UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
-----------------------
FORM 10-Q/A
[X] Quarterly Report amendment Pursuant to Section 13 or 15(d) of the
Securities Exchange Act of 1934
For the quarterly period ended September 30, 2003
or
[ ] Transition Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
For the transition period from to
---------- ----------
Commission file number: 001-12351
METRIS COMPANIES INC.
(Exact name of registrant as specified in its charter)
Delaware 41-1849591
(State of Incorporation) (I.R.S. Employer Identification No.)
10900 Wayzata Boulevard, Minnetonka, Minnesota 55305-1534
(Address of principal executive offices)
(952) 525-5020
(Registrant's telephone number)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
Yes X No
----- -----
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act).
Yes X No
----- -----
As of January 31, 2004, 57,917,318 shares of the registrant's common stock, par
value $.01 per share, were outstanding.
METRIS COMPANIES INC.
FORM 10-Q
TABLE OF CONTENTS
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SEPTEMBER 30, 2003
Page
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INDEPENDENT ACCOUNTANTS' REVIEW REPORT...................................................4
PART I. FINANCIAL INFORMATION
ITEM 1. Consolidated Financial Statements (unaudited):
Consolidated Balance Sheets.................................5
Consolidated Statements of Income...........................6
Consolidated Statements of Changes in Stockholders'Equity...7
Consolidated Statements of Cash Flows.......................8
Notes to Consolidated Financial Statements..................9
ITEM 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations..............42
ITEM 3. Quantitative and Qualitative Disclosures About Market Risk.............66
ITEM 4. Controls and Procedures................................................67
PART II. OTHER INFORMATION
ITEM 1. Legal Proceedings......................................................67
ITEM 2. Changes in Securities and Use of Proceeds..............................68
ITEM 3. Defaults Upon Senior Securities........................................68
ITEM 4. Submission of Matters to a Vote of Security Holders....................68
ITEM 5. Other Information......................................................68
ITEM 6. Exhibits and Reports on Form 8-K.......................................68
Signature..............................................................71
2
EXPLANATORY NOTE #1
This Amendment No. 1 on Form 10-Q amends Part I, Item 1 and 2 of the
Registrant's Quarterly Report on Form 10-Q for the quarterly period ended
September 30, 2003, to make certain changes to numbers appearing in the
consolidated statements of cash flows (page 8), Note 2 (page 10) and Note 9
(page 30) to the Registrant's financial statements. These changes restate prior
information filed to correct identified clerical errors or conform the affected
numbers to the presentation of the Company's restated financial information
being filed concurrently with the SEC for the quarterly periods ended June 30,
2003, and March 31, 2003, and the annual periods ended December 31, 2002, 2001
and 2000. The principal clerical error identified was related to earnings per
share in the three months ended March 31, 2003, which was originally reported as
($0.94) per share and correctly stated is ($1.62) per share. The conforming
adjustments related primarily to classification of items on the statement of
cash flows as operating or investing activities, the classification of items
within net securitization income (note 9), and the classification of items
related to interest and fee income and provision for loan losses on loans
securitized in the 2001 and 2000 income statements. In addition, in connection
with the filing of this Form 10-Q/A-1 and pursuant to the rules of the
Securities and Exchange Commission, the Registrant is including with this Form
10-Q/A-1 certain currently dated certifications. No other changes have been made
to the Form 10-Q for the fiscal quarter ended September 30, 2003 and this Form
10-Q/A-1 does not modify or update the disclosure contained in the Form 10-Q in
any way other than as required to reflect the amendments discussed above and
reflected below.
EXPLANATORY NOTE #2
As previously announced, Metris Companies Inc. (the "Company") delayed
the filing of this report pending the resolution of an issue related to the
valuation of the Company's "Retained interests in loans securitized." As a
result of its analysis of this issue, the Company has determined that it will
restate its financial results for 1998 through 2002 and for the first three
quarters of 2003.
This report reflects restatements of the following financial statements
which have previously been reported in the Company's Annual Report on Form 10-K
for the year ended December 31, 2002, its Quarterly Reports on Form 10-Q for the
quarters ended March 31, 2003 and June 30, 2003, and its Current Report on Form
8-K filed on October 23, 2003 containing financial results for the three-months
ended September 30, 2003:(a) consolidated balance sheets as of December 31,
2001, December 31, 2002, March 31, 2003, June 30, 2003, and September 30, 2003,
(b) consolidated statements of income for the three-months ended March 31, 2003
and 2002, the three- and six-months ended June 30, 2003 and 2002, the three- and
nine-months ended September 30, 2003 and 2002, and the years ended December 31,
2002, 2001 and 2000; and (c) consolidated statements of cash flows for the
three-months ended March 31, 2003 and 2002, the six-months ended June 30, 2003
and 2002, the nine- months ended September 30, 2002 and the years ended December
31, 2002, 2001 and 2000. Included in these restatements, in addition to changes
made as a result of the Company's revised accounting policies and procedures
related to valuing its retained interests, were corrections to conform with
accounting principles generally accepted in the United States of America
("GAAP") related to securitization transaction costs, credit card solicitation
costs, interest rate caps and debt waiver revenue associated with credit card
receivables sold to the Metris Master Trust, as well as the transfer of
allowance for loan losses that was incorrectly classified as a valuation reserve
in "Retained interests in loans securitized" as of December 31, 2001. In
addition, we have restated certain other prior period amounts to conform with
the current period's presentation. For a more detailed description of the
restatements, see Note 2 to the accompanying unaudited consolidated financial
statements and "Restatements" in Management's Discussion and Analysis of
Financial Condition and Results of Operations contained in this Quarterly Report
on Form 10-Q.
At the earliest possible time, Metris Companies Inc. will file an
amended Annual Report on Form 10-K/A for the year ended December 31, 2002 and
amended Quarterly Reports on Form 10-Q/A for the quarters ended March 31, 2003
and June 30, 2003 containing restated financial statements for the relevant
periods. As a result of these restatements, the Company's financial statements
and related financial information contained in the Company's previously filed
Annual Report on Form 10-K for the year ended December 31, 2002 and Quarterly
Reports on Form 10-Q for the quarters ended March 31, 2003 and June 30, 2003,
and the independent auditors' report included in such Annual Report on Form
10-K, should no longer be relied upon.
3
Independent Accountants' Review Report
To the Board of Directors and Stockholders of
Metris Companies Inc.:
We have reviewed the accompanying consolidated balance sheets of Metris
Companies Inc., (the "Company") and subsidiaries as of September 30, 2003 and
December 31, 2002, the related consolidated statements of income for the
three-month and nine-month periods ended September 30, 2003 and 2002, and the
related consolidated statements of changes in stockholders' equity and cash
flows for the nine-month periods ended September 30, 2003 and 2002. These
consolidated financial statements are the responsibility of the Company's
management.
We conducted our reviews in accordance with standards established by the
American Institute of Certified Public Accountants. A review of interim
financial information consists principally of applying analytical procedures and
making inquiries of persons responsible for financial and accounting matters. It
is substantially less in scope than an audit conducted in accordance with
generally accepted auditing standards, the objective of which is the expression
of an opinion regarding the consolidated financial statements taken as a whole.
Accordingly, we do not express such an opinion.
Based on our reviews, we are not aware of any material modifications that should
be made to the consolidated financial statements referred to above for them to
be in conformity with accounting principles generally accepted in the United
States of America.
As discussed in note 2, the Company has restated its consolidated financial
statements.
KPMG LLP
Minneapolis, Minnesota
March 2, 2004, except for note 2,
which is dated April 9, 2004
4
PART I. FINANCIAL INFORMATION
ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS
METRIS COMPANIES INC. AND SUBSIDIARIES
Consolidated Balance Sheets (unaudited)
(Dollars in thousands)
SEPTEMBER 30, DECEMBER 31,
2003 2002
AS RESTATED AS RESTATED
-------------- --------------
ASSETS:
Cash and due from banks $ 35,927 $ 62,813
Federal funds sold -- 88,000
Short-term investments 122,485 429,419
-------------- --------------
Cash and cash equivalents 158,412 580,232
-------------- --------------
Liquidity reserve deposit 83,875 --
Credit card loans 110,922 846,417
Less: Allowance for loan losses 42,402 90,315
-------------- --------------
Net credit card loans 68,520 756,102
-------------- --------------
Retained interests in loans securitized 857,186 808,026
Property and equipment, net 39,039 83,831
Purchased portfolio premium, net 21,459 64,579
Other receivables due from credit card
securitizations, net 85,490 110,471
Other assets 97,042 187,151
-------------- --------------
TOTAL ASSETS $ 1,411,023 $ 2,590,392
============== ==============
LIABILITIES:
Deposits $ 6,298 $ 892,754
Debt 351,511 357,649
Accounts payable 62,079 53,589
Deferred income 22,865 143,148
Accrued expenses and other liabilities 93,287 88,579
-------------- --------------
TOTAL LIABILITIES 536,040 1,535,719
-------------- --------------
STOCKHOLDERS' EQUITY:
Convertible preferred stock - Series C, par
value $.01 per share; 10,000,000
shares authorized, 1,235,891 and 1,156,086
shares issued and outstanding, respectively 460,370 430,642
Common stock, par value $.01 per share;
300,000,000 shares authorized, 64,911,718 and 64,223,231
shares issued and outstanding, respectively 649 642
Paid-in capital 230,393 227,376
Unearned compensation (158) --
Treasury stock - 7,055,300 shares (58,308) (58,308)
Retained earnings 242,037 454,321
-------------- --------------
TOTAL STOCKHOLDERS' EQUITY 874,983 1,054,673
-------------- --------------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 1,411,023 $ 2,590,392
============== ==============
See accompanying Notes to Unaudited Consolidated Financial Statements.
5
METRIS COMPANIES INC. AND SUBSIDIARIES
Consolidated Statements of Income
(In thousands, except per-share data) (Unaudited)
THREE-MONTHS ENDED NINE-MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
2003 2002 2003 2002
AS RESTATED AS RESTATED AS RESTATED AS RESTATED
----------- ----------- ----------- -----------
INTEREST INCOME:
Credit card loans $ 23,250 $ 27,433 $ 82,870 $ 182,283
Federal funds sold 264 145 787 369
Other 1,142 3,838 4,592 7,400
----------- ----------- ----------- -----------
Total interest income 24,656 31,416 88,249 190,052
----------- ----------- ----------- -----------
Deposit interest expense 7,882 14,453 28,387 56,440
Other interest expense 14,414 8,799 31,966 25,932
----------- ----------- ----------- -----------
Total interest expense 22,296 23,252 60,353 82,372
----------- ----------- ----------- -----------
NET INTEREST INCOME 2,360 8,164 27,896 107,680
Provision for loan losses 33,019 26,340 107,838 178,817
----------- ----------- ----------- -----------
NET INTEREST EXPENSE AFTER
PROVISION FOR LOAN LOSSES (30,659) (18,176) (79,942) (71,137)
----------- ----------- ----------- -----------
OTHER OPERATING INCOME:
Securitization income 93,779 148,313 73,516 293,505
Servicing income on securitized / sold receivables 43,849 51,948 136,997 144,515
Credit card fees, interchange and other
credit card income 17,934 19,749 67,713 135,946
Enhancement services revenue 16,549 42,957 99,748 113,975
Loss on sale of credit card loans (117,183) -- (117,183) --
Gain on sale of membership club and warranty
business 80,391 -- 80,391 --
----------- ----------- ----------- -----------
135,319 262,967 341,182 687,941
----------- ----------- ----------- -----------
OTHER OPERATING EXPENSE:
Credit card account and other product
solicitation and marketing expenses 19,325 47,625 85,045 140,502
Employee compensation 41,997 51,875 141,099 162,788
Data processing services and communications 16,770 20,054 52,982 63,155
Credit protection claims expense 6,585 11,452 26,537 34,263
Occupancy and equipment 8,716 11,665 27,253 36,753
Purchased portfolio premium amortization 8,107 7,232 21,102 23,430
MasterCard/Visa assessment and fees 2,444 3,377 7,090 10,794
Credit card fraud losses 988 1,981 2,997 7,162
Asset impairments, lease write-offs and severance 29,976 -- 52,764 9,523
Loss on sale of deposits 32,963 -- 32,963 --
Other 28,965 19,279 68,624 66,214
----------- ----------- ----------- -----------
196,836 174,540 518,456 554,584
----------- ----------- ----------- -----------
(LOSS) INCOME BEFORE INCOME TAXES (92,176) 70,251 (257,216) 62,220
Income tax (benefit) expense (17,198) 25,201 (74,660) 23,012
----------- ----------- ----------- -----------
NET (LOSS) INCOME (74,978) 45,050 (182,556) 39,208
Convertible preferred stock dividends 10,131 9,605 29,728 28,187
----------- ----------- ----------- -----------
NET (LOSS) INCOME APPLICABLE TO COMMON
STOCKHOLDERS $ (85,109) $ 35,445 $ (212,284) $ 11,021
=========== =========== =========== ===========
(LOSS) INCOME PER SHARE:
Basic $ (1.48) $ 0.50 $ (3.70) $ 0.18
Diluted $ (1.48) $ 0.50 $ (3.70) $ 0.18
SHARES USED TO COMPUTE LOSS PER SHARE:
Basic 57,546 89,574 57,426 60,653
Diluted 57,546 89,579 57,426 60,965
DIVIDENDS DECLARED PER COMMON SHARE -- $ 0.01 -- $ 0.03
See accompanying Notes to Unaudited Consolidated Financial Statements.
6
METRIS COMPANIES INC. AND SUBSIDIARIES
Consolidated Statements of Changes in Stockholders' Equity
(In thousands) (Unaudited)
NUMBER OF SHARES PREFERRED COMMON PAID-IN
PREFERRED COMMON STOCK STOCK CAPITAL
----------- ----------- ----------- ----------- -----------
BALANCE AT DECEMBER 31, 2001, AS PREVIOUSLY
REPORTED 1,058 63,419 $ 393,970 $ 642 $ 232,413
Cumulative restatements to prior periods,
see Note 2 -- -- -- -- --
BALANCE AT DECEMBER 31, 2001, AS RESTATED 1,058 63,419 $ 393,970 $ 642 $ 232,413
Net income (as restated) -- -- -- -- --
Cash dividends -- -- -- -- --
Common stock repurchased -- (5,747) -- -- --
Preferred dividends in kind 73 -- 27,196 -- --
Issuance of common stock
under employee benefit plans -- 326 -- 3 2,678
Issuance of restricted stock under employee
benefit plans -- 76 -- 1 967
Amortization of restricted
stock -- -- -- -- --
----------- ----------- ----------- ----------- -----------
BALANCE AT SEPTEMBER 30, 2002,
AS RESTATED 1,131 58,074 $ 421,166 $ 646 $ 236,058
=========== =========== =========== =========== ===========
BALANCE AT DECEMBER 31, 2002, AS
PREVIOUSLY REPORTED 1,156 57,168 $ 430,642 $ 642 $ 227,376
Cumulative restatements to prior periods,
see Note 2 -- -- -- -- --
BALANCE AT DECEMBER 31, 2002, AS RESTATED 1,156 57,168 $ 430,642 $ 642 $ 227,376
Net loss (as restated) -- -- -- -- --
Preferred dividends in kind 80 -- 29,728 -- --
Issuance of common stock
under employee benefit plans -- 426 -- 4 2,547
Issuance of restricted
stock under employee
benefit plans -- 303 -- 3 546
Restricted stock forfeitures -- (41) -- -- (76)
Amortization of restricted
stock -- -- -- -- --
----------- ----------- ----------- ----------- -----------
BALANCE AT SEPTEMBER 30, 2003,
AS RESTATED 1,236 57,856 $ 460,370 $ 649 $ 230,393
=========== =========== =========== =========== ===========
TOTAL
UNEARNED TREASURY RETAINED STOCKHOLDERS'
COMPENSATION STOCK EARNINGS EQUITY
-------------- ------------ ------------ -------------
BALANCE AT DECEMBER 31, 2001, AS PREVIOUSLY
REPORTED $ (4,980) $ (13,014) $ 532,924 $ 1,141,955
Cumulative restatements to prior periods,
see Note 2 -- -- (36,619) (36,619)
BALANCE AT DECEMBER 31, 2001, AS RESTATED $ (4,980) $ (13,014) $ 496,305 $ 1,105,336
Net income (as restated) -- -- 39,208 39,208
Cash dividends -- -- (2,805) (2,805)
Common stock repurchased -- (43,717) -- (43,717)
Preferred dividends in kind -- -- (27,196) --
Issuance of common stock
under employee benefit plans -- -- -- 2,681
Issuance of restricted stock under employee
benefit plans (968) -- -- --
Amortization of restricted
stock 1,359 -- -- 1,359
------------- ----------- ----------- ------------
BALANCE AT SEPTEMBER 30, 2002,
AS RESTATED $ (4,589) $ (56,731) $ 505,512 $ 1,102,062
============= =========== =========== ============
BALANCE AT DECEMBER 31, 2002, AS
PREVIOUSLY REPORTED $ -- $ (58,308) $ 458,673 $ 1,059,025
Cumulative restatements to prior periods,
see Note 2 -- -- (4,352) (4,352)
BALANCE AT DECEMBER 31, 2002, AS RESTATED $ -- $ (58,308) $ 454,321 $ 1,054,673
Net loss (as restated) -- -- (182,556) (182,556)
Preferred dividends in kind -- -- (29,728) --
Issuance of common stock
under employee benefit plans -- -- -- 2,551
Issuance of restricted
stock under employee
benefit plans (549) -- -- --
Restricted stock forfeitures 76 -- -- --
Amortization of restricted
stock 315 -- -- 315
------------- ----------- ----------- ------------
BALANCE AT SEPTEMBER 30, 2003,
AS RESTATED $ (158) $ (58,308) $ 242,037 $ 874,983
============= =========== =========== ============
See accompanying Notes to Unaudited Consolidated Financial Statements.
7
METRIS COMPANIES INC. AND SUBSIDIARIES
Consolidated Statements of Cash Flows
(Dollars in thousands) (Unaudited)
NINE-MONTHS
NINE-MONTHS ENDED
ENDED SEPTEMBER 30,
SEPTEMBER 30, 2002
2003 AS RESTATED
--------------- ---------------
OPERATING ACTIVITIES:
Net (loss) income $ (182,556) $ 39,208
Adjustments to reconcile net (loss) income to net cash provided
by (used in) operating activities:
Depreciation, amortization, and accretion (135,733) (135,904)
Provision for loan losses 107,838 178,817
(Gain) loss from credit card securitization 182,788 1,618
Gain on sale of membership club and warranty business (80,391) --
Asset impairments, lease write-offs, and severance 52,764 9,523
Loss on sale of deposits 32,963 --
Market loss on derivative financial instruments 6,169 15,195
Changes in operating assets and liabilities, net:
Liquidity Reserve deposit (83,875) --
Fair value of retained interests in loans securitized 70,333 270,357
Spread accounts receivable (242,290) 26,219
Other receivables due from credit card securitizations, net 24,981 26,322
Accounts payable and accrued expenses (12,007) (19,409)
Deferred income (37,568) (37,602)
Other (19,305) 30,851
--------------- ---------------
Net cash (used in) provided by operating activities (315,889) 405,195
--------------- ---------------
INVESTING ACTIVITIES:
Proceeds from transfers of portfolios to the Metris Master Trust 670,965 2,098,022
Net cash from loan originations and principal collections on loans
receivable (417,614) (603,044)
Proceeds from sales of credit card portfolios to third parties 494,784 --
Proceeds from sale of club and warranty business 45,000 --
Disposal of property and equipment 25,151 --
Additions to property and equipment (538) (5,607)
--------------- ---------------
Net cash provided by investing activities 817,748 1,489,371
--------------- ---------------
FINANCING ACTIVITIES:
Proceeds from issuance of debt 125,606 214
Repayment of debt (132,417) (292,000)
Sale of deposits (559,282) --
Net decrease in deposits (327,174) (958,779)
Premium paid and transaction costs on sale of deposits (32,963) --
Cash dividends paid -- (2,805)
Proceeds from issuance of common stock 2,551 2,681
Repurchase of common stock -- (43,717)
--------------- ---------------
Net cash used in financing activities (923,679) (1,294,406)
--------------- ---------------
Net (decrease) increase in cash and cash equivalents (421,820) 600,160
Cash and cash equivalents at beginning of period 580,232 381,639
--------------- ---------------
Cash and cash equivalents at end of period $ 158,412 $ 981,799
=============== ===============
SUPPLEMENTAL DISCLOSURES AND CASH FLOW INFORMATION:
Cash paid (received) during the period for:
Interest $ 59,395 $ 87,025
Income taxes (78,131) (15,551)
Tax benefit from employee stock option exercises 1 174
See accompanying Notes to Unaudited Consolidated Financial Statements.
