2023-03-30 11:14:54 ET
Summary
- Conn's Inc is a Texas based furniture, television and appliance retailer that trades at a steep discount when compared to book value adjusted for VIE consolidation.
- With a proven shareholder aligned CEO appointed in October, a strong growth strategy, and industry tailwinds hopefully the company can return to profitability in a year.
- The company's unique credit offerings provide value to target customers and will likely experience more demand during periods of tightened lending standards.
Conn's ( CONN ), like many other retailers, is currently facing macroeconomic headwinds due to decreased consumer sentiment and recessionary fears. These headwinds are temporary though, and CONN is uniquely positioned to benefit from a tightening credit environment with a 50-year history of offering credit solutions to subprime customers. Indeed, approximately 50% of sales are to customers with a credit rating of 550-650, so any tightening in bank lending standards could increase demand for their financing options.
Additionally, the use of variable interest entities (VIEs) obfuscates the balance sheet, making the company appear more indebted than it is to those who take a cursory glance. Net of VIEs, the company seems to be trading at a large discount when looking at book value. CONN has an odd business model, with a loss-making credit segment offset by a historically profitable retail segment. With new risk adjusted credit offerings in the pipeline to expand their customer base, a ramping up of e-commerce sales, no significant near-term debt maturities and a company veteran and one of the largest shareholders recently appointed as interim CEO, the company is hopefully setting itself up for a return to its historic profitability.
Company Overview
Conn's is a durable consumer goods retailer which offers its customers credit solutions to finance purchases. Founded in 1890, the company primarily sells furniture, home appliances, and televisions. The credit solutions began as a way to assist their customers primarily in Texas purchase big ticket items despite the booms and busts of the oil market. The company has two separate operating segments, retail and credit. The company believes these unique credit offerings for target customers provides a competitive advantage and is a strong sales driver.
What Is a Variable Interest Entity or VIE?
Exclusively taking loans from a bank and then giving money to subprime customers would be a risky business indeed and would expose Conn's to high levels of debt and bankruptcy risk. Instead, Conn's is a little shrewder than that. They securitize portions of their accounts receivables (loans made to customers) using a special entity called bankruptcy remote variable interest entities or VIEs. The term basically means that the company does not necessarily have direct ownership over this entity but has a controlling interest and therefore must consolidate the VIEs into its balance sheet.
The company, through the VIEs, is then able to sell receivables backed interest bearing securities, or asset backed notes "ABNs," to investment institutions and collect cash in the process. As customers make payments on their loans, CONN collects a servicing fee and interest is paid to the ABN investors. If loan loss occurs, obligations owed to the ABN holders take priority, but the security holders have no claim to the assets of CONN as a whole. The only claim they have is the securitized accounts receivable, as well as restricted cash associated with the VIEs. According to the most recent annual report:
The assets of the VIEs serve as collateral for the obligations of the VIEs. The holders of asset-backed notes have no recourse to assets outside of the respective VIEs.
Understanding The Balance Sheet
The assets and liabilities of the VIEs are not really attributable to CONN equity holders, as the ABN holders have claims on the assets, and the liabilities do not have a claim on the rest of Conn's assets. Therefore, it makes sense to subtract the values out to get a better understanding of stockholder's equity. Excluding the VIEs, equity is approximately $441 million, as can be seen below. There is no goodwill or intangibles listed on the balance sheet, and net of VIEs and leases, the company has only $225 million of long-term debt as of January 31, 2023.
2023 CONN Adjusted Equity () (This writer, Data from CONN 10K)
Poor Operating History of the Credit Segment
The operating history of the credit operations is abysmal, to say the least. From fiscal 2016-2023, the credit operation was only profitable in 2022 (which includes most of calendar 2021). This was an abnormally prosperous year due to pent up demand . Fiscal 2019 was one of the most profitable years in recent history for the company aside from 2021, but the credit segment operated at a $63 million dollar loss. It seems that as a standalone business, the credit segment is not great, but when combined with the retail segment, it's a sales driver and can be viewed as a calculated risk, as the company has historically been profitable as a whole.
The goal of any normal credit operation should be to borrow money at as low of an interest rate as possible, loan it out at a higher rate, and collect the difference. This seems to be their plan, but the massive losses due to provisions for bad debts year after year destroys profitability as can be seen in the segment's earnings above.
Growth Prospects:
CONN Q4 2023 Investor Presentation
Store locations are heavily concentrated in the south, with 50% of locations in Texas. This may be a tailwind in the short term, as Texas has been experiencing one of the highest migration rates in the country, second only to Florida. Additionally, in 2023 the company has been piloting a new store within a store concept , with the department store Belk, which is cited as a win-win for both companies. The combination will drive foot traffic from one store to the next, reduce capex and leasing expense necessary to fund new retail sales locations, and make a one stop shop for consumers as the two companies sell different types of products.
