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Trading Stats
% of Current 52-Week High 52-Week Low Short Interest $ 34.64 $ 13.14 30% 103% 39%
No te: Estimates are per Wall Street co nsensus. Shares o utstanding and cash are pro fo rma December 201 seco ndary o ffering. 2
Thesis Overview
This is a follow-up to our initial report from 6 months ago when we first initiated a short recommendation on Conns, Inc. Since then the stock has appreciate 40% as the company continues to out-grow and out-earn its competition by taking advantage of an over-levered customer base. We outlined in our original thesis that Conns subprime lending practices were becoming more and more aggressive, and we could not see the company continue to raise retail prices at a 20%+ clip for much longer. We admit that we were early to the game on this short position, but the thesis has not changed. Conns questionable strategy has lasted longer than we thought, however, as announced in the companys 4Q pre-release, same-store-sales growth has begun to slow, and retail margins have peaked. Insiders just recently sold a large chunk of shares, and the President of the Credit segment left in December. We feel as though in the coming quarter or two, aggressive price increases will come to a halt, and defaults will start to pick up.
Company Overview
Conns is a big-box retailer which sells a variety of consumer products to the average retail customer across the Southern U.S.: TVs, electronics, home appliances, furniture, mattresses, and home office items. Conns operates in two distinct yet intertwined segments: Retail (82% of sales) and Credit (18% of sales). Conns unique offering is its ability to provide financing to its customers, most of whom have an average FICO credit score about ~600. The majority of customers are in the lower/middle class economic demographic (speaking to the company, they estimate the average pre-tax income of each customer is
Consumer Electronics Home appliances Furniture and mattresses Home office Other Repair service commissions Service revenue Total Retail Sales
Despite lagging overall volumes, Conns began to turn around its Retail segment in the summer/fall of 2011 with the help of two strategies: (1) begin selling furniture and mattresses to consumers (something that wasnt part of its primary strategy in the past), and (2) start aggressively raising prices on all consumer products sold. Due to the existence of its credit offering, the company is able to sell most of its products at a sizeable premium vs. other big-box retailers. The one example the company gave to us is that on average Conns sells TVs for about $884 vs. a market average of $551 - a 60% premium to market. As a result, Conns has seen its retail segment achieve record same-store-sales growth and gross margins.
Apr-10
($ in millio ns)
Jul-10 2Q11
Oct-10 3Q11
Apr-12 1Q13 17.8% 152 11 3 0 $167 6.3% $110 $57 34.2% 46 27.5% 0 $11 6.4%
Jul-12 2Q13 21.5% 156 12 3 0 $172 13.1% $112 $60 34.7% 47 27.1% 1 $13 7.3%
Oct-12 3Q13 12.6% 152 12 3 0 $167 8.0% $107 $58 34.7% 47 28.3% 1 $10 5.9%
SSS Grow th Product Sales RSA Commissions Service Rev Finance Charge Total Rev Growth % COGS GP Margin % SG&A SG&A as % of Sales Bad Debt Provis & Other EBIT Margin %
36.5%
0 $5 3.1%
4 ($1) (0.6%)
Interest income and fees Insurance commissions Other income Total Credit Sales
As of the October 2012 quarter end, Conns finances ~72% of its business in-house, GE capital finances about 15% of Conns sales, and RAC Acceptance (basically worse credit score customers) provides about 4% of financing. Historically Conns has financed about ~60% of its retail sales in-house. Conns charges gross annual interest of 18-19% to its customers, and the average maturity of a loan is ~2 years. The clear leverage that the Credit segment has been is that it will yield margin improvements to the Retail segment (in good economic times) as it allows Retail to sell products at a higher price which will obviously benefit margin. As you can imagine, this relationship is a give-and-take the more you utilize the Credit segment to finance purchases on Retail products, the more credit risk the company is taking on. The average FICO score credit for its customers is 603. (As a reference, in many cases you need 620 FICO score to quality for a mortgage - http://smallbusiness.yahoo.com/advisor/answers/credit20110502175115AAUGWYF.html.)
