Over the weekend, I was inspired by several blogs (The bull case for Conn’s; How to Analyze Receivables & Inventory; Conn’s Inc.) to dig further into the annual reports of the company CONN. What I found was very interesting, and highlights the dangers of investing blindly solely on the basis of financial numbers, without peering deeper into what those numbers mean.
Conns is a retailer of electronics and electrical appliances, with 75 stores in Texas. On casual inspection, the company appears to be moderately undervalued. On an asset basis, Conns has a book value of $337 million, compared to a current market cap of $102 million. On a cash flow basis, Conns has had declining earnings for years, earned $25 million in 2008, and will probably earn $2-12 million in 2009 (depending on whether one calculates on an earnings or cash flow basis). The problem, as has been pointed out before, is that Conns relies heavily on extending credit to its customers to buy its products in its business. Therefore, Conns is a combination of a retailer and a bank, and both parts of its businesses should be examined.
The electronics retail industry is a cut-throat one, as seen by the bankruptcy of Circuit City. While some have argued that Conns should gain additional market share with the demise of Circuit City, revenue has been declining in 2009 versus 2008, suggesting that Conns is losing market share instead. I detect no obvious reason why one would want to shop at Conns versus, say, at Best Buy or Walmart, except perhaps for its more generous credit policies. In the most optimistic scenario, disregarding finance charges, free cash flow is about $12 million. However, current trends of declining revenue suggest that this will further decline in 2010. The upshot is that the retail business is poised to generate rapidly declining cash flows, and the bulk of the intrinsic value of Conns is in its assets.
More than 50% of sales at Conns is financed by Conns itself. In the past, Conns has offloaded credit risk to other investors by securitizing the loans and selling them in the secondary market. Typically, such securitization deals are structured as a trust with various tranches, and the most toxic tranche which bears the risk of first loss is usually retained by the originator, as a guard against reckless underwriting. Conns has almost $150 million of these toxic securitized interests on its books. Since the collapse of the securitization markets, Conns has been unable to offload loans off its books, and hence customer receivables have been building up at a startling rate of more than 100% in a year, reaching $136 million in 2009. To finance these receivables, Conns has been drawing down its line of credit.
Clearly, Conns entire business model was based on easy credit and is now unsustainable. At some point, banks will stop extending credit to Conns, and Conns will no longer be able to extend credit to customers. The ensuing loss of 50% of revenue will be a great challenge to most businesses, and will be fatal in an industry with razor thin margins like retail. Banks and creditors will demand an immediate liquidation to protect their assets. The $150 million of securitized on its books are likely to be worth zero, given that even modest 5-10% losses in the underlying loans will likely wipe out the entire toxic tranche. The other $136 million of customer receivables will likely be sold under duress, generating an additional haircut on top of credit losses on the receivables, so I estimate a value of 50% recoverable ($70 million). I estimate that the value of inventory and cash will cover current liabilities, while the long term liabilities of $120 million will be partially covered by the sale of $60 million of hard physical assets (stores, equipment and land), held on the books at cost. In the best case scenario, the physical assets are sold at prices way above their book value (likely but not completely certain), meaning that after liquidation, the company has residual value of about $70 million derived from its customer’s receivables. This exact scenario, while speculative, is not particularly far-fetched, and is the primary reason why the company is now trading at a value of $100 million market cap, and has an incredible 44% short interest despite this. In summary, stay away from this company.
Stock Investment Risks: This is a retailer with a broken business model in its terminal spiral of death. Enormous uncertainties surround the recoverable value from the enterprise.
Stock Investment Disclosure: I have no position in CONN.
