After Conn’s released its earnings, the stock fell by roughly two fifths from $35.09 to $20.83. The market was presumably spooked because credit losses were fairly high relative to expectations. While management has previously stated that the aspirational goal for static loss rates was 8%, it looks like Conn’s may exceed that for 2013 and 2014 vintage originations. Refer to the static loss tables in the 10-Q (page 32) and make your own extrapolations.
The loan book
In general, I feel like the history of subprime lending is repeating itself. Matt Taibbi wrote an interesting piece on Household Finance, a subprime mortgage lender that engaged in dubious re-aging practices. The piece is definitely worth reading to gain a better understanding of the history of subprime lending. (To be fair, Taibbi is a demagogue and has a bias against large corporations.) Ironically, Household Finance was not a very good short despite its serious flaws. It can be difficult to make money even if it turns out that you are correct about an extreme viewpoint.
As far as Conn’s goes, there is not much information on whether or not Conn’s is hiding bad loans through its re-aging practices. As I mentioned in a previous Conn’s post, it is possible that Conn’s is rolling over a very significant number of old loans given that originations exceed the amount of money it lends out to customers in a year. The danger here is that “a rolling loan gathers no loss”.
In my opinion, I think that the loan book is far worse than what management would like investors to believe. The 10-Q states:
The total amount of customer receivables past due one day or greater was $314.0 million and $249.3 million as of October 31, 2014 and January 31, 2014, respectively.
I estimate that roughly a quarter of all Conn’s loans are past due one day or greater. Presumably, re-aging loans would deflate this number. The true figure would otherwise be higher.
Book value is $637M.
Current market cap is $606M at $15.68/share.
Suppose that every loan past due one day of greater was worth zero. (This may overstate the worst-case scenario because some of these loans will be repaid in full.) In that scenario, adjusted book value would be $323M and the adjusted price-to-book ratio would be 1.88. Conn’s would not be terribly overvalued. There are many other shorts out there where the overvaluation is far greater.
However, let’s think about what Conn’s would look like a few years from now. If you believe that Conn’s is poorly managed and that it is bleeding money in its current state, then it is a melting ice cube. Given enough time it will go to zero.
Unfortunately, it is difficult to prove that thesis objectively and with high certainty. To me, it is very difficult to determine Conn’s profitability and the quality of its loan book given that there isn’t enough information. Given the price collapse, I would consider Conn’s at its current price to be a speculative short.
The CFO quits
Here’s a snippet from the press release:
Conn’s today announced the departure of Brian Taylor, the Company’s Chief Financial Officer. Effective immediately, the Company has appointed Mark Haley as Interim Chief Financial Officer. Prior to joining Conn’s as Vice President and Chief Accounting Officer in October 2014, Mr. Haley was Vice President and Chief Accounting Officer at Coldwater Creek, Inc. for four years. He previously served as Senior Director, Financial Reporting at Supervalu, Inc. for three years and spent 16 years with Deloitte in Assurance Services. The Company has engaged an executive search firm to identify qualified candidates for the permanent Chief Financial Officer position. The search process will include both internal and external candidates.
“On behalf of Conn’s Board of Directors, I would like to thank Brian for his valuable contributions to Conn’s growth over the last several years and wish him the best in his future endeavors. Brian’s commitment and effort were essential to the expansion of the Company. Given Mark’s relevant industry and leadership experience, I have the utmost confidence in his ability to assume the responsibilities of CFO during the search for a permanent successor,” Mr. Wright said.
The press release does not seem to give a reason for the CFO leaving. There is no quote from the CFO. The press release does not seem to mention a succession plan. Normally, companies may retain the departing CFO on a contract/part-time basis to ensure a smooth transition.
The sudden departure is a red flag because CFOs usually do not suddenly quit their positions. Brian Taylor likely made a lot of sacrifices to become the CFO of a mid-cap company. I suspect that the reason for his departure is because he knows that Conn’s is a sinking ship.
Mark Haley is an interesting choice for the interim CFO position. Haley seems to have a death touch or plain bad luck. At his previous jobs, his employers ran into catastrophic financial distress within a few years of Haley joining.
Earnings guidance withdrawn
From the press release:
With the ongoing review of strategic alternatives and the oversight initiatives being undertaken by the Company, the Company has decided to withdraw its earnings guidance for fiscal 2015 and is not currently providing earnings guidance with respect to fiscal 2016.
This is a little weird.
My take: management knows that the company is in trouble. However, they have no plan. So, management hired external consultants in the hope that the consultants might develop a better plan than what management could come up with.
In the past, management was fairly promotional about how Conn’s could achieve year 1 cash on cash return of 300%+ whenever it opens a new store (source: June 2 2014 presentation). If this were really true, then the obvious plan would be to grow Conn’s and to open more stores. There would be no need for consultants to develop “strategic alternatives”. Since then, management has changed its tune. It is considering the possibility of “slowing store openings”. Its October 6, 2014 press release states:
THE WOODLANDS, Texas–(BUSINESS WIRE)– Conn’s, Inc. (NASDAQ:CONN), today announced that its Board of Directors authorized management to explore a full range of strategic alternatives for the Company to enhance value for stockholders, including, but not limited to, a sale of the Company, separating its retail and credit businesses or slowing store openings and returning capital to investors.
Now that the 10-Q has come out on EDGAR, it seems that Conn’s is facing an informal SEC inquiry:
The Company received a voluntary request for information dated November 25, 2014 from the Fort Worth Regional Office of the SEC. The information request generally relates to the Company’s underwriting policies and bad debt provisions. The request states that it is part of an informal, non-public, inquiry, which, as noted by the SEC, should not be construed as an indication by the SEC or its staff that any violations of law have occurred. The Company intends to cooperate with the SEC’s inquiry.
This was not previously disclosed in an 8-K or in the earnings press release.
An inquiry is not the same as a formal order of investigation where the SEC would have the power to issue subpoenas. The SEC inquiry is not necessarily a massive red flag. SEC inquiries often do not lead to a collapse in the share price.
Personally, I think that the SEC is a weak regulator. There are too many instances of regulatory capture. Going after market makers and kickbacks on payment for order flow should be very easy for the SEC. Market makers are incredibly guilty when it comes to fleecing investors. Yet the fines against guilty parties have been abysmally low because the SEC staff is busy trying to setup their private careers once they leave the SEC. There are also instances where the SEC fails to protect investors. For example, HGSH is still trading despite the SEC suing an individual for manipulating the ex-penny stock so that it could be listed on the NASDAQ. Guilty or not, I would not put too much hope on the SEC inquiry being a catalyst for the short thesis.
Churning the store base
Conn’s has been closing old locations and opening new locations. I interpret this as a “hail mary”. Conn’s is taking a gamble on new locations. Locations vary in their quality. In any retail operation, some stores will perform better than others due to things like pedestrian traffic by that location, proximity to potential customers, etc. Some locations will be awful while others will be excellent. The only way to figure that out is to try and fail.
As far as closures go, rational management teams do not close profitable stores. If a store is closed (without being moved to a new location), presumably the store was unprofitable. Given the large number of closures over the past several years, I would infer that Conn’s economics were never very good despite double-digit same store sales growth.
Management has indicated that older stores have a better credit profile since repeat customers are better credit risks than first-time customers.
*Disclosure: Short CONN via common shares and put options. Because I bought LEAPs instead of puts that would expire shortly after earnings, my put options only went up 2X instead of ~11X. I am not sure if the reward justified the risk I took in buying out-of-the-money LEAP puts on Conn’s.