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Where Credit Is Due

Companies lending to hard-pressed consumers can learn a few lessons from Sears
Robert Stowe England, CFO Magazine
November 1, 1997

What's wrong with this picture? Six years into the current economic expansion, both stock prices and personal bankruptcies are at record levels. A case of the rich getting richer and the poor getting poorer? Maybe, maybe not. This much is clear: Companies that depend on consumer credit for much of their earnings had better watch their step. Not only are consumers pretty well tapped out, but they're also more likely than ever to default on their debt by declaring bankruptcy.

That explains why a growing number of credit card issuers, including at last count Sears, Roebuck and Co.; Federated Department Stores Inc.; GE Capital Services; and AT&T Corp., have all recently run into legal trouble by dunning deadbeats. To make matters worse for lenders, Congress may make it even harder to go after such customers.

The issue is gaining attention as the National Bank-ruptcy Review Commission puts the final touches on several recommendations for overhauling federal bankruptcy law. The idea is to bring more uniformity to the kinds of protection from creditors that bankruptcy provides. Currently, in many states, state exemption laws hold sway over federal when it comes to what assets can be kept and what debts can be discharged, and the statutes vary widely. In such states as Florida, for example, homes are off limits for creditors no matter how valuable they are. But other states are much more restrictive.

At press time, the commission was due to submit its recommendations to Congress. And if Congress extends the protection afforded by Chapter 7, the section of the federal law that applies to individuals, consumers could "see bankruptcy court as a way to manage their finances rather than as a last resort," says David Sandor, a spokesman for Visa U.S.A. Inc., in San Francisco.

Consumer advocates challenge that view. "The notion that consumers are standing gleefully at the door of bankruptcy court is erroneous," says Karen Gross, a professor at the New York Law School and author of a book on bankruptcy. Also, the commission's recommendations are not without congressional opponents. A bipartisan bill introduced in September would make it less attractive for some people to declare bankruptcy, and should improve the chances that those with the ability to pay be required to pay off a portion of their debts.

While it is too early to predict the outcome of the debate, Gross points out that "the best thing that could have happened to debtors is the Sears debacle. For the first time, the media have focused on creditor behavior instead of debtor behavior."

Whatever the motivation, personal bankruptcies are rising even as the economy continues to expand. The number of new bankruptcies throughout the nation rose to an all-time high of 1 million last year, and it is should exceed 1.4 million this year, says the Administrative Office of the U.S. Court.

Adding to the confusion, consumers with no history of late payments are seeking the law's protection, giving no warning to lenders.

THE SEARS BLUEPRINT
But the phenomenon is surely linked to a larger problem: a continuing decline in personal savings. Household debt as a percentage of disposable income keeps soaring. At last count, it was up to around 92 percent, a far cry from 66 percent in 1980 (see chart, right). So what will happen if the good economic times end? The problem threatens to grow worse even if Congress doesn't side with consumers.

Of course, not all companies that lend heavily are equally vulnerable to mounting credit card losses and to attempts to make it more difficult to collect. Take what happened to Sears. Mounting credit card losses have not prevented it from executing a dramatic turnaround. Despite a $26 billion credit card portfolio that makes it one of the biggest issuers in the nation, Sears is one of the least vulnerable, thanks to its astute management practices. But you never would have guessed it from the scandal that broke last April. Remember the headlines? Sears suddenly found itself embroiled in class-action lawsuits and potential legal action by attorneys general in all 50 states over charges that the company had illegally tried to collect from consumers who had declared bankruptcy while owing Sears money.

What sparked the suits? A decision by Judge Carol Kenner in the U.S. Bankruptcy Court in Boston to cite Sears for contempt for "willful and intentional flouting of the Bankruptcy Code." The matter first came to Judge Kenner's attention in the case of Francis Latanowich, who had filed for bankruptcy in 1995 and was having trouble making so-called reaffirmation payments he had agreed to make on several items bought at Sears.

