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Knowing how not to lose money is as important as knowing how to make it.
We spend most of our time here at WyattResearch.com giving you actionable trading ideas. The idea is to help you make money. However, there is another side to this equation that is rarely discussed, and that’s how not to lose your shirt in an investment.
So I’m going to do a two-part series, using one recent mishap as a case study, in how not to lose a lot of money in a given investment. You MUST do more research than you probably are doing and that’s why Warren Buffett rarely makes a losing bet.
The blowup at Conn’s (NASDAQ: CONN) after reporting earnings on Sept. 2, in which the stock fell 30% to about $30 per share, hasn’t been analyzed in depth. That’s likely because most financial writers don’t really understand what happened. Now you will, and it will give you lots to think about when you look at your investment portfolio.
What is the Company’s Story?
You first want to understand exactly what a company does. That seems pretty easy, but that’s not always the case, because there are nuances, as there is with Conn’s.
The company is a hybrid household retailer and rent-to-own operation. It caters to a very specific demographic: the nonprime consumer. “Nonprime” is the new name for what used to be called “subprime”, in an effort to remove the stigma by referring to consumers as not “below prime”. These are people with FICO scores below 650. They often have annual salaries between $25,000 and $60,000. They generally have little credit history or have a history of not managing credit responsibly.
Because of poor credit, these consumers cannot walk into Macy’s (NYSE: M) or Best Buy (NYSE: BBY) and purchase home appliances, furniture, mattresses, or big-screen TVs on those retailers in-house credit programs, which are generally reserved for prime borrowers.
Two thoughts should come to you immediately. First, this could be a potentially lucrative business, because it solves a problem. But it comes with a lot of risk. This is a business built around people with poor credit behaving responsibly enough for the company to make money.
Like most consumers, these people are probably better off purchasing second-hand household items rather than new ones. Nevertheless, the enticement of owning new furniture, appliances, a new mattress, or a new big screen TV sends them into Conn’s.
It’s what is referred to in the industry as an “aspirational purchase”. Conn’s prices its products at higher price points than the market, because these consumers can’t get these aspirational products at market price.
So here’s elevated risk: people living beyond their means.
Thus, not only are they paying above market, but they are financing the purchase as well. Conn’s boasts that the average TV selling price is $1,071 vs. a $445 market rate. Conn’s also states in its September Investor Presentation that while product and price drives the consumer’s call to action at a regular store, product and price AND financing is what drives consumer decision at Conn’s.
And so, the consumers shop for what they want. 23.9% of sales are consumer electronics (mostly big screen TVs), 29.3% of sales are home appliances, 28.2% are furniture and mattresses, and 8.3% are home office products.
Now we know we have people living beyond their means, paying a high price for it, and that they need to behave responsibly enough to make a profit. Sounds like a tall order. Let’s keep going.
The Credit Angle
Conn’s underwrites the consumers, and if they meet certain criteria, are approved for the company’s in-house financing option. If not, they are shuttled into a rent-to-own arrangement with a third party. Prime consumers are offered credit via GE Capital.
So it appears there are some consumers who are too good for Conn’s and others who are not good enough. Let’s keep that in mind.
The retail operation is not involved in the underwriting, so as to keep the underwriting decision separate. Conn’s handles the collections of its financing program as well, with the loans secured by the purchased items themselves.
The company has increasingly relied on financing options, moving away from full-payment arrangements. In FY12, 76.4% of sales were paid for under one of these payment options. In FY14, it is 92.4%. 77.3% of sales are driven by the in-house option, 12% by third party promotional financing, 7.6% by cash and credit cards, and 3.1% via rent-to-own.
So, really, most people are good enough for Conn’s to finance.
So Conn’s is driving all of its customers into some form of credit. This is also reflective of the broader consumer credit landscape. The NY Fed’s quarterly report on consumer credit has shown that, after five years of reduction in overall consumer credit balances, that trend has reversed. The American consumer is levering up.
It’s not essential that you know about the NY Fed report. However, if you are thinking about buying a credit-driven business, you want to research things like this.
Credit Means Sales
What might investors expect in earnings reports, given this increase in financing options? If you said, “higher same store sales”, you’d be right. Conn’s has been delivering incredible SSS numbers. In FY13, SSS rose 14.3% and in FY14, they exploded 26.5%.
No surprise here. If Conn’s offers a brand new washer/dryer or big-screen TV for little money down, or a promotional interest rate of 0%, Conn’s is going to sell more products.
So now we have a heads-up about earnings reports. Same store sales at Conn’s means something a bit different than other companies.
Part 1 Conclusion
So far, we’ve evaluated what the company does and we have numerous thoughts to consider.
Conn’s solves a big problem: quality retail, high-ticket merchandise for nonprime consumers. It solves another problem: helping people to afford these items.
Conn’s has an inherent problem with its customers: they historically do not do well with credit, likely do not pay on time as well as other consumers, and are being offered expensive financing.
If you realize that Conn’s success will be wrapped around the ultimate delinquency and default rate for payments, you’ve highlighted the major risk that I think most investors missed.
In Part 2, we’ll dig more into bad debt and what to do from here if you own the stock.
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