Additionally, the company has been focused on growing ecommerce sales and transforming its online presence. CONN is behind its competitors in this regard, and management has justified the lack of adaptation in the past by stating their customers prefer to be physically present to purchase their products. I believe CONN offers unique value with this transition, as they can offer their credit services online as well as leverage their already established 24-hour delivery services.
CONN Q4 2023 Investor Presentation
The company is also preparing to offer in house lease to own financing options this fiscal year, which will likely drive sales growth to a new customer base. As we can see from the diagram below, the company has denied over 600,000 applications for in house credit, and offering in house lease to own options could allow for more risk adjusted approvals. Prior to this, the company was offering lease to own options from third party sources.
Conn's Inc Q3 2023 Investor Presentation
Finally, it's worth noting that the appointed in October 2022 interim CEO , Norman Miller, serves on the board of directors and was previously the CEO between September 2015 and August 2021. The return of Mr. Miller brings an optimistic tune back to the company, and he is confident the credit solutions offered by the financing division will offer unique value, especially in times of uncertainty and credit tightening. The company was largely profitable during his tenure, and the company cites improvements of gross margins from 7% to 12% and a 40% increase in book value while he was at the helm. Additionally, he owns over 600,000 shares of CONN, beneficially aligning his interests with shareholders.
Valuation
The company is difficult to value, as it continues to operate at a loss and suspends guidance. All we really have to go on from an earnings perspective, is a rosy picture painted by the CEO, claiming that bank lending standard tightening will provide massive tailwinds for the credit offerings of CONN. Meanwhile, earnings swung to a massive $1.79/share loss in the 4th quarter, which is usually a strong period for the company due to the holidays. GAAP loss for FY 2023 is $60 million, including $121 million in provisions for bad debts.
In this scenario we can look at a couple of areas for value. First is the book value of the company. The aforementioned $441 million in book value net of VIEs is largely tangible. I believe this adds a great margin of safety. With a market capitalization of $150 million at the time of writing, and $143 million available on the revolver, shareholders can endure another year of massive losses and still get rewarded handsomely if the company can return to profitability. If we assume the company burns another $60 million in FY 2024 but can return to profitability after that, the present value of the equity discounted at a 10% rate would be approximately $340 million. Whatever cash the company can earn on top of that would further increase valuation (of course, losses would also decrease valuation).
A second place to look at is qualitative factors and operating history. As mentioned before, the company operates in a niche market, offering subprime credit solutions for the big-ticket items it sells. Admittedly an odd business, but one that has generally worked in the past. Seven out of the last ten years the company operated at a GAAP profit, with an average EPS around $1.20. I don't believe there has been any sort of fundamental shift that would imply a permanent change in the business, as we are experiencing a downturn in discretionary spending during a normal market cycle.
With the margin of safety provided by the $441 million in book value (net of VIEs) and no near-term maturities, the strong operating history of the company, and the tailwinds related to tightening in bank lending standards, our calculations suggest a $300 million valuation, with a target price of $12.50/share.
Risks
Competition
The company faces immense competition in an industry with virtually no barriers to entry. Online retailers like Amazon ( AMZN ), warehouse stores like Costco ( COST ) and specialty retailers like Mattress Firm all compete for the same customers, to name just a few competitors.
Credit Risk
The company cites their unique credit offerings as a strength. This also puts the company at risk of major loan losses, if underwriting is not performed carefully. Indeed, the company's credit segment has only been profitable in one of the last five years, despite the company generally being profitable as a whole. Additionally, the new in-house lease to own strategy for higher credit risk is unproven and may lead to substantial loss.
Growth
The company is quickly expanding with new locations and integration into Belk stores. The latter is an unproven strategy with no guarantee it will be accretive to shareholder value. Additionally, the company is expanding in FY 2024 combining a period of financial stress and higher interest rates with aggressive capital spending.
Geographical Risk
The company's stores are heavily concentrated in the southern US, primarily in Texas. Though currently a tailwind due to the aforementioned US migration patterns, if these trends reverse it could result in headwinds and restructuring costs.
Lack of profitability
In my valuation, I assume that the company will be able to return to profitability in a year. As the company is operating at a large loss and has suspended guidance, this conjecture is speculative in nature, and there is no guarantee the company can be profitable again.
Conclusion
As the company is trading at a significant discount to book value, has no near-term maturities, and has $140 million of borrowing available on its revolver, I believe current market prices offer a significant margin of safety to intelligently speculate on a turnaround. The tightening in bank lending standards, the new lease to own options, ecommerce growth, and the proven shareholder aligned CEO could all help drive profitability in the mid to long term. I also believe the presence of VIEs on the balance sheet makes the company appear riskier than it is, for investors who take a cursory glance. Our calculations suggest CONN is worth at least $12.50/share if they can limit cash burn and return to profitability in a year. Shrewd investors may be interested in purchasing long dated call options for asymmetric risk/reward realization.
For further details see:
Conn's: Bottom Fishing For A Turnaround