Conn's Inc.

When Circuit City declared bankruptcy near the beginning of the recession, opportunities were created for other electronics retailers. One company that aggressively stepped forward to fill the void is Conn's Inc. (CONN), a home appliance and electronics retailer. Conn's even took over some of Circuit City's previous locations on its quest of aggressively growing its market share.

A quick look at the financial statements shows that Conn's has indeed been successful at grabbing consumers, with flat year-over-year sales (in an otherwise negative environment for consumer electronics) and decent profitability. In the last four quarters, Conn's has earned operating income of almost $40 million while the company trades for just $150 million on the market. The numbers are enticing until you consider how the company is making its sales: on credit.

Indeed, the company's "receivables" balance has increased from $30 million to $140 million in the last year, as the company counts the increase as sales and then subsequently counts on consumers to pay that money back (using repossession as an incentive). In the past, the company has sold these receivables to an off-balance sheet qualifying special purpose entity (QSPE) to fund these consumer financings, but the QSPE's funding is currently near its limit, requiring the company to show the difference on its balance sheet.

In principle, there is nothing wrong with a business that lends money to consumers to finance purchases. But investors must recognize that this is not a simple business: this is partly a retailer, and partly a bank, and therefore contains risks inherent to both industries. From a bank-type risk point of view, the company has had to take on $130 million in debt to fund these receivables; if consumers have trouble paying their bills, this spells trouble. From a retail-type risk point of view, the company has over $150 million in operating lease commitments; if the company can't find enough consumers that pay cash or that have good credit, this also spells trouble.

Reported sales numbers don't always tell the story. In this case, past sales numbers, however accurate they may have been at the time, may be covering for the fact buyers can't actually afford items they purchased on credit. On the other hand, it's entirely possible that the company is extremely accurate with its credit scoring system and its strategy will pay off in the long run. Either way, to avoid being surprised by the downside risk, investors must be aware that they cannot simply evaluate this company as a retailer alone, but must take into account the risks that are inherent in investing in banks as well.

Disclosure: None