Tuesday was the day of reckoning for Conn's. Having set out about two years ago to stimulate sales by weakening its underwriting standards finally resulted in a spike of souring loans.
Going back to the 19th century, Conn's has been a typical purveyor of furniture in small towns in places like Texas and
Louisiana. Over time, as the world changed, they added appliances and then electronics to their retail inventory. But two years ago, a new management team arrived. They decided to build on "credit-based messaging," based on a strategy that said people would buy more if they could pay later. Conn's generally offers credit at about 19 percent, but a key part of more credit was the presumption that the company could sell at very high margins. Some of their product lines enjoy gross margins of more than fifty percent, and during the last quarter the gross margin company-wide was 40.8 percent. Selling something with a fifty percent markup to people who pay nineteen percent to finance that purchase sounds like a pretty healthy way to generate a lot of cash.
On the ground, this means that Conn's is selling televisions for an average price of a bit more than one thousand dollars to consumers with an average income of about $38,000. Then they finance it at twenty-one percent (or 26 percent in states that allow it), broker a property insurance contract for 6 percent per year for three years, and offer to broker three more versions of credit insurance.
Recently, the company decided to start offering "Ye$ Money." Yes$ Money is about as confusing as it gets. It is a no-interest promotion. Usually that means you pay no interest for a period of time, during which an interest obligation accrues. The typical assumption is that you can avoid that interest if you pay off a debt at an earlier point in time. But at Conn's, that idea is flipped on its head. The no-interest borrower pays interest. If they can pay on time and then make a balloon at the end of the promotional term, then their interest is repaid. If that happens, then everyone wins: Conn's gets their capital back early, which then allows the company to re-lend that money for high gross margin opportunity. When the borrower gets the rebate, he or she has been able to get back some interest expense. One difference, of course, is that the time value of money goes not to the percent getting free interest but instead to the lender.
Turns out that this is easier said than done. At the moment, Conn's says that only about one in three borrowers is actually satisfying the terms of the deal. The fact that the company uses the Rule of 78ths means that it is all that much harder for a borrower to come up with the balloon.
Here's what Conn's CEO said shortly about the underwriting for Ye$ Money:
“The promotional receivables are being originated at all of our stores. And when we talk about promotional, it’s not based on any kind of underwriting standards.”[i] – Conn’s CEO Theodore Wright during a call to investors on April 3rd, 2013.
This is the kind of statement that could only be made by someone who has been ignoring the CFPB. There's probably no principle that means more to Richard Cordray than the idea that loans should only be made to people who have the ability to repay them.
This is a unique business model. One thing that recently stands out is how higher margins and higher delinquencies have the net effect of negating each other.
"Significant tightening of underwriting," Wright said on Tuesday, "would not result in improvement in profitability."
Conn's has been opening a lot of new stores recently. To get a sense of the scale, consider that they currently have about 65 stores but they are planning to grow that number by fifteen every year in the near term. That also means that they will soon have a footprint from Colorado to Texas to North Carolina.
Last month, a group of pension funds sued Conn's. They said that Conn's had been talking one way and walking another. The new stores were the locus of that concern. In their complaint, they quoted a number of former employees who said that staff at new stores were being instructed to approve anyone - even those with credit scores of 400 - and to simultaneously make sure that they spend every last dollar of their credit line. Their loan portfolio increased by forty percent between July 2013 and July 2014.
The Fan has been Hit
Turns out that this kind of approach didn't go so smoothly. Last year, delinquency rates increased by 150 basis points and this quarter they jumped another 60 points.
In turn, the company's shares dropped thirty percent in the first five minutes of trading on Wednesday.
The good news is that Conn's seems ready to re-think their underwriting. In August, they dropped their six-month promotional Ye$ Money program and they have decided to drop the 12-month no-interest program for the customers with in the lowest credit segment.
Last year at this time, the company said it was going to set aside about $22 million for expected losses. This time, they decided to make it a whopping $40 million. It isn't just that loans are going bad more frequently; a compounding problem is that they have been originating so many more loans than in the past.
