I wrote the following article for Institutional Investor magazine. Well, kind of. First I wrote to our clients as part of our first-quarter letter, explaining why we bought Conn’s during the quarter. I feel a little bit uneasy sharing this article, because Conn’s has a tremendous run-up since. Despite the run-up, we were buying it for new accounts at $30 just a few weeks ago. I have no idea where the stock is going to be in a week or a month, and for all I know I could get lucky and the stock will go into the $20s again (I’ll buy more).

I strongly advise my readers to do their own homework – and there are many reasons to do so. I may end up being completely wrong about Conn’s. Investing is an art of probabilities. Not every stock in our portfolio will work out (trust me on this). If you blindly buy a stock because I wrote about it, you only know what to do in the beginning but not during or at the end of the journey. It may prove to be an easy one. Often it will not be. One day you might wake up and find out that this darling just took a 30% dive (take a look at Conn’s stock chart; it has done so a few times). 

We’ve put hundreds of hours of research into this and our other picks – new news becomes just another data point for us on the backbone of our intensive research. If you have done zero research of your own, then you won’t know what to do: buy more, do nothing, or sell. 

The Conn’s Paradox, or the Synergy of Awful
by Vitaliy Katsenelson

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 (CONN) 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 (WMT)and Best Buy (BBY)), often have more-efficient distribution systems (Amazon (AMZN)) 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.

Continue reading at Institutional Investor.