How Plastic Put Sears in a Pickle


When Sears Roebuck launched its own Gold MasterCard two years ago, the strategy seemed straightforward. Sears would roll out a multipurpose card to keep the business of Sears store-card customers, who were fleeing to lower interest rate offers on other bank cards.

Yet the retailing giant's earnings bombshell on Oct. 17 suggests that things aren't working quite as planned. Sears reported a 28% decline in third-quarter profits and cut earnings guidance for the year, from 22% growth to 15%. The disappointing news sent Sears stock tumbling 32%. The main culprit? The MasterCard. Sears said it needed to raise its bad-debt reserve by $189 million largely to cover rising charge-offs on the card, which management had said would be less risky than the Sears store card.

Sears' stock has since recovered somewhat, to around $26.40 from $23.50, and company officials say concerns on Wall Street were overblown. While CEO Alan Lacy acknowledged that the MasterCard problem is a setback, he affirmed his commitment to the card. "This is still a very important product for us and a very important part of our growth," he announced on Oct. 17.

"ILL-CONCEIVED." Still, this strategy has turned out to be dicier and less profitable than Sears expected. "The MasterCard program was clearly ill-conceived," says Richard Church, managing director at Shumway Capital Partners, a hedge fund. Analysts' biggest beef: The card appears to run counter to the needs of the bulk of customers who shop in Sears' 870 stores. Some analysts now question if the move will affect Lacy's attempts to reverse declining sales. "That's certainly a possibility," says Elaine Rees, a retail analyst at mutual fund company Dreyfus Corp.

Lacy was counting on Sears' credit operations to power earnings as he upgraded apparel offering and cut store costs to compete with rivals. Joining forces with MasterCard looked like a smart way to protect Sears' huge credit business, which accounts for more than 60% of profits. Before Sears began offering the MasterCard in June, 2000, it had only the store card. Yet its high rate was causing Sears' most creditworthy customers to accept lower interest rate offers on other credit cards.

Sears certainly launched its MasterCard program with gusto. In the first three quarters of this year, the retailer more than doubled credit-card balances to $10.8 billion, or 37%, of its $29 billion in total credit receivables. Sears achieved most of that growth by shifting more creditworthy customers to MasterCard from the store card.

TOO GENEROUS. While Sears' overall bad-debt charge-off rate as a percent of receivables has actually declined slightly to 5.55% due to fast growth in receivables, the company says the dollar amount of bad debts has risen, predominantly on the MasterCard.

Sears credit head Paul Liska told analysts on Oct. 17 that some of the increase is to be expected as a new credit-card portfolio ages, exposing bad borrowers. But he conceded that Sears had been too lenient in allowing cardholders to transfer outside balances to the new card and had been too generous in granting cash advances.

Credit-card analysts worry that such programs attract riskier

customers who hope to ease onerous monthly debt payments with lower-rate, balance-transfer offers or use cash advances to help pay bills. "The reality is you can end up with a lower-quality portfolio than you expected," says Moshe Orenbuch, an analyst at Credit Suisse First Boston.

MISSED PROJECTIONS. Sears says average balances on the MasterCard are now $1,333, about $200 more than on the Sears card. Since balances on general-purchase cards average about $2,400, Sears believes it still has a strong opportunity to build the MasterCard business by boosting balance sizes. In fact, only 27% of its MasterCard customers now use the card outside of Sears. Shumway's Church believes the card isn't hitting profit projections because balance sizes aren't large enough to offset the lost income from the MasterCard's lower rates, which average 15.2%, vs. 19.8% on the Sears card.

A bigger problem may be that Sears' credit strategy appears to run counter to the routine of most shoppers at Sears stores, says Walter Loeb, a New York retail consultant. The retailer is trying to attract lower-risk customers on the MasterCard than those on its store card. But the store card still fuels Sears' retail business, accounting for 63% of credit balances.

By attempting to redirect those credit customers -- who Liska terms "Middle America" -- Sears is messing with the credit spigot that fuels its core customer base, Loeb says. "There is a disconnect in Sears' objectives," he adds.

"WORST FEARS." Cost-cutting efforts in its stores will certainly help support Sears' earnings this year, as operating profits from credit declines. But to sustain earnings growth, Sears needs retail sales to rise. Lacy was counting on credit profits to buy some time as he executes his retail plan.

Lacy has already made some risky moves -- revamping store interiors and merchandise without first testing how effective the changes will be. He added nearly $1.9 billion in debt to acquire cataloger Land's End earlier this year. That increase in liabilities, combined with the recent earnings hit, have prompted Sears to stop buying back shares, something it was doing aggressively to boost the stock's price. At the analysts meeting, Lacy admitted his "worst fears have now come to bear."

Management says the reserve increase for bad credit debts should cover foreseeable credit problems, including the impact of the slowing economy. But plenty of caution signs are up for investors. Sears admits having created a riskier pool of borrowers on its store card by shifting better customers over to the MasterCard. That leaves the store cardholders -- and their debt -- much more sensitive to an economic slump, Sears says.

POSSIBLE DOWNGRADES. Also, charge-off rates on new card programs, like the MasterCard, generally don't peak until balances are two to three years old, says David Wyss, chief economist at Standard & Poor's. The doubling of receivables this year suggests Sears has "not hit the worst of it yet," he estimates.

Following the earnings announcement, bond-rating agencies S&P and Fitch have warned they may lower Sears credit ratings, a move that would increase costs to fund its credit-card receivables. And Sears credit-card and retail businesses are closely linked. The steps Sears takes to tighten credit and curb card losses could also dampen store sales. This much is clear: Lacy isn't likely to get the helping hand from credit cards that he once expected. By Robert Berner in Chicago


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