Selling strung-out American consumers something they can’t afford, can’t get financed elsewhere because they already bought things they couldn’t afford and ruined their credit in the process, and overcharging them for the privilege is one of the most irresistible money makers. These customers are captives. And it boosts sales like nothing else. It’s called subprime lending. It’s risky, as certain lenders, now defunct, found out during the financial crisis.
Now Conn’s Inc., a rapidly growing chain of 89 retails stores selling appliances, electronics, furniture, and mattresses, issued a warning on subprime. A broad warning. It has been offering in-house financing to customers who can’t afford the product and don’t have the credit score to finance it elsewhere.
Business has been booming. In the second quarter ended July 31, same-store sales rose 12% “on top of an 18% increase in the prior year and 22% two years ago,” as CEO Theodore Wright proudly pointed out during the earnings call. The company opened an additional 14 stores in 11 markets over the last five months, and total revenues in the quarter jumped 30% from a year ago to $353 million.
“The retail segment had another outstanding quarter with higher gross margins, expanded operating margins, and the twelfth consecutive quarter of increasing same store sales,” Wright said. “We are reaching customers that were underserved before, giving low-income consumers the opportunity to purchase quality, durable, branded products for their homes at affordable monthly payments.”
So 77% of its retail sales were financed in-house, with the company borrowing the money to lend it to its customers so that they can buy its products. Conn’s is profiting not only from the sale but also from the loan. Subprime is irresistibly profitable. The portfolio’s average FICO score is 592, with 15% of the portfolio being below 550 (below 640 is considered subprime). It has worked wonderfully before. It has led the housing industry to great success. And the auto industry has come to depend on it. Nothing can go wrong.
Until Wright spoiled the party: “Overall results were not satisfactory….”
Turns out, this subprime bonanza “ran into unexpected headwinds” that slammed the credit portfolio of $1.18 billion – about a year’s worth of sales! It’s up $336 million from a year ago. Bad debt charges jumped to 10% of the annual outstanding balance, from 7% a year earlier. The provision for bad debt soared 85% to nearly $40 million. This hit knocked earnings per share 25 cents below analysts’ expectations. And the company cut its outlook for the year.
The stock plunged 30% in one fell swoop. At $31, it’s down 61% from its end of the year peak of $80 after a phenomenal run-up from below $5 in early 2011. Subprime giveth, subprime taketh away.
Wright explained the system this way:
As it has for half a century, our combined retail and credit business model proved its strength in resiliency. Retail profitability cushioned the impact of credit performance volatility inherent in subprime consumer credit. Had we not pushed ahead to expand our retail sales, we would have not mitigated negative credit trends with strongly growing retail profits. The growth in gross margin helped cushion the impact of credit performance as well.
On the principle that the more you sell by relying on subprime, and the more you raise the price on people who don’t have a choice because they don’t have the money and can’t afford to buy it and can’t get if financed elsewhere, the more the profits from those sales cushion the impact when that very subprime credit from those sales blows up in your face.
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