Apr-10
($ in millio ns)
Jul-10 2Q11
Oct-10 3Q11
Apr-11 1Q12
Jul-11 2Q12 $600 (15.1%) (25) (5) $570 95.1% 473,386 (11.2%) $1,248 (6.9%) 6,563 0 31 $31 14 5 $12 39.5%
Oct-11 3Q12 $606 (10.5%) (40) (5) $561 92.6% 472,791 (9.3%) $1,268 23.2% 6,807 0 25 $25 14 19 ($9) (34.9%)
Jan-12 4Q12 $643 (4.8%) (50) (4) $589 91.6% 484,169 (7.9%) $1,640 14.2% 7,250 0 47 $47 14 20 $13 28.5%
Apr-12 1Q13 $635 1.6% (45) (5) $585 92.1% 458,493 (6.7%) $1,417 14.7% 7,307 0 34 $34 (2.9%) 14 9 $11 32.9%
Jul-12 2Q13 $662 10.3% (44) (6) $612 92.4% 460,675 (2.7%) $1,494 19.7% 7,125 0 36 $36 13.2% 13 12 $11 29.9%
Oct-12 3Q13 $684 12.9% (45) (6) $633 92.6% 462,200 (2.2%) $1,450 14.4% 7,099 0 39 $39 57.9% 14 13 $12 29.9%
Total Customer A/R (EoP) $625 Growth % yoy (10.7%) Allow ance for Uncollectible Accounts (33) Allow ance for Promotional Credit Programs(6) Net A/R Balance $586 Net A/R as % of Total A/R 93.7%
# of active accounts (EoP) 491,441 Growth % yoy (6.4%) Net Sales / Active Account (annualized) $1,235 Grow th % yoy 0.0% # of accounts per store 6,738 Service Rev Finance Charge Total Rev SG&A Bad Debt Provis & Other EBIT Margin % 0 35 $35 15 9 $10 28.6%
Recent News
December 2012: Secondary Offering Conns issued 2.2 million new shares at $26.75/share raising net proceeds of $56 million to be used to
Market Overview
The overwhelming issue for big-box retailers is that online retailing is replacing much of our daily discretionary consumer needs such as TVs, furniture, appliances, etc. Brick-and-mortar stores have become more of a showcase for consumers to walk in, touch and feel the products; then they return home to order the product online at a cheaper price. It is hard to find someone who passionately argues that big-box retail is not experiencing a structural decline. Now, lets look how Conns compares to traditional retailers. On a sales per square foot basis, the company clearly earns a premium because of the fact that it is enable to sell its products to lowerincome people at a huge price premium to the market (thanks to its subprime lending arm).
Sales per sqr ft Recent FY SSS Grow th Conn's Bed Bath (Retail) BBBY $264 $268 2.8% 5.9% Dick's PetSm art DKS PETM $195 $227 2.0% 5.4% Target JCPenny TGT JCP $292 $158 3.0% 0.2% Sears SHLD $74 NA AVERAGE $211 3.2%
On a gross margin basis, Conns again above most of its peers by taking advantage of higher priced retail products.
Gross Margin Conn's Bed Bath (Retail) BBBY 35.1% 41.4% Dick's PetSmart DKS PETM 30.6% 29.5% Target Staples Best Buy JCPenny TGT SPLS BBY JCP 32.1% 26.9% 24.8% 35.5% Sears SHLD 27.3% AVERAGE 31.5%
Conns has stated that it thinks it can eventually generate ~35% gross margins annually going forward (on the Retail side), which is roughly what it earned today (LTM end January 2013). Now, these outsized
Stock Price % of 3/6/13 52-high TARGET CORP WAL-MART STORES INC BEST BUY CO INC GAMESTOP CORP-CLASS A MATTRESS FIRM HOLDING CORP ETHAN ALLEN INTERIORS INC LOWE'S COS INC HOME DEPOT INC $66.12 $73.38 $18.75 $24.41 $28.72 $27.49 $38.83 $70.48 98.8% 94.6% 67.1% 86.1% 59.6% 90.8% 97.1% 99.3%
Market Cap $43,031 $245,474 $6,339 $2,958 $970 $793 $43,671 $105,380
Enterprise Value $58,616 $298,998 $8,572 $2,592 $1,150 $874 $51,070 $113,639
EV / EBITDA 2013E 2014E 7.8x 7.8x 4.1x 3.2x 10.5x 9.3x 9.0x 11.0x 7.1x 7.4x 4.1x 3.2x 7.7x 7.9x 8.4x 10.3x
Price / EPS 2013E 2014E 13.8x 13.7x 9.3x NA 23.7x 20.1x 18.5x 20.2x 11.7x 12.5x 9.1x 7.1x 14.3x 14.9x 15.2x 17.4x
EBITDA '13E Price / Margin Leverage Book 9.9% 7.8% 4.3% 9.2% 10.9% 12.4% 10.8% 13.4% 2.3x 1.5x 1.0x 0.0x 2.1x 1.7x 1.6x 1.0x 2.6x 3.3x 1.8x 1.4x 4.3x 2.4x 3.1x 5.9x
Average Median
So urce: Co mpany filings and Wall Street co nsensus.
