) core business peddling appliances, tools, and clothing has always gotten a big boost from the company's credit-card arm. These days, though, those old favorites aren't much more than a sideline--the venerable Chicago retailer is essentially a finance company. Last year, its finance arm brought in nearly 70% of the $2.3 billion in operating income, up from 58% in 1999.
Sears' reliance on lending to offset sagging merchandise sales is sure to keep growing. Chief Executive Alan J. Lacy pushed hard to develop the business even before taking the top post in 2000. As chief financial officer, he rolled out the Sears MasterCard to tap income from purchases at other merchants. Now, the company has 22 million MasterCard accounts, making it the 13th-largest issuer. Lacy's latest move is to charge Sears store card customers variable rates. The already lofty 21.9% fixed rate is going up to prime rate plus 17.15% in July. So, when interest rates pick up, the business will be as profitable as ever.
The stock market loves it. Lacy's financial bent coupled with a focus on cost-cutting has helped boost Sears stock 60% in the past 12 months, to $53 on Apr. 24. Never mind that revenues from Sears' retail business dropped 1.4% in the first quarter of the year--revenues from the finance division were up 26%.
But the rapid growth in its credit-card lending, particularly to low-to-middle-income customers, is raising some red flags. Sears is aggressively expanding its credit-card lines when many rivals are cutting back. "Many companies serving a similar customer base have gotten themselves into trouble," says William Ryan, an analyst with Ventana Capital, an independent research firm. Metris Cos. and Providian Financial Corp. were forced by the Office of the Comptroller of the Currency to cut back lending after posting higher-than-expected losses. Sears Credit Services President Kevin T. Keleghan says Sears customers are more creditworthy. He points to Sears' low charge-off rate--5.43% of receivables, compared with an industry average of about 6.5%--as proof of its skill at judging customers: "We have the lowest write-offs in the industry right now," he says.
It's not quite that simple. Sears extends credit through an Arizona-based bank subsidiary but transfers accounts to its parent. So, neither the OCC nor the Federal Reserve regulate the whole company. Sears waits until loans are 240 days late before writing them off; for regulated banks the cutoff is 180 days. Keleghan says that by waiting longer, Sears recovers more losses.
Still, investors may want to be wary. The last time Sears stepped on the credit pedal, under former CEO Arthur C. Martinez, the results were a disaster. He nearly doubled the rate at which Sears issued its own store cards in the mid-'90s, fueling sales. But defaults began to soar by 1996, hurting earnings in 1997 and 1998. Martinez appointed Lacy to clean up the mess.
Now, Lacy is applying the gas. Although the MasterCard carries a lower rate than the Sears store card, he aims to make up profits by encouraging customers to borrow more. The tactic seems to be working. In the first quarter, MasterCard receivables more than tripled from a year ago, to $6.3 billion. Outstanding credit lines jumped 30%, to $250 billion.
But the MasterCard gains are cannibalizing store cards, where receivables fell by 14.7%. Lacy is trying to offset the drop by tacking on fees as well as raising rates. Last July, Sears upped the interest on its store card to 21.9% as the Fed cut rates. This summer, Sears will test cash advances, a novelty for store cards, and charge 18.15% above prime. The high rates lead some to suspect Sears is lending to risky borrowers who can't get credit elsewhere. Sears says customers are attracted by discounts on merchandise, but skeptics question that. "Sears must feel that the people they have on that card are a captive market and it might as well milk them as hard as possible," says David A. Wyss, chief economist at Standard & Poor's.
Lacy's dilemma: He isn't getting profit from top-line growth. Sales at existing stores have fallen the past five quarters. Nowhere is the drop more pronounced than in apparel sales, which have fallen for 16 straight months. In an effort to end the slump, Sears in the fall will launch Covington, a classically styled clothing line. It is also taking cost-cutting measures. But as long as sales decline, it's hard to boost margins that way. Although Sears cut costs by $90 million in the first quarter, its store operating expenses remained essentially flat as a percentage of sales.
Lacy's plan to eke more profits from the Sears store card could even crimp sales. As rates move up, sales may slow in Sears' one strong area, home appliances, where it has a 40% market share. Sears derives over half of its finance income from such big-ticket items. But Lowe's Cos., No. 2 behind Sears with a 10% market share, still has a 21% fixed rate on its own store card, vs. Sears' 21.9%--a gap that is likely to widen when rates start to rise. Last year, Lowe's gained market share faster than Sears, according to market research firm Stevenson Co.
Turning to the MasterCard isn't a long-term solution to Sears' problems, either, says Brian James, a retail analyst at investment firm Loomis, Sayles & Co. Sears is pushing into a highly competitive arena, where its costs of acquiring new customers will ultimately rise once it has tapped existing customers. "Lacy is tweaking the credit side of the model when he has a gaping wound on the other side of the business," James says. Lacy may be buying some time with his finance push, but he can't mask Sears' deteriorating retail business forever. By Robert Berner in Chicago and Heather Timmons in New York