Latanowich's pleas to get Sears off his back prompted Judge Kenner to take a closer look at the company's collection practices. Granted, tens of thousands or more customers had voluntarily accepted the reaffirmation of all or part of their debt in return for being able to keep their merchandise and continue charging items to their Sears card. But Kenner found that the company had failed in many, if not most, cases to get the court approval that the law requires before dunning the customers for late payment. Moreover, this had been Sears's standard practice with reaffirmations for more than a decade, according to analysts.


RESOLVING THE DISPUTE
Sears agreed to settle the dispute. And the $320 million aftertax cost of the $475 million that the company has set aside for the entire liability comes to a whopping 80 cents per share for the second quarter of 1996, or 73 percent of its earnings for the quarter. But analysts applaud Sears's chairman and CEO, Arthur Martinez, for forthrightly tackling the problem. They say he wisely decided that the remaining reaffirmation balances were not worth the potential public relations damage that might follow if Sears fought the issue in court. After all, it was only five years ago that Sears was caught red-handed for overcharging customers in its auto repair business.

But are Sears's problems with reaffirmations over? Many analysts think so. "For all practical purposes, other than a diminished ability to obtain reaffirmations, it is," says David Poneman, an analyst at Sanford C. Bernstein & Co., in New York. But some caution that the matter won't be fully put to rest until all payments have been confirmed and paid out.

To limit losses on reaffirmations, Sears may have to accept a lower price in its negotiations with the consumer, explains Edward Kimmel, principal in the Washington, D.C., law firm of Hambright & Kimmel and legal counsel to a number of consumers facing Sears in bankruptcy court. Kimmel suspects that Sears may have avoided filing some reaffirmations in the past because the terms in those cases were probably more favorable to the debtor than Sears's standard offer.

By making such deals public with a court filing, Sears risks tipping off other debtors that it is willing to accept a lower figure for allowing debtors to keep their merchandise and their credit cards, Kimmel says. So, depending on the outcome of pending court cases, Sears's credit card business could become less profitable than it currently is. Not only will Sears no longer be able to dun deadbeats as easily as it did in the past, but its dependence on reaffirmations may increase even as it earns less from them. Remember: While the $40 million in "bad" reaffirmations that Sears is forgoing under the court settlement represents only 5 percent of the $750 million that analysts estimate the company currently earns from credit cards, bankruptcies continue to mount.

ANATOMY OF A TURNAROUND
So how have investors responded to all this? They've bid up the stock from about $30 at the start of Martinez's reign to a high of $65.50 recently. Is the market missing something? Not really, says Poneman. Sears is "offsetting skyrocketing losses [in credit card write- offs] with skyrocketing revenues," he says. As a result, Poneman and other analysts expect Sears's overall earnings growth to continue to exceed its annual target of 15 percent unless there is a recession.

That says a lot about Sears's turnaround. It was, after all, only five years ago that the proud retailer was closing stores amid predictions of its impending demise. Its domestic merchandising profits, then separately reported, were a paltry $64 million in 1992, a fifth of what it earned from its U.S. credit card operations.

But Sears's financial health has come a long way since then. A former head of merchandising at Sears, CEO Martinez is credited with turning around the retailing operation after his predecessor, Edward Brennan, refocused the company by jettisoning noncore financial services subsidiaries, including The Allstate Corp.; Coldwell Banker; and Dean Witter, Discover. After closing down the storied but dowdy catalog business, Martinez revamped the retail operations' merchandising mix to focus on women's apparel and other "soft goods," which carry higher margins than hard goods, and backed the effort up with jazzy marketing. Consequently, Poneman predicts that merchandising profits this year will account for more than Sears's credit card earnings for the first time since 1989.

Analysts also point to a dramatic decline in sales, general, and administrative expenses (SG&A), as an indication of merchandising's rebound. In 1992, when such figures were broken out separately by Sears for its merchandising operations, SG&A was at a worrisome 28.5 percent. SG&A in the second quarter was estimated most recently by Sears at only 20.4 percent--a stunning eight percentage point drop.

