Please ensure Javascript is enabled for purposes of website accessibility

Why Retailers Love Gift Cards (And Why You Should Be Wary of Them)

By Daniel B. Kline – Dec 1, 2019 at 2:00PM

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

The popular gifts can bolster strong retail stocks in a number of ways.

Retailers love gift cards. They win when you buy one, in a number of ways. First, you have essentially given the store an interest-free loan of indeterminate length. A person might cash in a gift card quickly, use some of it, and sit on the rest for longer -- or just leave it in a drawer for a long time (or forever).

When you buy a gift card, you essentially agree to promote that retailer. Store-specific cards can't be used elsewhere, and guarantee that someone will either come in and redeem these cards (a win for the store) or not use them at all (also a win).

Even when you use the card, the retailer wins because it got you in the store and gained a chance to sell you things. You might overspend, or you may underspend and never use the remaining balance. Even if you hit it right on the nose, the retailer has come out ahead because of the time it had the money before it sold the goods.

A present is in a bear trap.

To quote Star Wars' Admiral Ackbar, "It's a trap!" Image source: Getty Images.

Be wary of buying gift cards

Retailers generally share very little data about their unclaimed gift card balance. That's because if consumers think that they may not use the full value of a card (or any of it) they might think twice before purchasing gift cards.

Finding out exactly how much the overall gift card industry has in outstanding balances is impossible because some retailers aren't public and don't report their revenue. Even public companies can hide the number depending on how they report their finances. CEB TowerGroup estimates that consumers buy over $130 billion in gift cards every year, with $1 billion of that going unused. 

Even if all those figures are rough estimates, the balance of unused gift cards is significant. The standard for how public companies record and report gift card revenue changed in 2018, according to generally accepted acocunting principles (GAAP). Essentially, when a gift card is sold, the public company records the card as a liability. That money does not become a sale until the card is redeemed. That system does not account for breakage -- the percentage of cards that are not redeemed. There are two GAAP ways to book that revenue:

  • Pro-rata: If a retailer has historic redemption data, it can use that to determine breakage as an average percentage. It can then recognize that revenue. If a retailer has a 10% breakage rate and sold $1,000 in gift cards one month, with 60% ($600) redeemed the next month, it will have booked $600 off an expected $900 in redemptions. That's 66.6% of the total expected redemptions, so it can also book $66.66 in revenue from the breakage column.
  • Remote method: When a retailer lacks historic data, it can book the revenue "when the likelihood of use becomes remote. For a retailer, this may be deemed to happen when a card hasn't been used for a certain period of time," according to CPA Lizz Farr.

That's an oversimplification, but it gives a basic picture of how it works on the revenue and reporting side. What's not shown -- and this benefits retailers -- is that for a time, no matter what the balance sheet says, the company has both your money and its merchandise.

Be very careful buying gift cards

There's very little benefit to giving gift cards. It may be considered classier than cash, but cash rarely goes unspent. If you do opt for gift cards, it's important to know that the person you're giving the gift to actually uses the retailer you plan to give them the gift to.

In addition, you may also consider only using retailers that allow a gift card balance to be applied to a user's online account. That puts the money someplace where the consumer won't forget about it and where it's not tied to an easily forgotten plastic gift card.

Gift cards benefit retailers and their shareholders. They drive spending, and at least some percentage will go unredeemed -- and that eventually hits the bottom line.

The Motley Fool has a disclosure policy.

Premium Investing Services

Invest better with The Motley Fool. Get stock recommendations, portfolio guidance, and more from The Motley Fool's premium services.