Should You Follow Greenlight Capital's Move Into Conn's?

The struggling shares of appliance and consumer-electronics retailer Conn's came to life in mid-April after noted hedge fund manager David Einhorn and his Greenlight Capital fund disclosed a new position in the specialty retailer. Is it time for investors to tune out the noise and buy in?

May 20, 2014 at 12:05PM

                                         

Conn

Source: Conn's.

Appliance and consumer electronics retailer Conn's (NASDAQ:CONN) has had a tough start to 2014. Its share price fell sharply in mid-February after it disclosed lower-than-expected profit in its fiscal fourth quarter, partially due to the poor performance of its credit operation. The company is hardly alone, though. Peer hhgregg's (NYSE:HGG) share price has been under similar duress, as the company was hurt by lower-than-expected sales and profit in its own fiscal fourth quarter.

However, shares of Conn's received a nice lift in mid-April after noted hedge fund manager David Einhorn revealed a new position in the specialty retailer through his Greenlight Capital fund. So should investors bet on some further upside for Conn's?

What's the value?
Conn's has been one of the best stories in the consumer-durable retailer space over the past few years thanks to its ability to remain flexible and its willingness to change with the times. This is evidenced by a constantly changing product mix that has recently tilted toward the appliances and furniture/mattress categories. The company has also anecdotally benefited from a general loosening of credit markets. This development has allowed it to bulk up its credit-providing capabilities and thus broaden its potential customer base. The net result for Conn's has been sharply higher profitability and a favorable five-year run for its stock price.

In its latest fiscal year, Conn's reported pretty solid financial results. These were highlighted by a 38% top-line gain that was a function of both strong comparable-store sales growth and a double-digit increase in its overall store base. During the period, the company benefited from a favorable product-pricing environment, especially in the appliances and furniture/mattress categories, which produced sharply higher operating profitability. More important, the higher profit led to better cash flow for Conn's. This will help it fund its various growth ambitions, which include another double-digit addition to its store network in fiscal 2015.

Trying to read the tea leaves
Of course, all is not rosy at Conn's, as one might surmise from the company's recent stock price action. While Conn's gross margin was strong in its latest fiscal year, rising more than 400 basis points compared to the prior-year period, Mr. Market may be questioning the company's ability to continue to deliver such strong numbers in the future.

Indeed, competitor hhgregg doesn't even come close to Conn's gross margin performance. It reported a much lower 28.4% gross margin in fiscal 2014 that has been negatively affected by a highly promotional selling environment. While the company's product mix differs slightly from that of Conn's, with a greater weighting in the appliance and consumer electronics categories, it has a similar operating strategy and store format. The major difference between the two competitors seems to be that HH Gregg doesn't have an in-house financing program while Conn's does. Conn's derives approximately three-quarters of its total sales from the program.

A better way to go
Given that much of Conn's sales momentum and ultimate value seems to come from its large, in-house financing program, which has displayed worsening credit metrics lately, prudent investors might want to look for a better play in the appliances retail space, like Home Depot (NYSE:HD). The home-improvement giant sells a huge assortment of products, with roughly 40,000 in its stores at last count. It has been heavily investing in a greater selection of inventory in the appliances area with the hope of riding the category's recent sales growth, a by-product of a slowly improving domestic-housing market.

Similarly to Conn's, Home Depot benefited from higher average product prices in its latest fiscal year, including products in the appliances area, which helped it post a top-line gain of 5.4%. More important, the company generated an even larger uptick of 18% in its operating profit, thanks to its successful drive to improve the productivity of its store labor force with its so-called Customers First initiative.  The net result for Home Depot was an increase in its operating cash flow. This provided a surplus of funds for the company to reinvest in a broader inventory selection, thereby making its stores even more valuable for customers.

The bottom line
Conn's certainly seems to be a value investor's dream, as it trades at roughly 12 times management's expected earnings per share for the current fiscal year, a data point that likely piqued the interest of Greenlight Capital. However, given the importance of Conn's credit operation to its bottom line, prudent investors might want to wait for the company's customer payment trend to stabilize prior to jumping in.

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Robert Hanley owns Conn's. The Motley Fool recommends Home Depot. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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