8
METRIS COMPANIES INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(Dollars in thousands, except as noted) (Unaudited)
NOTE 1 - ORGANIZATION AND BASIS OF PRESENTATION
The consolidated financial statements include the accounts of Metris
Companies Inc. ("MCI") and its subsidiaries. MCI's principal subsidiaries are
Direct Merchants Credit Card Bank, National Association ("Direct Merchants Bank"
or the "Bank"), Metris Direct, Inc. and Metris Receivables, Inc. MCI and its
subsidiaries, as applicable, may be referred to as "we," "us," "our" or the
"Company."
All dollar amounts are presented as pre-tax amounts unless otherwise
noted. We have eliminated all significant intercompany balances and transactions
in consolidation.
INTERIM FINANCIAL STATEMENTS
We have prepared the unaudited interim consolidated financial
statements and related unaudited financial information in the footnotes in
accordance with accounting principles generally accepted in the United States of
America ("GAAP")and the rules and regulations of the Securities and Exchange
Commission ("SEC") for interim financial statements. These interim financial
statements reflect all adjustments consisting of normal recurring accruals,
which, in the opinion of management, are necessary to present fairly our
consolidated financial position and the results of our operations and our cash
flows for the interim periods. You should read these consolidated financial
statements in conjunction with the financial statements and the notes thereto
contained in our Annual Report on Form 10-K for the fiscal year ended December
31, 2002. Certain amounts in such Annual Report on Form 10-K will be restated
(See Note 2). The nature of our business is such that the results of any interim
period may not be indicative of the results to be expected for the entire year.
PERVASIVENESS OF ESTIMATES
We have prepared the consolidated financial statements in accordance
with GAAP , which require us to make estimates and assumptions that affect the
reported amounts in the consolidated financial statements and accompanying
notes. The most significant and subjective of these estimates is our
determination of the adequacy of the allowance for loan losses and our
determination of the fair value of "Retained interests in loans securitized."
The significant factors susceptible to future change that have an impact on
these estimates include default rates, net interest spreads, payment rates,
liquidity/ability to finance future receivables activity and overall economic
conditions. The actual losses in our loan portfolio and the fair value of our
"Retained interests in loans securitized" as of September 30, 2003, and December
31, 2002, could materially differ from these estimates. The accompanying
unaudited consolidated financial statements do not include an adjustment to the
fair value of retained interests that might result from the inability to finance
future receivables.
COMPREHENSIVE INCOME
SFAS No. 130 "Reporting Comprehensive Income," does not apply to our
current financial results and therefore, net income equals comprehensive income.
SEGMENT REPORTING
In the third quarter of 2003, we sold our membership club and warranty
business. After the sale of this business, the Company conducts all operations
through a single segment, and as such, management no longer separately evaluates
the results of the former enhancement services segment in deciding how to
allocate resources or in evaluating performance.
9
NOTE 2 - RESTATEMENTS
The consolidated statements of income as presented for the three and
nine-month periods ended September 30, 2003 and 2002 and the consolidated
balance sheets as of September 30, 2003 and December 31, 2002 have been restated
to reflect the following:
o The valuation model and related collateral assumptions used to
estimate the fair value of the Company's "Retained interests in loans
securitized" did not properly reflect the structure of the Metris
Master Trust and related series supplements. All periods presented
have been restated to reflect the changes in the valuation model and
the related collateral assumptions. These restatements impact
"Retained interests in loans securitized," "Other receivables due from
credit card securitizations, net" and "Securitization income."
o The Company's policy for recognizing transaction costs related to the
securitization of receivables through the Metris Master Trust or
conduits was not in accordance with GAAP. Historically, these costs
had been capitalized and amortized over the estimated life of the new
debt securities. These costs are now allocated and recognized over the
initial and reinvestment periods of the respective debt securities or
Metris Master Trust financing unless the transaction results in a
loss, in which case the costs are expensed as incurred. All periods
presented have been restated to reflect the revised policy. This
restatement impacts "Other assets" and "Securitization income."
o The Company's policy for recognizing expenses related to credit card
solicitation costs was not in accordance with GAAP. Historically, the
Company had capitalized and expensed these costs over the estimated
period over which the new credit card accounts were established,
approximately three months. These costs are now expensed as incurred.
All periods presented have been restated to reflect the revised
policy. This restatement impacts "Other assets" and "Credit card
account and other product solicitation and marketing expenses."
o The Company corrected its accounting for interest rate caps purchased
in May of 2002 and forward to comply with SFAS 133, "Accounting for
Derivative Instruments and Hedging Activities," as amended, on January
1, 2001. These costs had been deferred and amortized over the
estimated life of the new debt securities. These instruments are now
recorded at fair value. All periods presented have been restated to
reflect this correction. This restatement impacts "Retained interests
in loans securitized," "Other assets" and "Securitization income."
o The Company historically recognized revenue in the month following
completion of the cancellation period, generally one month. Cash flows
related to debt waiver are now included in the valuation of the
interest-only strip receivable. All periods presented have been
restated to reflect the revised policy. This restatement impacts
"Retained interests in loans securitized," "Deferred revenue,"
"Enhancement services revenue," and "Securitization income."
o At December 31, 2001 we had $50 million of "Allowance for loan losses"
classified as valuation reserve in our "Retained interests in loans
securitized." The valuation reserve was transferred to "Allowance for
loan losses" through "Provision for loans losses" during the first
quarter of 2002. We have restated the December 31, 2001 balance sheet
and 2001 income statement and March 31, 2002 income statement to
reflect this transfer occurring during the fourth quarter of 2001.
This restatement impacts "Allowance for loan losses," "Retained
interests in loans securitized," "Provision for loan losses" and
"Securitization income."
The cumulative impact of the above restatements as of December 31, 2001 is a
$36.6 million decrease in retained earnings and consists of the following
adjustments:
Retained interests in loans securitized $ 4.6
Allowance for loan losses (50.0)
Transaction costs 6.6
Pre-paid costs (17.9)
Income tax 20.1
-----------
$ (36.6)
===========
In addition, the information provided below has been restated from the
original 9/30/03 10-Q filing to reflect certain changes (labeled "as restated")
to the Registrant's financial statements. These changes correct identified
clerical errors or conform the affected numbers to the presentation of the
Company's restated financial information being filed concurrently with the SEC
for the quarterly periods ended June 30, 2003, and March 31, 2003, and the
annual periods ended December 31, 2002, 2001 and 2000. The principal clerical
error identified was related to earnings per share in the three months ended
March 31, 2003, which was originally reported as ($0.94) per share and correctly
stated is ($1.62) per share. The conforming adjustments related primarily to
classification of items on the statement of cash flows as operating or investing
activities, the classification of items within net securitization income (note
9), and the classification of items related to interest and fee income and
provision for loan losses on loans securitized in the 2001 and 2000 income
statements.
10
In addition, we have restated certain prior-period amounts to conform
with the current period's presentation.
o In prior periods, we classified interest income, provision for loan
losses, and related credit card loan fees generated from retained
interests in loans securitized on the income statement as "Interest
Income-Credit card loans and retained interests in loans securitized,"
"Provision for loan losses" and "Credit card fees, interchange and
other credit card income." For all periods presented, these amounts
are now included in the estimation of the fair value of the
interest-only strip receivable and "Securitization income."
o In prior periods we classified spread accounts receivable in "Other
receivables due from credit card securitizations, net." For all
periods presented, we have reclassified our spread accounts receivable
from "Other receivables due from credit card securitizations, net" to
"Retained interests in loans securitized."
o In prior periods, we classified servicing income in "Net
securitization and credit card servicing income." For all periods
presented, we have reclassified these amounts to "Servicing income."
o In prior periods, income from our debt waiver product sold to
customers of Direct Merchants Bank with receivables held by Direct
Merchants Bank was included in "Enhancement services revenue." For all
periods presented we have reclassified this income to "Credit card
fees, interchange and other credit card income."
o In prior periods, we classified the liquidity reserve deposit and
other restricted cash deposits maintained at Direct Merchants Bank as
"Short-term investments." We have reclassified these items to
"Liquidity reserve deposit" for all periods presented.
o In the third quarter of 2003, we sold our membership club and warranty
business. Revenue related to this business for current and prior
periods is classified as "Enhancement services revenue." Claims
expense related to the sold business has been reclassified as "Other"
expenses for all periods presented.
o In addition to the tax effects of the pre-tax restatement amounts, the
restated presentation also reflects the revised probable amounts of
future taxable and deductible temporary differences, resulting in a
reclassification of certain deferred income taxes to current income
taxes. The effects of the reclass for each of the years ended December
31, 1998 through 2002 amounted to a reduction (addition) to deferred
income taxes of $15.1 million, $40.3 million, $23.8 million, $1.0
million, and ($16.5 million), respectively. Such reclasses did not
result in any adjustment to net income.
See Notes 3,4,6,7,8,9 and 14, all of which are impacted by these changes.
The following tables present certain captions of the consolidated
financial statements, for all periods presented, which were affected by the
restatements.
11
SEPTEMBER 30, 2003 JUNE 30,2003
------------------------------- -------------------------------
AS AS AS AS
PREVIOUSLY PREVIOUSLY PREVIOUSLY PREVIOUSLY
REPORTED RESTATED REPORTED RESTATED
-------------- -------------- -------------- --------------
BALANCE SHEETS:
ASSETS:
Short-term investments $ 206,360 $ 122,485 $ 346,963 $ 266,373
Liquidity reserve deposit -- 83,875 -- 80,590
Retained interests in loans securitized 1,533,013 -- 1,623,652 --
Less: Valuation allowance 902,606 -- 858,605 --
Net retained interests in loans securitized 630,407 857,186 765,047 852,215
Other receivables due from credit card securitizations, net 322,528 85,490 281,233 92,611
Other assets 113,327 97,042 167,783 207,397
LIABILITIES:
Accounts payable $ 67,132 $ 62,079 $ 49,996 $ 49,996
Deferred income 35,500 22,865 119,807 106,134
Accrued expenses and other liabilities 76,229 93,287 92,173 115,274
STOCKHOLDERS' EQUITY
Retained earnings $ 267,951 $ 242,037 $ 398,414 $ 327,146
MARCH 31, 2003 DECEMBER 31, 2002
------------------------------- -------------------------------
AS AS AS AS
PREVIOUSLY PREVIOUSLY PREVIOUSLY PREVIOUSLY
REPORTED RESTATED REPORTED RESTATED
-------------- -------------- -------------- --------------
BALANCE SHEETS:
ASSETS:
Short-term investments $ 412,155 $ 342,934 $ 429,419 $ 429,419
Liquidity reserve deposit -- 69,221 -- --
Retained interests in loans securitized 1,670,171 -- 1,736,912 --
Less: Valuation allowance 931,052 -- 986,517 --
Net retained interests in loans securitized 739,119 805,633 750,395 808,026
Other receivables due from credit card securitizations, net 276,134 114,347 184,220 110,471
Other assets 168,843 203,761 174,987 187,151
LIABILITIES:
Deferred income $ 138,207 $ 123,570 $ 159,267 $ 143,148
Accrued expenses and other liabilities 100,125 116,631 72,062 88,579
STOCKHOLDERS' EQUITY
Retained earnings $ 424,026 $ 361,802 $ 458,673 $ 454,321
12
DECEMBER 31,2001
-------------------------------------------------
AS AS
PREVIOUSLY PREVIOUSLY AS
REPORTED RESTATED RESTATED
-------------- -------------- -------------
BALANCE SHEETS:
ASSETS:
Short-term investments $ 134,502 $ 134,502 $ 28,055
Cash and cash equivalents 488,086 488,086 381,639
Allowance for credit card loan losses (410,159) (460,159) (460,159)
Retained interests in loans securitized 1,339,178 -- --
Less: Valuation allowance 537,499 -- --
Net retained interests in loans securitized 801,679 859,559 859,559
Other receivables due from credit card
securitizations, net 114,456 33,386 139,833
Other assets 268,155 278,634 278,634
LIABILITIES:
Deferred income $ 215,031 $ 188,735 $ 188,735
Accrued expenses and other liabilities 82,313 82,517 82,517
STOCKHOLDERS' EQUITY
Retained earnings $ 532,924 $ 496,305 $ 496,305
THREE-MONTHS ENDED THREE-MONTHS ENDED
SEPTEMBER 30,2003 SEPTEMBER 30,2002
---------------------------------------------- --------------------------
AS AS AS AS
PREVIOUSLY PREVIOUSLY PREVIOUSLY PREVIOUSLY
REPORTED RESTATED AS RESTATED REPORTED RESTATED
-------------- ------------- ------------- ------------ -----------
STATEMENTS OF INCOME:
Other operating income:
Securitization income $ -- $ 93,779 $ 93,779 $ -- $ 148,313
Servicing income on securitized/sold receivables -- 43,849 43,849 -- 51,948
Net securitization and credit card servicing
(expense) income (101,936) -- -- 71,287 --
Credit card fees, interchange and other
credit card income 15,925 17,934 17,934 20,834 19,749
Credit protection revenue 42,614 -- -- 57,730 --
Enhancement services revenue 15,835 16,549 16,549 41,887 42,957
Loss on sale of credit card loans -- (117,183) (117,183) -- --
Other operating expenses:
Credit card account and other product solicitation
and marketing expenses 19,574 19,325 19,325 48,824 47,625
Credit protection claims expense 6,944 6,585 6,585 12,370 11,452
Asset impairments, lease write-offs and severance 30,839 29,926 29,976 -- --
Other 28,604 28,965 28,965 18,358 19,279
(Loss) Income Before Income Taxes (175,776) (92,176) (92,176) (2,175) 70,251
Income tax (benefit) expense (55,444) (17,198) (17,198) (848) 25,201
Net (loss) income (120,332) (74,978) (74,978) (1,327) 45,050
(Loss) earnings per share (2.27) (1.48) (1.48) (0.19) 0.50
Diluted (loss) earnings per share (2.27) (1.48) (1.48) (0.19) 0.50
13
NINE-MONTHS ENDED NINE-MONTHS ENDED
SEPTEMBER 30,2003 SEPTEMBER 30,2002
--------------------------------------------- -----------------------------
AS AS AS AS
PREVIOUSLY PREVIOUSLY AS PREVIOUSLY PREVIOUSLY
REPORTED RESTATED RESTATED REPORTED RESTATED
-------------- -------------- ------------ -------------- --------------
STATEMENTS OF INCOME:
Provision for loan losses $ 107,838 $ 107,838 $ 107,838 $ 228,817 $ 178,817
Net interest expense after provision for loan
losses (79,942) (79,942) (79,942) (121,136) (71,137)
Other operating income:
Securitization income -- 73,516 73,516 -- 293,505
Servicing income on securitized/sold receivables -- 136,997 136,997 -- 144,515
Net securitization and credit card servicing
(expense)income (14,430) -- -- 299,929 --
Credit card fees, interchange and other
credit card income 57,828 67,713 67,713 114,593 135,946
Credit protection revenue 139,738 -- -- 179,272 --
Enhancement services revenue 97,349 99,748 99,748 110,990 113,975
Loss on sale of credit card loans -- (117,183) (117,183) -- --
Other operating expenses:
Credit card account and other product
solicitation and marketing expenses 83,766 85,045 85,045 145,569 140,502
Credit protection claims expense 27,734 26,537 26,537 38,259 34,263
Asset impairments, lease write-offs and severance 53,627 52,764 52,764 -- 9,523
Other 67,428 68,624 68,624 62,215 66,214
(Loss) Income Before Income Taxes (237,106) (257,216) (257,216) 23,999 62,220
Income tax (benefit) expense (76,112) (74,660) (74,660) 9,360 23,012
Net (loss) income (160,994) (182,556) (182,556) 14,639 39,208
(Loss) earnings per share (3.32) (3.70) (3.70) (0.22) 0.18
Diluted (loss) earnings per share (3.32) (3.70) (3.70) (0.22) 0.18
14
THREE-MONTHS ENDED THREE-MONTHS ENDED
MARCH 31, 2003 MARCH 31, 2002
----------------------------------------- --------------------------
AS AS AS AS
PREVIOUSLY PREVIOUSLY AS PREVIOUSLY PREVIOUSLY
STATEMENTS OF INCOME: REPORTED RESTATED RESTATED REPORTED RESTATED
----------- ----------- ----------- ----------- -----------
Provision for loan losses $ 44,786 $ 44,786 $ 44,786 $ 111,876 $ 61,876
Net interest expense after provision for loan
losses (31,966) (31,966) (31,966) (54,197) (4,197)
Other operating income:
Securitization (expense) income -- (37,970) (37,970) -- 102,446
Servicing income on securitized/sold receivables -- 47,813 47,813 -- 45,039
Net securitization and credit card servicing income 56,396 -- -- 157,419 --
Credit card fees, interchange and other
Credit card income 21,757 26,319 26,319 61,000 75,659
Enhancement services revenue 93,684 43,509 43,509 94,996 34,274
Other operating expenses:
Credit card account and other product solicitation
and marketing expenses 36,054 33,688 33,688 40,552 47,253
Enhancement services claims expense 13,022 -- -- 11,207 --
Credit protection claims expense -- 12,306 12,306 -- 9,179
Other 19,639 20,351 20,352 16,461 18,490
(Loss) Income Before Income Taxes (37,644) (127,441) (127,441) 84,830 72,131
Income tax (benefit) expense (12,686) (44,611) (44,611) 32,490 27,851
Net (loss) income (24,958) (82,830) (82,830) 52,340 44,280
(Loss) earnings per share (0.61) (0.94) (1.62) 0.55 0.46
Diluted (loss) earnings per share (0.61) (0.94) (1.62) 0.54 0.46
15
THREE-MONTHS ENDED THREE-MONTHS ENDED
JUNE 30, 2003 JUNE 30, 2002
---------------------------------------------- --------------------------
AS AS AS AS
PREVIOUSLY PREVIOUSLY AS PREVIOUSLY PREVIOUSLY
STATEMENTS OF INCOME: REPORTED RESTATED RESTATED REPORTED RESTATED
