Conn's: An Undervalued Retailer

| About: Conn's, Inc. (CONN)

Conn’s Inc. (NASDAQ: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:

  1. 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.
  2. 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.
  3. 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:

  1. 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.
  2. 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.
  3. 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.

Disclosure: I am long CONN.