Canada's Raging Store Card Fight

  When Wal-Mart Canada teamed up with GE Consumer Finance in October 2003 to offer credit cards to its customers, it was entering a lucrative market that is well-served with store cards.
  In fact, Canada's largest retail chains are locked in an intense battle for the spending power of the country's estimated 12 million households. Not only are credit cards and their associated loyalty schemes important weapons in this fight, but card portfolios also contribute a growing proportion of the retailers' profits. So much so, in fact, that the retailers are looking to offer their customers other financial products besides credit cards.
  But analysts are becoming concerned about weak retail sales and a lack of transparency, accountability and financial-services expertise at retailers. In Canada, it's not easy to ignore the bad experiences of some retailers based in the United States, including Sears, Roebuck and Co., which expanded traditional card programs into cobranded cards, or Spiegel Inc., which used cards to drive flagging store sales and ended up with a pile of bad debt.
  Canadian retailers, however, are undaunted. A sign of the attractiveness of the credit card market to them is that, when Sears sold its U.S. card portfolio to Citigroup Inc. late last year, Sears Canada immediately made plans to become a federally regulated bank so it could continue issuing cards across Canada. Sears Canada is 55% owned by Sears, Roebuck.
  According to UBS Investment Research analyst Jason Bilodeau, Canadian consumers have so far proved a better credit risk than their counterparts in the United States and are hence very attractive to retailers. In the third quarter of 2003, U.S. credit card chargeoffs rose to 6.79% of receivables from 6.15% in the year-earlier quarter, according to Moody's Investors Service. The Canadian rate in the third quarter was less than half that, 3.08%.
  When Sears obtained its banking license in December 2003, it was following Canadian Tire and Loblaws, a supermarket chain, all of which are now issuing MasterCard credit cards. Obtaining a federal banking license frees Canadian issuers from having to comply with provincial regulations in every province where they issue cards, not unlike the way a national bank or limited-purpose credit card bank charter in the U.S. frees issuers from state banking regulations.
  Issuing general-purpose cards is a defensive move by Canadian retailers, whose store cards face growing competition from low-rate or no-fee MasterCard and Visa credit cards, many with their own reward and loyalty incentives. Bilodeau notes that the major Canadian retailers' card programs account for C$5.5 billion in receivables-about 10% of the total Canadian retail and bank credit card market. This represents a decline in market share from nearly 20% in 1997.
  Issuing general-purpose cards will enable retailers to generate new income from interchange fees and higher balances as well as fees from foreign-exchange conversions and cash advances. The retailers hope that this new income will compensate them for the loss of income due to the much lower interest that they charge on bank cards compared with store cards.
  Both Canadian Tire and Sears Canada have been migrating store card customers over to their MasterCard offerings, while Loblaws went straight in with a MasterCard program.
  Among Canada's leading retailers, only Hudson's Bay Co. (HBC), Wal-Mart Canada and RadioShack Canada, which introduced a store card through Household International Inc. last September, have chosen to stick with private-label cards. Shoppers Drug Mart, another big retailer, has teamed up with Canadian Imperial Bank of Commerce to offer a cobranded Visa credit card.
  * Sears Canada. In December, Canada's bank regulator granted Sears Canada a federal license to open Sears Canada Bank, a wholly owned subsidiary that will take over the retailer's credit-granting functions.
  "Rather than hook up with a bank, we are going to become a bank ourselves, which will open up a vast panoply of opportunities in the future for a lot more financial products than we have historically offered," Mark Cohen, Sears Canada chairman and chief executive, told a Scotia Capital Markets conference in Toronto last September.
  Sears Canada actually earns more from its credit card operation than it does from merchandising. For the third quarter of 2003, operating earnings from credit cards were C$29.9 million, compared with C$29.1 million for the same period in 2002. From merchandising, earnings before interest, unusual items and income taxes were C$24.2 million in 2003's third quarter and C$19.2 million a year earlier.
  In the nine months ending last Sept. 30, purchases made with the proprietary Sears Card and Sears MasterCard jointly accounted for 61.1% of total transactions in Sears Canada stores, up from 60.9% a year earlier.
  At the end of September, Sears had C$150 million in receivables on its MasterCard credit cards and 125,000 active accounts, said Cohen. Accounts rose to 150,000 by December.