------------ ----------- --------- ----------- -----------
Other operating income:
Securitization income $ -- $ 17,707 $ 17,707 $ -- $ 42,746
Servicing income on securitized/sold
receivables -- 45,335 45,335 -- 47,528
Net securitization and credit card
servicing income 31,110 -- -- 71,223 --
Credit card fees, interchange and other
credit card income 20,146 23,460 23,460 32,759 40,538
Enhancement services revenue 84,954 39,690 39,690 95,649 36,744
Other operating expenses:
Credit card account and other product
solicitation and marketing expenses 28,138 32,032 32,032 56,193 45,624
Enhancement services claims expense 8,087 -- -- 15,917 --
Credit protection claims expenses -- 7,646 7,646 -- 13,632
Other 18,866 19,308 19,307 26,161 28,445
Loss Before Income Taxes (23,686) (37,599) (37,599) (58,656) (80,162)
Income tax benefit (7,982) (12,851) (12,851) (22,282) (30,040)
Net loss (15,704) (24,748) (24,748) (36,374) (50,122)
Loss per share (0.44) (0.60) (0.60) (0.74) (0.97)
Diluted loss per share (0.44) (0.60) (0.60) (0.74) (0.97)
SIX-MONTHS ENDED SIX-MONTHS ENDED
JUNE 30, 2003 JUNE 30, 2002
---------------------------------------- --------------------------------------
AS AS AS AS
PREVIOUSLY PREVIOUSLY AS PREVIOUSLY PREVIOUSLY AS
STATEMENTS OF INCOME: REPORTED RESTATED RESTATED REPORTED RESTATED RESTATED
------------ ----------- --------- ----------- ----------- --------
Provision for loan losses $ 74,819 $ 74,819 $ 74,819 $ 202,477 $ 152,477 $ 152,477
Net interest expense after provision for
loan losses (49,282) (49,282) (49,283) (102,960) (52,961) (52,961)
Other operating income:
Securitization (expense) income -- (20,263) (20,263) -- 145,192 145,192
Servicing income on securitized/sold
receivables -- 93,148 93,148 -- 92,567 92,567
Net securitization and credit card
servicing income 87,506 -- -- 228,642 -- --
Credit card fees, interchange and
other credit card income 41,903 49,779 49,779 93,759 116,197 116,197
Enhancement services revenue 178,638 83,199 83,199 190,645 71,018 71,018
Other operating expenses:
Credit card account and other product
solicitation and marketing expenses 64,192 65,720 65,720 96,745 92,877 92,877
Enhancement services claims expense 21,109 -- -- 27,124 -- --
Credit protection claims expense -- 19,952 19,952 -- 22,811 22,811
Other 38,505 39,659 39,659 42,622 46,935 46,935
(Loss) Income Before Income Taxes (61,330) (165,040) (165,040) 26,174 (8,030) (8,031)
Income tax (benefit) expense (20,668) (57,462) (57,462) 10,208 (2,189) (2,189)
Net (loss) income (40,662) (107,578) (107,578) 15,966 (5,842) (5,842)
Loss per share (1.05) (2.22) (2.22) (0.04) (0.39) (0.39)
Diluted loss per share (1.05) (2.22) (2.22) (0.04) (0.39) (0.39)
16
DECEMBER 31, 2002
------------------------------------------------
AS AS
PREVIOUSLY PREVIOUSLY AS
STATEMENTS OF INCOME: REPORTED RESTATED RESTATED
------------ ---------- ----------
Provision for loan losses $ 573,478 $ 219,805 $ 219,804
Net interest expense after provision for loan
losses (149,635) (93,919) (93,918)
Other operating income:
Securitization income -- 325,038 323,517
Servicing income on securitized/sold
receivables -- 195,214 195,214
Net securitization and credit card
servicing income 271,348 -- --
Credit card fees, interchange and other
credit card income 202,664 161,653 163,174
Enhancement services revenue 384,049 153,516 153,516
Other operating expenses:
Credit card account and other product
solicitation and marketing expenses 190,259 173,269 173,269
Enhancement Services claims expense 51,542 -- --
Credit protection claims expense -- 44,550 44,550
Other 93,221 100,215 100,216
(Loss) income before income taxes (49,781) 283 283
Income tax (benefit) expense (15,930) 1,867 1,867
Net (loss) (33,851) (1,584) (1,584)
Loss per share (1.20) (0.66) (0.66)
Diluted loss per share (1.20) (0.66) (0.66)
17
DECEMBER 31, 2001 DECEMBER 31, 2000
-------------------------------------- ------------------------------------
AS AS AS AS
PREVIOUSLY PREVIOUSLY AS PREVIOUSLY PREVIOUSLY AS
STATEMENTS OF INCOME: REPORTED RESTATED RESTATED REPORTED RESTATED RESTATED
----------- ----------- -------- ----------- ---------- ---------
Finance charge income $ -- $ 499,813 353,650 $ -- $ 546,455 $ 106,549
Credit card loans and retained interests in
loans securitized 681,503 -- -- 490,929 -- --
Federal funds and other interest income -- 15,488 15,488 -- 13,849 13,849
Federal funds sold 3,115 -- -- 9,139 -- --
Other 12,372 -- -- 4,710 -- --
Net interest income (expense) 530,710 286,125 202,861 371,772 371,770 (12,608)
Provision for loan losses 549,145 501,212 461,106 388,234 388,237 164,800
Other operating income:
Net securitization and credit card
servicing income 517,399 -- -- 444,254 -- --
Securitization income -- 606,823 650,400 -- 436,781 644,457
Servicing income on securitized/sold
receivables -- 159,074 159,074 -- 128,823 128,823
Credit card fees, interchange and other
credit card income 296,926 322,466 322,048 223,333 236,947 185,431
Enhancement services revenue 340,132 141,922 141,922 266,200 121,558 121,559
Other operating expenses:
Credit card account and other product
solicitation and marketing expenses 174,883 115,341 188,009 144,481 172,953 149,205
Credit protection claims expense -- 30,457 30,457 -- 20,811 20,811
Enhancement services claims expense 35,628 -- -- 26,431 -- --
Other 84,519 162,358 89,694 80,308 62,182 85,929
Income before income taxes 421,868 287,919 287,915 322,911 308,504 303,723
Income tax expense 161,577 113,660 113,660 124,320 119,164 117,305
Net income 245,792 160,029 160,029 195,153 185,902 185,902
Earnings per share 2.52 1.64 1.64 2.19 2.08 2.08
Diluted earnings per share 2.47 1.61 1.61 2.11 2.01 2.01
18
THREE-MONTHS ENDED THREE-MONTHS ENDED
MARCH 31, 2003 MARCH 31, 2002
----------------------------------------- ---------------------------------------
AS AS AS AS
PREVIOUSLY PREVIOUSLY PREVIOUSLY PREVIOUSLY AS
STATEMENTS OF CASH FLOWS: REPORTED RESTATED AS RESTATED REPORTED RESTATED RESTATED
------------ ------------ ------------ ------------ ------------ -----------
Net (loss) income $ (24,958) $ (82,830) $ (82,830) $ 52,340 $ 44,280 $ 44,280
Depreciation, amortization and accretion 39,254 (27,726) (36,420) 27,240 (43,787) (43,787)
Provision for loan losses 44,786 44,786 44,786 111,876 61,876 61,876
Retained interests valuation income (56,920) -- -- (7,557) -- --
Loss from credit card securitizations -- 60,714 66,209 -- 14,839 39,087
Changes in fair value of retained interests
in loans securitized -- 83,608 83,608 -- 47,817 48,868
Market loss on derivative financial
instruments -- 2,286 3,710 -- 9,272 9,272
Changes in operating assets and liabilities,
net:
Liquidity reserve deposit -- (69,221) (69,221) -- -- --
Other receivables due from credit card
securitizations, net (99,401) (3,876) (3,876) (18,825) 10,936 9,439
Accounts payable and accrued expenses 12,336 12,325 12,325 (5,384) (4,128) (4,128)
Deferred income (21,060) (19,578) (19,578) (10,503) (8,413) (8,413)
Spread accounts receivable -- (99,604) (164,549) -- (30,224) (30,224)
Other (15,946) (50,063) (42,793) 59,528 50,338 50,338
Net cash (used in) provided by operating
activities (105,132) (132,402) (191,852) 208,715 152,806 176,608
Net use of cash from sales and repayments of
securitized loans (723,527) -- -- (292,037) -- --
Net loans collected 738,427 -- -- 33,017 -- --
Net cash from loan originations and principal
collections on loans receivable -- (27,051) 32,399 -- (551,479) (228,410)
Net cash provided by investing activities 219,959 178,008 237,458 356,889 412,798 387,499
Net (Decreases)Increase in cash and
cash equivlants 24,993 (44,228) (44,228) (75,189) (75,189) (76,686)
Cash and cash equivalents at end of period 605,225 536,004 536,004 412,897 412,897 304,953
19
SIX-MONTHS ENDED SIX-MONTHS ENDED
JUNE 30, 2003 JUNE 30, 2002
---------------------------------------- ------------------------------------------
AS AS AS AS
PREVIOUSLY PREVIOUSLY AS PREVIOUSLY PREVIOUSLY AS
STATEMENTS OF CASH FLOWS: REPORTED RESTATED RESTATED REPORTED RESTATED RESTATED
------------ ------------ ---------- ------------- ------------ ----------
Net (loss) income $ (40,662) $ (107,578) $ (107,578) $ 15,966 $ (5,842) $ (5,842)
Depreciation, amortization and accretion 67,518 (86,968) (81,545) 52,374 (92,351) (92,351)
Provision for loan losses 74,819 74,819 74,819 202,477 152,477 152,477
Retained interests valuation (income)
expense (131,893) -- -- 38,126 -- --
Loss (gain) from credit card securitizations -- 117,775 123,982 -- (54,500) 20,695
Changes in fair value of retained interests
in loans securitized -- 103,898 103,897 -- 177,682 183,201
Market loss on derivative financial
instruments -- 5,086 8,161 -- 12,247 12,248
Changes in operating assets and liabilities,
net:
Liquidity reserve deposit -- (80,590) (80,590) -- -- --
Other receivables due from credit card
securitizations, net (104,500) 17,860 17,860 54,024 24,201 27,888
Accounts payable and accrued expenses (2,111) (20,930) 4,473 43,770 43,459 43,459
Deferred income (39,460) (37,014) (37,014) (17,045) (21,008) (21,008)
Spread accounts receivable -- (141,321) (201,314) -- 29,491 29,491
Other (29,477) (89,033) (67,123) 36,398 1,760 1,759
Net cash (used in) provided by
operating activities (182,978) (179,348) (219,184) 435,613 277,139 361,540
Net use of cash from sales and repayments of
securitized loans (773,955) -- -- (785,856) -- --
Net loans collected 733,600 -- -- 337,903 -- --
Net cash from loan originations and principal
collections on loans receivable -- (124,575) (84,739) -- (289,479) (370,193)
Net cash provided by investing activities 293,235 209,015 248,851 1,035,502 1,193,976 1,113,262
Net (decrease) increase in cash and
cash equivalents (113,051) (193,641) (193,641) 410,535 410,535 414,222
Cash and cash equivalents at
end of period 467,181 386,591 386,591 898,621 898,621 795,861
20
NINE-MONTHS ENDED NINE-MONTHS ENDED
SEPTEMBER 30, 2003 SEPTEMBER 30, 2002
------------------------ ---------------------------------------
AS AS AS
PREVIOUSLY AS PREVIOUSLY PREVIOUSLY AS
STATEMENTS OF CASH FLOWS: REPORTED RESTATED REPORTED RESTATED RESTATED
------------ --------- ----------- ---------- -----------
Net income $ (182,556) $(182,556) $ 14,639 $ 39,208 $ 39,208
Depreciation, amortization and accretion (121,497) (135,733) 78,775 (135,904) (135,904)
Provision for loan losses 107,838 107,838 445,378 178,817 178,817
Retained interests valuation (income) expense -- -- (89,300) -- --
Change in fair value of retained interests in loans securitized 97,156 70,333 -- 262,818 270,357
Market loss on derivative financial instruments 1,558 6,169 16,835 15,195 15,195
Spread accounts receivable (189,330) (242,290) -- 26,219 26,219
Loss (gain) from credit card securitizations 161,588 182,788 -- (103,501) 1,618
Changes in operating assets and liabilities, net:
Other receivables due from credit card
securitizations, net 24,981 24,981 39,822 28,755 26,322
Accounts payable and accrued expenses 4,450 (12,007) (12,756) (19,409) (19,409)
Deferred income (37,568) (37,568) (36,491) (37,602) (37,602)
Other (50,810) (19,305) 23,876 30,851 30,851
Net cash provided by operating activities (262,729) (315,889) 480,778 294,970 405,195
Proceeds from transfers of portfolios to the Metris Master Trust -- -- -- 2,098,022 2,098,022
Net proceeds from sales and repayments of securitized loans -- -- 163,155 -- --
Net loans originated and collected 666,480 670,965 1,258,673 -- --
Net cash from loan originations and principal
collections on loans receivable (466,289) (417,614) -- (490,386) (603,044)
Net cash provided by investing activities 764,588 817,748 1,416,221 1,602,029 1,489,371
Net (decrease) increase in cash and cash equivalents (421,820) (421,820) 602,593 602,593 600,160
Cash and cash equivalents at end of period 158,412 158,412 1,090,679 1,090,679 981,799
DECEMBER 31, 2002
----------------------------------------------------
AS AS
PREVIOUSLY PREVIOUSLY AS
STATEMENTS OF CASH FLOWS: REPORTED RESTATED RESTATED
----------- ------------ ----------
Net loss $ (33,851) $ (1,584) $ (1,584)
Depreciation, amortization and accretion 130,013 (175,314) (175,314)
(Gain) loss from credit card securitizations -- (63,246) (41,873)
Retained interests valuation income (118,953) -- --
Market loss on derivative financial instruments -- 22,562 22,562
Changes in operating assets and liabilities, net:
Fair value of retained interests in loans
securitized -- 334,540 342,080
Spread accounts receivable -- (107,220) (39,785)
Other receivables due from credit card
securitizations, net (23,680) (77,088) 29,362
Accounts payable and accrued expenses (43,476) (27,163) (27,163)
Deferred income (55,764) -- (45,587)
Other 43,871 47,314 (1,727)
Net cash (used in) provided by operating activities 499,374 459,390 308,511
Net use of cash from sales and repayments of
securitized loans (1,145,947) -- --
Net loans collected 211,458 -- --
Net cash from loan originations and principal
collections on loans receivable -- (961,940) (704,614)
Net cash provided by investing activities 1,162,727 1,135,276 1,392,602
21
DECEMBER 31, 2001
--------------------------------------------------
AS AS
PREVIOUSLY PREVIOUSLY AS
STATEMENTS OF CASH FLOWS: REPORTED RESTATED RESTATED
------------ ------------ -----------
Net income $ 245,792 $ 160,029 $ 160,029
Cumulative effect of accounting changes 14,499 -- 14,226
Depreciation, amortization and accretion 106,703 (114,967) (125,096)
Provision for loan losses 549,145 501,211 461,106
(Gain) loss from credit card securitizations -- 83,484 95,246
Retained interests valuation income (131,992) -- --
Tax benefit of options, net with common stock -- (8,988) --
Asset impairments, lease right offs and severence -- 14,499 --
Mark to market on interest rate caps -- (10,128) (10,128)
Changes in operating assets and liabilities, net:
Fair value of retained interests in loans
securitized -- (38,903) (28,069)
Spread accounts receivable -- 6,570 6,570
Other receivables due from credit card
securitizations, net (5,583) (32,498) (132,177)
Accounts payable and accrued expenses 6,446 8,603 32,370
Deferred income (20,476) (23,306) (23,306)
Other 45,878 49,344 26,990
Net cash provided by operating activities 810,412 594,950 477,761
Net use of cash from sales and repayments of
securitized loans 1,272,438 -- --
Net loans collected (2,617,045) -- --
Net cash from loan originations and principal
collections on loans receivable -- (1,475,129) (1,127,389)
Additions to property and equipment (5,706) (5,708) (5,708)
Net cash provided by investing activities (1,087,907) (881,443) (870,691)
Proceeds from issuance of common stock 17,260 26,248 26,248
Net cash used in financing activities 244,141 253,129 253,129
22
DECEMBER 31, 2000
-----------------------------------------------
AS AS
PREVIOUSLY PREVIOUSLY AS
STATEMENTS OF CASH FLOWS: REPORTED RESTATED RESTATED
------------ ------------ ----------
Net income $ 195,153 $ 185,902 $ 185,902
Depreciation, amortization and accretion 76,256 (203,244) (203,244)
Provision for loan losses 388,234 -- 164,800
Retained interests valuation income (104,710) -- --
(Gain) loss from credit card securitizations -- 77,222 77,222
Changes in operating assets and liabilities, net:
Fair value of retained interests in loans
securitized -- 61,639 97,964
Spread accounts receivable -- 6,570 79,964
Other receivables due from credit card
securitizations, net 55,240 (19,879) (14,955)
Accounts payable and accrued expenses 45,877 37,623 37,623
Deferred income 60,403 61,367 61,367
Other (53,058) (104,495) 116,529
Net cash provided by operating activities 666,833 494,380 603,630
Net proceeds from sales and repayments and repayment
of securitized loans 551,911 -- --
Net loans originated (1,976,341) -- --
Net cash from loan originations and principal
collections on loans receivable -- 1,251,977 (1,361,227)
Net cash provided by investing activities (1,705,034) (1,532,581) (1,641,831)
23
In addition, the restatements will have the following impact on the
previously reported annual information for the year ended December 31:
BASIC (LOSS) EARNINGS DILUTED (LOSS) EARNINGS
NET (LOSS) INCOME PER SHARE PER SHARES
---------------------------- --------------------------- ---------------------------
AS AS AS
PREVIOUSLY AS PREVIOUSLY AS PREVIOUSLY AS
REPORTED RESTATED REPORTED RESTATED REPORTED RESTATED
---------- -------- ---------- -------- ---------- --------
2002 (33,851) (1,584) (1.20) (0.66) (1.20) (0.66)
2001 245,792 160,029 2.52 1.64 2.47 1.61
2000 195,152 185,902 2.19 2.08 2.11 2.01
1999 64,555 109,555 (1.07) 1.50 (1.07) 1.44
1998 57,348 66,691 0.97 1.14 0.94 1.09
A summary of the Company's revised accounting policies related to
retained interests is as follows:
Upon securitization, the Company removes the applicable credit card
loans from the balance sheet and recognizes the "Retained interests in loans
securitized" at their allocated carrying value in accordance with SFAS No. 140,
"Accounting for Transfers and Servicing of Financial Assets and Extinguishments
of Liabilities-a replacement of FASB Statement No. 125" ("SFAS No. 140"). Credit
card receivables are sold to the Metris Master Trust at the inception of a
securitization series. We also sell credit card receivables to the Metris Master
Trust to replenish receivable balances that have decreased due to payments and
charge-offs. The difference between the allocated carrying value and the
proceeds from the assets sold is recorded as a gain or loss on sale and is
included in "Securitization (expense) income." At the same time, the Company
recognizes the "Retained interests in loans securitized."
The "Retained interests in loans securitized" are financial assets
measured at fair value consistent with trading securities in accordance with
SFAS No. 115, "Accounting for Certain Investments in Debt and Equity
Securities," and includes the contractual retained interests, an interest-only
strip receivable, excess transferor's interests and spread accounts receivable.
The contractual retained interests consist of non-interest bearing securities
held by the Company. The interest-only strip receivable represents the present
value of the excess of the estimated future interest and fee collections
expected to be generated by the securitized loans over the period the
securitized loans are projected to be outstanding above the interest paid on
investor certificates, credit losses, contractual servicing fees, and other
expenses. The excess transferor's interests represent principal receivables held
in the Metris Master Trust above the contractual retained interests. Spread
accounts receivable represents restricted cash reserve accounts held by the
Metris Master Trust that can be used to fund payments due to securitization
investors and credit enhancers if cash flows are insufficient. Cash held in
spread accounts is released to us if certain conditions are met or a
securitization series terminates with amounts remaining in the spread accounts.
The fair value of the "Retained interests in loans securitized" is determined
through estimated cash flows discounted at rates that reflect the level of
subordination, the projected repayment term, and risk of the securitized loans.
