Bring Home 9.0% YTM with Conn’s Inc., Bonds Maturing July 2022

  • Record third quarter retail gross margin of 41.2%
  • Record quarterly credit segment revenues of $89.9 million.
  • Excellent interest coverage of 2.4x.

This week’s bond review delves into the retail sector with a specialty retailer of durable consumer goods who also offers its customers financing on their purchases. Conn’s Inc., which is headquartered in Texas, has a market presence that stretches across the southern United States. Conn’s set some records in its most recent quarterly results (third quarter for its fiscal year 2019).

  • Record third quarter retail gross margin of 41.2%
  • Record quarterly credit segment revenues of $89.9 million.
  • For the first nine months of fiscal year 2019, the company registered its second highest nine month operating income ever
  • Excellent interest coverage of 2.4x.

Conn’s has opened seven new stores in fiscal year 2019 and has plans to open up to 15 more stores in fiscal year 2020, with anticipated revenue growth between 8% and 10% as a result. The company’s 2022 bonds, couponed at 7.250% and currently trading at a discount, are an excellent opportunity for portfolio diversification into the retail sector. In addition to diversification, these shorter maturity bonds provide a competitive yield-to-maturity of about 9.0%, which makes them a smart addition to Durig Capital’s Fixed Income 2 (FX2) High Yield Managed Income Portfolio, shown below.

 

Third Quarter Results

Conn’s most recent published quarterly results should encourage investors. For the three months ending October 31, 2018, the company posted some impressive gains in several categories including the following:

  • Record third quarter retail gross margin of 41.2%.
  • Record quarterly credit segment revenues of $89.8 million, an increase of 10.5% over the prior year period revenues of $81.3 million.
  • Net income for the third quarter FY 2019 was $14.6 million, as compared to $1.6 million in the prior year period.
  • Adjusted earnings of $0.59 per diluted share, an increase of 228% over the prior year period.
  • Through the first nine months of fiscal year 2019, operating income was $107.5 million, an increase of 53.1% from the prior fiscal year period, with increases in both the retail and credit segment. This number also represents the second highest nine-month operating income the company has ever achieved.

Conn’s Chairman and Chief Executive Officer, Norm Miller was extremely positive about the company’s most recent results. “Fiscal year 2019 is shaping up to be one of the best years of profitability in Conn’s 128-year history. I am pleased with the progress we are making, and the positive momentum our highly profitable and differentiated business is achieving.”

About the Issuer

Conn’s is a specialty retailer of durable consumer goods and provider of financing solutions to credit-constrained consumers. Headquartered in The Woodlands, Texas, the company has 122 stores located throughout 14 states. Conn’s operates through two segments, retail and credit, and provides the opportunity to purchase high quality premium brand products across four primary categories: furniture and mattresses, appliances, electronics, and home office goods. The company’s product selection is focused on higher priced, large ticket items (such as bedroom sets, mattresses, refrigerators and televisions) which generate higher margins and typically require some form of financing. Unlike many of its competitors, Conn’s provides flexible, in-house credit options for its customers in addition to third-party financing and third-party lease-to-own payment plans.

Conn’s Core Demographic

Conn’s has very specifically defined its target market. Conn’s core customer demographic represents underserved consumers that typically have credit scores between 550 and 650 and who usually have limited financing options. (According to FICO, in 2017, this credit score demographic represented 20% of the U.S. population). These customers typically earn $25,000 to $60,000 in annual income, live in densely populated and mature neighborhoods and usually shop to replace older household goods with newer items. When studying the makeup of Conn’s actual retail and finance customers, these characteristics are definitely present. For the nine months ending October 31, 2018, (FY2019), the weighted average origination credit score for sales financed was 609. With roughly 1 in 5 people falling into Conn’s core target market, there are substantial opportunities for growth, both within the company’s existing footprint as well as in urban areas where the company does not currently operate.

New Store Growth

In fiscal year 2019, Conn’s will have opened 7 new stores across their existing markets. In fiscal year 2020, the company will open between 12 and 15 stores in their current states. With this increase in number of stores, the company also expects retail revenue growth. The company believes that its retail model and credit platform can consistently support total annual retail sales growth of 8% to 10%.

Improving the Balance Sheet

For Conn’s third quarter FY 2019, interest expense was $15.1 million, which is a decrease of $3 million or 16.6% from the seam period last year. This is the 7th consecutive quarter where the company’s interest expense has declined sequentially and the lowest quarterly interest expense in the last 13 quarters as a result of the company’s continued deleveraging.

Interest Coverage and Liquidity

Interest coverage is of paramount importance to bondholders as it indicates a company’s ability to service its existing debt. For its most recent quarter (three months ending October 31, 2018), Conn’s had operating income of $35.5 million and interest expense of $15.1 million, for an interest coverage of 2.4x. In terms of liquidity, as of October 31, 2018, Conn’s had $401.6 million of available capacity under its revolving credit facility, as well as $3.5 million in cash.

Risks

The risk for bondholders is whether Conn’s can continue its growth trajectory of adding additional stores while still deleveraging their balance sheet. The company is predicting annual retail sales growth between 8% and 10% with the addition of its new stores in fiscal year 2020. And company management has stated their commitment to remain focused on deleveraging its balance sheet and reducing annual interest expense. Considering Conn’s very successful third quarter, the about 9.0% yield-to-maturity on the company’s shorter maturity 2022 bonds, does appear to outweigh the risks identified.

In general, bond prices rise when interest rates fall and vice versa. This effect tends to be more pronounced for lower couponed, longer-term debt instruments. Any fixed income security sold or redeemed prior to maturity may be subject to a gain or loss. Higher yielding bonds typically have lower credit ratings, if any, and therefore involve higher degrees of risk and may not be suitable for all investors.

 

Summary and Conclusion

According to the IRS, 62.4% of U.S. households have annual adjusted gross incomes of less than $50,000. This means that the prospective target market for Conn’s is significant. Not only is there opportunity for growth in states where they already maintain a presence, but also in urban areas where Conn’s has yet to establish stores. The company has continued with its growth plan, opening seven new stores in fiscal year 2019, and plans to open up to 15 stores in fiscal year 2020. This growth is expected to fuel between 8% and 10% annual revenue growth and assist the company in its efforts to deleverage. In light of the company’s excellent third quarter results, the company’s shorter maturity 2022 bonds make an ideal addition to Durig Capital’s Fixed Income 2 (FX2) High Yield Managed Income Portfolio, which, historically, has been an excellent investment vehicle in a higher interest rate environment.

Issuer: Conn’s Inc.
Ticker: (NASDAQ:CONN)
Coupon: 7.250%
Maturity: 07/15/2022
Ratings: B3 / B
Pays: Semiannually
Price: 95.0
Yield to Maturity: ~9.0%

 

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Disclosure: Durig Capital and certain clients may hold positions in Conn’s July 2022 bonds.

Disclaimer: Please note that all yield and price indications are shown from the time of our research. Our reports are never an offer to buy or sell any security. We are not a broker/dealer, and reports are intended for distribution to our clients. The high yield strategies presented in this review by Durig Capital may not be suitable for all investors. This is not investment advice from Durig Capital, nor a specific recommendation to buy or sell securities. If you have any questions or concerns about its suitability for your personal investment, you should seek specific investment advice from a registered professional before making an investment decision.

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