Question: How do you lose money while selling your products at a gross margin of 40.6 percent?
Answer: You misjudge the ability of borrowers to repay loans, and then you make those mistakes with house money.
This morning, Texas-based retailer and consumer finance company Conn's released some very bad news. The outcomes were entirely consistent with what happens when a high-margin inventory is sold in tandem with easy financing.
The first part sounds like Conn's has been doing very well. They reported that revenues increased 19 percent on a year-over-year basis, that their gross margin added 50 basis points, and that they opened six new stores. In the last three months, Conn's realized a profit of $37.8 million on their sales.
But none of that matters because it turns out that they've been driving growth by selling to people who don't pay their bills. After including revenue from fees and interest, their credit segment lost $42.2 million (EBIT). The company set aside $72 million for future losses during that period, which is fairly enormous when you consider that they only sold $278.1 million in goods.
In my opinion, the whole value proposition is suspect. The target buyer has lower-than-average income ($40,100). Moreover, of those customers who use Conn's financing, the average credit score is 597. Does that mean that they offer the kinds of low-cost goods that might fit with a low-income lifestyle?
At the moment, they are offering five televisions for more than $3,999.98. They are advertising a 78" Samsung Smart TV for $7999.99. Those prices underscore how offering credit helps to cross-subsidize the retail side. The same model is available from East Coast TV for $4,126. There are two differences between the two offers. First, Conn's offers credit for the purchase of the television. Second, East Coast will throw in a free a wall mount.
The drive to market on credit is a fairly recent strategy for a company that has been around for more than 100 years. This morning, a Conn's executive elaborated on that during their 3rd quarter investor call:
A year ago we began to communicate to the consumer more directly the availability of credit. If you think of the typical customer, if we communicate the price and the product, that is not enough to facilitate the transaction because they didn’t have the funds. We did more to communicate that…as a result we generated a lot of business with significant growth from customers that have never purchased form us before.
According to the company, the average indebtedness of borrowers is about $2,300 and the average monthly payment is $130.
Drill Down on Credit
The company's credit portfolio grew by 32.7 percent in just twelve months. Unless some force exogenous to the company intercedes, the growth is unlikely to abate.
Like most lenders who serve subprime and deep subprime consumers, Conn's complements the insights produced by traditional FICO scoring with in-house algorithms that ideally help to sort out the good risks from the bad ones. This is an emerging wave in underwriting. For the moment, people are optimistic about the ability of data-driven analytics. But something isn't working here. By the company's most recent estimate, about a quarter of Conn's receivables are expected to go unpaid. Things are going bad quickly. Past due balances (60 plus days) have increased by 17.6 percent. Charge-offs are picking up pace as well.
Conn's CEO has said that the company is willing to frame loan applications, not for the ability of their customers to repay, but instead based upon the potential for a transaction to generate enough margin to make up for expected losses on credit. On April 23rd of last year, Wright had this to say about a new zero interest credit promotion:
The promotional receivables are being originated at all of our stores. And when we talk about promotional, it's not based upon any kind of underwriting standards.
He made a similar comment during a call two months ago:
Significant tightening of underwriting," said Wright, "would not result in improvement in profitability.
I'll reiterate a comment I have made in the past. There is a naivete reflected in these kinds of statements. Their managers do not seem to understand the risk they face from a potential intervention by the Consumer Financial Protection Bureau. Nothing is more at the heart of the CFPB's institutional DNA than their belief in the idea that lenders should only make loans to borrowers who demonstrate an ability to repay. The staff at the CFPB cares deeply about consumers. When a company is willing to acknowledge that they are employing a cynical strategy of cross-subsidizing gross sales margins through easy financing, it grabs their attention. Here we have a company whose business model accepts a certain level of collateral damage, and furthermore, there is a CEO on record who is candid about those expectations.