Value Investing

The Conn’s Paradox, Or The Synergy Of Awful

The Conn’s Paradox, Or The Synergy Of Awful by Vitaliy Katsenelson, Contrarian Edge

One plus one equals three: That is a business school definition of synergy. Two companies join forces, and the quality and profitability of the combined entity improves more than the arithmetical sum of the parts. On the other hand, when you combine two awful businesses you get the inverse synergy: Negative one plus negative one equals negative three.

I expected to see inverse synergy at Conn’s when we started analyzing it; after all, the company consists of two pretty awful businesses — a retailer of electronics, furniture and appliances and a subprime lender. However, we discovered the opposite phenomenon and are now proud to reveal Conn’s paradox: the (positive) synergy of awful.

Conn’s brick-and-mortar retail business — especially in electronics — has very few competitive advantages. The company sells commodities and is therefore fighting for its life against competitors that are much larger and have greater buying power (think Wal-Mart and Best Buy), often have more-efficient distribution systems ( Amazon) and therefore have structural cost advantages. The subprime lending business is not any better: Just a few years ago, that industry was the culprit that almost bombed the U.S. into a depression.

Conn’s paradox is that the severe unattractiveness of each business in isolation opened a unique niche for a combined business that allowed the company to build a competitive advantage by nonaligning it with its perceived competition — the Best Buys, Wal-Marts and Amazons of the world. All of those retailers offer some or even all the products sold by Conn’’s, but its customers don’t have the credit to buy them from the other guys.

Conn’s, despite being an unknown quantity to most of our clients and readers, has been around for a long time. The company started more than 120 years ago in Texas, where it still has its largest number of stores. Though it does sell electronics, it has been deemphasizing that category for a while, taking it down from 40 percent of sales a few years ago to only a quarter of sales today. If you visit a Conn’s HomePlus store, it looks a lot more like a furniture, mattress and appliance retailer than an electronics seller. Conn’s customers are underbanked consumers — the U.S. has 30 million of those. They usually have poor credit (low FICO scores) and don’t have access to bank or plain vanilla credit and thus cannot otherwise actualize their constitutionally granted right to pursue happiness, which in the modern version of the American dream means watching Netflix on a 60-inch TV.

Thirty million people is a large number — it’s only a few million shy of the total population of Canada — but from Best Buy’s or Wal-Mart’s perspective, the rest of the country (300 million Americans) represents much-lower-hanging fruit. The upper 90 percent of consumers have far more buying power than the lowest 10 percent; and although Best Buy would love to sell a 60-inch TV to anyone who comes into its stores, it will not get into the subprime lending business to go after 10 percent of the market to sell an extra TV.

Under its new CEO, Theo Wright, Conn’s has modified its retailing strategy: As the company has slowly moved away from electronics, it has focused on improving margins by trying to offer the lowest prices. It also stopped carrying category losers — products that by their nature have low or no margins. For instance, a $300 TV has only a 10 percent gross margin, so the company makes just $30 on that sale and generates little financing income. But a $2,000 top-of-the-line TV has a 28 percent margin, bringing almost $600 of gross profit along with plenty of finance income.

This change in approach makes a lot of sense: Conn’s doesn’t have to fight with Amazon or Best Buy for a sale on which it would make very little profit and where its ability to finance the purchase would have much lower value to the customer. This strategy has proved to be very successful, as the company’s operating margins have improved notably in recent years and its retail business has become a significant profit center.

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The Conn's Paradox, Or The Synergy Of Awful