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Conn's Should Be Avoided Despite Strong Momentum and Low Valuation

- By Ishan Majumdar

2018 was rough for investors as the second half of the year saw many stocks fall on worldwide economic issues. 2019, however, has been relatively good and a number of stocks have started to recover. Durable goods retailer Conn's Inc. (CONN) is one such company that has shown a significant recovery. The stock's recent momentum and its low valuation make it appear to be a compelling investment, but there are a number of underlying risks associated with it that investors must beware of before moving forward.


Company overview and performance

Conn's is a Texas-based retailer that offers a broad range of durable goods in the home consumer segment. It sells branded furniture, mattresses, household electronic goods and appliances. The company also provides financing to its customers purchasing more expensive products, for which it earns interest.

For fourth-quarter 2019, the company reported revenue of $432.98 million, a 3% increase from the prior-year quarter. While revenue missed Wall Street's expectations, earnings of 96 cents per share topped estimates by 20 cents.

Growth through credit-constrained consumers

Conn's management sees a huge market of potential buyers in the credit-constrained consumers of the U.S. As a result, they acquired a license to distribute direct loans to consumers in Texas, Oklahoma, Louisiana and Tennessee in order to help finance the purchase of products. The company has its own proprietary credit evaluation mechanism, which ensures minimal bad debt, but the provisioning is certainly high on its income statement, causing a reduction in its overall net margin. Management hopes to achieve stable same-store sales growth of between 8% and 10% in the coming years through this model.

Shifting focus to the top line comes as a welcome change after the company's store optimization efforts. Conn's is in a position to provide the best brands through its retail outlets and has good economies of scale with respect to procurement. It is about time the retailer started to focus on scale and growing revenue. The target of 8% to 10% same-store sales growth seems difficult given its track record of uncertainty, but it is a good place to start.

Decent fundamentals, but highly erratic price movements

In terms of financial and operating ratios, Conn's is reasonably strong. The company has a decent operating margin of 10.45%, resulting in a strong return on equity of 12.90%. The current ratio of 4.27 indicates good working capital management and is superior to industry peers. The debt-to-equity ratio of 1.54 is on the higher side, indicating a reliance on borrowed funds for running its operations. This is partly why the retailer's Altman Z-Score of 2.35 falles in the "grey" zone, meaning it is under some financial pressure. Debt levels are about five times Ebitda, implying it is manageable and that the company is not overleveraged.

After a bad 2018, Conn's has kicked the new year off on a very positive note. The stock has appreciated by more than 30% since the beginning of the year. The company is currently trading at a price-earnings multiple of 11.38 and an enterprise value-revenue multiple of 1.11, which is on the lower side but can be justified by weak top-line growth. The stock has a very high beta of 2.09 and its price movements have been highly erratic over the years. This is why it is not a compelling investment despite low valuations.

Key takeaways

Conn's has a number of risks associated with its business that have resulted in high volatility. Since it is in the lending space, it faces regulatory risks as well as the big risk of low provisioning for bad debt. There has not been much stability in its financial performance over the years, so management's goal of stable same-store sales growth of 8% to 10% seems farfetched. Also, a beta of 2.09 indicates volatility traders would make a lot on this stock.

Regardless, Conn's performance is not convincing enough for it to be part of any long-term investor's portfolio. It is best to avoid investing in the stock for now and wait for management to achieve the long-desired goal of revenue stability.

Disclosure: No positions.

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This article first appeared on GuruFocus.