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 retail 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 it 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.

Sales boomed because Conn’s was buying them with financing. A strategy that has now caught up with it. Nevertheless, Wright explained bravely: “We remain confident in the business model….”

Despite these “unexpected headwinds” and the credit segment performance that “unexpectedly” deteriorated, the company had seen this coming a year ago: “In Q3 and Q4 of fiscal 2014, and Q1 of fiscal 2015, we made changes to our underwriting to reduce risks” and “to improve delinquency performance,” Wright admitted.

So the originations with FICO scores below 525 dropped to “virtually zero,” while originations to customers with “no scores” are “down 40%” from a year ago. The average FICO score underwritten in Q2 rose to 607, up from 599 in Q3 of fiscal 2014. The approval rate dropped 6.4% year-over-year. Down payments rose 50 basis points to a still minuscule 3.6% – “the fifth quarter in a row with a year-over-year increase in the down payment percentage,” COO Michael Poppe explained.

Further, some of the interest-free programs are gone “as of today,” others will be phased out, and interest rates will be raised by “a few points.” On the prudent principle: if you’re going to have credit losses, you need to charge for them upfront. Hence the irresistible, if temporary and often illusory, profits of subprime.

But there would be a price to pay for backing out, even just a smidgen, from subprime. These efforts to be prudent will trigger, year over year, “a reduction in sales of 8% to 10%.” Aha! Once you back off subprime with which you bought the sales, these sales will swoon!

The issue was much broader. Late stage delinquency rose for “all FICO scores, markets, product categories, years of origination, and customer groups,” Wright said. It went beyond appliances and mattresses and beyond even Conn’s:

Customers are under pressure from the number of directions. Inflation of rents is one example. Increased sub-prime issuance for vehicle purchases are also pressuring customers’ ability to pay Conn’s. Car loans and rent will generally rank ahead of Conn’s in customers priority to pay.

Wright was speaking about the strung-out American consumer who’d been keeping up consumption by getting subprime financing. Now an increasing number of consumers can no longer service the subprime loans they took out to buy products they couldn’t afford, and they’re defaulting on Conn’s loans first, before they’ll default on their subprime car loans and before they stop paying for inflated rents.

That’s what Wright was saying. He was issuing a warning about all subprime. He was issuing a warning about auto sales. By dint of consumer logic, Conn’s got hit first. Autos would be next.

Consumer spending, the key to the American economy, and by extension the global economy, is one of the most watched activities in the world, but results may vary, as they say, depending on who is doing the counting. Read….Consumer Spending in August Drops below a Year Ago

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