7.8x 8.4x
7.0x 7.5x
17.0x 18.5x
12.8x 13.4x
9.8% 10.4%
1.4x 1.6x
3.1x 2.9x
1Q'13 Price Volum e 27.4% 28.7% 25.2% 69.5% 37.7% (21.0%) (15.9%) 12.5% (12.1%) (9.1%)
2Q'13 Price Volum e 32.1% 25.0% 19.3% 78.5% 38.7% (20.5%) (19.1%) 36.5% (18.8%) (5.5%)
84.9%
3Q'13 Price Volum e "Higher" "Declined" NA NA 24.4% (17.4%) 15.2% 16.4% 41.6% (5.4%) 27.1% (2.1%)
4Q'13 Price Volum e NA 21.5% 17.8% 35.5% 24.9% NA (7.3%) NA 3.5% (1.9%)
The company has been increasing product prices by over 20% year over year for more than a year now, and a Conns rep finally admitted to us that the most recent quarter would most likely be the end of aggressive price increases. Management publicly stated that its long-term retail gross margin goal is 35%, and for the 12-month period ended 3Q13, the retail gross margin was 35%. The margin expansion story is on its last leg.
This balance per customer metric has surpassed the $1,400 per customer peak in 2008. Conns is now financing an over-levered customer base as it jacks up prices, requires minimal down payments, and increases its use of promotional lending practices. I mention all the above because this portfolio of credit accounts is the spitting image of subprime lending. When it works, it works great; but inevitably this type of lending does not typically end well. History has shown this over and over. Timing the trade is the toughest part though. We admit that we were too early on this trade per our September 2012 initiation report. However, customers continue to rack up record amounts of Conns debt, promotional lending is at its peak, and it has been well over one full year since the company began raising prices at a dramatic clip. Customer loans at typically ~2 years in length, so after each quarter, the likelihood of cracks starting to show become more and more likely.
Valuation
Wall Street pegs Conns to continue with its outsized growth through FY2015E, with Street consensus projecting an average of 28% EPS growth a year over the next two years. You may think paying 15 EPS (currently where Conns trades on an FY2014E basis) is fair for a retailer with such high growth prospects, but you must value Conns retail and credit businesses differently. Retail First, we look at the Retail segment and project performance over the next few years. We know the basic trend of planned store openings over the next year (per management). Then we make assumptions as to how many accounts per store and how much sales generated by active account. It is difficult to imagine that the segment will generate that significantly more than $1,500 per account
CY2011 65 7,164 484,169 (7.9%) $1,294 5.2% $9.3 $654 (1.4%) $193 29.5% 183 28.0% $10 1.5%
CY2012E CY2013E CY2014E CY2015E CY2016E CY2017E 68 4.6% 6,764 459,961 (5.0%) $1,542 19.2% $10.9 $728 11.4% $255 35.0% 207 28.5% $47 6.5% 75 10.0% 6,800 484,239 5.3% $1,619 5.0% $10.7 $765 5.0% $275 36.0% 206 27.0% $69 9.0% $84 11.0% 82 10.0% 6,800 534,072 10.3% $1,700 5.0% $11.0 $866 13.2% $312 36.0% 234 27.0% $78 9.0% $95 11.0% 86 5.0% 6,800 573,492 7.4% $1,785 5.0% $11.7 $989 14.2% $356 36.0% 267 27.0% $89 9.0% $109 11.0% 91 5.0% 6,800 602,166 5.0% $1,875 5.0% $12.4 $1,102 11.5% $397 36.0% 298 27.0% $99 9.0% $121 11.0% 95 5.0% 6,800 632,274 5.0% $1,968 5.0% $13.1 $1,215 10.3% $437 36.0% 328 27.0% $109 9.0% $134 11.0%
Price: Net Sales / Active Account$1,339 Growth % Net Sales / Store Net Sales Growth % Gross Profit Gross Margin % SG&A % of Sales Retail EBIT Margin % Retail EBITDA Margin % $729 (10.3%) $190 26.1% 197 27.1% ($7) (1.0%)
