Conns: From Long to Short?
Today, however, the situation is much different, as the stock has run-up substantially and now trades above book value.
I found that really interesting: Conn’s stock has been on a complete tear over the past year, while almost every other consumer electronics stock in the world has been cut in half twice over.
And then I saw this post saying the author was short Conn’s. And I found the thesis incredibly interesting.
Basically, Conn’s consists of two pieces: the actual retail business, and the finance business. The retail business is divided (very roughly) 40/40/20 between consumer electronics, consumer appliances, and furniture/mattresses. The finance business provides financing to Conn’s customers.
Let’s start with the retail business. The appliance and furniture pieces are decent businesses that aren’t extremely vulnerable to the Amazon threat (yet) simply because the items are so large and heavy that they need delivery and installation. But just because they aren’t vulnerable to amazon doesn’t mean they’re great businesses: Conn’s has no competitive advantages over Home Depot, Sears, or any of the dozens of other chains, both local and national, that sell those items.
However, the consumer electronics business is absolutely horrible right now. Not only do they face fierce competition from Wal-Mart and Best Buy, but Amazon is turning them into a “showroom” and demolishing the business. The three “pure play’ consumer electronic stores I can think of (RSH, BBY, and HGG) all trade for between 2x-3x EV / EBITDA and seem priced to go out of business.
So that’s 40% of the retail business that seems set to go away completely. Now, let’s turn to the finance business, and remember- it’s captive to Conn’s sales, so if the consumer electronics piece goes away, a major piece of the finance business goes away.
The finance business provides consumer financing for the purchase of Conn’s goods. They segment their customers into three parts- consumers with credit scores over 650 are referred to low interest financing from GE Capital and Conn’s earns what basically amounts to a referral fee. Consumers with scores under 550 are referred to a rent to own plan through RAC. For consumers with scores between 550 and 650, Conn’s provides in house financing.
Now, 550 – 650 may sound high. But it’s not. 600-650 is consider “bad” or “high risk”, and most lenders consider below 650 sub-prime. Below 600 is “very high risk”. In other words, Conn’s is maintaining a subprime credit portfolio!
And that’s pretty evident in what Conn’s charges for their loans- the average interest rate on their portfolio is over 18%!
Now, that may sound like an outstanding return, but it’s actually not that great once put into context w/ the risk. Conn’s write-off rate is 7-8%, and their debt all carries floating interest rates that are currently ~6%. Put the two together and CONN’s is netting ~4% on the portfolio. A net return of 4% that’s almost entirely dependent on low interest rates doesn’t seem very sustainable to me, nor does it seem like it’s worth the risk, given this type of portfolio is pretty much what took Circuit City down during the financial crisis and almost took Conns down as well.
So those are the qualitative. And honestly, those alone are enough to raise some pretty big red flags (at least IMO). So now let’s look a bit more at the quantitatives.
CONN trades at 9 times forward earnings and 1.4x book value. Let’s take these one at a time.
First- earnings. Best Buy has a much better balance sheet than Conn’s, yet it trades for just 5x forward earnings. True, Conn’s isn’t as “exposed” to amazon as Best Buy, but I can’t find a single retailer w/ a similar sales profile to Conn’s that trades at more than low double-digit earnings multiples.
Second- book value. When a company trades above book value, it’s generally because the market is forecasting the company can earn excess ROE in the future. If a company’s cost of equity is 10% and it can earn 10% ROE, than it’s fair value is going to be book value. Since CONN’s trades above book value, the market is clearly forecasting excess returns.
But, even putting the negative consumer electronic industry issues aside, I wonder if Conn’s can earn ROE in excess of their cost of equity over a full cycle. Check out their ROE for the past ten years here. Remember, CONN’s employs a tremendous of leverage- assets are more than double equity (debt ~= equity), and they lease basically all of their stores. That’s two big piles of leverage, and yet CONN’s still averages only mid-teen ROE during the boom years (which were especially kind to all three of CONN’s categories due to the housing boom), and zero or negative returns during bad years. Over the whole cycle, their average ROE was in the single digits, well below their cost of equity even ignoring their leverage.
Finally, there’s concerns over incentives. The company plans to open 5-7 new stores this year, all in completely new markets. They only have 65 stores total, so this is a pretty big increase in store count. Given their ROE is currently barely positive, their current return on invested capital is likely below their WACC, and the company is quite levered, I have to wonder if it’s really in shareholders best interests for the company to be expanding instead of focusing on paying down debt. However, I have no doubt that it is in management’s best interest- the top executives share ownership pales in comparison to their salaries and bonus, and increasing the company’s size will increase the bonus / salaries they are eligible for.
There are plenty of other concerns and places to look if you’re interested in Conns as a potential short, including their re-aging practices and their plan to remodel all of their stores over the next two years (which should serve as a significant cash drag).
But ultimately, this is a long only blog, and (from my point of view, at least) the asymmetrical risk/reward of shorting anything but a complete outright fraud makes it a pretty poor bet. Just thought I’d bring the idea up for those interested.