Credit-card misadventures at sears and federated are a reminder that plastic can be less than fantastic.

They can be profit centers and relationship builders.

But just as they are apt to do to the consumers who carry them, credit cards can turn around and bite the hands that issue them.

The majority of larger retailers have credit card operations or extend credit to their customers in some way. By and large, they are profitable businesses that drive sales and ingratiate stores with their customers.

Like a bad dream, though, the innocent work-a-day businesses sometimes increase risk, distract management, worry Wall Street and pull down multiples.

While this is the extreme, to what degree are retailers acquiring additional risk with their sidecar credit card businesses? And what’s their upside potential when things are operating as they were designed?

Sears, Roebuck & Co. forced that question on the industry anew last month, and in dramatic fashion, when it realized one of Wall Street’s worst fears. The firm registered a large, unexpected credit-related charge that dragged down earnings, and dismissed one of its top executives over questions of personal credibility. Last year, Sears’ credit business contributed 62.1 percent, or $1.52 billion, of the firm’s overall operating profits, before noncomparable items. While the waters have calmed a bit, Sears still has a tough row to hoe in fixing its image after the meltdown. Similarly, its stock, which fell 38.5 percent as these problems unfolded in October, still has ground to make up.

Besides Sears, which offers a Gold MasterCard, the highest profile merchant in the world of retail plastic is Target Corp., with its co-branded Visa card. Sears and Target are only a part of credit extension in retail, an industry in which virtually all major stores extend some kind of credit to their customers in some way. According to Salomon Smith Barney analyst Deborah Weinswig, Sears carried receivables, or outstanding credit card balances, of $27.6 billion at the end of 2001, while Target had receivables of $4.2 billion in its rapidly expanding credit business.

"In general, having credit card operations for retailers makes a lot of sense," said Steven Skinner, a partner in the retail industry group at Accenture. "It enables them to create an ongoing, out-of-store relationship with their customer."Every month people with retailer-issued credit cards receive a statement that can also include promotional offerings for the customers as well as brand- and relationship-building opportunities for the firm. "If I can build a great experience around my credit card, that makes my brand stronger," observed Skinner. "At the end of the day, it’s all about having a deeper understanding of who your customer is. In terms of relationship possibilities, credit cards are a good business. In terms of financials, credit cards are a great business."

Kohl’s Corp. is one example of a retailer that chooses to connect with its customers by offering credit cards for use in its own stores. Weinswig noted that 5.6 percent or about $27.9 million of the firm’s bottom line came from credit last year.

"Kohl’s uses its proprietary credit card as a vehicle to drive sales through marketing and loyalty programs, such as its MVC (Most Valuable Customer) program that provides special discounts and sale events for top customers, rather than to receive finance charge income," she said.

Despite the profit opportunities, some firms have ditched entirely the heavy lifting of owning and managing the back-end finances of their credit card operations, while maintaining the brand-building, contact-with-the-customer front end.

In July, Saks Inc. agreed to sell Household International the majority of its private label credit card accounts and balances for $1.4 billion. Household will also assume the firm’s securitization liabilities, estimated at $1.1 billion, leaving $300 million in net cash proceeds for the Birmingham, Ala.-based department store operator. The deal is expected to close in January.

Saks, however, will retain the business’ customer-service function through a 10-year alliance with Household. The credit card business generates annual EBITDA — earnings before interest, taxes, depreciation and amortization — in the neighborhood of $100 million. Even so, selling it "provides us enormous financial flexibility" by reducing leverage and risks associated with financing the operation, said Steve Sadove, vice chairman of Saks. "We won’t have to deal with the vagaries of interest rates or bad debt."

Philip Zahn, fixed income analyst with Fitch Ratings, noted, "It makes sense for lower-rated retailers to outsource because a higher-rated company is in a better position to finance a credit card."While not dismissing the relationship-building benefits of credit operations, Zahn pointed out: "If you’re able to drive higher sales by offering a credit card, that’s the primary benefit. They’re generally profitable businesses for retailers."

