Walk through the checkout line at most clothing stores and you'll notice the same thing – gift cards for sale. Of course, the goal is to upsell you that gift card, getting you or the recipient to essentially "lock in" future purchases. But there's more to gift cards than you might think.
Companies that issue gift cards see at least four major benefits:
1. Increase profits
People lose stuff. Based on research from financial consulting firm TowerGroup, an estimated $41 billion in gift cards went unspent between 2005 and 2011, almost $7 billion per year. The year 2007 was the peak, when an astounding 10% of all gift card purchases went to waste due to non-use, fees, and expiration.
If a gift card gets lost (and not replaced) or a customer forgets about it, the issuer essentially pockets the amount as free cash. In 2012, for example, Best Buy (NYSE:BBY) booked $54 million in income from gift card "breakage," up from $51 million the prior year and from $43 million in 2010.
Unfortunately for retailers, the government is taking notice of the trend, and some states are issuing laws that force companies to fork over unused gift cards after a certain period of time. The new laws give consumers the ability to check with the state and potentially claim any lost gift card amounts.
Nonetheless, companies still get to hold onto the cash for years, bringing in a second valuable point.
2. Get low-cost financing
Gift cards allow companies to borrow money today (from customers) and return it back later in the form of the company's products or services.
For the sake of simplicity, assume a $50 Macy's (NYSE: M) or Kohl's (NYSE: KSS) gift card costs the company $0.25 to create and manage. Let's also assume that on average the gift card won't get used for three months (85% of consumers use a gift card within two months, but between 2% and 10% of cards may never be used).
If that were the case, the effective cost of financing for Macy's and Kohl's would be 2% annually, a steal of a rate, even considering today's ultra-low rate standards.
3. Increase sales
When you buy a $50 Macy's gift card, you're essentially guaranteeing Macy's $50 in future sales. Macy's can't book that money as revenue yet (it's called unearned revenue), since the company didn't actually give you any goods in return. However, Macy's knows that it's getting at least $50 at some point in the future.
Gift cards also increase the amount of money that consumers will spend: over one-third of consumers will spend more than the gift card amount, estimates Brian Riley of TowerGroup. Companies like Panera Bread (NASDAQ:PNRA) are taking advantage.
Panera ran a special last December that gave customers $5 free for buying a $25 card. The deal encouraged Panera customers to buy Panera gift cards for themselves and others, boosting Panera's future sales. However, it also boosted something else.
4. Boost market and mind share
The same time consumers are spending $25 at Panera, they're probably not going to spend an extra $25 at Starbucks. If I have a Panera gift card, the next time I drive by a Panera and a Starbucks, I'll likely lean toward the Panera. Because, for the coffee or meal, I won't have to pay for it -- I already did.
And if I have a $50 Kohl's gift card, the next time clothing coupons come in the mail, my wife and I will probably turn to the Kohl's coupons first.
All cards are not equal
When thinking about gift cards remember that customers do not treat all of them the same way. For example, customers may use a Starbucks gift card far more quickly than one from Macy's or Kohl's. The reason -- people eat food far more often than they shop for clothes.
Selling gift cards is a good thing for businesses because it grants them increased profits, low-cost financing, increased revenue, and stronger mind share.
So the next time you buy a gift card from companies like Starbucks, Best Buy, Panera, Kohl's, or Macy's, give some thought to making an investment in that company, because you're helping it become a more stable, profitable business.
Chris Marasco has no position in any stocks mentioned. The Motley Fool recommends Panera Bread and Starbucks. The Motley Fool owns shares of Panera Bread and Starbucks. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.