One plus one equals three: That is a business school definition of synergy. Two companies join forces, and the quality and profitability of the combined entity improves more than the arithmetical sum of the parts. On the other hand, when you combine two awful businesses you get the inverse synergy: Negative one plus negative one equals negative three.
I expected to see inverse synergy at Conn’s when we started analyzing it; after all, the company consists of two pretty awful businesses — a retailer of electronics, furniture and appliances and a subprime lender. However, we discovered the opposite phenomenon and are now proud to reveal Conn’s paradox: the (positive) synergy of awful.
Conn’s brick-and-mortar retail business — especially in electronics — has very few competitive advantages. The company sells commodities and is therefore fighting for its life against competitors that are much larger and have greater buying power (think Wal-Mart and Best Buy), often have more-efficient distribution systems ( Amazon) and therefore have structural cost advantages. The subprime lending business is not any better: Just a few years ago, that industry was the culprit that almost bombed the U.S. into a depression.
Conn’s paradox is that the severe unattractiveness of each business in isolation opened a unique niche for a combined business that allowed the company to build a competitive advantage by nonaligning it with its perceived competition — the Best Buys, Wal-Marts and Amazons of the world. All of those retailers offer some or even all the products sold by Conn’s, but its customers don’t have the credit to buy them from the other guys.
Conn’s, despite being an unknown quantity to most of our clients and readers, has been around for a long time. The company started more than 120 years ago in Texas, where it still has its largest number of stores. Though it does sell electronics, it has been deemphasizing that category for a while, taking it down from 40 percent of sales a few years ago to only a quarter of sales today. If you visit a Conn’s HomePlus store, it looks a lot more like a furniture, mattress and appliance retailer than an electronics seller. Conn’s customers are underbanked consumers — the U.S. has 30 million of those. They usually have poor credit (low FICO scores) and don’t have access to bank or plain vanilla credit and thus cannot otherwise actualize their constitutionally granted right to pursue happiness, which in the modern version of the American dream means watching Netflix on a 60-inch TV.
Thirty million people is a large number — it’s only a few million shy of the total population of Canada — but from Best Buy’s or Wal-Mart’s perspective, the rest of the country (300 million Americans) represents much-lower-hanging fruit. The upper 90 percent of consumers have far more buying power than the lowest 10 percent; and although Best Buy would love to sell a 60-inch TV to anyone who comes into its stores, it will not get into the subprime lending business to go after 10 percent of the market to sell an extra TV.
Under its new CEO, Theo Wright, Conn’s has modified its retailing strategy: As the company has slowly moved away from electronics, it has focused on improving margins by trying to offer the lowest prices. It also stopped carrying category losers — products that by their nature have low or no margins. For instance, a $300 TV has only a 10 percent gross margin, so the company makes just $30 on that sale and generates little financing income. But a $2,000 top-of-the-line TV has a 28 percent margin, bringing almost $600 of gross profit along with plenty of finance income.
This change in approach makes a lot of sense: Conn’s doesn’t have to fight with Amazon or Best Buy for a sale on which it would make very little profit and where its ability to finance the purchase would have much lower value to the customer. This strategy has proved to be very successful, as the company’s operating margins have improved notably in recent years and its retail business has become a significant profit center.
Conn’s ability to lend profitably to subprime customers is an important skill that requires a laser-like focus on that relatively small niche, which its mass-retail brethren don’t have. But why wouldn’t Best Buy team up with a different subprime lender to compete against Conn’s?
One of the biggest obstacles is that the lending partner would have to overcome considerable losses in the initial years. When Conn’s opens stores in new areas, it loses money on new loans (we estimate that credit losses peak at 15 percent). The new stores remain profitable only because credit losses are subsidized by the profit generated by the retail side of the business. Only a competitor that does both retail and subprime financing can pull that off, and Conn’s has no such competitors.
As stores mature, bad borrowers naturally filter out (if you don’t pay for your TV, Conn’s will not lend you money to buy a couch), and underwriting losses settle at somewhere around 5 percent. During the financial crisis Conn’s had a very mature store base and held underwriting losses below 5 percent. That’s a good number for any lender and an incredibly low number for a subprime lender, especially at a time of severe economic distress. By contrast, American Express, which lends to the very-high-end tier of the market, had losses around 8 percent during the crisis.
One of the keys to Conn’s underwriting success is the recurrence of revenue from existing customers. Conn’s provides great customer service, its prices are reasonable (not the best but fair), and, most important, it offers one of the few avenues for its customers to get financing at decent rates. Thus customers keep coming back to its stores and buying from Conn’s, which explains the low default rates.
A current opportunity in Conn’s has been created thanks to its aggressive expansion strategy. Conn’s almost doubled its store base during the past five years. As I discussed above, new stores bring higher underwriting losses, at least initially. The extent of credit losses was magnified by the fact that Conn’s opened stores in markets where it had no or few existing stores. Management was as surprised by the severity of the losses as investors were. The company’s CFO and the stock paid the price: The CFO was fired, and the stock collapsed.
Management vowed to be less promiscuous with lending in new stores. They kept their promise, and delinquencies have been on a steady decline over the past two quarters. It is easy to hate a subprime lender that in theory competes with Best Buy and Amazon, especially when the delinquency rate on its loans is going through the roof; but once you understand that higher delinquency is a natural by-product of opening new stores, it stops being a surprise and can be treated as part of the company’s competitive advantage. In fact, if Conn’s stopped opening stores today, then in a few years — as stores it has opened over the past few years mature — it would generate about $5 of earnings a share (versus fiscal year 2015 diluted earnings of $1.59 a share). But because the company continues to open new stores, the initial underwriting losses mask significant earnings power. Today, Conn’s has 90 stores, but it has the potential to have 500. At current prices you have an opportunity to buy at a bargain basement price a retailer with a significant growth runway ahead of it.
Originally written for Institutional Investor…