Report on Conns (CONN)

Introduction/Thesis
Although Conns has achieved double digit same store sales growth and margin expansion over the past few years, the
companys paper profits are driven by credit deterioration as it sells more and more expensive items to people who
cant afford them. This suggests that the fundamentals of the business are deteriorating and the company is failing on an
actual cash flow basis. Despite Conns recent setback in 2013 Q2 results of high delinquencies due to procedural lapses
following collection software upgrade, the companys stock price has mostly recovered from that 25% drop in
September 2013 and is trading near $75 now. This price implies an extremely high valuation based on analyst estimates,
suggesting 25x forward EPS, and 14x forward EBITDA. The high growth priced into Conns stock is unlikely to come to
fruition, as the companys growth is supported by the unsustainable business practice of attempting to thwart
competition by relaxing its lending standards. Given these fundamental issues with the company and the richness of the
valuation compared to its main competitors that trade closer to 15x EPS and 7x EBITDA, I think Conns should trade at
much lower multiples and recommend the company as a compelling short idea.
Conns faces intense competition from bigger names in the industry
Conns faces intense competition in the low-credit-score big box retailing market, such as Aarons and Rent-A-Center,
not to mention the higher-end stores such as Sears, Wal-Mart, and Target. Focusing on just the low-credit-score end of
the market where Conns primarily competes; the company is at a fundamental disadvantage. Its brand is not as large
popular as that of Rent-A-Center or Aarons, and it has a much smaller footprint. Conns has 55 stores total, with 38 in
Texas, while Rent-A-Center and Aarons have 290 and 229 stores in Texas alone. Most sell side analysts appear to view
Conn as poised to expand its operations aggressively outside Texas, which may occur given the company would build
stores in states where it does not face interest rate caps on its loans. Given the companys rather static store count
number for the past 5 years, store growth is possible if they are able to execute properly.
So what is Conns strategy to compete?
Given this competition, the company has implemented a differentiated strategy to set it apart from its peers. Conns is
expanding its margins by selling higher brand goods to its customers and booking income statement profits, financing
their purchases with the companys own balance sheet, and then trying to collect on these loans afterwards. We can see
this strategy reflected in the companys financials. The company has seen an uptick in same store sales, as Conns is
willing to sell premium goods to customers, whereas its competitors are likely not selling such high-end goods to low-
credit customers. The company has also seen increased retail gross margins by expanding the mix of higher-end
products it holds in stores. The company calls this strategy: combining our retail stores and supporting services with
financing alternatives that provide our customers the ability to make aspirational purchases. In essence, Conns is
pushing premium brand goods onto its customers.
Metric 2008 2009 2010 2011 2012
Stores open at end of period 76 76 76 65 68
Same stores sales growth 2.0% -13.8% -9.6% 2.8% 14.3%
Retail gross margin 27.5% 25.2% 26.5% 28.7% 35.2%

Selling expensive goods to low-credit customers has led to deterioration in credit quality
When companies sell premium goods, they have to make sure that their customers can afford the products. Conns has
focused so much on booking accounting profits (the revenue is recognized when they make the sale) that it has
overlooked that its customers are not repaying their receivables. The companys underwriting standards have been
decreasing significantly over the past 5 years. Conns has increased the percent of its sales financed by its own balance
sheet by 10 percentage points, such that 70% of its sales now risk the companys own capital. Conns also accepts lower
Report on Conns (CONN)


down payments from customers that owe the company more money per account. We can see that this has increased
the days sales outstanding to increase more than four times over since 2008. It now takes 178 days for the company to
collect on its sales. Finally, Conns has changed its accounting practice of what constitutes delinquent loans. I cant really
speak for the companys intentions, but this rather obfuscates the credit quality of its customer receivables portfolio.
Nevertheless, there are other metrics that we can look at to assess credit quality. Net charge-offs have increased over
3.5 percentage points over the past 5 years, which is a huge indicator of credit deterioration.
Metric 2008 2009 2010 2011 2012
Percent of retail sales financed, including down payment 67.2% 62.5% 61.2% 60.4% 70.9%
Average down payment 8.2% 6.9% 5.3% 5.3% 3.2%
Average outstanding customer balance 1,401 1,335 1,285 1,329 1,535
Days Sales Outstanding 38.52 68.08 174.24 166.01 178.83
% of balances 60+ days past due to total outstanding balance 7.3% 10.0% 8.6% 8.6% 7.1%
Net charge-offs as a percent of average outstanding balance 4.4% 5.0% 7.3% 7.5% 8.0%

The credit deterioration is most evident when we look across the receivables portfolio. If you look down the columns, it
is clear that newer loans have increasingly higher cumulative loss rates. The company booked higher provisions for loan
losses in 2013Q2 as a result of not being able to contact customers with delinquencies. While this may have been a one-
time event, provisions were even elevated in 2013Q1 before this fiasco. Given the companys recent push for greater
sales backed by these receivables and the looseness with which they offer financing, I think it is likely that the company
will soon see tremendous losses, forcing it to book higher provisions for losses.

Risks to thesis
The company has improved its re-aging policy, such that they cannot re-age loans as much as before. My analysis could
be wrong if there are actual improvements in the delinquent receivables that have yet to flow through to charge-offs.
Furthermore, perhaps there is a niche market for low-credit-score customers to buy premium goods on store credit and
pay them off at sufficient rates to justify the companys risk
Valuation
Given the companys fundamentals and the risks to my thesis, I value Conns at 15x 2014 estimated EPS of $2.83, in line
with the average multiple attributed to its peers. This implies a value of approximately $42, or 44% downside.