At least quarterly, the Company reviews its "Retained interests in
loans securitized" for changes in fair value and recognizes those changes as
"Securitization (expense) income." The changes in fair value reflect the
Company's revisions in the expected timing and amount of future cash flows. The
significant factors that affect the timing and amount of future cash flows
relate to the collateral assumptions, which include payment rate, default rate,
gross yield and discount rate.
The Company recognizes future cash flows associated with its retained
interests using the effective yield method in accordance with EITF 99-20
"Recognition of Interest Income and Impairment on Purchased and Retained
Beneficial Interests in Securitized Financial Assets." Accordingly,
"Securitization (expense) income" includes discount accretion associated with
the contractual retained interests, the excess transferor's interests, the
interest-only strip receivable, spread accounts receivable as well as the
difference in the actual excess spread received as compared to the estimated
amount recorded related to the interest-only strip. Since the Company's retained
interests are trading securities, the impairment provisions of EITF 99-20 are
not applicable.
24
Up-front transaction costs related to securitizations are allocated and
recognized over the initial and reinvestment periods unless the transaction
results in a loss, in which case, the costs are expensed as incurred and
recorded as "Securitization (expense) income."
The Company services the receivables held by the Metris Master Trust,
and receives annual servicing fees based upon the principal receivables
outstanding. "Servicing income" is recognized when earned. We consider these
fees to be adequate compensation and as a result no servicing asset or liability
is recorded.
"Other receivables due from credit card securitizations, net" primarily
represents cash accumulated in the Metris Master Trust during a month, which is
released to Metris Receivables, Inc. the following month.
25
NOTE 3 - EARNINGS PER SHARE
The following table presents the computation of basic and diluted
weighted-average shares used in the per-share calculations:
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
-------------------------------- --------------------------------
2003 2002 2003 2002
------------ ------------ ------------ ------------
Net (Loss) income $ (74,978) $ 45,050 $ (182,556) $ 39,208
Preferred dividends - Series C 10,131 9,605 29,728 28,187
------------ ------------ ------------ ------------
Net (loss) income applicable to common
stockholders $ (85,109) $ 35,445 $ (212,284) $ 11,021
============ ============ ============ ============
Weighted-average common shares outstanding 57,546 58,311 57,426 60,653
Adjustments for dilutive securities:
Assumed conversion of convertible preferred
stock (1) -- 31,263 -- --
------------ ------------ ------------ ------------
Basic common shares 57,546 89,574 57,426 60,653
Assumed exercise of outstanding stock
options (1) -- 5 -- 312
------------ ------------ ------------ ------------
Diluted common shares 57,546 89,579 57,426 60,965
============ ============ ============ ============
The convertible preferred stock is participating. The loss per share calculation
for the three- and nine-month periods ended September 30, 2003 and 2002 excludes
the assumed conversion of the convertible preferred stock and the outstanding
stock options, as they are anti-dilutive.
NOTE 4 - STOCK-BASED COMPENSATION PLANS
We recognize compensation cost for stock-based employee compensation
plans based on the difference, if any, between the quoted market price of the
stock on the date of grant and the amount an employee must pay to acquire the
stock. No expense was reflected in net income related to stock options as all
options granted had an exercise price equal to the market value of the
underlying common stock on the date of grant. We recorded $0.2 million of
amortization of deferred compensation obligation, net of related tax benefit, in
"Employee compensation" related to restricted stock granted in 2003.
Pro forma information regarding "Net (loss) income" and "Loss per
share" has been determined as if we accounted for our employee stock options
under the fair value method. The fair value of the options was estimated at the
grant date using a Black-Scholes option-pricing model. The fair value of the
options is amortized to expense over the options' vesting periods. Under the
fair value method, our net (loss) earnings and (loss) earnings per share would
have been recorded at the pro forma amounts indicated below:
26
THREE-MONTHS ENDED NINE-MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
----------------------------- ----------------------------
2003 2002 2003 2002
---------- ---------- ---------- ----------
Net (loss) income, as restated $ (74,978) $ 45,050 $ (182,556) $ 39,208
Add: Stock-based employee compensation
expense included in restated net
(loss) income, net of related tax effects 69 285 206 866
Deduct: Annual stock-based employee compensation
(benefit) expense determined based on the fair
value for all awards, net of related tax effects (9,217) 6,149 (13,974) 19,734
---------- ---------- ---------- ----------
Pro forma net (loss) income $ (65,692) $ 39,186 $ (168,376) $ 20,340
========== ========== ========== ==========
Loss per share (as restated):
Basic, as restated $ (1.48) $ 0.50 $ (3.70) $ 0.18
========== ========== ========== ==========
Basic-pro forma $ (1.32) $ 0.44 $ (3.45) $ 0.22
========== ========== ========== ==========
Diluted, as restated $ (1.48) $ 0.50 $ (3.70) $ 0.18
========== ========== ========== ==========
Diluted-pro forma $ (1.32) $ 0.44 $ (3.45) $ 0.22
========== ========== ========== ==========
Weighted-average assumptions in option valuation:
Risk-free interest rates 1.8% 3.7% 1.5% 3.7%
Dividend yields -- 1.6% -- 1.6%
Stock volatility factor 128.4% 92.9% 111.4% 92.9%
Expected life of options (in years) 2.7 6.0 3.7 6.0
The above pro forma amounts may not be representative of the effects on
restated net (loss) earnings for future periods. During the three-months ended
September 30, 2003, no equity-based compensation was granted.
NOTE 5 - ACCOUNTING CHANGES
In January 2003, FASB issued SFAS No. 148, "Accounting for Stock-Based
Compensation-Transition and Disclosure," which amends SFAS No. 123, "Accounting
for Stock-Based Compensation." SFAS No. 148 provides alternative methods of
transition for a voluntary change to the fair value based method of accounting
for stock-based employee compensation. In addition, SFAS No. 148 amends the
disclosure requirements of SFAS No. 123 to require more prominent and more
frequent disclosures in financial statements about the effects of stock-based
compensation. SFAS No. 148 requirements are effective for fiscal years ending
after December 15, 2002. The adoption of SFAS No. 148 did not have a material
impact on our financial statements.
In January 2003, FASB issued Interpretation No. 46, "Consolidation of
Variable Interest Entities," in an effort to expand upon and strengthen existing
accounting guidance that addresses when a company should include in its
financial statements the assets, liabilities and activities of another entity.
FASB Interpretation No. 46 requires a variable interest entity to be
consolidated by a company, if that company is subject to a majority of the risk
of loss from the variable interest entity activities or entitled to receive a
majority of the entity's residual returns or both. Interpretation No. 46 also
requires disclosures about variable interest entities that a company is not
required to consolidate, but in which it has a significant variable interest.
The consolidation requirements of Interpretation No. 46 apply immediately to
variable interest entities created after January 31, 2003, and apply to existing
variable interest entities in the first fiscal year or interim period ending
after December 15, 2003. Interpretation No. 46 provides a specific exemption for
entities qualifying as Qualified Special Purpose Entities as described in SFAS
No. 140, "Accounting for Transfers and Servicing of Financial Assets and
Extinguishments of Liabilities-a replacement of FASB Statement No. 125." All of
our non-consolidated entities are Qualified Special Purpose Entities under the
definition in SFAS No. 140. In December 2003, FASB issued a revision of FIN 46
to clarify some of the provisions of the original Interpretation, and to exempt
certain entities from its requirements. The revision did not change the
exemption in the original Interpretation for Qualified Special Purpose Entities.
We do not expect the adoption of this Interpretation to have a material impact
on our financial statements.
27
In April 2003, FASB issued SFAS No. 149, "Amendment of Statement 133 on
Derivative Instruments and Hedging Activities." SFAS No. 149 amends and
clarifies accounting for derivative instruments, including certain derivative
instruments embedded in other contracts, and for hedging activities under SFAS
No. 133. SFAS No. 149 is effective for contracts entered into or modified after
September 30, 2003. In addition, certain provisions relating to forward
purchases or sales of when-issued securities or other securities that do not yet
exist, should be applied to existing contracts as well as new contracts entered
into after September 30, 2003. The adoption of SFAS No. 149 did not have a
material impact on our financial statements.
In May 2003, FASB issued SFAS No. 150, "Accounting for Certain
Financial Instruments with Characteristics of both Liabilities and Equity." This
Statement establishes standards for classification and measurement of certain
instruments with characteristics of both liabilities and equity. It requires
that financial instruments within its scope be classified as a liability (or
asset in some circumstances). Many of those instruments were classified as
equity under previous accounting guidance. The statement is effective for
financial instruments entered into or modified after May 31, 2003, and otherwise
is effective at the beginning of the first interim period beginning after June
15, 2003. The adoption of SFAS No. 150 did not have a material impact on our
financial statements.
NOTE 6 - LIQUIDITY RESERVE DEPOSIT
Direct Merchants Bank has established restricted deposits with
third-party depository banks for the purpose of supporting Direct Merchants
Bank's funding needs and to satisfy banking regulators' requirements under the
Operating Agreement, dated March 18, 2003, which was modified on December 11,
2003, among Direct Merchants Bank, MCI and the Office of the Comptroller of the
Currency. These deposits are invested in short term liquid investments. As of
September 30, 2003, the balance of these deposits was $83.9 million and is
classified on the balance sheets as "Liquidity reserve deposit."
NOTE 7 - ALLOWANCE FOR LOAN LOSSES
The activity in the "Allowance for loan losses" is as follows:
THREE-MONTHS ENDED NINE-MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
-------------------------------- --------------------------------
2003 2002 2003 2002
------------ ------------ ------------ ------------
Balance at beginning of period $ 109,162 $ 275,279 $ 90,315 $ 460,159
Allowance related to assets
transferred to the Metris
Master Trust (32,784) (95,614) (36,765) (264,194)
Provision for loan losses 33,019 26,340 107,838 178,817
Principal receivables charged-off (1) (68,454) (91,509) (121,924) (271,995)
Recoveries 1,459 6,472 2,938 18,181
------------ ------------ ------------ ------------
Net principal receivables charged-off (66,995) (85,037) (118,986) (253,814)
------------ ------------ ------------ ------------
Balance at end of period $ 42,402 $ 120,968 $ 42,402 $ 120,968
============ ============ ============ ============
(1) Included in principal receivables charged-off for all periods presented is
the effect of sales of "Credit card loans" to third parties.
"Credit card loans" greater than 30 days contractually past due as of
September 30, 2003, December 31, 2002, and September 30, 2002, were $16.7
million, $7.9 million and $47.3 million, respectively.
28
NOTE 8 - RETAINED INTERESTS IN LOANS SECURITIZED
Our credit card receivables are primarily funded through asset
securitizations. As part of the asset securitizations, credit card receivables
are transferred to the Metris Master Trust, a non-consolidated, qualifying
special purpose entity that issues asset backed securities representing
undivided interests in receivables held in the Metris Master Trust and the right
to receive future collections of principal, interest and fees related to those
receivables. The senior classes of these securities are sold to third party
investors. We retain subordinated interests in the securitized receivables,
including contractual retained interests, an interest-only strip receivable,
excess transferor's interests maintained above the contractual retained
interests, and spread accounts receivable. The components of these retained
interests are recorded at their fair value.
The following table shows the fair value of the components of the
"Retained interests in loans securitized" as of September 30, 2003 and December
31, 2002.
SEPTEMBER 30, DECEMBER 31,
2003 2002
------------- ------------
Contractual retained interests $ 584,585 $ 685,197
Excess transferor's interests 56,049 57,447
Interest-only strip receivable 4,867 13,882
Spread accounts receivable 211,685 51,500
------------ ------------
Retained interests in loans securitized $ 857,186 $ 808,026
============ ============
The following table illustrates the significant assumptions used for
estimating the fair value of retained interests as of September 30, 2003 and
December 31, 2002.
SEPTEMBER 30, DECEMBER 31,
2003 2002
------------- ------------
Monthly payment rate 6.7% 6.7%
Gross yield (1) 25.3% 26.0%
Annual interest expense and servicing fees 3.9% 4.0%
Annual gross principal default rate 21.3% 21.7%
Discount rate:
Contractual retained interests 16.0% 16.0%
Excess transferor's interests 16.0% 16.0%
Interest-only strip receivable 30.0% 30.0%
Spread accounts receivable 15.3% 16.0%
(1)Includes expected cash flows from finance charges, late and
overlimit fees, debt waiver premiums and bad debt recoveries. Gross
yield for purposes of estimating fair value does not include cash
flows from interchange income, or cash advance fees.
At September 30, 2003, the sensitivity of the current fair value of the
retained interests to immediate 10% and 20% adverse changes are as follows (in
millions):
ADVERSE IMPACT ON FAIR VALUE
10% ADVERSE CHANGE 20% ADVERSE CHANGE
------------------ ------------------
Annual discount rate $ 22.5 $ 44.2
Monthly payment rate 149.3 342.9
Gross yield 127.7 266.5
Annual interest expense and servicing fees 22.5 50.1
Annual gross principal default rate 101.5 206.0
As the sensitivity indicates, the value of the Company's retained
interests on its balance sheet, as well as reported earnings, could differ
significantly if different assumptions or conditions prevail.
29
NOTE 9 - SECURITIZATION INCOME
The following summarizes "Securitization (expense) income" for the
three- and nine-month periods ended September 30, 2003 and 2002.
THREE-MONTHS ENDED NINE-MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
-------------------------------- --------------------------------
2003 2002 2003 2002
------------ ------------ ------------ ------------
Loss on new securitization of receivables to
the Metris Master Trust $ (23,015) $ -- $ (55,214) $ (70,578)
(Loss) gain on replenishment of receivables to the
Metris Master Trust (35,792) 19,078 (127,574) 68,960
Discount accretion 85,549 84,149 240,035 228,875
Change in fair value 33,564 (87,157) (70,333) (270,357)
Interest-only revenue 60,694 141,773 151,374 373,781
Transaction and other costs (27,221) (9,530) (64,772) (37,176)
------------ ------------ ------------ ------------
Securitization income $ 93,779 $ 148,313 $ 73,516 $ 293,505
============ ============ ============ ============
NOTE 10 - SALE OF MEMBERSHIP CLUB AND WARRANTY BUSINESS
On July 29, 2003, we sold our membership club and warranty business to
CPP Group, a privately-owned leading provider of assistance products and
services throughout Europe, for cash proceeds of $45 million. We recorded a gain
on the sale of $80.4 million. Included in the gain was the recognition of $82.7
million of "Deferred income" and the write-off of $36.6 million of deferred
costs, which are included in "Other assets." After the sale we have $11.0
million of "Deferred income", $7.0 million in deferred costs, and $14.2 million
of "Accrued expenses and other liabilities" on our balance sheet related to
certain obligations associated with the sold business, which will expire
throughout 2004.
NOTE 11 - SALE OF CREDIT CARD LOANS
On September 16, 2003, we sold approximately 160,000 credit card
accounts amounting to $590.9 million of "Credit card loans" to a third party for
cash proceeds of $488.3 million. The sale included $144.4 million of receivables
from Direct Merchants Bank and $446.5 million of receivables from Metris
Receivables, Inc., which were removed from the Metris Master Trust pursuant to a
random removal of account provision ("ROAP"). This was the first time we had
exercised the ROAP. Under the terms of the pooling and servicing agreement, as
amended, we are limited to one random removal of accounts per month from the
Metris Master Trust. We recorded a loss on the sale of $72.1 million, including
a write-off of purchased portfolio premium and other transaction costs. The sale
was undertaken in order to provide funding for the sale of Direct Merchants
Bank's certificates of deposit and to create additional liquidity in the Metris
Master Trust.
NOTE 12 - SALE OF CERTIFICATES OF DEPOSIT
On September 30, 2003, we sold all of the brokered and retail jumbo
certificates of deposit issued by Direct Merchants Bank. The face value of the
"Deposits" sold was $559.3 million. We recorded a loss on that sale of $33.0
million. Upon completion of the sale, we were in full compliance with a request
by the Office of the Comptroller of the Currency ("OCC") to eliminate the
deposit risk to the Federal Deposit Insurance Corporation ("FDIC") by September
30, 2003.
NOTE 13 - SUBSEQUENT EVENTS
On November 13, 2003, we sold approximately 125,000 credit card
accounts amounting to $494.3 million of "Credit card loans" to a third party for
cash proceeds of $396.5 million. Prior to the sale these credit card receivables
were held by the Metris Master Trust. During the third quarter of 2003, we
recognized the expected loss on the sale of $71.3 million, which included a
write-off of purchased portfolio premium and estimated transaction costs related
to this sale. This sale was undertaken at the request of our conduit providers.
30
On November 19, 2003, we entered into a back up servicer agreement with
a third party. The agreement is intended to ensure that the Metris Master Trust
will be serviced by a third-party should Direct Merchants Bank be unable to
provide such service. The terms of the agreement are consistent with the current
servicing agreement between the Metris Master Trust and Direct Merchants Bank.
On December 11, 2003, we entered into a Modified Operating Agreement
with the OCC, which replaced the original Operating Agreement dated March 18,
2003. The Modified Operating Agreement requires, among other things, the
following:
o The Bank must maintain capital at the dollar level reported on
the September 30, 2003, Call Report, unless otherwise approved by
the OCC. The Bank may continue to pay dividends in accordance
with applicable statutory and regulatory requirements, provided
capital remains at the aforementioned level.
o The Bank shall maintain, at a minimum, liquid assets of not less
than $35 million or 100% of the average highest daily funding
requirement for managed receivables.
o The Bank is required to continue to comply with the terms of the
Liquidity Reserve Deposit Agreement.
o The Bank and MCI are required to comply with the terms of the
Capital Assurance and Liquidity Maintenance Agreement.
If the OCC were to conclude that the Bank failed to adhere to any
provision of the Modified Operating Agreement, the OCC could pursue various
enforcement options.
NOTE 14 - INCOME TAXES
The components of the (benefit) provision for income taxes consisted of
the following:
THREE-MONTHS ENDED NINE-MONTHS ENDED
SEPTEMBER 30 SEPTEMBER 30
2003 2002 2003 2002
------------ ------------ ------------ ------------
Current:
Federal $ (41,623) $ (40,232) $ (94,179) $ (31,296)
State 797 (2,002) 148 (311)
------------ ------------ ------------ ------------
(40,826) (42,234) (94,031) (31,607)
------------ ------------ ------------ ------------
Deferred:
Federal 23,059 65,213 18,813 53,138
State 569 2,222 558 1,481
------------ ------------ ------------ ------------
23,628 67,435 19,371 54,619
------------ ------------ ------------ ------------
(Benefit) provision for
income taxes $ (17,198) $ 25,201 $ (74,660) $ 23,012
============ ============ ============ ============
A reconciliation of our effective income tax rate compared to the
statutory federal income tax rate is as follows:
THREE-MONTHS ENDED NINE-MONTHS ENDED
SEPTEMBER 30 SEPTEMBER 30
2003 2002 2003 2002
------------ ------------ ------------ ------------
Statutory federal income tax rate 35.0% 35.0% 35.0% 35.0%
State income taxes, net of federal
benefit (0.9) 0.2 (0.2) 1.2
Valuation allowance (14.5) -- (5.2) --
Other, net (0.9) 0.7 (0.6) 0.8
------------ ------------ ------------ ------------
Effective income tax rate 18.7% 35.9% 29.0% 37.0%
============ ============ ============ ============
31
Our deferred tax assets and liabilities are as follows:
SEPTEMBER 30 DECEMBER 31
2003 2002
------------ ------------
Deferred income tax assets resulting from future
deductible and taxable temporary differences:
Allowance for loan losses and retained
interests fair value adjustments $ 158,676 $ 172,299
Deferred revenues 12,031 59,042
Other 82,897 68,143
Valuation allowance (13,357) --
------------ ------------
Total deferred tax assets 240,247 299,484
------------ ------------
Deferred income tax liabilities resulting from future taxable and
deductible temporary differences:
Accrued interest on credit card loans 211,205 207,984
Deferred marketing costs 5,909 35,689
Other 21,679 34,986
------------ ------------
Total deferred tax liabilities 238,793 278,659
------------ ------------
Net deferred tax assets $ 1,454 $ 20,825
============ ============
During the third quarter of 2003, the Company recorded a $13.4 million
valuation allowance against its deferred tax assets due to uncertainties related
to the Company's realization. We believe, based on our operating earnings in
prior years and expected reversal of taxable temporary differences, the
remaining deferred tax assets are fully realizable.
