A Case Study in Capital Preservation: Conn’s (Part 2)

Knowing how not to lose money is as important as knowing how to make it.
In Part 1, we learned about Conn’s business and it’s major risk.  Now let’s delve into that risk.
The issue for Conn’s is the credit quality of the consumer and just how much he is being financed. Apparently, Conn’s has done a lousy job of underwriting, to the point where bad debt losses have crept up to 9.2%, far above the company’s historical loss rate of 8%.
When it comes to bad debt, every basis point counts, and a 120 bps increase over historical losses is huge.  In a credit-driven business, you must realize that a default means the entire loss of principal.  Yes, Conn’s can repossess the item, but by then it’s value has been diminished.  It is used, not new.
That huge increase in default rate is one reason the stock blew up. Another reason is that management said this loss rate is the “new normal”. They also clearly believe operating margins are going to fall from 13.8% in FY14 to 12.1% in FY15. They expect credit segment operating income to fall from $46.4MM in FY13 down to $27.8MM in FY14, and $11.1 in FY15.
If you are on the outside looking in – meaning, you are not long the stock – you are probably running for the hills.  You may even short the stock.  But before you do, you want some explanation for the huge increase in bad debt and why management expects this to continue.  Why, if they know so much about underwriting, would they tell us to expect these loss rates?   Can’t they just tighten underwriting?

Why the Bad Debt?

There are two reasons. The first has to do with Conn’s underwriting in the absolute. The second has to do with Conn’s underwriting in the present economic environment.
Given that Conn’s expects higher levels of bad debt and declining income in its credit division, and based on management’s statements in the conference call, they will likely tighten underwriting, but not by much. This suggests that Conn’s may continue to provide financing for customers who really have no business being handed a line of credit at 20-25% APR.
The macro economic issues are relevant, as well. The Labor Force Participation Rate is at a 30-year low, with more than 5 million people having left the workforce, many of them in the demographic Conn’s serves. For those who are still working, wages remain stagnant while inflation continues to eat away at people’s salaries.
The result, which management pointed out in the conference call, is that people are faced with tough choices regarding bills and where Conn’s falls in that decision tree. People have to pay for gas first, then rent, then food, and then pay for that mattress. With the macro environment working against Conn’s, and the company throwing financing at nonprime consumers, no wonder bad debt is exploding.
Does this sound familiar? It should. It’s analogous to the mortgage crisis. Banks were shoving mortgages at borrowers – people who had no business buying a home, especially as prices soared. They couldn’t keep up with the mortgages and lost their homes, with the banks taking the hit.
Okay, by now you probably have started running for the hills for sure.  But wait one more second…
Yes, Conn’s is throwing financing at people. The customer portfolio balance was $1.18 billion at the end of the quarter, up 40% from the year before! Not surprising, credit revenues were up 37.8% to $64.3 million. Ah, but provision for bad debts more than doubled from $18.3 million to $39.6 million. The result is that total revenues increased YOY by about $82 million…but so did expenses including the bad debt provision. Thus, operating income was flat.
Breaking out the retail segment, it saw an $8.5 million increase in operating income, so it isn’t the selling where the problem lies. The credit segment went from a $7.5MM profit to a loss of $212,000, and $6.4MM loss if you include interest expense.
Conn’s appears to be very aware of what’s going on. Reading between the lines of the conference call, and noting the company’s ambitious growth plans, it sure seems to me that the company will continue its loose underwriting strategy. They seem to think the retail division will carry the company, that they will see some losses in the financing arm, but that the move to push higher margin products is going to offset these losses.
That’s why I told you to wait before running.  Now you have the entire picture.

How Not to Lose Your Shirt

The lesson in this case study is not only to understand the risk (bad debt) but the extent of the risk.  If you had read the last few earnings reports before investing, you’d have seen bad debt creeping up.  You’d have seen the effect on the finance division.  You might have anticipated it would get worse.  If you examined other credit businesses, you’d know that even a small bad debt increase can crater a stock.
That means, before investing, you should have done research beyond the company.

Where Does the Stock Go From Here?

Let’s say you are long the stock.  What do you do?
It depends on what you think is going to happen over the long term.  If you think Conn’s strategy is going to work, then it is now a value play, so then buy more and average down on your loss.  There are other strategies to lower your cost basis, also.  If you aren’t sure, then hold, but set a 7% stop loss to limit further losses.  If you think this whole thing is a terrible idea, or if you want to harvest some capital losses, then sell.
There appears to be a near-term floor around $28. Selling appears to have been exhausted after the stock fell from $45. I suspect another quarter of high bad debt losses is priced in, but if the numbers come in worse than 9.5%, it could fall even more.
Regardless, I don’t see much upside to the stock for some time to come, so be patient.

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