be woefully inadequate, standing at a mere 6.3% of the total outstanding balance of their customer receivable credit portfolio. This is actually down from a 6.5% allowance last year despite the fact that the percentage of account balances 60 days past due has increased to 8.5% from 7% over the past year, as shown in the following table from the annual report:

Customer Receivable Portfolio Data

 

The following tables present, for comparison purposes, information about our credit portfolios (dollars in thousands, except average outstanding customer balance):

As of October 31,
 2013 2012
Total outstanding balance$944,826 $683,744
Weighted average credit score of outstanding balances591 603
Weighted average months since origination of outstanding balances (1)8.6 9.7
Percent of total outstanding balances represented by balances over 36 months from origination (1)0.5% 1.1%
Average outstanding customer balance$1,676 $1,479
Number of active accounts563,573 462,200
Account balances 60+ days past due (2)$80,505 $47,691
Percent of balances 60+ days past due to total outstanding balance8.5% 7.0%
Total account balances reaged (2)$102,802 $77,837
Percent of re-aged balances to total outstanding balance10.9% 11.4%
Account balances re-aged more than six months$20,738 $20,225
Percent of total bad debt allowance to total outstanding balance6.3% 6.5%
Percent of total outstanding balance represented by promotional receivables33.4% 23.5%

Clearly, these trends seem to be headed in opposite directions, which could cause problems when more of these loans start going bad than the company has allowed for. Furthermore, this trend might be expected to continue given that their total outstanding balance has ballooned recently, likely driven by lower quality loans and advertising gimmicks, as evidenced by the declining average credit score and much increased percentage of promotional receivables shown above.

These short-term, no-interest promotional financing offers have also reduced portfolio interest by 150 basis points over the past year and now comprise a full third of the total outstanding balance. This should be worrisome to investors since they should realize that much like the interest only mortgages that imploded during the housing crisis, these loans are much more likely to go bad, despite what management is saying with the reduced allowance.

While bulls are focused on the strong earnings growth driven by increasing accounts receivable, investors should instead focus on cash flow to see that most of these "earnings" result from revenue that flows directly to an ever increasing accounts receivable balance that may or may not be able to be completely collected. When we subtract out this growth in receivables and inventory, we get a hugely negative operating cash flow, over negative $70M in the past quarter alone.

This shortfall must be covered by increased borrowing or additional sales of stock. This problem is explained away by bulls as that the company is rapidly expanding. However, despite capital expenditures of over $37M in the first nine months of the year, Conn's has actually closed 2 stores and only opened 9 new ones. Closing underperforming stores and opening new locations in other areas that haven't been "fished out" artificially boosts the same store sales numbers that analysts seem to be so keen to focus on.

Together with boosting sales by relaxing already low credit standards or offering promotional incentives that could exacerbate rising delinquency rates, these short term measures paint the stock in an artificially good light when looking only at its impressive earnings increases. However, a deeper look at other metrics like cash flow shows a worrisome buildup of accounts receivable that could rear their ugly head at some point if the liquidity driven good times don't keep rolling forever.

Investors would be prudent to take a closer look at Conn's to see if they conclude that it is a dangerous business built on debt and lax lending standards. I think you'll agree with me that it contains enough risk to avoid at these high prices, or could even be a good short if it continues its reckless expansion in both number of locations and outstanding loans. Like the easy profits racked up by the banks during the housing boom, they could evaporate when more loans go bad than are expected, so investors should exit before this second debt-fueled house of cards collapses.

Source: Conn's Is Creating A New Subprime Lending Bubble