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When Target Corp. (TGT
) reported its first-quarter earnings in mid-May, analysts were annoyed that the retailer missed their consensus forecast by a penny per share. But few seemed to notice that three-quarters of the company's 15% earnings gain came from its credit-card operations, not its retail business.
They should be paying closer attention. Credit industry watchers say a rise in defaults is coming. Higher interest rates and energy costs will squeeze some consumers; others will be hurt by a weaker housing market, which makes it harder to tap home equity to pay bills. The result, say experts, will be rising delinquencies and defaults for credit-card lenders.
That could be bad news for Target, one of the few retailers that underwrites Visa cards and keeps some of the risk on its books. "If the consumer weakens, Target will be hurt," says Allen Puwalski, senior financial analyst at the Center for Financial Research & Analysis in Rockville, Md. "And it will be hurt disproportionately to other lenders."
When the company added Target Visa to its regular department-store card in 2001, the idea was to attract high-credit-quality borrowers and expand the lending business. But only one of those things has happened. A close look at Target's $5.8 billion credit-card operation reveals a portfolio growing at four times the rate of other lenders and brimming with riskier borrowers -- a dangerous combination.
Data culled from regulatory filings show clear signs of rising credit risk. For example: Target's increase in overdue accounts that have yet to be written off, taken as a percentage of total receivables. That's an indication that a rise in write-offs is coming, notes Puwalski, who used to do risk analysis at the Federal Deposit Insurance Corp. Comparing Target with eight finance companies that have similar portfolio characteristics, including GE Capital (GE
) and Capital One Financial Corp. (COF
), Puwalski found that Target had the biggest jump in delinquency rates, from 4% at the end of last year to 4.8% in April. Five of the other lenders declined or remained flat. Target's adoption this year of new rules that require higher monthly payments accounts for some of the rise.
Even more surprising is the yield -- the combination of interest and fee income -- that Target earns on its portfolio. Given that it is competing against other Visa issuers for customers, William Ryan, an analyst at New York investor research firm Portales Partners, says he would expect Target to have a relatively low yield, close to that of a mainstream lender such as Citibank, which clocks in at 17.4%. But Target's 27.2% is closer to the 31% of Metris, now part of HSBC Finance Corp. (HBC
) Metris is a so-called subprime lender that specializes in lending to the riskiest consumers. It charges such high rates because its borrowers are subprime; Target's high yield suggests that it's attracting subprime borrowers, too, says Ryan. Target counters that its yield is high in part because it does not offer low teaser rates.BOTTOM FISHING
By another benchmark, Target appears just as shaky. The three-month average of seriously delinquent accounts -- those more than 60 days late -- plus write-offs, amounts to 8.4% of Target's receivables, Puwalski says. That's the second-highest rate in the nation among lenders with securitized receivables over $1 billion, trailing only the 16% at Metris. "This belies the perception that Target's customers have pristine credit," Puwalski says. Target says that it runs a "high-quality" credit-card portfolio, and that "the presumption of heightened risk...is unfounded."
Indeed, Target is expanding its portfolio aggressively. In May its $5.8 billion in receivables was up 12% from the same month a year ago, vs. 3% growth for the industry as a whole. Much of the expansion is coming from accounts with large balances and high credit limits, says Victor Stango, an economics professor at Dartmouth College's Tuck School of Business who studies retail credit cards. From March, 2002, to September, 2005, balances in excess of $5,000 made up the fastest-growing portion of the portfolio, increasing from 9.5% to 28.6%, according to regulatory filings. The fastest growth in the total number of accounts came from those with credit limits over $10,000, which nearly tripled, to 3 million. Puwalski says that suggests Target is raising credit limits to get existing customers to borrow more.
The question is: Did Target also lower its underwriting standards as it lifted balances and credit limits? That's what happened to Metris, whose rapid rise in high-balance and high-limit accounts led to losses in 2002 and 2003. Target insists it hasn't lowered its standards. Even so, it was happy in 2004 to grant a Visa card to Cathi Austin, 48, of Superior, Wis., although she had maxed out the $12,000 credit line on her Citibank card and was earning $17,000 annually at the YMCA. She took the 10% off, in-store incentive to buy patio furniture and got a $7,000 credit limit. "I didn't think I would qualify because I was maxed out on my Citi card," she says. When she hit the $7,000 limit a year later, Austin says, Target bumped her line to $10,000. When she hit that mark and Target raised her limit to $12,000, she turned to a credit counseling agency, which has negotiated lower payments with Citi and Target.
Some credit counseling agencies say that among the debts they see, balances on Target cards are growing fastest. At Lutheran Social Service of Minnesota, the number of new clients with Target Visas is has risen 8.7% this year, while the balances are up 12%. "You have to assume Target has relaxed its [underwriting] standards," says Lutheran Counseling Coordinator Daniel Williams.
When Target's credit customers start to falter more dramatically, it stands to reason that its retail sales will suffer, too. Maybe by then more analysts will be paying attention. By Robert Berner