Granted, Sears's method of reporting may overstate the gains. Current accounting includes credit card operations in the calculation, whereas previous accounting did not, and credit card SG&A is a much smaller percentage of revenues than are merchandising costs. Another problem with the 20.4 percent estimate is that it includes significant gains in total revenues without any gains in SG&A costs. That's also due to the new accounting, which was prompted by a new rule issued by the Financial Accounting Standards Board that went into effect last January 1. The rule requires Sears to immediately account for much of the gain from securitizing its credit card receivables rather than spreading the income across the life of the asset-backed bonds that generate the cash flow. So Sears's SG&A and, indeed, the progress of its turnaround, are benefiting from an accounting change the effects of which will diminish after this year.

And Sears is by no means invulnerable to a sharp jump in personal bankruptcies. Sears's charge-offs for bad loans spiked last year, catching management by surprise. As a result, some analysts contend the problem could throw a monkey wrench into their earnings projections for Sears. The issue, says L. Wayne Hood, an analyst for Prudential Securities Research, in Atlanta, is a "wild card."


But the hit to earnings wouldn't be disastrous. Reason: Sears has taken such bold measures to increase the profitability of its credit card operation in recent years that it will remain easily in the black during a recession. For one thing, the divestiture of Allstate and Dean Witter, Discover strengthened Sears's balance sheet. And Sears paid off or refinanced high-interest debt from earlier years. The result was an upgrade in Sears's credit ratings and a reduction in the company's cost of debt.

"Sears basically has no debt except credit card debt," that is, debt to fund its credit card operations, says Joseph Ronning, an analyst for Brown Brothers Harriman & Co., in New York. So the company's lending arm, Sears Roebuck Acceptance Corp., "is a prime credit," he says. This allows Sears to fund its credit card operations at a lower cost than other retailers, who are more highly leveraged and have lower credit ratings.

BALANCING COMPETEING GOALS
To be sure, Sears, like other retailers, imposes a fixed interest rate on its card balances. In contrast, banks levy a floating rate, which allows banks to more closely manage the spread between that rate and their cost of funds. But unlike most other retailers, Sears, in 1995, jettisoned a policy of letting its fixed rate vary by locale. Now it has established a uniform rate in all markets, and at 21 percent recently, it is two to three percentage points higher than that charged by most banks. Also, the company has developed a funding strategy that allows it to balance the competing goals of keeping costs as low as possible while managing interest rate risk. "We try to solve for the lowest cost over time with an acceptable volatility [in interest rates] in the short term," says Alan Lacy, Sears's executive vice president and CFO. To achieve that goal, Sears typically seeks to issue a mix of notes, commercial paper, and credit card securities whose maturities average out to intermediate, he says.

By contrast, GE Capital, which issues variable- rate cards for Montgomery Ward, Macy's, Home Depot, and others, funds its credit card operations by leaning heavily on commercial paper, according to Edward Stewart, executive vice president at GE Capital.

And while Sears began securitizing its credit card portfolio several years ago to diversify its funding, the company is currently holding back. For one thing, says Lacy, the spread between medium-term notes and credit card­ backed securities isn't particularly wide. "There's not a big rate incentive," he says. And he notes that by restraining securitization now, Sears is engaged in some "rainy-day planning." If, for instance, the economy falls into a recession, Lacy says the spread most likely would widen, prompting Sears to take securitization back to a higher level. But it would have that much less to securitize if it were going full bore now.

Sears has taken still more steps to strengthen the profitability of its credit card operations. At the end of 1993, after Sears began to allow the use of Master Card, Visa, and American Express to make purchases at Sears, it took steps to assure that the Sears Card would remain competitive in its appeal to Sears customers. "The credit organization wanted to make sure that sales associates were advising customers about the advantages of using the Sears Card," Lacy says. Sears clerks actively encouraged customers to set up new accounts, pointing out such advantages as access to special sales offers. The company also marketed preapproved cards and offered discounts on initial purchases made on a new Sears Card.

A SOURCE OF FUNDING
The effort to raise prices and lower costs "has allowed us to have growth in credit profitability in spite of a rise in charge- offs," says Lacy.