In addition to the tax effects of the pre-tax restatement amounts, the
restated presentation also reflects revised probable amounts of future taxable
and deductible temporary differences, resulting in a reclassification of certain
deferred income taxes to current income taxes. The effects of the reclass for
each of the years ended December 31, 1998 though 2002 amounted to a reduction
(addition) to deferred income taxes of $15.1 million, $40.3 million, $23.8
million, $1.0 million, and ($16.5 million), respectively. Such reclasses did not
result in any adjustment to net income.
The Internal Revenue Service ("IRS") has completed its examination of
the Company's tax returns through December 31, 1998. The IRS has proposed
adjustments to increase the Company's federal income tax by $42.9 million, plus
interest of more than $16 million, pertaining to the Company's treatment of
certain credit card fees as original issue discount ("OID"). Although these fees
are primarily reported as income when billed for financial reporting purposes,
we believe the fees constitute OID and must be deferred and amortized over the
life of the underlying "Credit card loans" for tax purposes. Cumulatively
through September 30, 2003, the Company has deferred approximately $200 million
in federal income tax under the OID rules. Any assessment similar to what has
been proposed by the IRS may ultimately require the Company to pay the federal
tax plus state taxes and related interest.
The Company believes its treatment of these fees is appropriate and
continues to work with the IRS to resolve the proposed adjustments. The
Company's position on the treatment of credit card fees is consistent with that
of many other U.S. credit card issuers. We do not expect final settlement or
additional tax to be paid over the next twelve months. However, both the timing
and amount of the final resolution of this matter are uncertain.
NOTE 15 - ASSET IMPAIRMENTS, LEASEHOLD WRITE-OFFS AND SEVERANCE
During the third quarter of 2003, the Company recorded $2.6 million for
a workforce reduction, approximately $5.4 million in write-downs of excess
property, equipment, and operating leases and a $22.0 million write-off of
purchased portfolio premium on "Credit card loans" sold in the third and fourth
quarters of 2003.
32
NOTE 16 - SUPPLEMENTAL CONSOLIDATING FINANCIAL STATEMENTS
We have various indirect subsidiaries that do not guarantee Company
debt. We have prepared condensed consolidating financial statements of the
Company, the guarantor subsidiaries and the non-guarantor subsidiaries for
purposes of complying with SEC reporting requirements. Separate financial
statements of the guaranteeing subsidiaries and non-guaranteeing subsidiaries
are not presented because we have determined that the subsidiaries' financial
information would not be material to investors.
33
METRIS COMPANIES INC.
SUPPLEMENTAL CONSOLIDATING BALANCE SHEETS
SEPTEMBER 30, 2003
(DOLLARS IN THOUSANDS)
UNAUDITED
METRIS
COMPANIES GUARANTOR NON-GUARANTOR
INC. SUBSIDIARIES SUBSIDIARIES ELIMINATIONS CONSOLIDATED
----------- ------------ ------------- ------------ ------------
ASSETS:
Cash and cash equivalents $ 19,198 $ 307 $ 138,907 $ -- $ 158,412
Liquidity reserve deposit -- -- 83,875 -- 83,875
Net credit card loans (354) -- 68,874 -- 68,520
Retained interests in loans securitized -- -- 841,408 15,778 857,186
Property and equipment, net -- 39,004 35 -- 39,039
Purchased portfolio premium, net 90 -- 21,369 -- 21,459
Other receivables due from credit card
securitizations, net 5 -- 85,485 -- 85,490
Other assets 23,275 4,775 136,795 (67,803) 97,042
Investment in subsidiaries 1,255,004 859,749 -- (2,114,753) --
----------- ----------- ----------- ----------- -----------
TOTAL ASSETS $ 1,297,218 $ 903,835 $ 1,376,748 $(2,166,778) $ 1,411,023
=========== =========== =========== =========== ===========
LIABILITIES:
Deposits $ (1,000) $ -- $ 7,298 $ -- $ 6,298
Debt 394,511 -- -- (43,000) 351,511
Accounts payable 1,417 26,532 34,179 (49) 62,079
Deferred income -- -- 24,489 (1,624) 22,865
Accrued expenses and other liabilities 27,307 (377,701) 451,033 (7,352) 93,287
----------- ----------- ----------- ----------- -----------
TOTAL LIABILITIES 422,235 (351,169) 516,999 (52,025) 536,040
----------- ----------- ----------- ----------- -----------
TOTAL STOCKHOLDERS' EQUITY 874,983 1,255,004 859,749 (2,114,753) 874,983
----------- ----------- ----------- ----------- -----------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 1,297,218 $ 903,835 $ 1,376,748 $(2,166,778) $ 1,411,023
=========== =========== =========== =========== ===========
34
METRIS COMPANIES INC.
SUPPLEMENTAL CONSOLIDATING BALANCE SHEETS
DECEMBER 31, 2002 (AS RESTATED)
(DOLLARS IN THOUSANDS)
UNAUDITED
METRIS
COMPANIES GUARANTOR NON-GUARANTOR
INC. SUBSIDIARIES SUBSIDIARIES ELIMINATIONS CONSOLIDATED
----------- ------------ ------------- ------------ ------------
ASSETS:
Cash and cash equivalents $ (3,795) $ 8,109 $ 575,918 $ -- $ 580,232
Net credit card loans 3,813 -- 752,289 -- 756,102
Retained interests in loans securitized -- -- 808,026 -- 808,026
Property and equipment, net -- 63,395 20,436 -- 83,831
Purchased portfolio premium, net 128 -- 64,451 -- 64,579
Other receivables due from credit card
securitizations, net 13 -- 110,458 -- 110,471
Other assets 10,160 44,252 180,591 (47,852) 187,151
Investment in subsidiaries 1,594,352 1,549,307 -- (3,143,659) --
----------- ----------- ----------- ----------- -----------
TOTAL ASSETS $ 1,604,671 $ 1,665,063 $ 2,512,169 $(3,191,511) $ 2,590,392
=========== =========== =========== =========== ===========
LIABILITIES:
Deposits $ (1,000) $ -- $ 893,754 $ -- $ 892,754
Debt 391,228 9,421 -- (43,000) 357,649
Accounts payable 71 20,683 38,949 (6,114) 53,589
Deferred income -- 16,681 129,978 (3,511) 143,148
Accrued expenses and other liabilities 159,699 23,926 (99,819) 4,773 88,579
----------- ----------- ----------- ----------- -----------
TOTAL LIABILITIES 549,998 70,711 962,862 (47,852) 1,535,719
----------- ----------- ----------- ----------- -----------
TOTAL STOCKHOLDERS' EQUITY 1,054,673 1,594,352 1,549,307 (3,143,659) 1,054,673
----------- ----------- ----------- ----------- -----------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 1,604,671 $ 1,665,063 $ 2,512,169 $(3,191,511) $ 2,590,392
=========== =========== =========== =========== ===========
35
METRIS COMPANIES INC.
SUPPLEMENTAL CONSOLIDATING STATEMENTS OF INCOME
THREE-MONTHS ENDED SEPTEMBER 30, 2003
(DOLLARS IN THOUSANDS)
UNAUDITED
METRIS
COMPANIES GUARANTOR NON-GUARANTOR
INC. SUBSIDIARIES SUBSIDIARIES ELIMINATIONS CONSOLIDATED
--------- ------------ ------------- ------------ ------------
NET INTEREST (EXPENSE) INCOME $ (13,825) $ 2,209 $ 13,976 $ -- $ 2,360
Provision for loan losses 2,028 -- 30,991 -- 33,019
--------- --------- --------- --------- ---------
NET INTEREST (EXPENSE) INCOME AFTER PROVISION
FOR LOAN LOSSES (15,853) 2,209 (17,015) -- (30,659)
--------- --------- --------- --------- ---------
OTHER OPERATING INCOME:
Securitization income (expense) 10,307 -- 82,816 656 93,779
Servicing (expense) income on securitized/
sold receivables -- -- 43,849 -- 43,849
Credit card fees,
Interchange and other
Credit card income 721 24,903 26,802 (34,492) 17,934
Enhancement services
(expense) revenue (832) 2,923 3,131 11,327 16,549
Loss on sale of credit card loans -- -- (117,183) -- (117,183)
Gain on sale of membership
and warranty business -- 9,445 70,946 -- 80,391
Intercompany allocations 2,324 52,687 4,439 (59,450) --
--------- --------- --------- --------- ---------
12,520 89,958 114,800 (81,959) 135,319
--------- --------- --------- --------- ---------
OTHER OPERATING EXPENSE:
Credit card account and
Other product solicitation and marketing
expenses -- 13,855 26,598 (21,128) 19,325
Employee compensation -- 40,118 1,879 -- 41,997
Data processing services and communications 7 (19,609) 40,905 (4,533) 16,770
Credit protection claims expense -- -- 6,585 -- 6,585
Occupancy and equipment -- 8,660 56 -- 8,716
Purchased portfolio premium
amortization 18 -- 9,383 (1,294) 8,107
MasterCard/Visa assessment
and fees -- 2,444 -- -- 2,444
Credit card fraud losses 14 -- 974 -- 988
Asset impairments, lease write-offs and
severance -- 7,046 22,930 -- 29,976
Loss on sale of deposits -- -- 32,963 -- 32,963
Other 2,652 14,143 27,234 (15,064) 28,965
Intercompany allocations 26 19,327 40,096 (59,449) --
--------- --------- --------- --------- ---------
2,717 85,984 209,603 (101,468) 196,836
--------- --------- --------- --------- ---------
(LOSS) INCOME BEFORE INCOME TAX BENEFIT AND
EQUITY IN LOSS OF SUBSIDIARIES (6,050) 6,183 (111,818) 19,509 (92,176)
Income tax (benefit)
Expense (1,848) 2,985 (24,294) 5,959 (17,198)
Equity in loss of
Subsidiaries (70,776) (87,524) -- 158,300 --
--------- --------- --------- --------- ---------
NET (LOSS) INCOME $ (74,978) $ (84,326) $ (87,524) $ 171,850 $ (74,978)
========= ========= ========= ========= =========
36
METRIS COMPANIES INC.
SUPPLEMENTAL CONSOLIDATING STATEMENTS OF INCOME
THREE-MONTHS ENDED SEPTEMBER 30, 2002 (AS RESTATED)
(DOLLARS IN THOUSANDS)
UNAUDITED
METRIS
COMPANIES GUARANTOR NON-GUARANTOR
INC. SUBSIDIARIES SUBSIDIARIES ELIMINATIONS CONSOLIDATED
--------- ------------ ------------- ------------ ------------
NET INTEREST (EXPENSE)
INCOME $ (10,526) $ 443 $ 18,247 $ -- $ 8,164
Provision for loan losses 38 -- 25,672 630 26,340
--------- --------- --------- --------- ---------
NET INTEREST (EXPENSE)
INCOME AFTER PROVISION FOR LOAN LOSSES (10,564) 443 (7,425) (630) (18,176)
--------- --------- --------- --------- ---------
OTHER OPERATING INCOME:
Securitization (expense) income (2,903) (13) 158,171 (6,942) 148,313
Servicing income on securitized/sold
receivables -- -- 51,948 -- 51,948
Credit card fees,
Interchange and other
Credit card income 763 53,926 26,805 (61,745) 19,749
Enhancement services
Revenue -- 8,208 34,749 -- 42,957
Intercompany allocations 38 65,528 11,174 (76,740) --
--------- --------- --------- --------- ---------
(2,102) 127,649 282,847 (145,427) 262,967
--------- --------- --------- --------- ---------
OTHER OPERATING EXPENSE:
Credit card account and
Other product solicitation and
marketing expenses 15 59,880 35,863 (48,133) 47,625
Employee compensation -- 46,278 5,597 -- 51,875
Data processing services and
communications 7 (24,641) 48,442 (3,754) 20,054
Credit protection claims expense -- -- 11,452 -- 11,452
Occupancy and equipment -- 11,210 455 -- 11,665
Purchased portfolio premium
amortization -- -- 7,925 (693) 7,232
MasterCard/Visa assessment and fees -- -- 3,377 -- 3,377
Credit card fraud losses 52 -- 1,929 -- 1,981
Asset impairments, lease write-offs and
severance -- -- -- -- --
Other 38 16,117 4,323 (1,119) 19,279
Intercompany allocations 16 25,554 51,170 (76,740) --
--------- --------- --------- --------- ---------
128 134,398 170,533 (130,519) 174,540
--------- --------- --------- --------- ---------
(LOSS) INCOME BEFORE INCOME
TAXES AND EQUITY IN
INCOME OF SUBSIDIARIES (12,794) (6,306) 104,889 (15,538) 70,251
Income tax (benefit)
expense (4,590) (2,262) 37,627 (5,574) 25,201
Equity in income of subsidiaries 53,254 67,262 -- (120,516) --
--------- --------- --------- --------- ---------
NET INCOME (LOSS) $ 45,050 $ 63,218 $ 67,262 $(130,480) $ 45,050
========= ========= ========= ========= =========
37
METRIS COMPANIES INC.
SUPPLEMENTAL CONSOLIDATING STATEMENTS OF INCOME
NINE-MONTHS ENDED SEPTEMBER 30, 2003
(DOLLARS IN THOUSANDS)
UNAUDITED
METRIS GUARANTOR NON-GUARANTOR
COMPANIES INC. SUBSIDIARIES SUBSIDIARIES ELIMINATIONS CONSOLIDATED
-------------- ------------ ------------- ------------ ------------
NET INTEREST (EXPENSE)INCOME $ (31,214) $ 2,307 $ 56,803 $ -- $ 27,896
Provision for loan losses 3,414 -- 104,526 (102) 107,838
--------- --------- --------- --------- ---------
NET INTEREST (EXPENSE)
INCOME AFTER PROVISION FOR LOAN LOSSES (34,628) 2,307 (47,723) 102 (79,942)
--------- --------- --------- --------- ---------
OTHER OPERATING INCOME:
Securitization (expense)
income (147) -- 75,046 (1,383) 73,516
Servicing income on securitized/sold
receivables -- -- 136,997 -- 136,997
Credit card fees,
interchange and other
credit card income 1,811 56,450 74,729 (65,277) 67,713
Enhancement services
(expense) revenue (831) 28,647 66,623 5,309 99,748
Loss on sale of credit card loans -- -- (117,183) -- (117,183)
Gain on sale of membership and warranty
business -- -- 80,391 -- 80,391
Intercompany allocations 7,664 192,018 22,676 (222,358) --
--------- --------- --------- --------- ---------
8,497 277,115 339,279 (283,709) 341,182
--------- --------- --------- --------- ---------
OTHER OPERATING EXPENSE:
Credit card account and
other product solicitation
and marketing expenses -- 44,286 93,086 (52,327) 85,045
Employee compensation -- 128,656 12,443 -- 141,099
Data processing services and communications 12 (61,312) 124,616 (10,334) 52,982
Credit protection claims expense -- -- 26,537 -- 26,537
Occupancy and equipment -- 27,033 220 -- 27,253
Purchased portfolio premium
amortization 39 -- 24,701 (3,638) 21,102
MasterCard/Visa assessment and fees -- -- 7,090 -- 7,090
Credit card fraud losses 25 -- 2,972 -- 2,997
Asset impairments, lease write-offs and
severance 5,129 23,573 24,062 -- 52,764
Loss on sale of deposits -- -- 32,963 -- 32,963
Other 7,994 46,140 36,118 (21,628) 68,624
Intercompany allocations 61 72,373 149,924 (222,358) --
--------- --------- --------- --------- ---------
13,260 280,749 534,732 (310,285) 518,456
--------- --------- --------- --------- ---------
LOSS BEFORE INCOME TAX BENEFIT AND EQUITY IN
LOSS OF SUBSIDIARIES (39,391) (1,327) (243,176) 26,678 (257,216)
Income tax (benefit) expense (13,111) 654 (71,083) 8,880 (74,660)
Equity in loss of subsidiaries (156,276) (172,095) -- 328,371 --
--------- --------- --------- --------- ---------
NET (LOSS) INCOME $(182,556) $(174,076) $(172,093) $ 346,169 $(182,556)
========= ========= ========= ========= =========
38
METRIS COMPANIES INC.
SUPPLEMENTAL CONSOLIDATING STATEMENTS OF INCOME
NINE-MONTHS ENDED SEPTEMBER 30, 2002 (AS RESTATED)
(DOLLARS IN THOUSANDS)
UNAUDITED
METRIS GUARANTOR NON-GUARANTOR
COMPANIES INC. SUBSIDIARIES SUBSIDIARIES ELIMINATIONS CONSOLIDATED
-------------- ------------ ------------- ------------ ------------
NET INTEREST (EXPENSE)
INCOME $ (19,025) $ (1,013) $ 127,718 $ -- $ 107,680
Provision for loan losses (695) -- 178,882 630 178,817
--------- --------- --------- --------- ---------
NET INTEREST EXPENSE AFTER PROVISION FOR
LOAN LOSSES (18,330) (1,013) (51,164) (630) (71,137)
--------- --------- --------- --------- ---------
OTHER OPERATING INCOME:
Securitization income (4,645) (13) 302,157 (3,994) 293,505
Servicing(expense) income on securitized/
sold receivables -- -- 144,515 -- 144,515
Credit card fees,
Interchange and other
Credit card income 1,216 67,645 139,964 (72,879) 135,946
Enhancement services
Revenue -- 27,034 86,941 -- 113,975
Intercompany allocations 109 190,795 35,961 (226,865) --
--------- --------- --------- --------- ---------
(3,320) 285,461 709,538 (303,738) 687,941
--------- --------- --------- --------- ---------
OTHER OPERATING EXPENSE:
Credit card account and
Other product solicitation and
marketing expenses 16 76,514 112,161 (48,189) 140,502
Employee compensation (1,101) 141,199 22,690 -- 162,788
Data processing services and
communications 44 (68,013) 136,672 (5,548) 63,155
Credit protection claims expense -- -- 34,263 -- 34,263
Occupancy and equipment -- 34,415 2,338 -- 36,753
Purchased portfolio premium
amortization -- -- 25,855 (2,425) 23,430
MasterCard/Visa assessment and fees -- -- 10,794 -- 10,794
Credit card fraud losses 179 -- 6,983 -- 7,162
Asset impairments, lease write-offs and
severance -- 9,523 -- -- 9,523
Other (73) 58,445 17,232 (9,390) 66,214
Intercompany allocations 62 67,142 159,661 (226,865) --
--------- --------- --------- --------- ---------
(873) 319,225 528,649 (292,417) 554,584
--------- --------- --------- --------- ---------
(LOSS) INCOME BEFORE INCOME TAXES AND
EQUITY IN INCOME OF SUBSIDIARIES (20,777) (34,777) 129,725 (11,951) 62,220
Income tax (benefit)
Expense (7,684) (12,862) 47,979 (4,421) 23,012
Equity in income of subsidiaries 52,301 81,746 -- (134,047) --
--------- --------- --------- --------- ---------
NET INCOME (LOSS) $ 39,208 $ 59,831 $ 81,746 $(141,577) $ 39,208
========= ========= ========= ========= =========
39
METRIS COMPANIES INC.
