How Credit Could Still Clip Sears

Shoppers buy billions of dollars' worth of merchandise at Sears (S) every year. But investors should think hard before buying into the company's all-important credit forecasts.

Like many retailers, Sears issues people credit cards to finance purchases in its stores and elsewhere. Its credit operations, with $30 billion in loans, are a key part of its business and have contributed a huge share of earnings in the past. But in 2002, more loans went into default than the company expected, which walloped Sears' earnings and caused its stock to plunge.

Now, with the stock trading at an ostensibly cheap valuation, some investors are buying Sears in the hope that its credit problems are subsiding. And this viewpoint will have gained ground after company executives predicted Thursday that bad loans would peak this year at what looks like a manageable level.

But skeptics argue that sloppy card issuance in recent years will cause defaults to keep rising into 2004 -- and possibly to rise higher and more quickly than forecast this year as well. If so, expect credit costs to eat a much bigger hole in the income statement than Sears is predicting.

Reserves and Reservations

The 2003 credit forecasts were made on a conference call to mark fourth-quarter earnings, which came in at $2.11 per share. Reacting to the credit guidance and good results at Sears' Lands' End division, investors bid up Sears stock $1.83, or 6.85%, to $28.53 Thursday.

Sears believes that the cost of reserving for bad loans in its credit operations, which finance over 40% of Sears' sales, won't be as costly in 2003 as in 2002. That might seem like a safe assertion, considering that the company added a whopping $2.26 billion last year to build its reserve for uncollectible accounts, nearly twice the 2001 figure. However, a little Detoxing of Sears' credit forecasts suggests that the provision could be even higher in 2003 -- maybe as much as $2.5 billion. How so?

Before we get to the numbers, it's important to understand how a bad loan reserve works. The reserve has a starting balance that is reduced by the amount of bad loans that are written off in a certain period. To fill that hole, a company adds to the reserve. That addition -- the $2.26 billion at Sears -- is called a provision, and that's what hits the income statement.

Sears says that its bad loans, or charge-offs, could rise to 6.5% to 7% of average loans by the end of 2003 -- up from 5.4% in the fourth quarter. But it's hard to see how that level of charge-offs won't lead to a provision in excess of $2.26 billion.