Shortly into the New Year, it was clear retail businesses of all stripes and sizes were witnessing severe declines in revenue. Further, well-known brands like Sharper Image, Circuit City and Linens 'n Things were disappearing from the retail landscape altogether. One bright spot in an otherwise dreadful business environment is the sale of gift cards, which have become quite elaborate in their design. Estimates put total gift card sales in 2008 at $88.4 billion, a huge number regardless of the 8.9% decline from 2007.

The big question for consumers is determining just how safe their investments really are. Close to $100 million in gift cards were affected by bankruptcies, and many wonder what the recession will do to other weakened merchants. Gift cards never go on sale, and penny-pinching consumers may decide to do more bargain hunting and less gift card shopping; a move that would definitely hurt retailers' return on investment. (Read more in our related article, The Impact Of Recession On Businesses.)

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Top Five Apparel Stores By Market Cap – Fiscal 2008 [Excluding Ross Stores (Nasdaq:ROST)]

Company Gift Card Liability
Net Sales
GCL/Net Sales
GAP (NYSE:GPS) $255.00 $14.53 1.8%
Nordstrom (NYSE:JWN) $175.00 $8.27 2.1%
Limited Brands (NYSE:LTD) $166.00 $9.04 1.8%
Urban Outfitters (Nasdaq:URBN) $22.31 $1.83 1.2%
American Eagle (NYSE:AEO) $42.30 $2.99 1.4%

Deferred Sales
I've taken the top five apparel stores by market cap and calculated each company's gift card liability at the end of 2008 as a percentage of net sales. For those unaware, retailers don't actually recognize revenue from gift card sales until the card is redeemed. In the meantime, it goes on the balance sheet as a current liability. Once the card is used, the liability disappears and a similar amount ends up on the earnings statement. Unfortunately, industry experts suggest as much as 19% of gift cards go permanently unused. As a result, individual companies determine the maximum amount of time they will continue to recognize the liability. Most are between 24 and 36 months. After that, it's considered breakage and finally recognized as revenue. It's a nuisance for finance departments but a tremendous benefit to the companies themselves. (Learn more in our related article, Reading The Balance Sheet.)

Insignificant Revenue
Looking at the table above, you can't help thinking these gift card liabilities are rounding errors for most large retailers and, of course, they are if you only think of them as a percentage of sales. However, if you consider the sales as no-interest cash advances, you essentially have the use of a couple hundred million in cash at almost no cost to the company. Sure, there is the cost of sales when the cards are redeemed for actual goods, but if and only if recipients do something about it. Evidence shows many don't.

On top of the obvious cash flow benefits, think about the balance sheet for a second. First, you sell a $100 gift card. The cash becomes an asset and an equal amount a deferred revenue liability. Then the card is redeemed and the liability goes away, replaced by $100 in increased book value. All your valuation metrics change. In the case of Nordstrom, $175 million in gift card liabilities, if redeemed, represents 81 cents per share in additional book value, a 13.8% increase, dropping price-to-book from 3.54 to 2.91. I'm not an accountant, but that sounds like a good deal.

Bottom Line
Gift cards are a great way for businesses to spread goodwill while simultaneously improving cash flow. If you happen to own a retail stock, have a look at the 10-K and ask yourself, "What is my gift card's return on investment?"

For more, see Analyzing Retail Stocks and our Industry Handbook: The Retailing Industry.