  However, Sears Canada does not plan to convert all its proprietary cardholders to the MasterCard. "The primary target for the foreseeable future is the inactive Sears Card holders who either don't use their Sears Cards anymore but shop at Sears stores regularly, or use their Sears Cards but pay off their balances and never carry a balance," Cohen said.
  The interest rate on the Sears Card is 28.8%, compared with 18.9% for the Sears MasterCard. While the interest rate is higher, certain benefits such as deferred payment are available only on the proprietary card, according to a Sears Canada spokesperson.
  * Canadian Tire. Canadian Tire received a banking license for its wholly owned financial-services subsidiary in September. "Obtaining a single federal banking license allows us to offer products and services nationally without needing clearance from different provinces," explains a spokesperson.
  In 2001, Canadian Tire began the migration of its retail card holders to the Options MasterCard. "The most significant result of the migration was that we noticed that the average balance of MasterCard users was twice the average balance of retail card holders," Wayne C. Sales, Canadian Tire's president and CEO, told the Scotia Capital Markets conference.
  "In-store customer acquisition is low-cost and high-volume," said Sales. "In giving customers a MasterCard, we can also sell insurance and warranty products, which are very profitable. With 40% of Canadians visiting a Canadian Tire store every week, we have an opportunity to market products to them."
  Customer Migration
  At the end of September, Canadian Tire had over 3.1 million Options MasterCard accounts, an increase of 49% year-on-year. The Canadian Tire spokesperson says that MasterCard cards now account for 90% of the company's cards. And while credit card receivables grew by 27.5% in the third quarter of 2003 compared with the year-earlier period, store sales only rose by 1.9% in the same timeframe.
  The higher receivables, however, did not lead to higher card profits. Third-quarter 2003 earnings before depreciation, interest and amortization for the financial-services unit were C$33.1 million, down 1.9% from C$33.8 million a year earlier. According to Thomas Gauld, Canadian Tire's president of financial services, this was due to customer migration from store cards charging an annual interest rate of 29.8% to MasterCard-branded cards charging 18.9%.
  Speaking at the Scotia Capital Markets conference, senior executives at Canadian Tire and HBC pointed to the compelling reasons why they are in credit card and other types of financial services-chief amongst these being recent growth figures. "We think financial services offer virtually unlimited growth," said Canadian Tire's Sales.
  Michael S. Rousseau, HBC's executive vice president and chief financial officer, echoed this sentiment. "Financial services have been a growing source of profit and cash flow over the years," said Rousseau. "We expect this to grow as we add partners."
  Yet alarm bells are sounding for UBS's Bilodeau. "I may be the only analyst thinking like this," he says, "but what happens if the current rise in credit card chargeoffs and consumer bankruptcies in Canada continues?"
  In the third quarter of 2003, according to the Moody's Investors Service Canadian Credit Card Index, Canadian bank card chargeoffs rose 15% to 3.08% of balances from 2.68% in the year-earlier period. This was the second straight quarterly increase in chargeoffs.
  About half the credit losses were due to bankruptcy, with nearly 7% more Canadians filing for bankruptcy than in 2002. Delinquencies rose to 2.37% of receivables from 2.29% in 2002's third quarter, while bank card debt increased by 10% to C$36.4 billion.
  The worsening credit-quality environment and portfolio growth is forcing retailers to boost loan-loss reserves. For example, Canadian Tire's net provision for credit card losses was C$37.9 at the end of the third quarter compared with C$27.2 million a year earlier.
  Canadian Tire, HBC and Sears Canada transfer their credit card receivables to securitization trusts, which in turn sell the debt to investors. These trusts have excellent credit ratings-for example, the senior notes of Canadian Tire's Glacier Credit Card Trust are rated AAA by Dominion Bond Rating Service and Standard & Poor's. The Canadian Tire spokesperson points to this rating as a sign of the creditworthiness of its cardholders.
  However, Bilodeau takes a different view. "The reason these trusts enjoy such good ratings is that they are very well cushioned from credit risk," he says. "If the consumer downturn continues, the trusts' noteholders will receive their interest, but the income that the companies receive from the trust will be affected."
  Bilodeau also wants more transparency. "Retailers' financial-services operations are now a very significant part of their business, but they have inadequate disclosure, and investors are not clear about the level of risk they are undertaking," he says. "A lot of investors who want exposure to financial services would prefer to invest in a pure-play company rather than a hybrid that is involved in retailing and finance. They would also like to see retailers making proper profits from their retail operations."