Why not just get out of the business, as so many other retailers have? "For hard-line retailers" like Sears, says Lacy, "it's important to have credit," if for no other reason than it "gives us a significant amount of free cash flow as a source of internal funding." And although he says he can't imagine Sears building up such a credit operation from scratch today, he contends that retailers that have sold their private-label credit card businesses to GE Capital operate at a disadvantage as a result. These retailers "got a fee for allowing someone else to use their customers to earn assets," he says. "They work together to do promotions," Lacy notes, such as making offers of zero percent for six months. "We can do that on our own," he says.

But the other retailers haven't been able to make enough money in the credit card business to prosper. Montgomery Ward transferred its credit card business to GE Capital in 1987 as part of a management buyout of the business that was financed by GE Capital. Macy's sold its credit card business when it was sinking into bankruptcy (irony of ironies), and before the company was sold to Federated Stores. Many midsized and smaller retailers have worked with GE Capital Services to gain economies of scale, management expertise, and financing, says Stewart. "Retailers need to look in every nook and cranny for profits," he says.

Those retailers still in the business earn far less than Sears. While Sears derives 50 percent of its earnings from credit cards, J.C. Penney Co., for instance, reports a loss on its credit card operations. And the typical contribution to earnings is about 10 percent. For others, such as Nordstrom and Bloomingdale's, the credit card business is viewed more as a means of stimulating business and as a convenience to the customer than a profit center, says Ronning. Because they, as well as other department stores, typically have lower average balances, lack the expertise and economies of scale of Sears, and see more customers switch to cash purchases in economic downturns, their profitability is more vulnerable to recession, says Sally Schaadt, an analyst with The Fourteen Research Corp., an institutional research firm in New York.


A paradox? Absolutely. Lacy notes that Sears's credit card operation is an ongoing source of strength in a recession. "It's a less volatile profit stream than the retail business," he explains. The huge portfolio of receivables guarantees a continuing stream of income even as merchandising sales and profits plummet. This was made abundantly clear in the recession early in this decade, when credit card profits sustained Sears's profits while merchandising profits fell to near zero.

Not that Sears is immune to a new downturn. While that would enable the company to lower costs still further, a recession also represents a double hit to earnings. Not only would credit card charge-offs rise, but revenues would decline as fewer customers charged new items. Still, the impact of this change is likely to hit Sears far less dramatically than other retailers, including Penney's and Federated's chains. Look closer at Sears's portfolio of existing credit card debt. Its $971 average balance last year was more than three times as big as Penney's. No wonder Federated recently unveiled a new marketing campaign to increase credit card use at Bloomingdale's, Bon Marché, Burdines, Goldsmith's, Lazarus, and Rich's.

But Sears has been at it for years. And while Ronning predicts that charge-offs will rise in the next recession at all retailers, he believes Sears can most easily handle the challenge. Adding to Ronning's confidence, Sears has stepped up its collection efforts since the third quarter of 1996 to prevent more accounts from becoming and remaining delinquent, the first step toward a possible charge-off, and has tightened its criteria for new accounts. As a result, Ronning estimates that charge-offs would have to quadruple to wipe out profits. "That's not going to happen," he insists.

Think Sears is too cautious? Remember the hard- pressed consumer. "We have seen a change in society's views on personal bankruptcies," says Ronning. "More people have become aware that the stigma attached to bankruptcy is not as great as it used to be. The world doesn't end." So when financial problems become difficult, he says, "more and more people call a friendly bankruptcy lawyer, who plugs in his Chapter 7 software and starts calculating what they can come away with" after declaring bankruptcy.

POT VS.KETTLE
Of course, consumer advocates contend lenders bear some responsibility for the problem after marketing credit cards so aggressively. "It's a case of the pot calling the kettle black," says Gross of the New York Law School.

Moral issues aside, the lessons for finance executives are clear: If your business depends on credit cards that you issue, your margins better be high enough to sustain more than the normal amount of write-offs that a recession produces. And if you're not already in the credit card business, this probably isn't a great time to get in. Even in the best of times, it takes a lot of capital, a good credit rating, and considerable time to develop the expertise.

Should you get out if you're already in? That depends. Says an analyst who requested anonymity: "If you're good at running a credit card in today's environment, it's almost a license to steal." Trouble is, it isn't easy to be as good as Sears, and a new environment could make it even harder.




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