Conn’s, Inc. (CONN) fell 40% Tuesday on earnings that were awful — far worse than anyone could have anticipated.
Well, anyone except me, apparently, because I was holding Conn stock puts that I sold for a 500% profit. (Excuse the tooting of my horn, but a 500% return in a single day doesn’t happen often.)
Conn’s earnings are also a lesson in reading the whole way through an earnings report, because up front, everything sounds rosy. Here are the highlights, directly from the Conn’s earnings report:
- Consolidated revenues increased 19.0% to $370.1 million.
- Furniture and mattress sales increased 37.4% and appliance sales rose 24.6%.
- Retail gross margin increased 50 basis points to 40.6%.
- Adjusted retail segment operating income increased 11.9% to $38.1 million.
That’s where the good news ends. The problem is that Conn’s entire business is based on selling appliances, furniture, mattresses and electronics to subprime consumers. If the underwriting is done properly, CONN stock would expect to have some losses, but still make money back on collections.
But Conn’s underwriting has been terrible.
CONN has been selling far too many goods to far too unreliable consumers. The number of accounts that are 60-plus days delinquent soared to 10% as of Oct. 31 — up from 8.7% at the end of July, and far ahead of the expected worst-case scenario of 9.1%.
To give you an idea of how bad those numbers are, the payday lending industry has a default rate of about 4%. And even that low percentage compresses net margins for payday to 10% to 12%. That’s because a single default wipes out the revenue from about 10 good clients. The default means the entire principal balance gets lost against the performing clients paying interest with APR in the mid-teens.
This spike in delinquent accounts resulted in a $33.2 million operating loss for the credit segment, down from a $10.4 million gain last year. Yes, that’s a $43 million difference. That drop caused the company to end the quarter with a loss of 8 cents per share against the expected 75-cent profit.
Ouch.
CONN Stock — What Happened?
The question investors are asking is why and how this happened. Bad debt has been increasing at CONN stock. The most facile explanation is that Conn’s salespeople likely pressure customers into making larger purchases than they can afford, or offer foolish incentives like 0% interest periods, in order to boost sales. That would explain the 20% to 35% same-store sales increases we’ve seen the past few quarters.
In conjunction with these tactics, the company is probably selling to consumers who have pretty gnarly credit — in the 550-600 FICO range.
Now, I want to stress that this is the most facile explanation, not necessarily what’s happening. I have no proof such tactics occur, other than what’s been anecdotally reported by other journalists. Regardless, we know that Conn’s has been way too loose with its underwriting, and CONN stock is paying the price.
Of course, something this bad means a head must roll. The CFO “resigned,” and a “Credit Risk and Compliance Committee” has been established to review credit risks, underwriting strategy, and credit compliance activities. Ya think?
I know what you’re thinking. “Hey, the stock is down 40% today, and 75% off its 52-week high. Maybe the selling is overdone and I should buy.”
True, CONN stock’s market cap is now $761 million. Arguably, the receivables portfolio alone – which is about $1.25 billion — is worth $761 million if sold at a discount and factoring in losses. That market cap doesn’t even include the retail business. So, perhaps there’s a buyer out there.
But don’t be suckered in to buying the stock until the company proves it knows how to underwrite effectively.
As of this writing, Lawrence Meyers did not hold a position in any of the aforementioned securities. He sold all his puts Tuesday morning for a wild profit. He is president of PDL Broker, Inc., which brokers financing, strategic investments and distressed asset purchases between private equity firms and businesses. He also has written two books and blogs about public policy, journalistic integrity, popular culture, and world affairs. Contact him at pdlcapital66@gmail.com and follow his tweets at @ichabodscranium.
