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The secret life of gift cards

Retailers love gift cards for many reasons, including the fact that a meaningful percentage of them are never redeemed.

By Karen Datko Oct 28, 2010 4:19PM

This guest post comes from Frank Curmudgeon at Bad Money Advice.

 

Am I in danger of becoming obsessed with plastic cards? It's possible. But there is one type of card I have somehow managed to avoid discussing in 21 months of blogging.

That type is gift cards, the anonymous chits that are as good as money in one particular store. In their current form, they are a relatively recent innovation. When I was your age (20-plus years ago) stores sometimes sold paper gift certificates for specified amounts, but they were a one-use item. If you bought a $50 sweater with a $100 gift certificate, you generally got $50 in actual cash as change.

 

It wasn't until we entered the digital age that modern gift cards, each a miniature debit account, were born. Spend $50 with a $100 gift card and your "change" is the same old card, only now it is worth just $50.

 

So festive

Retailers love gift cards for several reasons, the most obvious of which is that they are an easy sale. If somebody shells out $100 for a gift card, it is, quite literally, money in the bank. And yet, the retailer does not, for the time being, need to deliver any goods other than a festively designed plastic card. If nothing else, that is an interest-free loan.

 

The psychology of gift card use is also beneficial for the store. Since a gift card cannot be used as cash by the holder, except in that one place, consumers think of it as being worth less than the face value. So they are much more likely to spend it on something they would not pay for with real money. That means they are less likely to wait for sales and might even be induced into spending more than just the card balance, for example buying that $125 jacket with the $100 card and $25 in cash.

 

The reason retailers love gift cards that is most often cited by us cynics is that a meaningful percentage of them are never redeemed. In retail lingo, this is called either "breakage" or "spillage," neither of which makes any sense to me. (I think retailers just like speaking in code. Stolen inventory is called "shrinkage," and nobody seems to have a convincing explanation of why the day after Thanksgiving is called Black Friday.)

 

Free money

The average level of breakage has been pegged at 6%, which seems to be from consulting firm TowerGroup. That sounds like free money for retailers, and to a certain extent it is, but it is not that simple. In many states, unused gift card balances are considered abandoned property and must be handed over to the government.

 

And in the rest of the country, the accounting is tricky. When a retailer sells a card, it does not book a profit. It gets cash in the bank but must also enter on its books a countervailing liability for the value of the card. Deciding when to extinguish that liability even though the card has not been used, on the theory that it will never be, is a bit of a controversial topic in the accounting world. Investors tend to think of that source of profit as suspect, since it involves so much management discretion.

 

Less waste

Also, the level of breakage may be shrinking. TowerGroup seems to think it has been down recently. And consumers may be getting better at harvesting their unused gift cards. There are several websites that act as used gift card dealers, e.g., CardWoo and CardPool. When I last checked, eBay had 1,779 listings for gift cards.

 

Somewhat to my surprise, the secondary market for gift cards is fairly efficient. Discounts off face value are modest, and the bid-ask spread from dealers -- the difference between what they will pay for a card and what they then will sell it for -- is pretty small. CardPool will pay $90 for a $100 Target card and offers it at $97.

 

In general, it seems the broader the selection that the store offers, the higher the gift card's value relative to face. Again based on CardPool's prices, Target has a discount of 3%, Barney's 10%, Brookstone 20%, and 1-800-Flowers 30%.

 

There are some people trying to peddle Blockbuster cards at 20% off on eBay. That seems like a dangerous purchase to me. Just ask the folks left holding more than $100 million worth of Sharper Image and Linens 'n Things cards. A gift card is basically a loan to the retailer, and if the store goes belly up all you can get for the card is a place in the long line of creditors.

 

The darker side

CardPool has iTunes at a 6% discount, which is interesting to me because sometime ago I noticed that they actually go at a premium on eBay. It took me several weeks to work out the reason. Songs are cheaper in the U.S. than they are in other places, in particular the eurozone. To open a U.S. account you need either a credit card with a U.S. billing address or a U.S. iTunes gift card.

 

Using a gift card to masquerade as an American might seem a little sleazy (does Homeland Security know about this?) but that is only the beginning of their darker side.

 

They are a de facto shadow banking system. The cards are easily transportable and concealable and completely anonymous. Having $10,000 in cash in your wallet might raise suspicions. A Macy's gift card will not, even with $10,000 stored on it. At many stores you can buy other stores' gift cards with your gift cards and if you need actual cash there is that efficient secondary market I just discussed.

 

The Treasury recently announced new rules to "to keep gift cards out of the hands of terrorists." Seriously.

 

Also, apparently, the thing to do if you have stolen a credit card is to buy gift cards with it before it gets canceled. This seems unlikely to me. Gift cards, by definition, are uniquely identifiable and therefore pretty easy to trace. So unless you can quickly sell the card on a street corner for cash, it seems to me that jewelry and electronics are a better choice. But then again, this is not my field.

 

For a roundup of other gift card-related fraud, see this Snopes entry.

 

One trick not mentioned there is a bit of household embezzlement I recently heard about. Non-working stay-at-home spouse buys a $25 Nordstrom/Home Depot card each time she/he goes to the supermarket. After a few weeks, she/he can buy those sexy shoes/power tools that she/he wants without it showing up on the credit card bill. To the other spouse, groceries are just a little more expensive.

 

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