From a DCF perspective, if you use a 9% WACC and a 6.5x terminal multiple (mid-point of the diversifieds like WMT and the commoditized BBY), this yields a $741 million valuation on the Retail segment. If you take a pure multiple approach and slap a 6.5x multiple on the average projected forward EBITDAs ($84 million and $95 million), this gets you to a $583 million valuation. The average of both valuation methods yields a $662 million Retail segment value. Credit The way we look at the Credit segment is a lot different. Conns credit portfolio is essentially a portfolio of subprime or high-yield debta simple credit instrument with default risk. This should trade off of a yield, just like any other high yield bond or credit instrument. As investors, we look to get a certain yield or return on this asset portfolio of receivables. Conns charges its customers an average gross interest rate of ~18%; however, after deducting charge-offs, some SG&A expenses, taxes, and interest, the net return (or net income) Conns is generating from its credit portfolio is less than 3% of its receivables. Corporate high-yield debt is currently yielding 78%, so if we take the average of 2013 and 2014 expected net income on Conns credit portfolio and imply a 7.5% yield, the credit business is worth $279 million.
CY2012E CY2013E CY2014E CY2015E CY2016E CY2017E $720 12.0% 18.5% $133 $22 $155 13.1% ($58) 8.0% ($54) 35.0% ($112) $43 27.9% $17 $26 $768 6.5% 18.5% $142 $23 $165 6.3% ($59) 7.8% ($58) 35.0% ($117) $48 29.0% ($19) $29 ($10) $19 2.5% 7.5% $279 $886 15.5% 18.5% $164 $24 $188 14.0% ($66) 7.5% ($66) 35.0% ($132) $56 29.7% ($21) $35 ($12) $23 2.6% $1,000 12.8% 18.5% $185 $25 $210 11.8% ($70) 7.0% ($74) 35.0% ($144) $67 31.7% ($24) $43 ($15) $28 2.8% $1,102 10.3% 18.5% $204 $27 $231 9.6% ($72) 6.5% ($81) 35.0% ($152) $78 33.9% ($26) $52 ($18) $34 3.1% $1,215 10.3% 18.5% $225 $28 $253 9.6% ($79) 6.5% ($88) 35.0% ($167) $85 33.8% ($29) $56 ($20) $37 3.0%
Credit Segm ent Customer A/R A/R Growth Interest Earned % Annual Interest Earned Insurance Sales Credit Revenue Growth % Annual Charge-Offs Net Charge-Off % SG&A % of sales Total Costs Credit EBIT Margin % Interest EBT Taxes Net Income
$157
$145 (7.7%)
$137 (5.4%)
5.0% 39.2%
7.3% 44.1%
7.5% 41.7%
These Credit estimates assume no hiccup in the companys collections even as its customer base is overlevered and its promotional offerings are at all-time highs. We are conservative in projecting a gradual decline in net charge-offs, yielding record EBIT margins in perpetuity. One interesting data point to keep in mind the U.S. 10 yr treasury bond yields ~2%, and if you buy into Conns customer receivable, you are getting a 2.5% return (500bps wider than a riskless U.S. security). Bulls may think that a 40 cent recovery ($279 / $720) on a portfolio of $720 million of customer A/R is very draconian. However, on 24% of these receivables, consumers are not paying any current interest, the customer base is extremely overlevered, and having a 603 FICO score literally means that you do not repay your debts in full. Combined Conns Enterprise Combining the above valuation scenarios, which we believe are quite optimistic, provides an implied stock price of $18 per share, compared with the current share price of $33. This is assumes no downturn or hiccup over the next few years and the consumer can keep paying the bills with no real issues.
Roll-Up Valuation Credit Retail DCF Combined EV Net Debt Combined Equity Value Shares Im plied Share Price $279 $662 $941 ($327) $615 33.54 $18.33
As a note of reference, even if you assume you get a 100% recovery on the credit receivables portfolio, this yields a $29 stock price for Conns (14% below the current stock price).
