Sears Crumples as MasterCard Bill Comes Due

The stock plunges 10% as the company's credit quality takes another hit.
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Sears'

(S) - Get Report

brutal stock slide continued Wednesday after the retailer released new data that showed a big jump in bad loans in its fast-growing MasterCard portfolio.

In addition to running department stores, the Hoffman Estates, Ill.-based company issues credit cards for use in its stores and Sears MasterCards that can be used anywhere. The credit business has expanded so robustly that it has come to account for around two-thirds of earnings.

But higher-than-expected bad loans forced Sears to take a

large credit charge in the third quarter to bolster its loan-loss reserve. Since then, investors have been trying to assess which of Sears' loans are toxic and what a serious downturn in credit quality could do to the retailer's earnings.

Wednesday's new data, contained in a quarterly filing with the

Securities and Exchange Commission

, shows deep deterioration in the MasterCard portfolio. A back-of-the-envelope calculation suggests that, if this rot continues, the company may have to make loan provisions in 2003 that could wipe out a large part of the earnings analysts currently forecast.

Sears spokeswoman Peggy Palter says the company has made sufficient provisions to build its loan loss reserve and adds: "We continue to review our reserves to see if they are appropriate -- and we will make additions as needed." The company intends to add $120 million to the reserve in the fourth quarter after increasing it by $222 million in the third quarter.

Investors mugged Sears stock Wednesday, kicking it down $2.15, or 9.5%, to $20.55. It's now 66% below its 52-week high. Detox raised a red flag over Sears because of its credit woes

a month ago.

So why are investors freaked out?

Balloon Payments

The bear thesis rests on Sears' MasterCards, which can be used by holders outside of Sears stores, unlike the classic Sears store card. Loans on store cards are declining, but credit advanced on MasterCards ballooned to $10.8 billion at the end of September from $3.1 billion in the year-ago period.

In the filing, MasterCard loans charged off as uncollectible rose to 3.63% of average loans in the third quarter, from 2.02% a year earlier and 3% in the prior quarter. That 3.63% works out as $346 million of charge-offs.

But when a portfolio is growing fast, it tells investors little about credit trends to compare current period charge-offs with current period loans. That's because it's unlikely that many of the recently added loans have yet had a chance to go bad.

Instead, an oft-used method is to compare the latest charge-off numbers with the year-ago amount of loans. After all, it primarily will be the loans up until that year-ago period that will be going bad today. And third-quarter MasterCard charge-offs were 13% of year-ago average MasterCard loans, which is a huge number.

$2 Billion Man

To be conservative, we probably shouldn't apply that 13% number to the current average MasterCard loan total of $9.5 billion; 10% might be a safer figure. Even so, that would mean $950 million of annualized losses on those loans by the end of next year. In other words, another $600 million of losses on those loans could materialize in 2003. And the company would also have to provide for losses on MasterCard loans made through 2003.

Washed Up?
Sears sinking this fall

As for store cards, if they continue to show charge-offs around the current 6.5% level, that could mean another $1.2 billion of losses. In total, Sears may have to add as much as $2 billion in 2003 to its reserve, which was $1.68 billion at the end of September.

What's more, bad-loan totals could be understated because Sears puts an undisclosed amount of troubled loans into a workout pool. Observers say that total is between $500 million and $1 billion.

Finally, if losses do keep spiking higher, Sears may find it hard to sell its loans to investors, a practice it uses to fund its lending business. That would cause it to cut back on lending, which would hurt already sagging store sales.

Expect more searing pain for Sears.