  The retailers' answer to Bilodeau's objections is that there is real value in combining financial services with retail. For example, credit scoring and customer relationship management can be closely linked. According to a report in Canadian newspaper The Globe and Mail, HBC's research has shown that a customer who shops at the different HBC subsidiaries and holds an HBC credit card and loyalty card is six times as valuable as a cash-paying customer who only shops at a single subsidiary and does not have a loyalty card.
  A Relationship Builder
  Canadian Tire's spokesperson also emphasizes the importance of CRM. "Canadian Tire is a marketer of credit card products and a relationship builder," the spokesperson says. "Before we could offer credit cards with personalized features, our old legacy (computer) system required an entire overhaul. We worked with TSYS (Columbus, Ga.-based card processor Total System Services Inc.) to do this."
  Canadian Tire's Sales told the Scotia Capital Markets conference that a key benefit of combining CRM with credit scoring is the ability to tell from each customer's shopping behavior whether they have a higher risk of defaulting on their debt. "We have access to customer information that other banks or retailers offering credit cards do not have," he said. "We know when a customer is a better credit risk, based on the purchases that they make from Canadian Tire stores.
  "We know that someone buying felt pads for the bottom of chairs is a better credit risk than someone buying a punk-rock CD. So we use this data to enhance our credit scoring. Also, the establishment of Canadian Tire as a bank gives us the opportunity to offer variable interest rates based on credit scoring."
  Canadian Tire has had a loyalty program since 1958. According to Market Retail Report 2003, an annual study published by Kubas Consultants, Canadian Tire Money is the most popular single-retailer program in Canada, with 51.7% of survey respondents saying that they actively participate in its scheme.
  Shoppers get C$1 for every C$100 spent at Canadian Tire, and can only redeem their paper gift certificate in the retailer's outlets. Kubas notes that Canadian Tire is also the most "shopped" retailer in Canada, attracting over 90% of the country's consumers last year.
  TSYS has been working with Canadian Tire to convert its paper gift certificates to electronic gift cards. Canadian Tire sells about C$40 million worth of paper gift certificates annually.
  Instead of receiving a separate Canadian Tire Money paper gift certificate, Canadian Tire MasterCard customers receive their reward points electronically-a program which the retailer refers to as "Canadian Tire Money on the Card." Points are added wherever the card is used, and can be redeemed in Canadian Tire stores, with the monthly MasterCard statement displaying the latest point balance.
  "Our MasterCard customers get 20% more Canadian Tire Money on the Card points using their MasterCard in our stores than they would receive in paper Canadian Tire Money if they paid cash ..." Sales said.
  TSYS also processes Canadian Tire's proprietary cards and its Options MasterCard under a contract that runs through 2006. In another project, TSYS helped the retailer to unify the loyalty schemes at its various retail operations on a single platform.
  In addition to Canadian Tire, TSYS also has Sears Canada as its customer. In October 2002, Sears Canada signed a deal with TSYS that enables the retailer, through TSYS' TS2 software platform, to offer its proprietary cardholders multiple interest rates based on their credit background.
  Temptation
  Sears says this flexibility will help boost activation rates among its cardholders. TSYS, which also provides processing services for Sears Canada's new MasterCard, will process Sears' private-label card through 2010.
  Still, as the Canadian retailers forge ahead in their plans to offer more financial services, they can't help but notice that some of their U.S. counterparts have been burned when they expanded their financial reach beyond the traditional proprietary card or lowered credit standards too much to drive sales. Sears booked thousands of bad risks when it launched its U.S. MasterCard, a mistake that helped pave the way for the portfolio sale to Citigroup.
  Spiegel is in bankruptcy mainly because of bad debt incurred by its now-defunct card bank, which passed out cards to high-risk consumers in an effort to boost store sales.
  Canadian retailers think they can avoid the fate of their American cousins by relying on their well-honed account-acquisition and management skills. Sears Canada, for instance, says it is avoiding some of the tactics used by Sears, Roebuck when it launched its Gold MasterCard in 2000 such as sending direct-mail card solicitations to non-Sears customers.
  But today's competitive financial environment provides plenty of temptation for retailers to stray from their traditionally conservative paths.