SUPPLEMENTAL CONDENSED CONSOLIDATING STATEMENTS OF CASH FLOWS
NINE-MONTHS ENDED SEPTEMBER 30, 2003
(DOLLARS IN THOUSANDS)
UNAUDITED
METRIS GUARANTOR NON-GUARANTOR
COMPANIES INC. SUBSIDIARIES SUBSIDIARIES ELIMINATIONS CONSOLIDATED
-------------- ------------ ------------- ------------ ------------
OPERATING ACTIVITIES:
Net cash (used in) provided by operating
activities $ (213,561) $ (537,441) $ 179,601 $ 255,512 $ (315,889)
----------- ----------- ----------- ----------- -----------
INVESTING ACTIVITIES:
Net cash from loan originations and principal
collections on loans receivable 753 -- 268,376 (15,778) 253,351
Proceeds from sales of credit card
portfolios to third parties -- -- 494,784 -- 494,784
Proceeds from sale of membership club and
warranty business -- 8,100 36,900 -- 45,000
Disposals of property and equipment -- 4,403 20,210 -- 24,613
Investment in subsidiaries 230,640 707,909 -- (938,549) --
----------- ----------- ----------- ----------- -----------
Net cash provided by investing activities 231,393 720,412 820,270 (954,327) 817,748
----------- ----------- ----------- ----------- -----------
FINANCING ACTIVITIES:
Net increase (decrease) in debt 2,610 (9,421) -- -- (6,811)
Net decrease in deposits -- -- (886,456) -- (886,456)
Premiums and transaction costs on
deposits sold -- -- (32,963) -- (32,963)
Proceeds from issuance of common stock 2,551 -- -- -- 2,551
Capital contributions -- (181,352) (517,463) 698,815 --
----------- ----------- ----------- ----------- -----------
Net cash (used in) provided by financing
activities 5,161 (190,773) (1,436,882) 698,815 (923,679)
----------- ----------- ----------- ----------- -----------
Net increase (decrease) in cash and cash
equivalents 22,993 (7,802) (437,011) -- (421,820)
Cash and cash equivalents at beginning of
period (3,795) 8,109 575,918 -- 580,232
----------- ----------- ----------- ----------- -----------
Cash and cash equivalents at end of period $ 19,198 $ 307 $ 138,907 $ -- $ 158,412
=========== =========== =========== =========== ===========
40
METRIS COMPANIES INC.
SUPPLEMENTAL CONDENSED CONSOLIDATING STATEMENTS OF CASH FLOWS
NINE-MONTHS ENDED SEPTEMBER 30, 2002 (AS RESTATED)
(DOLLARS IN THOUSANDS)
UNAUDITED
METRIS GUARANTOR NON-GUARANTOR
COMPANIES INC. SUBSIDIARIES SUBSIDIARIES ELIMINATIONS CONSOLIDATED
-------------- ------------ ------------- ------------ ------------
OPERATING ACTIVITIES:
Net cash provided by operating activities $ 101,539 $ 76,161 $ 175,187 $ 52,308 $ 405,195
----------- ----------- ----------- ----------- -----------
INVESTING ACTIVITIES:
Net cash from loan originations and
principal collections on loans receivable 228 -- 1,494,750 -- 1,494,978
Additions to (disposals of) property and
equipment -- (6,650) 1,043 -- (5,607)
Investment in subsidiaries 121,398 (68,239) -- (53,159) --
----------- ----------- ----------- ----------- -----------
Net cash (used in) provided by investing
activities 121,626 (74,889) 1,608,451 (53,159) 1,489,371
----------- ----------- ----------- ----------- -----------
FINANCING ACTIVITIES:
Net increase (decrease) in debt 673 (459) (292,000) -- (291,786)
Net decrease in deposits -- -- (958,779) -- (958,779)
Cash dividends paid (2,805) -- -- -- (2,805)
Proceeds from issuance of common stock 2,681 -- -- -- 2,681
Repurchase of common stock (43,717) -- -- -- (43,717)
Capital contributions -- (336) (515) 851 --
----------- ----------- ----------- ----------- -----------
Net cash (used in) provided by financing
activities (43,168) (795) (1,251,294) 851 (1,294,406)
----------- ----------- ----------- ----------- -----------
Net increase in cash and
cash equivalents 179,997 477 419,686 -- 600,160
Cash and cash equivalents at beginning of
period 17,614 1,505 362,520 -- 381,639
----------- ----------- ----------- ----------- -----------
Cash and cash equivalents at end of period $ 197,611 $ 1,982 $ 782,206 $ -- $ 981,799
=========== =========== =========== =========== ===========
41
ITEM 2.
METRIS COMPANIES INC. AND SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
BUSINESS OVERVIEW
The following discussion and analysis provides information management
believes to be relevant to understanding the financial condition and results of
operations of the Company. You should read this discussion along with the
following documents for a full understanding of our financial condition and
results of operations: Management's Discussion and Analysis of Financial
Condition and Results of Operations in our Annual Report on Form 10-K for the
fiscal year ended December 31, 2002; and our Proxy Statement for the 2003 Annual
Meeting of Stockholders. Certain amounts in such Annual Report on Form 10-K will
be restated (see note 2, page 9). In addition, you should read this discussion
along with our condensed consolidated financial statements and related notes
thereto for the period ended September 30, 2003.
MCI was incorporated in Delaware on August 20, 1996, and completed an
initial public offering in October 1996. We provide financial products and
services to moderate-income consumers throughout the United States. Our consumer
lending products are primarily unsecured credit cards, including the Direct
Merchants Bank MasterCard(R) and Visa(R). We also offer co-branded credit cards
through partnerships with other companies. Our credit cards generate consumer
loans through Direct Merchants Bank. These loans in turn generate income and
cash flow from principal, interest and fee payments. The sales of our other
consumer financial products, such as credit protection products, generate
additional cash flow.
Our target market is particularly susceptible to changes in the
economy. Over the past few years, the economic recession experienced in the
United States has led to increased unemployment rates, increased incidences of
personal bankruptcy, and decreased consumer confidence, all of which have
challenged the Company and the near-prime consumer loan industry. In addition,
in 2001, we implemented a program to increase the credit lines of certain
customers, which put increased payment pressure on those customers. We continued
to experience the residual effects of the recent economic downturn and the 2001
credit line increase program in the third quarter of 2003 as evidenced by our
high charge-off rates. However, our primary focus continues to be on improving
asset quality and we have taken several actions over the year to ensure this
improvement, including strengthening credit line management strategies, limiting
marketing efforts to better credit quality consumers, tightening credit
authorization criteria and enhancing collection strategies. We have started to
see the results of our efforts with the Metris Master Trust two-cycle plus
delinquency rates falling from their peak of 12.05% in November 2002 to 11.04%
as of September 30, 2003. An additional key indicator of improvement is the
recent performance of the Metris Master Trust compared to the first half of
2003. The three-month average excess spread as of September 30, 2003 was 2.70%
compared to 1.94% for the second quarter. The one-month excess spread was 2.96%
as of September 30, 2003 and 3.69% as of October 31, 2003.
In January 2003, the Federal Financial Institutions Examination Council
("FFIEC") issued guidance with respect to account management, risk management,
and loss allowance practices for institutions engaged in credit card lending.
The guidance provides requirements for certain operational and accounting
policies, which are designed to bring consistency in practice between
institutions engaged in credit card lending. We continue testing alternative
approaches to comply with several aspects of this guidance, the results of which
are not expected until the second half of 2004. At this time we are unable to
provide assurance that the final implementation of any new policies will not
have a material adverse effect on our financial condition.
We continue to evaluate and modify our marketing programs to improve
the overall credit quality of the portfolio. Beginning late in 2002 and
continuing throughout 2003, we began testing pricing and line assignments for
new customers. These actions were in response to a lower interest rate
environment, increased competition in the near-prime sector and overall
tightening of our underwriting. The early results of these initiatives indicate
improved credit quality from our most recent marketing campaigns.
42
We have taken several steps to right-size our business during the third
quarter to meet the current economic situation. In July of 2003, we sold our
membership club and warranty business in order to focus our resources on our
core consumer lending business. The sale generated approximately $45 million of
cash for the Company. We reduced our managed portfolio using a combination of
decreased marketing efforts, higher account attrition, and the sale of $1.1
billion of credit card portfolios in September and November 2003. We have also
taken steps to match our workforce needs with the size of our portfolio by
eliminating approximately 380 positions throughout 2003. We will continue to
take further actions to manage our expenses and liquidity.
Our business requires a high degree of liquidity. Thus, ensuring
appropriate liquidity is, and will continue to be, at the forefront of our
business objectives. We rely heavily on the securitization of our consumer loans
for funding, primarily by selling the loans to the Metris Master Trust. Our
receivable funding needs for 2004 as of September 30, 2003 include $2.95 billion
in maturing asset-backed financing and conduits in the Metris Master Trust,
$102.5 million outstanding on our $125 million term loan due in June 2004 and
$100 million of senior notes due in November 2004. Our strategies to meet these
funding needs are portfolio attrition, the renewal of some of these facilities,
new securitizations, and asset sales as necessary. Downgrades in our credit
ratings and the historical deterioration in our asset quality have reduced our
access to funding and have resulted in higher funding costs and less favorable
terms than were previously available to us. Future downgrades in our debt
ratings or those of Direct Merchants Bank, as well as further deterioration in
our asset quality in 2002 and 2003, could continue to negatively impact our
funding capabilities.
RESTATEMENTS
The consolidated statements of income as presented for the three and
nine-month periods ended September 30, 2003 and 2002 and the consolidated
balance sheets as of September 30, 2003 and December 31, 2002 have been restated
to reflect the following:
o The valuation model and related collateral assumptions used to
determine the fair value of the Company's "Retained interests
in loans securitized" did not properly reflect the structure
of the Metris Master Trust and related series supplements. All
periods presented have been restated to reflect the changes in
the valuation model and the related collateral assumptions.
This restatement impacts "Retained interests in loans
securitized," "Other receivables due from credit card
securitizations, net" and "securitization income."
o The Company's policy for recognizing transaction costs related
to the securitization of receivables through the Metris Master
Trust or conduits was not in accordance with GAAP.
Historically, these costs had been capitalized and amortized
over the estimated life of the new debt securities. These
costs are now allocated and recognized over the initial and
reinvestment periods of the respective debt securities or
Metris Master Trust financing unless the transaction results
in a loss, in which case the costs are expensed as incurred.
All periods presented have been restated to reflect the
revised policy. These restatements impact "other assets" and
"securitization income."
o The Company's policy for recognizing expenses related to
credit card solicitation costs was not in accordance with
GAAP. Historically, the Company had capitalized and expensed
these costs over the estimated period over which the new
credit card accounts were established, approximately three
months. These costs are now expensed as incurred. All periods
presented have been restated to reflect the revised policy.
This restatement impacts "other assets" and "credit card
account and other product solicitation and marketing
expenses."
o The Company corrected its accounting for interest rate caps
purchased in May of 2002 and forward to comply with SFAS 133,
"Accounting for Derivative Instruments and Hedging
Activities," as amended, on January 1, 2001. These costs had
been deferred and amortized over the estimated life of the new
debt securities. These instruments are now recorded at fair
value. All periods presented have been restated to reflect
this correction. This restatement impacts "Retained interests
in loans securitized," "other assets" and "securitization
income."
43
o The Company historically recognized revenue in the month
following completion of the cancellation period, generally one
month. Cash flows related to debt waiver are now included in
the valuation of the interest-only strip receivable. All
periods presented have been restated to reflect the revised
policy. This restatement impacts "Retained interests in loans
securitized," "Deferred revenue," "Enhancement services
revenue," and "Securitization income."
o At December 31, 2001 we had $50 million of "Allowance for loan
losses" classified as valuation reserve in our "Retained
interests in loans securitized." The valuation reserve was
subsequently transferred to "Allowance for loan losses"
through "Provision for loans losses" during the first quarter
of 2002. We have restated the December 31, 2001 balance sheet
and 2001 income statement and March 31, 2002 income statement
to reflect this transfer occurring during the fourth quarter
of 2001. This restatement impacts "Allowance for loan losses,"
"Retained interests in loans securitized," "Provision for loan
losses" and "securitization income."
In addition, we have restated certain prior-period amounts to conform
with the current period's presentation.
o In prior periods, we classified interest income, provision for
loan losses, and related credit card loan fees generated from
retained interests in loans securitized on the income
statement as "Interest income-credit card loans and retained
interests in loans securitized," "Provision for loan losses"
and "Credit card fees, interchange and other credit card
income." For all periods presented, these amounts are now
included in the determination of the fair value of the
interest-only strip receivable and "securitization income."
o In prior periods we classified spread accounts receivable in
"Other receivables due from securitizations, net." For all
periods presented, we have reclassified our spread accounts
receivable from "Other receivables due from credit card
securitizations, net" to "Retained interests in loans
securitized."
o In prior periods, we classified servicing income in "Net
securitization and credit card servicing income." For all
periods presented, we have reclassified these amounts to
"Servicing Income."
o In prior periods, income from our debt waiver product sold to
customers of Direct Merchants Bank with receivables held by
Direct Merchants Bank was included in "Enhancement services
revenue." For all periods presented we have reclassified this
income to "Credit card fees, interchange, and other credit
card income."
o In prior periods, we classified the liquidity reserve deposit
and other restricted cash deposits maintained at Direct
Merchants Bank as "Short-term investments." We have
reclassified these items to "Liquidity reserve deposit" for
all periods presented.
o In the third quarter of 2003, we sold our membership club and
warranty business. Revenue related to this business for
current and prior periods is classified as "Enhancement
services revenue." Claims expense related to the sold business
has been reclassified as "Other" expenses for all periods
presented.
o In addition to the tax effects of the pre-tax restatement
amounts, the restated presentation also reflects revised
probable amounts of future taxable and deductible temporary
differences, resulting in a reclassification of certain
deferred income taxes to current income taxes. The effects of
the reclass for each of the years ended December 31, 1998
through 2002 amounted to a reduction (addition) to deferred
income taxes of $15.1 million, $40.3 million, $23.8 million,
$1.0 million, and ($16.5 million), respectively. Such
reclasses did not result in any adjustment to net income.
44
RESULTS OF OPERATIONS
OVERVIEW
Net loss for the three-months ended September 30, 2003, was $75.0
million compared to net income of $45.1 million for the third quarter of 2002.
Diluted loss per common share for the three-months ended September 30, 2003 was
$1.48 compared to diluted income per common share of $0.50 for the third quarter
of 2002. The $120.1 million decrease in net income is due to a $5.8 million
decrease in "Net interest income," a $6.7 million increase in "Provision for
loan losses," a $127.6 million decrease in "Other operating income" and a $22.3
million increase in "Other operating expense." Included in the third quarter
2003 results is a $74.9 million after-tax net loss consisting of special items
associated with the impacts from the sale of our membership club and warranty
business, a credit card loan portfolio sale of $590.9 million, a workforce
reduction, the sale of certificates of deposit, the write-down of certain fixed
assets and leases, and a $494.3 million credit card portfolio sale which closed
on November 13, 2003.
Net loss for the nine-months ended September 30, 2003 was $182.6
million, compared to net income of $39.2 million for the first nine-months of
2002. Diluted loss per common share for the nine-months ended September 30, 2003
was $3.70 compared to diluted income per common share of $0.18 for the
nine-months ended September 30, 2002. The $221.8 million decrease in net income
primarily relates to a $79.8 million decrease in "Net interest income," and a
$346.8 million decrease in "Other operating income" offset by a $71.0 million
decrease in "Provision for loan losses" and a $36.1 million decrease in "Other
operating expense." In addition to the $74.9 million after-tax net loss related
to the special items noted above, the nine-month period ended September 30, 2003
includes a $16.2 million after-tax charge for workforce reductions and the
write-down of certain assets and leases taken in the first and second quarters
of 2003. Included in the same nine-month period of 2002 is a $6.7 million
after-tax write-down of a portfolio of charged-off loans purchased in 2001 and
2000.
STATEMENT OF INCOME ANALYSIS
Net Interest Income
"Net interest income" consists primarily of interest earned on our
"Credit card loans," less interest expense on borrowings to fund loans. Table 1
provides an analysis of interest income and expense, net interest spread, net
interest margin and average balance sheet data for the three- and nine-month
periods ended September 30, 2003 and 2002.
45
TABLE 1: ANALYSIS OF AVERAGE BALANCES, INTEREST AND AVERAGE YIELDS AND RATES
(Dollars in thousands)
THREE-MONTHS ENDED SEPTEMBER 30,
2003 2002
--------------------------------------------- --------------------------------------------
AVERAGE YIELD/ AVERAGE YIELD/
BALANCE INTEREST RATE BALANCE INTEREST RATE
----------- ----------- ----------- ----------- ----------- -----------
ASSETS:
Interest-earning assets:
Federal funds sold $ 106,282 $ 264 1.0% $ 33,108 $ 145 1.7%
Short-term investments 395,820 958 1.0% 877,792 3,838 1.7%
Liquidity reserve deposit 83,723 184 0.9% -- -- --
Credit card loans 512,710 23,250 18.0% 874,955 27,433 12.4%
----------- ----------- ----------- ----------- ----------- -----------
Total interest-earning assets $ 1,098,535 $ 24,656 8.9% $ 1,785,855 $ 31,416 7.0%
Other assets 1,258,569 1,483,151
Allowances for loan
Losses (97,032) (172,122)
----------- -----------
Total assets $ 2,260,072 $ 3,096,884
=========== ===========
LIABILITIES AND EQUITY:
Interest-bearing liabilities:
Deposits $ 605,492 $ 7,882 5.2% $ 1,214,548 $ 14,453 4.7%
Debt 365,891 14,414 15.6% 356,306 8,799 9.8%
----------- ----------- ----------- ----------- ----------- -----------
Total interest-bearing
Liabilities $ 971,383 $ 22,296 9.1% $ 1,570,854 $ 23,252 5.9%
Other liabilities 209,404 418,070
----------- -----------
Total liabilities 1,180,787 1,988,924
Stockholders' equity 1,079,285 1,107,960
----------- -----------
Total liabilities and equity $ 2,260,072 $ 3,096,884
=========== ----------- =========== -----------
Net interest income and
Interest margin (1) $ 2,360 0.9% $ 8,164 1.8%
=========== ===========
Net interest rate spread (2) (0.2%) 1.1%
(1) We compute Interest margin by dividing annualized "Net interest income"
by average total interest-earning assets.
(2) The Net interest rate spread is the annualized yield on average
interest-earning assets minus the annualized funding rate on average
interest-bearing liabilities.
"Net interest income" decreased from $8.2 million for the three-months
ended September 30, 2002, to $2.4 million for the three-months ended September
30, 2003. The decrease is primarily due to a decrease in average
interest-earning assets of $687.3 million and a 90 basis point reduction in net
interest margin. The decrease in average interest-earning assets is primarily
due to the transfer of $686.6 million of credit card receivables to the Metris
Master Trust during the nine-months ended September 30, 2003, and the sale of
$286.7 million of receivables to third-parties since September 30, 2002. The
decrease in margin is primarily due to a 320 basis point increase in our funding
costs versus the third quarter of 2002. Overall, yield increased 190 basis
points primarily due to the 560 basis point increase in yield on "Credit card
loans." The credit card loan yield increased as a result of new account
receivables maturing and the expiration of promotional interest rates as the
portfolio ages. The increase in cost of funds is a result of higher interest
expense incurred on the term debt instruments outstanding during the respective
three-month periods.
