Conn’s Inc. (CONN) is a specialty/electronics retailer operating retail locations in Texas, Louisiana and Oklahoma. Conn’s primarily sells electronics and home appliances but also sells furniture and other home furnishings.
While functionally a retailer, I believe the value of Conn’s to be on its balance sheet -- specifically in its accounts receivable. Conn’s utilizes several forms of consumer financing and finances roughly 65% of client purchases either through itself or through third parties. Historically, the company would off-load these receivables but has recently been forced to bring these receivables onto the balance sheet, increasing receivables from $342mm in receivables in 2009 to $620mm in the latest quarter. These receivables on average pay a rate of 18.5% in interest. The market has not received this change well, and the stock price has moved from a high near $45 in 2007 to a low of around $3, with a current price near $6.
The question then becomes: What is the value of these receivables? Is a retailer able to handle the credit issues involved? Currently the company has $653mm in receivables with an allowance of $33mm vs. equity of $396mm (gross of allowance). Hence, 61% of its receivables could go bad (with no recoveries) before it has negative tangible equity.
As we are beginning to see a recovery in the economy, so we are also seeing a recovery in Conn’s credit metrics. Balances overdue by 60 days have decreased from a peak of 10% of accounts receivable to 7.1% in the most recent quarter. I model the company generating $7.8mm pre-tax from its finance group in 2012 (fiscal year end is Jan. 31), vs. a loss of $1.7mm in 2011.
Beyond the advantage of offering your customers a unique value proposition through in-house financing, I believe the finance division to be a real value creation vehicle for Conn’s. Moving forward, I can think of several catalysts that could easily drive shares north of $10:
- ABS markets begin to open up and the company finds more advantageous terms. To the extent it offloads receivables anywhere near dollar:dollar, the company would generate a lot of cash.
- During the transition to the current model, the company generated negative cash from operations as net working capital increased. Even if it does not shrink the AR book, moving to a steady state where change in working capital is no longer a drag on the company should allow it to generate substantial free cash flow moving forward. Specifically, I think it will generate north of $50mm in free-cash flow in 2012.
- In obtaining financing for the accounts receivable held on the portfolio, the company entered into a $100mm subordinated term loan at a rate of L+11.5%, with a 3% LIBOR floor -- currently a 14.5% interest rate. The loan has a prepayment penalty of 5% before November 30, then moves down to 3%. Should the company repay that at some point, interest cost could fall by $7mm, boosting EPS by $0.14.
Valuation for a business like Conn’s can be tricky as you essentially are valuing both a retail operation and a financial operation. Therefore I use several metrics to get there:
- Price to Cash Flow: I’m modeling $49.5mm of free cash flow (ex changes in NCWC) for fiscal 2012, and using a 10x multiple arrive at $15.56/share.
- Price to Book: Assuming markets reopen and CONN is able to begin to divest its AR book, the company should easily sell at book value, which at fiscal YE 2012 is modeled at $11.50/share.
- Sum of Parts: Assuming scenario #2 for the finance arm and a 10x P/E ratio for the retail segment would get me to $12.58/share.