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Target Takes a Gamble the Markets Don't Like


February 28 should have been a good day for Target Corp. (TGT) The trendy discounter released its annual earnings for the fiscal year ended Feb. 2, and its profit-growth figure far exceeded that of rival Wal-Mart Stores (WMT), for the first time since 1997. But Target's stock fell nearly 5%.

What rattled investors? One reason may be Target's growing reliance on credit-card income. Seeking the flush profits credit can provide, Target is expanding its credit-card business at a faster pace than any other big retailer. The worry, though, is that Target could be left with bad debts should it misjudge the creditworthiness of customers. "It's a much more volatile business [than selling merchandise]," warns UBS Warburg analyst Linda Kristiansen.

The attraction of offering credit cards is simple: operating margins on the order of 11%, compared with about 7% from retail operations. Target executives have made it clear that credit income will play an increasingly important role in helping the company meet its long-term goal of 15% earnings growth. Indeed, credit could account for as much as three percentage points of that gain. Wal-Mart, by comparison, aims at a similar objective without relying on credit income at all. In 2001, Target's profit growth came to 8.6% and Wal-Mart's 6%.

That raises an important question: Why does Target have to count on credit income? Some industry observers believe the company has no place else to turn. They say that Target is having less success than Wal-Mart with its combination supermarket and merchandise stores. These supercenters generally provide a huge boost in store traffic. Kristiansen says: "They are between a rock and a hard spot."

There's no denying the credit-card business can help paper over other problems. Earnings at its Marshall Field's department stores have fallen the past two years, and management admits the division would barely be profitable if not for credit-card income. Mervyn's, its casual clothing chain, meanwhile, is facing stiffer competition from Kohl's Corp. (KSS)

Target's earnings from credit cards now account for about 15% of the company's profits. In 2001, Target increased its credit-card receivables by 41%, to $4.1 billion. It hopes it will grow an additional 50% in 2002. Virtually all the growth last year came from the Target Visa card, which the Minneapolis-based chain launched in September. It also offers proprietary store cards at Target, as well as Marshall Field's and Mervyn's. The Visa card, though, could capture much more business since customers can use it anywhere.

Target does have a reputation for cautious expansion and sound execution. It boasts a strong record in running its proprietary store cards. Even in last year's sour economy, Target beat the credit-card industry average in terms of bad-debt write-offs as a percentage of average receivables: 6% at Target vs. 6.5% industrywide.

Still, the Visa card carries some new risks. With it, Target has entered an oversaturated market where it competes with national card companies. It has already had to offer lower interest rates than on its Target store card. Keeping growth up once it has switched customers from store cards will be another challenge. The danger then will be the temptation to lower credit standards to continue to boost card growth. Gerald L. Stroch, Target's vice-chairman, insists he won't go down that path: "We refuse to take unnecessary risk in our credit business."

But this is not an idle worry. Plenty of other retailers have fallen into that trap. Sears, for instance, nearly doubled the rate at which it issued its proprietary retail card in the mid-1990s, fueling store sales. By 1996, defaults began to soar, pulling down earnings in 1997 and 1998.

Indeed, no matter how cautious the management, dependence on credit can create a perception of higher risk among investors. That's why the stocks of pure card companies such as Capital One trade at a price-earnings multiple of 17, while a growth retailer like Wal-Mart trades at 36. For now, Target's is 25. "Investors don't believe anyone can predict credit quality with any accuracy," says Moshe Orenbuch, a credit analyst at Credit Suisse First Boston. So even if all goes as planned with the credit business, Target's multiple isn't likely to match Wal-Mart's anytime soon. By Robert Berner in Chicago


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