Stores (EoP)
Jan-10 2010 76
LTM
Jan-12 4Q12 65
Apr-12 1Q13 64
Jul-12 2Q13 65
Oct-12 3Q13 65
% of Retail Sales financed 62.5% Net Charge-Offs as % of Outstanding Bal 5.0% Wgtd Avg Monthly Payment Rate 5.2% Avg Dow n Payment 7.6% P&L Sum m ary Consumer Electronics Home appliances Furniture and mattresses Home office Other Product Sales RSA commissions Service revenue Total Net Sales Interest income and fees Insurance commissions Other income Total Revenue Growth % yoy Product Sales growth % Retail SSS Change % Credit Sales growth % COGS % of Sales Gross Profit Margin % SG&A Costs re store closings Impairments Provision for bad debts Other SG&A & Other % of Sales EBIT Margin % D&A Adjustments Stock Comp Adj EBITDA Margin % Adj EPS Growth % yoy Avg Dil Shrs Out LTM EBITDA Margin % LTM Adj EPS $540 60.8% $347 39.2% 259 0 10 49 0 $317 35.7% 30 3.4% 14 10 2 $57 6.4% $ 0.42 (72.6%) 25.081 $57 6.4% $ 0.42
258 188 77 55 31 608 38 17 663 125 20 1 $809 (8.8%) (8.7%) (9.6%) (7.5%) $482 59.7% $326 40.3% 240 0 2 51 0 $294 36.3% 33 4.1% 17 2 2 $55 6.8% $ 0.02 (95.7%) 26.091 $55 6.8% $ 0.02
229 189 100 53 26 596 42 15 654 117 20 1 $792 (2.0%) (2.0%) 2.8% (5.1%) $462 58.3% $330 41.7% 238 7 2 54 0 $301 37.9% 30 3.7% 13 9 2 $54 6.8% $ 0.07 270.1% 31.860 $54 6.8% $ 0.07 $
52 48 28 12 11 152 11 3 167 29 5 0 $201 4.6% 5.4% 17.8% (2.9%) $110 54.8% $91 45.2% 60 0 0 9 0 $69 34.4% 22 10.9% 3 0 1 $26 12.8% $ 0.35 152.3% 32.904 $61 7.6% $ 0.28
47 52 32 14 11 156 12 3 172 32 4 0 $207 12.4% 12.9% 21.5% 5.0% $111 53.5% $96 46.5% 59 0 0 12 0 $72 34.7% 24 11.7% 3 0 1 $29 13.8% $ 0.01 (119.3%) 33.119 $68 8.3% $ 0.32
47 48 32 16 8 152 12 3 167 32 6 0 $206 14.9% 8.0% 12.6% 32.0% $107 51.9% $99 48.1% 61 0 0 13 1 $75 36.5% 24 11.6% 4 0 1 $29 14.2% $ 0.35 (189.2%) 33.539 $110 12.9% $ 1.06
$460 54.1% $391 45.9% 243 4 1 54 1 $304 35.7% 87 10.2% 14 6 3 $110 12.9% 1.06 $
$132 55.9% $104 44.1% 63 4 1 20 0 $87 36.9% 17 7.2% 4 5 1 $26 11.1% 0.35
Jan-10 2010 57 (21) (18) (20) (10) 0 ($12) (1.4%) $64 ($10)
Jan-12 4Q12 26 (5) 1 (58) (2) 0 ($38) (16.2%) ($10) ($2) $26
Oct-12 3Q13 29 (5) 0 (41) (10) 0 ($27) (13.2%) ($7) ($10) $15
Sum m ary Cash Flow EBITDA Cash Interest Cash Taxes Change in WC Capital Expenditures Other Free Cash Flow as % Sales Cash Flow from Ops Cash Flow from Inv
Balance Sheet Data Cash $12 $11 $6 ST Customer A/R, net of allowance of $28,979 and $28,400, respectively$316 $338 LT Customer A/R, net of allowance of $24,999 and $24,026, respectively$273 $286 Total Customer A/R $623 $589 Other A/R $30 $39 Inventories $82 $63 PP&E $47 $38 A/P Debt Book Equity Credit Stats EBITDA / Cash Int Expense Total Debt / EBITDA Net Debt / EBITDA Capex as % of Sales $58 $374 $353 $45 $322 $353
$452 $328