46
TABLE 1: ANALYSIS OF AVERAGE BALANCES, INTEREST AND AVERAGE YIELDS AND RATES
(CONT.)(Dollars in thousands)
NINE-MONTHS ENDED SEPTEMBER 30,
2003 2002
------------------------------------------- ----------------------------------------
AVERAGE YIELD/ AVERAGE YIELD/
BALANCE INTEREST RATE BALANCE INTEREST RATE
----------- ----------- ----------- ----------- ----------- -----------
ASSETS:
Interest-earning assets:
Federal funds sold $ 92,417 $ 787 1.1% $ 29,937 $ 369 1.6%
Short-term investments 413,447 4,016 1.3% 544,575 7,400 1.8%
Liquidity reserve deposit 75,497 576 1.0% -- -- --
Credit card loans 650,887 82,870 17.0% 1,699,445 182,283 14.3%
----------- ----------- ----------- ----------- ----------- -----------
Total interest-earning assets $ 1,232,248 $ 88,249 9.6% $ 2,273,957 $ 190,052 11.2%
Other assets 1,346,042 1,504,374
Allowances for loan
losses (111,313) (295,742)
----------- -----------
Total assets $ 2,466,977 $ 3,482,589
=========== ===========
LIABILITIES AND EQUITY:
Interest-bearing liabilities:
Deposits $ 723,811 $ 28,387 5.2% $ 1,551,567 $ 56,440 4.9%
Debt 371,549 31,966 11.5% 387,811 25,932 8.9%
----------- ----------- ----------- ----------- ----------- -----------
Total interest-bearing
Liabilities $ 1,095,360 $ 60,353 7.4% $ 1,939,378 $ 82,372 5.7%
Other liabilities 304,226 418,009
----------- -----------
Total liabilities 1,399,586 2,357,387
Stockholders' equity 1,067,391 1,125,202
----------- -----------
Total liabilities and equity $ 2,466,977 $ 3,482,589
=========== ----------- =========== -----------
Net interest income and
Interest margin (1) $ 27,896 3.0% $ 107,680 6.3%
=========== ===========
Net interest rate spread (2) 2.2% 5.5%
(1) We compute Interest margin by dividing annualized "Net interest income"
by average total interest-earning assets.
(2) The Net interest rate spread is the annualized yield on average
interest-earning assets, minus the annualized funding rate on average
interest-bearing liabilities.
"Net interest income" decreased from $107.7 million for the nine-months
ended September 30, 2002, to $27.9 million for the nine-months ended September
30, 2003. The decrease is primarily due to a decrease in average
interest-earning assets of $1.0 billion and a 330 basis point reduction in net
interest margin. The decrease in average interest-earning assets is primarily
due to the transfer of $686.6 million of receivables to the Metris Master Trust
and the sale of $286.7 million of receivables to third-parties since September
30, 2002. The decrease in margin is primarily due to a $1.0 billion reduction in
average "Credit card loans," which has resulted in short-term, lower yielding
investments increasing to 47% of average interest-earning assets, versus 25% for
the nine-months ended September 30, 2002. In addition, we have experienced a 170
basis point increase in our funding costs compared to the same period in 2002.
Overall yield decreased 160 basis points primarily due to the shift in asset mix
to lower yielding assets, offset by a 270 basis point increase in yield on
"Credit card loans." The credit card loan yield increased as a result of the
expiration of promotional interest rates as the portfolio ages. The increase in
costs of funds is a result of higher interest expense incurred on the term debt
instruments outstanding during the respective nine-month periods.
OTHER OPERATING INCOME
"Servicing income on securitized / sold receivables" was $43.8 million
for the three-months ended September 30, 2003 compared to $51.9 million for the
same period in 2002. The decrease in servicing income of $8.1 million is caused
by a $1.6 billion reduction in average credit card loans in the Metris Master
Trust. For the nine-month period ended September 30, 2003, "Servicing income on
securitized/sold receivables" was $137.0 million compared to $144.5 million for
the nine-months ended September 30, 2002. The decrease of $7.5 million was a
result of a $0.4 billion reduction in average credit card loans in the Metris
Master Trust.
47
"Securitization income" was $93.8 million for the three-months ended
September 30, 2003, compared to $148.3 million for the same period in 2002. For
the nine-month period ended September 30, 2003, "Securitization income" was
$73.5 million compared to $293.5 million for the nine-months ended September 30,
2002. The following table details "Securitization income" for the three and
nine-month periods ended September 30, 2003 and 2002.
THREE-MONTHS ENDED NINE-MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
-------------------------------- --------------------------------
2003 2002 2003 2002
------------ ------------ ------------ ------------
Loss on new securitization of receivables to
the Metris Master Trust $ (23,015) $ -- $ (55,214) $ (70,578)
(Loss) gain on replenishment of receivables to the
Metris Master Trust (35,792) 19,078 (127,574) 68,960
Discount accretion 85,549 84,149 240,035 228,875
Change in fair value 33,564 (87,157) (70,333) (270,357)
Interest-only revenue 60,694 141,773 151,374 373,781
Transaction and other costs (27,221) (9,530) (64,772) (37,176)
------------ ------------ ------------ ------------
Securitization income $ 93,779 $ 148,313 $ 73,516 $ 293,505
============ ============ ============ ============
The significant decrease in "securitization income" in the third
quarter of 2003 versus 2002 reflects (1) the loss of $23.0 million and related
transaction costs of $16.0 million associated with the refinancing of ABS Series
2001-1, (2) a $81.1 million reduction in interest-only revenue due to a $1.4
billion reduction in receivables in the Metris Master Trust and a .94% reduction
in three-month average excess spreads between December 31, 2002 and September
30, 2003, and (3) a $35.8 million loss on replenishment of receivables and (4) a
$120.7 million increase in fair value adjustments due primarily to changes in
excess spreads, quarter over quarter.
"Credit card fees, interchange, and other credit card income" was $17.9
million compared to $19.7 million for the three-months ended September 30, 2003,
and 2002, respectively, and $67.7 million compared to $135.9 million for the
nine-months ended September 30, 2003 and 2002, respectively. The decrease for
both the three- and nine-month periods is primarily due to a decrease in average
"Credit card loans" of $362.2 million and $1.0 billion for the respective three-
and nine-month periods. Furthering this decline was an amendment to the core
transaction documents of the Metris Master Trust agreement, effective June 2002,
resulting in interchange income earned on receivables held in the Metris Master
Trust being recorded as a contribution to the excess spread of the Metris Master
Trust.
During the third quarter of 2003, we sold our membership club and
warranty business which resulted in a gain of $80.4 million. Primarily as a
result of the sale, "Other enhancement services revenue" decreased to $16.5
million for the third quarter 2003 compared to $43.0 million for the third
quarter of 2002. Included in the gain was the recognition of $82.7 million of
"Deferred income" and the write-off of $36.6 million of deferred costs, included
in "Other assets." After the sale we have $11.0 million of "Deferred income,"
$7.0 million in deferred costs, and $14.2 million of "Accrued expenses and other
liabilities" on our balance sheet related to certain obligations associated with
the sold business, which will expire throughout 2004.
OTHER OPERATING EXPENSE
"Credit card account and other product solicitation and marketing
expenses" were $19.3 million compared to $47.6 million for the three-months
ended September 30, 2003 and 2002, respectively, and $85.0 million compared to
$140.5 million for nine-months ended September 30, 2003 and 2002, respectively.
The decreases of $28.3 million and $55.5 million, respectively, over the
comparable periods in 2002 are the result of the Company incurring less
marketing expense as we implement our plan to decrease the size of our managed
credit card portfolio and exit the membership club and warranty business.
"Employee compensation" decreased $9.9 million and $21.7 million over comparable
periods in 2002, due to lower staffing levels. "Data processing services and
communications" expense decreased $3.3 million and $10.2 million for the three-
and nine-month periods ended September 30, 2003, primarily due to the reduction
in our managed credit card portfolio and a reduction in marketing efforts.
"Credit protection claims expense" decreased $4.9 million and $7.7 million for
48
the three- and nine-month periods ended September 30, 2003, primarily due to a
decrease in receivable balances covered by our debt waiver products. "Occupancy
and equipment" expense decreased $2.9 million and $9.5 million over comparable
periods in 2002 due to the reduction in facilities as a result of decreased
staffing levels.
"Purchase portfolio premium amortization" was $8.1 million for the
three-months ended September 30, 2003 compared to $7.2 million for the
three-months ended September 30, 2002. The $0.9 million increase is primarily
due to $3.0 million of additional amortization recorded for higher than expected
account attrition offset by premium run-off. "Purchase portfolio premium
amortization" for the nine-month period ended September 30, 2003 was $21.1
million compared to $23.4 million for the nine-month period ended September 30,
2002. The decrease of $2.3 million for the nine-month period is primarily due to
premium run-off, offset by the higher amortization taken in the third quarter of
2003.
"Asset impairments, lease write-offs and severance" were $30.0 million
and $52.8 million for the three- and nine-month periods ended September 30,
2003, compared to zero and $9.5 million for the same periods in 2002. In the
third quarter of 2003, we recorded $2.6 million for a workforce reduction,
approximately $5.4 million in write-downs of excess property, equipment, and
operating leases and a $22.0 million write-off of purchased portfolio premium on
"Credit card loans" sold in the third and fourth quarters of 2003. In the second
quarter of 2003, we recorded $0.9 million for a workforce reduction and wrote
off commitment fees of $5.1 million related to a backup financing facility
entered into in March of 2003, with Thomas H. Lee Equity Fund IV, L.P. During
the first quarter of 2003, we recorded approximately $12.0 million of
write-downs in excess property, equipment, and operating leases and a $4.8
million charge for a workforce reduction. In the second quarter of 2002, a
write-down of $9.5 million was taken for portfolios of charged-off loans
purchased in 2001 and 2000.
We also recorded a $33.0 million loss on the sale of Direct Merchants
Bank's certificates of deposit in the third quarter of 2003.
"Other" expense was $29.0 million compared to $19.3 million for the
three-months ended September 30, 2003 and 2002, respectively. "Other" expense
was $68.6 million compared to $66.2 million for the nine-months ended September
30, 2003 and 2002, respectively. The increases over the prior periods were
primarily due to transaction costs associated with the sale of "Credit card
loans."
ASSET QUALITY
Our delinquency and net loan charge-off rates at any point in time
reflect, among other factors, the credit risk of loans, the average age of our
various credit card account portfolios, the success of our collection efforts,
the impacts of our 2001 credit line increase program, and general economic
conditions. The average age of our credit card portfolio affects the stability
of delinquency and loss rates. In order to minimize losses, we continue to focus
our resources on refining our credit underwriting standards for new accounts and
on collections efforts.
We also use credit line assignment, customer transaction authorization
controls and account management strategies to minimize loan losses. Our internal
risk models determine initial credit lines at the time of underwriting. We
manage credit lines on an ongoing basis and adjust them based on customer usage,
risk profile, and payment patterns. We continually monitor customer accounts and
initiate appropriate collection activities when an account is delinquent or
overlimit.
Delinquencies
It is our policy to accrue interest and fee income on all credit card
accounts, except in limited circumstances, until we charge-off the account. In
November 2002, we stopped billing late fees once an account became 120 days
contractually delinquent and in March 2003, we stopped billing overlimit fees
once an account became 120 days contractually delinquent. Past due accounts are
re-aged to current status only after we receive at least three minimum payments
or the equivalent cumulative amount. Accounts can only be re-aged to current
status once every twelve months and two times every five years. Accounts
entering long-term fixed payment forbearance programs may receive a re-age upon
49
entering the debt forbearance program ("workout re-age"). Workout re-ages can
only occur after receipt of at least three consecutive minimum monthly
payments, or the equivalent cumulative amount, as defined by the debt
management program. Workout re-ages can only occur once in five years, in
accordance with FFIEC guidance. Table 2 presents the delinquency trends of our
credit card loan portfolio.
TABLE 2: LOAN DELINQUENCY
(Dollars in thousands)
SEPTEMBER 30, % OF DECEMBER 31, % OF SEPTEMBER 30, % OF
2003 TOTAL 2002 TOTAL 2002 TOTAL
------------- ----------- ------------ ----------- ------------- -----------
Loans outstanding $ 110,922 100% $ 846,417 100% $ 761,297 100%
Loans contractually
delinquent:
30 to 59 days 3,461 3.1% 1,673 0.2% 18,961 2.5%
60 to 89 days 3,811 3.4% 2,121 0.2% 14,010 1.8%
90 or more days 9,474 8.6% 4,082 0.5% 14,351 1.9%
----------- ----------- ----------- ----------- ----------- -----------
Total $ 16,746 15.1% $ 7,876 0.9% $ 47,322 6.2%
=========== =========== =========== =========== =========== ===========
As part of our overall portfolio management, we periodically sell
portfolios of delinquent credit card accounts to third-parties. These
transactions have a direct effect on our delinquency dollars and rates.
Excluding the sale of $39.9 million of 2-cycle plus delinquent assets and the
portfolio sale of approximately $144.4 million in September 2003, the
delinquency ratio would have been 22.4 percent as of September 30, 2003.
Excluding the sale of $72.5 million of 2-cycle plus delinquent assets in
December 2002, the delinquency ratio would have been 8.7 percent as of December
31, 2002. Excluding the sale of $47.6 million of 2-cycle plus delinquent assets
in September 2002, the delinquency ratio would have been 11.3 percent as of
September 30, 2002.
Net Charge-Offs
Net charge-offs are the principal amount of losses from cardholders
unwilling or unable to make minimum payments, bankrupt cardholders and deceased
cardholders, less current period recoveries. Net charge-offs exclude accrued
finance charges and fees, which are charged-off against the applicable revenue
line item at the time of charge-off. We charge-off and take accounts as a loss
within (i)60 days following formal notification of bankruptcy; (ii) at the end
of the month during which most unsecured accounts become contractually 180 days
past due; (iii) at the end of the month during which unsecured accounts that
have entered into a credit counseling or other similar debt forbearance program
and later become contractually 120 days past due; or (iv) at the end of the
month during which secured accounts become contractually 120 days past due after
first reducing the loss by the secured deposit.
Charge-offs due to bankruptcies were $6.6 million, representing 9.7% of
total gross charge-offs for the three-month period ended September 30, 2003, and
$12.7 million, representing 13.9% of total gross charge-offs for the three-month
period ended September 30, 2002. Charge-offs due to bankruptcies were $18.9
million, representing 15.5% of total gross charge-offs for the nine-month period
ended September 30, 2003, and $54.6 million, representing 20.1% of total gross
charge-offs for the nine-month period ended September 30, 2002. We charge-off
accounts that are identified as fraud losses no later than 90 days after
discovery. We enter into forward flow agreements with third-parties for the sale
of a majority of charged-off credit card loans. We also refer some charged-off
accounts to our recovery unit for coordination of collection efforts to recover
the amounts owed. When appropriate, we place accounts with external collection
agencies or attorneys.
TABLE 3: NET CHARGE-OFFS
(Dollars in thousands)
THREE-MONTHS ENDED NINE-MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
2003 2002 2003 2002
----------- ----------- ----------- -----------
Average credit card loans $ 512,710 $ 874,955 $ 650,887 $ 1,699,445
Net charge-offs 66,995 85,037 118,986 253,814
Net charge-off ratio 51.8% 38.6% 24.4% 20.0%
=========== =========== =========== ===========
50
As part of our overall portfolio management, we periodically sell
portfolios of delinquent credit card accounts. These transactions have a direct
effect on our charge-off dollars and rates as any reduction in the loan's value
is reflected as a charge-off. We sold $39.9 million of 2-cycle plus delinquent
assets in September 2003 and $47.6 million of 2-cycle plus delinquent assets in
September 2002. The effects of the portfolio sales of delinquent assets and the
sale on September 16, 2003 of $144.4 million of receivables from Direct
Merchants Bank are included in the net charge-off rates presented in Table 3.
Provision and Allowance for Loan Losses
We record provision for loan losses in amounts necessary to maintain
the allowance at a level sufficient to absorb probable loan losses inherent in
the existing loan portfolio as of the balance sheet date.
In order to mitigate credit losses, we have focused our collection
efforts to aggressively address any potential delinquency dollar and severity
increases. If a cardholder experiencing payment difficulties qualifies, we also
leverage debt forbearance programs and credit counseling services. These
programs include reduced interest rates, reduced or suspended fees and other
incentives to induce the customer to continue making payments. The amount of
customer receivables in debt forbearance programs was $5.9 million or 5.3% of
total "Credit card loans" as of September 30, 2003, compared to $34.7 million or
4.1% of total "Credit card loans" as of December 31, 2002. All delinquent
receivables in debt forbearance programs are included in Table 2.
The "Provision for loan losses" was $33.0 million and $107.8 million
for the three- and nine-month periods ended September 30, 2003, compared to a
provision of $26.3 million and $178.8 million for the same periods in 2002. The
increase in the "Provision for loan losses" in the third quarter of 2003,
compared to the same period in 2002 reflects the credit quality of the remaining
"Credit card loans" at Direct Merchants Bank. The decrease in the "Provision for
loan losses" for the nine-month period ended September 30, 2003, versus the
first nine-months of 2002 is mainly due to the decrease in credit card loan
balances. The "Allowance for loan losses" was $42.4 million as of September 30,
2003, versus $90.3 million as of December 31, 2002. Our roll-rate analysis,
including judgmental factors, indicated our required "Allowance for loan losses"
was in the range of $35 million to $40 million as of September 30, 2003, versus
$75 million to $90 million as of December 31, 2002. The ratio of "Allowance for
loan losses" to period-end "Credit card loans" was 38.2% at September 30, 2003,
compared to 10.7% at December 31, 2002. The increase in this rate relates to the
deteriorated credit quality of "Credit card loans" remaining at Direct Merchants
Bank.
We believe the "Allowance for loan losses" is adequate to cover
probable losses inherent in the loan portfolio under current conditions.
However, we cannot give assurance as to future credit losses that may be
incurred in connection with our loan portfolio, nor can we provide assurance
that the established "Allowance for loan losses" will be sufficient to absorb
future losses.
Valuation of Retained Interests in Loans Securitized
Our credit card receivables are primarily funded through asset securitizations.
Upon securitization, the Company removes the applicable credit card loans from
the balance sheet and recognizes the retained interests in loans securitized at
their allocated carrying value in accordance with SFAS No. 140, "Accounting for
Transfers and Servicing of Financial Assets and Extinguishments of Liabilities-a
replacement of FASB Statement No. 125" ("SFAS No. 140"). Assets are sold to the
Metris Master Trust at the inception of a securitization series. We also sell
receivables to the Metris Master Trust on a daily basis to replenish receivable
balances that have decreased due to payments and charge-offs. The difference
between the allocated carrying value and the proceeds from the assets sold is
recorded as a gain or loss on sale and is included in "Securitization (expense)
income." At the same time, the Company recognizes the "Retained interests in
loans securitized." The "Retained interests in loans securitized" are financial
assets measured at fair value consistent with trading securities in accordance
with SFAS No. 115, "Accounting for Certain Investments in Debt and Equity
Securities," and includes the contractual retained interests, an interest-only
strip receivable, excess transferor's interests and spread accounts receivable.
The contractual retained interests consist of non-interest bearing securities
51
held by the Company. The interest-only strip receivable represents the present
value of the excess of the estimated future interest and fee collections
expected to be generated by the securitized loans over the period the
securitized loans are projected to be outstanding above the interest paid on
investor certificates, credit losses, contractual servicing fees, and other
expenses. The excess transferor's interests represent principal receivables
held in the Metris Master Trust over the contractual retained interests. Spread
accounts receivable represents restricted cash reserve accounts held by the
Metris Master Trust that can be used to fund payments due to securitization
investors and credit enhancers if cash flows are insufficient. Cash held in
spread accounts is released to us if certain conditions are met or a
securitization series terminates with amounts remaining in the spread accounts.