Bebe Stores Inc. is just the latest retailer to offer a private label credit card for use in its stores. The specialty store, though, decided not to go it alone and partnered with GE Consumer Finance for the offering. "We are at a pivotal point in our growth strategy," noted John Kyees, Bebe’s chief financial officer. "This partnership with GE Consumer Finance will propel us forward, improve communications with our customers and enable more customers to become loyal Bebe shoppers."

Still, Sears’ recent history shows how painful it can be when a credit business goes awry.

In the midst of a major restructuring of its full-line stores, chairman and chief executive Alan Lacy, on an Oct. 7 conference call, said the firm asked Kevin Keleghan, president of the credit business, to leave amid questions surrounding his "personal credibility."

Lacy asserted that the departure was not related to business performance. The shake-up, which the following week extended to the division’s vice president of risk management as well, may have been set in motion by personal credibility, but it was accompanied soon after by a $222 million increase in the credit unit’s domestic provision for uncollectible accounts to $588 million for the third quarter.

Analysts have said since that Keleghan was not fully forthcoming with Lacy about the business he headed.

"Frankly, it was the realization of our worst-case scenario regarding the state of the company’s credit operations," said WR Hambrecht & Co. analyst Bill Dreher, in research notes. The provision was increased, he said, summing up management’s explanation, on account of the weakening macroeconomic picture, which increases credit-default risk; rapid-receivables growth; increases in charge-off trends and greater risk associated with the proprietary credit card portfolio, as the higher quality customers upgraded to the Sears Gold MasterCard.

The doubts that lingered over Sears’ credit card operations cast a pall over similar operations in the rest of retailing, especially Target.In a research noted titled "Why Target is Not Sears," Weinswig noted that while the two companies in the mind of Wall Street are linked by the common thread of having credit operations, Target’s approach is less risky.

Last year, she noted, 10.9 percent, or about $154.3 million of Target’s earnings last year came from credit. "Our findings show a rapidly growing credit card portfolio at Target and one that appears conservatively reserved," she said. "However, with the economy remaining sluggish, we have become increasingly concerned that credit quality may worsen as the Visa portfolio seasons, leading to a fate similar to what Sears is experiencing with their MasterCard: As the portfolio seasoned, trends did not materialize as expected, leading to an increase in the bad-debt reserve and a substantial earnings miss."

Target, she maintained, has a solid retail-growth story that will continue to deliver earnings growth in the midteen percentages. However, "an increasing percentage of the growth will come from credit, which will relegate Target to a lower price-earnings multiple due to the lower valuation of credit card companies. This is despite the fact that credit, when managed properly, results in lower earnings risk than retail operations."

Generally, credit card operations are a much more complicated and sophisticated business than retail, Weinswig said. "It’s a distraction, absolutely."

Federated Department Stores learned this the hard way when its acquisition of Fingerhut wound up making it the not-so-proud owner of a slew of consumer credit delinquencies. Federated has since sold or liquidated most of the Fingerhut assets it had picked up, but it’s been burdened by weak sales and earnings since.

Many wonder if this is the best use of a retailer’s time.

Ladenburg, Thalmann & Co. analyst Eric Beder isn’t convinced. "The returns for new stores should be higher than credit cards," he said. "If you’re putting significant money into credit cards, it indicates that the store returns have peaked."

He cited Target as an example of this: "We’re starting to see more and more of the business be credit card driven and, at the end of the day, that’s not as desirable."Specialty stores especially, he said, can drive sales by offering credit cards for use in their stores. However, they lack the systems to run the business and partner with a firm like Household or GE and get what Beder described as "the best of both worlds," driving sales to their stores and letting their partner shoulder the financial burden.

"It’s like crack cocaine for the consumer," he said. "If you give them a card they didn’t have before, they go to town. It’s a great business to be in, but we don’t like the risk."

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