The Cons of Conn's

My tingling value-senses recently led me to home electronics retailer Conn's (NASDAQ:CONN). I wanted to find out why the stock has gone from a high-flier to mere mortal in less than a year. I always love the opportunity to find a bargain, especially a smaller, underfollowed company with high insider ownership. Yeah, that's right: a potential Hidden Gem.

As a big fan of Best Buy (NYSE:BBY) and Circuit City (NYSE:CC), two investments for which I continually kick myself for failing to pull the trigger when I had the chance, I'm always looking to make up for that mistake. Could Conn's be my redeemer?

The shorts are at it again
Not right away, it won't. First, I had to answer an important question: Why does Conn's carry such a high short interest? Here's what I mean.

Since Hurricane Rita ripped through the Gulf Coast, the area Conn's serves, short interest has nearly doubled. It couldn't just be because of the storm. Yes, it caused damage, but the stores have kept on selling.

Intrigued, I kept looking. Sales growth is good, though the financial restatement is probably causing some fear. (As a value investor, I like fear. Fear brings down prices.) According to Jaywalk, analyst sentiment has dropped considerably over the past five months. As I've noted before, sometimes this herding behavior causes drops in price as well.

But even with the price drops, short interest continued to rise. What was I missing? Sure, there could be some copycatting going on -- but I doubt it. Copycat shorting doesn't seem like a winning strategy to me. Heck, I'm scared to short shares on my own, let alone copy someone else doing it.

I ain't going to join them, but I don't think I can beat them
After reading the restatements and trying to understand what separates Conn's from the Best Buys, Circuit Cities, and Tweeters (NASDAQ:TWTR) of the world, three pieces of information got me thinking:

1. 57% of all company sales use Conn's internal credit/financing department.
2. The use of interest-free promotional financing has nearly doubled since FY 2004.
3. The ratio of pre-tax operating income to finance and other revenue is less than 1.0.

So what does this data tell me, besides the fact that I enjoy reading and analyzing financial statements way too much? Here's how I see it.

Conn's tries to differentiate itself on being able to offer excellent financing options. Best Buy farms that responsibility out to a third-party vendor, and Circuit City sold its financing division in 2004. So it makes sense that Conn's, looking to differentiate itself, would want to use that asset. Hence, more than half its sales go through financing because it securitizes the receivables, sells them, and generates income from the spread, while collecting interest on receivables it doesn't sell.

But interest-free promotions carry lower spreads. And look how the interest-free sales have increased.

By itself, that's not necessarily bad. There could be lots of reasons why the use of interest-free promotions has gone up. However, the financing division is crucial to both the company's sales and profitability. It brings customers in the door and gets them to purchase big-ticket items. (The average balance was slightly more than $1,000, according to the company's financials.) But it seems to have become the sole breadwinner for the retailer, since financing revenue is greater than operating income (EBIT).

To me, that indicates that the financing unit has to make up for a bloated cost structure in the retail side of the business. I couldn't break out the SG&A costs associated with the financing revenue (I assume they are relatively small, given the nature of the revenue), but it doesn't seem as though selling products and services is generating enough margins to cover Conn's costs. So is the retailing portion of the business a loss-leader to generate financing income? That's certainly a valid way to run a business, but is the business a bank or a retailer at this point? When will the retail part get back to turning a profit on its own, as it did in FY 2000, when the ratio was greater than 1? And doesn't this type of business structure carry more risk? I think so, and I think that's what the short sellers may see as well.

Prose and Conn's
Admittedly, I'm still intrigued, and I plan to learn more. But given the information above, I don't see Conn's as a bargain or a Hidden Gem today. Sorry. I like my retailers to sell products profitably, using financing units to put more icing on the cake.

This whole exercise just reiterates the importance of looking past earnings and sales growth to try and understand how a business operates, and what may happen in the future. There may be opportunity for Conn's to harness the benefits of scale: more stores, selling more goods and services, could generate more absolute gross profit. Like I said, though, I'd learn more about this company before I considered purchasing shares.

For more home electronics Foolishness, check out:

• Checking Out at REX
• Good, Better, Best Buy
• Battle of the Electronics Retailers

Interested in learning more about what makes a small company a Hidden Gem? Sign up today for a free trial to Motley Fool Hidden Gems, where you'll discover more superior small caps singled out by Tom Gardner and Bill Mann.

Fool contributor David Meier does not own shares in any of the companies mentioned. You can see his profile here. Best Buy is a Motley Fool Stock Advisor selection. The Fool is serious about its disclosure policy.