Commentary: Sears: Are Long Term Profits In The Cards?

The breeze off the lakes at its 200-acre campus at Hoffman Estates, Ill., may be getting chilly these days, but Sears, Roebuck & Co.'s recent results are warming the hearts of its executives. While other retailers struggle, shoppers apparently can't get enough of Sears' revamped apparel and bargain-priced appliances and computers. For the first nine months of 1996, earnings soared 23.6%, to $704 million, on an 8.6% revenue increase, to $24.1 billion. With a seemingly good story to tell, Sears Chairman and CEO Arthur C. Martinez has his dog-and-pony show in high gear on Wall Street. Sears stock has risen more than 64%, to around $50 a share, in the past 15 months.

But there's something Martinez doesn't want investors to know: Most of Sears' profit comes from credit-card interest, not retailing. You won't find a figure on credit-card earnings in Sears' shareholder reports or Securities & Exchange Commission filings. Sears stopped disclosing the number after Martinez, the former chief financial officer at Saks Fifth Avenue, took over Sears' merchandising operation in 1993. Most analysts disregard the omission. One of the few who doesn't--Edward A. Weller, managing director at Robertson, Stephens & Co. in San Francisco--puts interest income at a whopping 72% of operating profit and 55% of net income in 1995. Martinez defends the nondisclosure, saying the credit-card business is "inextricably woven with what we do as merchants."

WEAK SPOT. But investors should be interested in the fact that Sears' No.1 business is actually lending. Those Kenmore washers and Canyon River Blues jeans are just lures to get customers to come into the store and rack up bigger and bigger balances. That makes the company highly vulnerable to interest-rate swings, the rise in credit-card delinquencies, and the unexpected spike in personal bankruptcies. And it calls into question whether Sears, with $23.8 billion in credit-card receivables, should be trading like financial stocks, which the market values at price-earnings ratios of around 13 vs. Sears' 17.

Sears customers are undeniably a credit-card gold mine. They carry almost a $912 average balance on their cards, far above the $275 average at its closest retail competitor, J.C. Penney Co. About 80% of Sears' 26 million active accounts carry balances, despite the hefty 21% interest rate. "Sears is unique in retailing for its high average balances and frequency of card use," says Robertson Stephens' Weller. He estimates Sears' operating margin on merchandise was a measly 2.6% last year, compared with an eye-popping 54.1% on credit.

Sears won't comment on Weller's numbers. The retailer says it provides substantial detail on its credit business, just not enough to precisely calculate the credit net income number.

Why should investors care where Sears' money is coming from as long as profits are good? Because Sears' dependence on credit-card interest makes the retailer doubly cyclical. If debt-strapped consumers stop buying during the next recession, Sears will be hurt twice--it won't be able to sell as much merchandise and, if many customers default, it won't get paid for goods it already sold and booked as revenue.

There's no question that Sears' reliance on credit has increased during the past three years. In a major expansion move, it has opened more than 11 million new accounts in 1994 and 1995. Last May, it lowered minimum monthly payments by stretching out maximum payment periods to four years from three years. With the retailer's dependence on the Sears card growing, card purchases will surpass 60% of all transactions this year.

Danger signs are already appearing. Despite a relatively strong economy, Sears has been forced to add $794 million to its bad-debt provision through the first nine months of 1996. That's 52% higher than it set aside last year. It's hardly alone. Other credit-card issuers are pumping up their provisions, too. Martinez downplays the bad news by explaining that Sears sees signs that delinquencies are bottoming out and has boosted its collection efforts.

But delinquencies are no longer as predictable as they once were. An August Federal Reserve study found that a growing number of consumers are filing for bankruptcy without ever becoming delinquent, which makes it nearly impossible for lenders to predict what their losses will be. Sears has historically used more lenient standards in granting credit to its core working-class customers, making the merchandiser more vulnerable to this trend.

Despite Martinez' protestations, there's little question that Sears is still internally calculating how much of its fatter profits come from credit-card interest. It's only fair to let Sears investors in on the secret.

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