I recommend a long position in CONN at $34.52, it has roughly 40% upside to fair value of $49.00 per share.  First off, tip of the hat to Novana on the well written and timed short thesis at $76.  I expect this to be a controversial write up with a low rating.  We’ve often found that when a heavily shorted stock with an intelligent bear script plays out it becomes “unownable” to most investors, despite the fact that the bears may be only partially right fundamentally and happen to have enough scary data points to catch a bunch of complacent longs off guard.  In the right situations these turn into great buys as the complacent longs are replaced with complacent shorts.

Since Novana did such a thorough job describing CONN a few months back I will refer readers to his work for any background they may need.  There is also a pretty good slideshow on their investor relations website.

Our argument from here is pretty simple:

• CONN was never as good as the bulls wanted to believe >$60, but it also isn’t as ugly as the bears are claiming down here in the $30s
• They have been in the proprietary credit business for roughly 40 years, lending very similar amounts to very similar customers that are secured by very similar merchandise—although they became more aggressive over the past 18 months most of the important metrics have remained essentially in line with longer term averages (the new CEO tightened the book in 2011 so it now looks like metrics are “spiking” the wrong way)
• Although the company may be painted as a “rip off” for consumers they serve a legitimate place in the market: the consumer who can’t afford to pay cash at AMZN/BBY but also doesn’t need to pay 2.5x ASP at ANN/RCII or take on a loan from WRLD/RM—the fact is CONN is usually the option that makes the most sense and they do exploit this via higher pricing
• Bears cite new management as being reckless and changing the risk profile of the credit operation, but Theo Wright has been on the CONN board since 2003, he knows the business very well.  Prior to CONN he was the CFO at Sonic Automotive and before that he was at Deloitte.  This is a guy who understands consumer finance.  In addition, the CFO Mike Poppe has been there for 10 years and was the Chief Accounting Officer at Group 1 Automotive prior to that.  These don’t seem like the kind of guys that would decide 2013 is the year to light themselves on fire with their credit book.
• 79 stores is a small base to grow off of, we aren’t expecting to see 300 any day soon, but it won’t be hard for them to put up 10-15% unit growth going forward—cash payback is 6 months on new units
• Since the pre-announcement the stock has traded roughly all of its 37m shares outstanding and three of the eight sell side analysts have downgraded (prior to the blow up they had been unanimous buys), my guess is there aren’t many new longs that aren’t aware that charge offs will rise, unit growth will likely slow, and $3.40 for FY2015 in eps may be subject to some trimming

First off, the credit operation:

• The stock was down approx. 40% last week when CONN announced they saw delinquencies rise to 8.8% and charge offs tick up to 10.6%.  Management claims this rise is temporary and caused by collection execution issues and weather.  Bears claim this is the beginning of the end and is a result of overly aggressive lending over the past 18 months.  We think the likely answer is somewhere in between.
• It is important to understand that when Theo Wright came on as CEO in 2011 he effectively tightened reporting practices of the credit arm by cutting the total amount of time a loan can be re-aged to 12 months, this has resulted in the re-aging rate getting cut almost in half which had the impact of rising the charge off rate as loans move more quickly through delinquency, it also cut down the number of active accounts.  In addition he changed the charge off policy to a max of 209 days past due vs the possibility of a loan going up to 330 days without being charged off in the past.  At the same time, store count and revenues were shrinking, as was the size of the credit book. 
  • Effectively this means that while the data looks like the book has drastically changed if you use 2011 as a starting point, its only slightly more aggressive if you take a longer time horizon, the important metrics are summarized below:

• The takeaways are really pretty simple:
  • They’re lending to the same type of consumer (FICO didn’t plunge by 50 points)
  • They’re being more aggressive with the amount of money they’re lending (promotional financing and down payments)
  • But the key metric on that grid is the 10.6% charge offs they reported in the Q4 pre-announce, this is why they took guidance down and will be the key metric for the stock going forward as it leads to provisions.  So it’s critical to understand where this might go.
    • At the upper end are guys like World Acceptance that charge a 64% APR to real deep subprime consumers secured with old stereos or whatever else they have lying around their living room, their charge offs are mid-teens (14% last year)
    • At the lower end most prime books see charge offs of <3%
    • The closest comp would probably be installment lender LEAF, which makes secured loans has a very similar customer to CONN (599 FICO, $47k avg income) has a charge off rate of about 4%, LEAF said during their road show that auto secured loans charge off at about 1/2 the rate of the house, meaning the rest would charge off at about 6-7% (assuming autos are roughly ½ the book)
    • Putting all this together makes the 7-8% rate CONN has seen over the past few years look a lot more like the right stabilized number than something closer to WRLD’s 14%, so I’m betting the 10.6% heads south not north over the next few qtrs.
    • Management does blame this on weather (60% of customers make their payments in-store), execution issues as the portfolio has grown 40% y/y, and late tax refunds.  I’m sure this did have something to do with the uptick, how much exactly is tough to say.

The Retail Business

• The retail arm is pretty straightforward and highly tied to the credit arm, so I won’t spend a lot of time on it.  If the credit book blows up they won’t be able to fund receivables to grow comp or units, if charge offs head right back to 7% the comp next year will likely be better than my +5% estimate.  As mentioned above, the prior write up and investor presentation give you everything you need to know here, but I will highlight a few important points
• Gross Margin has moved from 26.5% in 2011 to approx. 40% at the end of 2014 for a few reasons (these are expected to be flat going forward)
  • a mix shift away from consumer electronics which carry a 30% GM into furniture and appliances which carry a 50% GM
  • pricing increases (yes, a bit exploitive)
  • replacing older high cost and unproductive stores with newer units
  • SSS of +14% in FY2013 and +27% FY2014E were driven by the introduction of a great selection of furniture and mattresses, store remodels, and newer/faster comping stores entering the comp base.  I don’t expect this to continue going forward.  I look for +5% based on the newer stores continuing to enter the comp base and a continued mix shift over to furniture and mattresses.  I don’t think they need much macro tailwind to put up that kind of a comp.

Valuation

• I get to $3.25 in EPS in FY2015 based on 10% charge offs, a 5% comp and 15 new stores.  In FY2016 I get to $3.90 based on 9% charge offs, a 5% comp and 15 new stores.
• AAN trades at 14x, BBY at 10x, MFRM at 15x…..CONN is growing units and comp much faster than all of them but clearly the credit arm deserves a large discount, 12.5x seems right to me, that rings up a $49 fair value

To Summarize

• They may have gotten a bit in front of their skis but this isn’t management’s first rodeo with the financing business and the characteristics of a CONN’s credit customer suggests charge offs will gravitate back to the 7-8% level
• This is a retail story with significant unit growth potential that’s comping positively, when the credit arm stabilizes investors will be paying a lot more than 9x out year earnings for the business
• The combination of intelligent shorts and frustrated longs has created a great entry point down 60% from the stock’s peak