A crumbling credit business could soon deliver a knockout blow to stumbling

Sears

(S) - Get Report

.

With the retailer's bombed-out stock trading at an ultralow valuation, the market is signaling serious problems ahead for the company. After an earnings warning that pointed to weakness in Sears' lending arm, investors are zeroing in on credit quality at the division, which accounts for more than 60% of the retailer's profits and finances some 40% of its sales.

In particular, Sears skeptics suspect that the company has a large amount of troubled loans that aren't explicitly broken out in publicly disclosed delinquency figures, a charge a company spokeswoman disputes. But if the Sears bears turn out to be right, even the stock's rock-bottom price-to-earnings ratio won't stave off a massive selloff. Sears fell 1.5% Tuesday, to close at $31.77.

Tough Times

Credit card firms are having a tough time right now, and those that focus on borrowers with blemished or incomplete credit histories, such as

Providian

(PVN)

and

Metris

(MXT)

, have reported sharply lower earnings as bad loans get out of hand. Little wonder, then, that the recent stream of bad news from Sears' credit division, which also lends to iffy debtors, should freak the market out.

To a Crisp
Sealing in the juices at Sears

Friday, Sears announced that the head of credit operations, Kevin Keleghan, had left the company. On a conference call Monday, CEO Alan Lacy said he had asked Keleghan to leave because he had "lost confidence in his personal credibility," but Lacy added that business performance had not played a role in the decision to let Keleghan go. Also Monday, Sears forecast third-quarter earnings that were below analysts' estimates and said the credit operations would be less profitable than expected this year.

Adding to the bad vibes, Sears said that the

Securities and Exchange Commission

had advised the company to change the way it booked a $300 million earnings-eroding provision it took earlier this year for uncollectible credit accounts.

Sears spokeswoman Peggy Palter declined to elaborate on reasons for Keleghan's departure. Sears has store cards that can be used only for purchases at Sears, but the company also is rapidly increasing credit extended on MasterCards that can be used elsewhere. At the end of June, Sears borrowers had a stunning $288 billion of unused credit lines on their cards, according to a bank regulator's Web site. That indicates the company has issued millions of new cards in recent years.

Cheap

Sears stock plunged 14% Monday before its minor retreat Tuesday. It's now trading at 5.8 times expected 2002 earnings of $5.19, compared with a price-to-earnings ratio of 16 times for the

S&P 500

.

That is super cheap -- unless earnings crater over the next 12 months. There are few indications in public numbers that credit profits will collapse because of bad loans. Delinquent, or past-due, loans accounted for 6.87% of Sears' $28 billion of U.S. loans at the end of June, down from 7.58% at the end of last year.

Loans written off as uncollectible, or charge-offs, amounted to 5.32% of loans at the end of June, down from 5.42% in the year-earlier period. Bad loans dent profits because when they are charged off as uncollectible, lenders have to rebuild the reserve they keep to cover loans they can't collect. Additions to the reserve are called provisions and are treated as an expense on the income statement.

But Sears' numbers may be understating the company's true problems when it comes to credit quality.

First off, Sears' delinquency disclosure is poor: It discloses only what proportion of loans are 60 or more days past due. Other lenders usually include loans 30 to 59 days past due, too. For example, in SEC filings for the trust set up to sell

Target's

loans, the company actually tells investors how many of its card loans are one to 29 days and 30 to 59 days past due.

In addition, Sears doesn't book charge-offs until later than nearly all other credit card lenders. It typically does so if a loan is around 240 days past due, compared with 180 days for Target. Sears' Palter says disclosing 60 days plus delinquencies is industry practice, but she didn't comment on the time it takes to book charge-offs.

Credit losses also may be understated by the fact that Sears appears to be booking fraud losses in its credit division's administrative expense line and not as part of its charge-offs. A quarterly SEC filing published last week says that expenses in the lending division went up in the year's first half partly because of "increased fraud losses, experienced due to the conversion of accounts to the MasterCard product." Credit card lenders often book these fraud-related expenses as part of their bad loan totals, which means they get provisioned for.

The Outer Limits

However, the potentially spookiest feature of Sears' loan-related financials is the high proportion of loans that have a credit limit of $0 to $99. Tables regularly published in documents filed by the trust that sell Sears loans show that 19.8% of Sears accounts in the trust had a sub-$100 credit limit at the end of last year, the latest date available. In the credit card industry, cards typically carry these super-low limits because the loans drawn on them are delinquent or because the cards were lost orstolen.

But one other potential reason is that the lender may be trying to help distressed borrowers by allowing them to defer payments. Workout loans like this may well be classified as current and therefore not enter delinquency totals. Palter says that workout loans "would not be a substantial number" and that any delinquent loans and charge-offs in the $0 to $99 category also are included in the company's reported delinquency and charge-off totals. She adds that the large amount of loans with low credit limits "shows that we are more conservative."

To be sure, there is nothing on the surface to suggest that the 20% of loans with limits under $100 at Sears contains a large amount of workout loans. And because the trust's filings says it holds $18 billion of loans, the credit limit statistics may not be representative of Sears' whole loan portfolio.

But it's hard to see what else could be in the $0-to-$99 bracket without expansive disclosure from the company. If 7% can be attributed to delinquencies and another 3% to loss, theft and customer request, that leaves 10% of accounts, or potentially $2.8 billion of loans, if applied to Sears' whole portfolio.

Up until late 1999, Sears regularly included a footnote with its credit limit table that said it may impose a $0 credit limit "under certain circumstances in which the customer's credit may be in question."

So, what could be the hit to earnings if there are $2.8 billion of workout loans and a substantial portion go bad? If we assume that the special $300 million provision booked in the second quarter implicitly recognized some of these losses and some of the loan will be recovered, it could mean at least a $2 billion pretax loss -- or nearly double last year's operating income. And a hit that big could slow lending and reduce demand for Sears' goods, hitting the retail segment's earnings, too.

Of course, at its Oct. 17 analyst meeting, Sears' new finance chief may clear up all of these doubts. Until the company does provide clarity, though, Sears stock is no store of value.