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Summary

  • Conn's has strong financial momentum in retail operations.
  • Investors overreacted to the increase in delinquencies in the credit portfolio.
  • Potential target price of $49, which is 44% above current price of $34.

Conn's (NASDAQ:CONN) is a specialty retailer operating in the southern U.S. that sells high-value merchandise (furniture, mattresses, consumer appliances, etc.) on credit to subprime customers (weighted average credit score = 594 as of Jan. 31). Historically, 65% of sales have been financed with in house credit. Since the end of last year the stock has been on a steady downtrend from $80, with the biggest decline occurring on Feb. 20 when the stock dropped 40% on revised lower guidance. Investors were spooked by the increase in delinquency rates. The percentage of customer portfolio balance 60-plus days delinquent increased to 8.8% from 8.5%. There also was a critical article on Seeking Alpha early in January. I suspect that upon hearing the word "subprime," more than a few people ran for the exits.

Investment Thesis

The company has strong financial momentum in its retail operations -- same store sales have gone ups 33% in the last quarter. The new revised company guidance calls for $2.59-$2.64 EPS in the fiscal year ending Jan. 31, 2014, and $3.40-$3.70 in the year ending Jan. 31, 2015. I expect revenues per store to go up 10% in 2015, tapering off to 2% in five years. With projected new-store openings of 15-19 in 2015, I believe the overall revenues could grow to $1.7 billion in FY 2019. However, my projection for 2015 EPS is lower than the company guidance:

Exp 2014FY 2015FY 2016FY 2017FY 2018FY 2019
Retail PBT122,105162,146190,060206,017214,423218,971
Credit PBT24,13317,21118,98524,71225,38128,653
Profit before Tax146,238179,356209,045230,730239,803247,624
Tax Rate0.360.360.360.360.360.36
Taxes52,64664,56875,25683,06386,32989,145
PAT93,592114,788133,789147,667153,474158,479
Shares37,00037,00037,00037,00037,00037,000
EPS2.533.103.623.994.154.28
EPS growth 22.6%16.6%10.4%3.9%3.3%

While there has been a focus on increase in delinquencies, the credit portfolio has an average yield of 18% while the 60-day delinquency has historically been in the range of 7%-10%. The expansion in the credit portfolio has been partially financed with external borrowing, with the weighted average interest rate of 3.3% as of Jan. 31, 2013. My financial projections show that at 10% bad debt expense, the credit segment will contribute roughly 10% to the overall EBT over the next five years.

The company has been offering in house credit for 45 years, which instills confidence in their ability to manage their receivables. The credit portfolio contains many small loans (average loan is ~$1,500), with 71% of credit balances belonging to repeat customers.

I used residual income model to estimate a fair value for the share. Using this model the value of the stock can be calculated as sum of the book value and the present value of the future residual income discounted at the cost of equity:

 V_0 = BV_0 + \sum_{t=1}^{\infty} { RI_t \over (1+r)^t }

Where

Residual Income (RI) = Net Income - Equity Charge

and

Equity Charge = Equity Capital x Cost of Equity.

This model is appropriate for a company such as Conn's, which is generating negative operating cash flow due to expansion of account receivables and the credit portfolio.

The model indicates that the fair price would be about $49.4:

3 year Beta vs S&P 5001.4
Mkt Risk Prem5.0%
Risk Free Rate1.0%
Cost of Equity8.0%
Exp 2014FY 2015FY 2016FY 2017FY 2018FY 2019
Ending Book Val/share15.8518.9622.5726.5630.7134.99
Cost of Equity charge 1.271.521.812.132.46
EPS2.533.103.623.994.154.28
EPS growth Rate 22.6%16.6%10.4%3.9%3.3%
Residual Income 1.832.102.192.021.83
Discount Factor 0.930.860.790.740.68
Terminal growth3.0%
Terminal Value37.62
Value per share49.42
5 Yr Avg Same Store Sales Growth4.40%
Bad Debt Provision rate10%

The sensitivity analysis shows that the fair price can significantly be impacted by decrease in sales growth and/or increase in bad debt rate:

Bad debt rate
5 yr avg same store sales gr7%10%13%
-4.40%41.9328.7015.46
4.40%66.9349.4231.91
8.00%79.7060.0840.46

Risks

The biggest risks lie in whether Conn's can sustain the momentum in its retail operations. The 2014 fiscal year was a strong one, and I expect the momentum to follow through to FY 2015. I would also be watching margins. I am less concerned about the risk of increasing delinquency in the credit portfolio. The 18% yield on its portfolio is a fair compensation for risk of extending loans to less creditworthy customers.

Moreover, I don't foresee that delinquency rate will skyrocket overnight. As the company has been in business for 45 years, I don't buy the argument that the company is creating a "subprime crisis" with the economy in the middle of recovery. I would be more concerned if we were going into recession.

Conclusion

The target price of $49.4 represents about 43% upside from the current price of about $34.4. I expect the share price to rebound within six to eight months as the year progresses. There are several reasons to be optimistic.

The credit segment performance in part has been impacted by the below-normal winter temperatures. With winter coming to an end, I expect the 60-day delinquency rate to stabilize and decline. Moreover, the company claims to have made adjustments to the underwriting standards, the benefits of which will be realized over next several quarters.

As the credit fears subside, investors will focus on the momentum in the retail operations. Given the sales growth in the last year, I expect the momentum to carry over to the next several quarters.

Disclosure: I am long CONN. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Conn's Inc. - Oversold Stock Poised For Rebound