The fair value of the "Retained interests in loans securitized" is determined
through estimated cash flows discounted at rates that reflect the level of
subordination, the projected repayment term, and the credit risk of the
securitized loans.
The following summarizes our "Retained interests in loans securitized"
as of September 30, 2003 and December 31, 2002.
TABLE 4: RETAINED INTERESTS IN LOANS SECURITIZED
(In thousands): SEPTEMBER 30, DECEMBER 31,
2003 2002
------------- ---------------
Contractual retained interests $ 584,585 $ 685,197
Excess transferor's interests 56,049 57,447
Interest-only strip receivable 4,867 13,882
Spread accounts receivable 211,685 51,500
------------- ---------------
Retained interests in loans securitized $ 857,186 $ 808,026
============= ===============
"Retained interests in loans securitized" increased by $49.2 million
between December 31, 2002, and September 30, 2003, to $857.2 million. The
increase is primarily due to a $160.2 million increase in spread accounts
receivable offset by a $100.6 million decrease in contractual retained interests
and a $9.0 million reduction in the interest-only strip receivable.
The contractual retained interests decreased $100.6 million from
December 31, 2002, to September 30, 2003, primarily due to the sale of
receivables to a third-party in the third quarter of 2003, attrition in the
securitized loan portfolio and a valuation adjustment associated with the sale
of receivables to a third party in the fourth quarter partially offset by higher
enhancement levels required by recent securitization agreements. The
interest-only strip receivable decreased to $4.9 million as of September 30,
2003, from $13.9 million as of December 31, 2002, due to lower projected excess
spreads from the receivables held in the Metris Master Trust. The projected
excess spreads have decreased primarily due to expected decreases in yield
partially offset by expected decreases in principal default rates. Spread
accounts receivable increased over December 31, 2002, as all excess spread
earned on receivables held in the Metris Master Trust is being restricted from
release to the Company due to the performance of the receivables. For more
information on restricted cash see the Liquidity, Funding and Capital section of
the Management Discussion and Analysis on pages 37 through 41.
At least quarterly, the Company adjusts the valuation of the "Retained
interests in loans securitized" to reflect changes in the amount and expected
timing of future cash flows. The significant factors that affect the timing and
amount of cash flows relate to the collateral assumptions, which include payment
rate, default rate, gross yield and discount rate. These values can, and will,
vary as a result of changes in the amount and timing of the cash flows and the
underlying economic assumptions. The components of retained interests are
recorded at their estimated fair value. (See Critical Accounting Estimates on
page 54 for more information on the valuation of the retained interests). The
significant assumptions used for estimating the fair value of the "Retained
interests in loans securitized" are as follows:
52
TABLE 5: SIGNIFICANT ASSUMPTIONS USED FOR ESTIMATING THE FAIR VALUE OF RETAINED
INTERESTS
SEPTEMBER 30, DECEMBER 31,
2003 2002
------------- ------------
Monthly payment rate 6.7% 6.7%
Gross yield (1) 25.3% 26.0%
Annual interest expense and servicing fees 3.9% 4.0%
Annual gross principal default rate 21.3% 21.7%
Discount rate:
Contractual retained interests 16.0% 16.0%
Excess transferor's interests 16.0% 16.0%
Interest-only strip receivable 30.0% 30.0%
Spread accounts receivable 15.3% 16.0%
(1) Includes expected cash flows from finance charges, late and overlimit fees,
debt waiver premiums and bad debt recoveries. Gross yield for purposes of
estimating fair value does not include interchange income, or cash advance fees.
In the third quarter of 2003, we repurchased $446.5 million of randomly
selected credit card loans from the Metris Master Trust and subsequently sold
the assets to a third-party. The sale was undertaken to generate liquidity
needed to fund the sale of certificates of deposit in order to comply with a
request by the OCC to eliminate federally insured "Deposits" at Direct Merchants
Bank, or the risk thereof to the FDIC, by September 30, 2003, and to create
additional liquidity in the Metris Master Trust. In addition, at the direction
of our conduit providers to reduce outstanding balances on November 13, 2003, we
repurchased and subsequently sold to a third-party an additional $494.3 million
of randomly selected credit card loans from the Metris Master Trust to create
additional liquidity by reducing outstanding conduit borrowings and to lower
2004 funding requirements. The proceeds from both sale transactions were less
than the valuation determined under the discounted cash flow methodology we use
in establishing the fair value of our "Retained interests in loans securitized."
These sales were necessary transactions given the Company's current liquidity
position and financing market conditions. We do not believe the sale prices in
the September and November sales are representative of the overall fair value of
our remaining "Retained interests in loans securitized," and therefore these two
events were factored separately into our retained interests valuations.
BALANCE SHEET ANALYSIS
Cash and Cash Equivalents
"Cash and cash equivalents" decreased $421.8 million to $158.4 million
as of September 30, 2003, compared to $580.2 million as of December 31, 2002.
The decrease is primarily due to the $559.3 million of cash used to fund the
sale of certificates of deposit during the third quarter of 2003, offset by
sales of receivables from Direct Merchants Bank to the Metris Master Trust and
other third-parties.
Credit Card Loans
"Credit card loans" were $110.9 million as of September 30, 2003,
compared to $846.4 million as of December 31, 2002. The $735.5 million decrease
is primarily a result of the sale of $686.6 million in "Credit card loans" sold
from Direct Merchants Bank to the Metris Master Trust. In addition there was
$213.3 million in "Credit card loans" sold to third-parties in the nine-month
period ended September 30, 2003.
Property and equipment
"Property and equipment, net" decreased to $39.0 million at September
30, 2003, primarily due to the sale of our Arizona facility in the second
quarter for cash proceeds of $19.3 million and the third quarter sale of other
assets for proceeds of $5.9 million, which were used to pay-down outstanding
debt. Additional decreases occurred from the write-down of excess leasehold
improvements, and furniture and fixtures.
53
Purchased Portfolio Premium
"Purchased portfolio premium" decreased to $21.5 million at September
30, 2003, from $64.6 million at December 31, 2002. The $43.1 million decrease
was due primarily to sales of credit card loans to third parties during the
third and fourth quarters of 2003.
Other Assets
"Other assets" decreased from $187.2 million at December 31, 2002 to
$97.0 million at September 30, 2003. The decrease is primarily due to the $66.8
million in deferred marketing costs related to the sold membership club and
warranty business.
Deposits
"Deposits" decreased $886.5 million to $6.3 million as of September 30,
2003, from $892.8 million as of December 31, 2002. The decrease relates to
$327.2 million of "Deposits" run-off during the first nine-months of 2003, and
the sale of $559.3 million of certificates of deposit on September 30, 2003. The
balance remaining at September 30, 2003, represents customer "Deposits" on
secured credit cards.
Deferred Income
"Deferred income" decreased $120.2 million to $22.9 million as of
September 30, 2003, compared to $143.1 million as of December 31, 2002. The
decrease primarily relates to the recognition of $82.7 million of "Deferred
income" as a result of the sale of our membership club and warranty business,
and a decrease in covered receivables under our debt waiver product resulting in
lower "Deferred income."
CRITICAL ACCOUNTING ESTIMATES
The Company's most significant accounting estimates are our
determination of the "Allowance for loan losses" and the valuation of "Retained
interests in loans securitized."
Allowance for Loan Losses
We maintain an "Allowance for loan losses" sufficient to absorb
probable loan losses inherent in the credit card loan portfolio as of the
balance sheet date. The "Allowance for loan losses" results in a reserve
approximating 18 months future charge-offs for subprime receivables and 13
months future charge-offs for prime receivables. At the time of charge-off, all
principal balances are written off against the allowance and all fees and
finance charges are netted against the applicable income statement line item.
The allowance is based on management's consideration of all relevant factors
including management's assessment of applicable economic and seasonal trends.
We segment the loan portfolio into several individual liquidating pools
with similar credit risk characteristics, and estimate (based on historical
experience for similar pools and existing environmental conditions) the dollar
amount of principal, accrued finance charges and fees that will charge-off. We
then aggregate these pools into prime and subprime portfolios based on the
prescribed FICO score cuts, credit counseling programs and various pools of
other receivables. We also isolate other potentially higher risk segments such
as accounts that are over their credit limit by more than 10%, accounts in
suspended status under our debt waiver benefits and accounts of other programs
as deemed necessary. We separately analyze the reserve requirement on each of
these groups or portfolios.
We continually evaluate the homogenous liquidating risk pools employing
a roll-rate model which uses historical delinquency levels and pay-down levels
(12 months of historical data, with influence given to the last six months'
performance to capture current economic and seasonal trends), loan seasoning and
other measures of asset quality to estimate charge-offs for both credit losses
and bankruptcy losses.
Additionally, in evaluating the adequacy of the loan loss reserves, we
consider several subjective factors which may be overlaid into the credit risk
roll-rate model in determining the necessary loan loss reserve, including:
54
o national and economic trends and business conditions,
including the condition of various market segments;
o changes in lending policies and procedures, including those
for underwriting, collection, charge-off and recovery, as well
as the experience, ability and depth of lending management and
staff;
o trends in volume and the product pricing of accounts,
including any concentrations of credit; and
o impacts from external factors - such as changes in
competition, and legal and regulatory requirements - on the
level of estimated credit losses in the current portfolio.
Significant changes in these factors could impact our financial
projections and thereby affect the adequacy of our "Allowance for loan losses."
Valuation of Retained Interests in Loans Securitized
The "Retained interests in loans securitized" on our balance sheet
associated with our securitization transactions includes contractual retained
interests, transferor's interests, interest-only strip receivable, and spread
accounts receivable. We determine the fair value of each component of the
"Retained interests in loans securitized" at the time a securitization
transaction or replenishment sale is completed using a discounted cash flow
valuation model and on a quarterly basis thereafter. Any change in the fair
value is recorded in "Securitization income."
The discounted cash flow valuation is limited to the receivables that
exist and have been sold to the Metris Master Trust. Therefore, the model
assumes current principal receivable balances amortize with no new sales,
interchange fees or cash advances. The future cash flows are modeled in
accordance with the debt series' legal documents and are applied to all series
on a pro-rata basis. Excess fee income, finance charge and recovery cash flows
above contractual expense payments are first applied to meet spread accounts
receivable requirements then returned to us as part of the interest-only strip
receivable. We determine upper and lower valuation limits of the "Retained
interests in loans securitized" based on historical and forecasted excess
spreads. We then determine the best estimate within the range based on
historical trends (weighted heavily toward the low end of the range), adjusted
when appropriate, for portfolio forecast information.
The contractual retained interests represent the subordinated
securities held by us. There is no stated interest/coupon rate associated with
these securities and they are not rated. They are subordinate to all other
securities, except for the interest-only strip receivable we own and
accordingly, are repaid last. Their fair value is determined by discounting the
expected future cash flows using a discount rate commensurate with the risks of
the underlying assets and the expected timing based on the scheduled maturity
date for the underlying securitization. If these securities are recoverable
based on the Metris Master Trust forecasts, cash flows related to the entire
subordinated principal balance are used in determining their fair value.
Transferor's interests represent undivided interests in receivables
that are not pledged to support a specific security series or class and
represent our interest in the excess principal receivables held in the Metris
Master Trust. The fair value is determined in the same manner as the contractual
retained interests and is discounted based on twelve months to maturity. We have
subordinated our rights to the excess cash flows on the principal receivables
underlying the transferor's interest, thus they are included in the value of the
interest-only strip receivable. Spread accounts receivable balances represent
cash held by the Metris Master Trust trustee due to Trust performance and
requisite reserves required by certain security series. These balances earn
interest and the change in fair value is determined in the same manner as the
contractual retained interests.
55
The interest-only strip receivable represents the contractual right to
receive from the Metris Master Trust interest and other fee revenue less certain
costs over the estimated life of the underlying debt securities. The fair value
is determined by discounting the expected future cash flows using a discount
rate commensurate with the risks of the underlying assets and the expected
timing of the amortization inherent in the retained interests valuation model.
We believe our discount rates are consistent with what other market place
participants would use to determine the fair value of these assets. The
valuation model assumes that we repurchase the outstanding principal receivables
at face value according to the clean up call provisions contained in the
respective security series' legal documents.
We use certain assumptions and estimates in determining the fair values
of "Retained interests in loans securitized." These assumptions and estimates
include estimated principal payments, credit losses, gross yield, interest
expense, fees, the timing of cash receipts, and discount rates commensurate with
the risks of the underlying assets. On a quarterly basis, we review and adjust
as appropriate the assumptions and estimates used in our model based on a
variety of internal and external factors, including national and economic trends
and business conditions, current lending policies, procedures and strategies,
historical trends and assumptions about future trends, competition and legal and
regulatory requirements. Significant estimates are required in determining these
factors and different judgments concerning these factors can result in a
material impact on our balance sheet and income statement. The accompanying
unaudited consolidated financial statements do not include an adjustment to the
fair value of retained interests that might result from the inability to finance
future receivables.
LIQUIDITY, FUNDING AND CAPITAL RESOURCES
One of our primary financial goals is to maintain an adequate level of
liquidity through active management of assets and liabilities. Liquidity
management is a dynamic process, affected by changes in the characteristics of
our assets and liabilities and short- and long-term interest rates. We use a
variety of financing sources to manage liquidity, funding, and interest rate
risks. Table 6 summarizes our funding and liquidity as of September 30, 2003 and
December 31, 2002.
56
TABLE 6: LIQUIDITY, FUNDING AND CAPITAL RESOURCES
(In thousands)
SEPTEMBER 30, 2003 DECEMBER 31, 2002
------------------------------------------- ------------------------------------------
DMCCB OTHER CONSOLIDATED DMCCB OTHER CONSOLIDATED
------------ ------------ ------------ ------------ ------------ ------------
Cash and due from
banks $ 37,091 $ (1,164) $ 35,927 $ 58,399 $ 4,414 $ 62,813
Federal funds
sold -- -- -- 88,000 -- 88,000
Short-term
investments 69,292 53,193 122,485 322,039 107,380 429,419
------------ ------------ ------------ ------------ ------------ ------------
Total cash and cash
equivalents $ 106,383 $ 52,029 $ 158,412 $ 468,438 $ 111,794 $ 580,232
============ ============ ============ ============ ============ ============
SEPTEMBER 30, 2003 DECEMBER 31, 2002
--------------------------------- -------------------------------
UNUSED UNUSED
ON-BALANCE SHEET FUNDING OUTSTANDING CAPACITY OUTSTANDING CAPACITY
-------------- -------------- -------------- ------------
Revolving credit line -
Expired in July 2003 $ -- $ -- $ -- $ 162,696
Term loan - Expired in June
2003 -- N/A 100,000 N/A
10% senior notes - November
2004 100,000 N/A 100,000 N/A
10.125% senior notes -
July 2006 147,497 N/A 146,824 N/A
Term loan - June 2004 102,500 N/A -- --
Other 1,514 N/A 10,825 N/A
Deposits 6,298 N/A 892,754 N/A
-------------- -------------- -------------- ------------
Subtotal $ 357,809 $ -- $ 1,250,403 $ 162,696
57
TABLE 6: LIQUIDITY, FUNDING AND CAPITAL RESOURCES (CONT.)
OFF-BALANCE SHEET FUNDING
Metris Master Trust:
Term asset-backed
securitizations -
various maturities
through January 2009 $ 6,400,000 $ -- $ 7,610,000 $ --
Conduits - maturing
March 2004 720,000 130,000 1,177,957 422,043
Amortizing term series -
maturing February 2004 227,200 -- -- --
Metris facility - Expired in
March 2003 -- -- 48,900 26,100
----------- ----------- ----------- -----------
Subtotal 7,347,200 130,000 8,836,857 448,143
----------- ----------- ----------- -----------
Total $ 7,705,009 $ 130,000 $10,087,260 $ 610,839
=========== =========== =========== ===========
The Company is bound by certain financing covenants and capital
requirements. The most significant covenants and requirements are related to the
Metris Master Trust, the term loan due June 2004 and Direct Merchants Bank's
capital requirements. The significant covenants related to the Metris Master
Trust are discussed on page 60. The covenants related to the term loan due June
2004 are included in the Credit Agreement as filed July 11, 2003 on Form 8-K.
Direct Merchants Bank's capital requirements are discussed on page 61.
During 2003, Direct Merchants Bank has declared and paid $190.8 million
of dividends indirectly to Metris Companies Inc.
Our contractual cash obligations during the next twelve months as of
September 30, 2003, are as follows:
TABLE 7: CONTRACTUAL CASH OBLIGATIONS:
(In thousands):
Long-term debt $ 103,015
Operating leases 11,266
Deposits 6,298
---------
Total $ 120,579
=========
In addition to the contractual cash obligations, open-to-buy on credit
card accounts as of September 30, 2003, were $9.1 billion.
As of September 30, 2003, $2.5 billion of off-balance sheet funding in
the Metris Master Trust is scheduled to amortize over the next twelve months. We
base the amortization amounts on estimated amortization periods, which are
subject to change based on the Metris Master Trust performance.
During the next twelve months we have contractual cash obligations of
$120.6 million and off-balance sheet funding scheduled to amortize of $2.5
billion. We base the amortization amounts on estimated amortization periods,
which are subject to change based on the Metris Master Trust performance. We
have historically utilized a variety of funding vehicles, as well as ongoing
cash generated from operations, to finance "Credit card loans," maturing debt
obligations and general operating needs. On November 13, 2003 we repurchased
$494.3 million of randomly selected credit card loans from the Metris Master
Trust and subsequently sold the assets to a third-party in order to create
additional liquidity in the Metris Master Trust. In addition, during the next
twelve months we intend to reduce outstanding "Credit card loans" in the Metris
Master Trust through lower credit card account acquisitions, attrition in the
portfolio and third-party sales as necessary. This reduction in the size of the
portfolio will significantly reduce our need for additional financing facilities
or the issuance of new asset-backed securities.
58
We believe that we will be able to obtain the requisite funding that
will provide us with adequate liquidity to meet anticipated cash needs. We have
approximately $213 million of equity and $106 million of cash, cash equivalents
and marketable securities at Direct Merchants Bank as of September 30, 2003. A
portion of this cash is available, upon approval of regulatory authorities, to
assist in the Company's financing needs. The Company is currently reviewing
alternatives to refinancing the $102 million term loan due June 2004, the $100
million of 10% senior notes due in November 2004 and the $850 million of
conduits maturing on March 15, 2004. Furthermore, the Company has received a
commitment from a group of banks to provide an amortizing term series financing
of $500 million maturing May 3, 2004 to defease a $500 million term asset-backed
securitization (Series 1999-1) that began an accumulation period on March 1,
2004. However, no assurance can be given either that we will be able to obtain
all future funding requirements or as to the terms and costs of any funding
obtained. If we are unable to obtain funding from a Third party, we would be
able to fund the accumulation with operating cash for a period of approximately
two weeks. Recent downgrades in our credit ratings and the deterioration in our
asset quality have reduced our access to funding and have resulted in higher
funding costs and less favorable terms than were previously available to us.
Future downgrades in our debt ratings or those of our banking subsidiary, as
well as further deterioration in our asset quality, could continue to negatively
impact our funding capabilities.
The following table shows the annualized yields, defaults, costs and
excess spreads for the Metris Master Trust on a cash basis:
TABLE 8: ANALYSIS OF ANNUALIZED YIELDS, DEFAULTS, COSTS AND EXCESS SPREADS
(Dollars in thousands) THREE-MONTHS ENDED SEPTEMBER 30,
2003 2002
-------- --------
Gross yield (1) $577,801 26.38% $692,604 26.71%
Annual principal defaults 438,779 20.03% 425,406 16.40%
-------- -------- -------- --------
Net portfolio yield 139,022 6.35% 267,198 10.31%
Annual interest expense and servicing fees 76,252 3.65% 104,010 4.30%
-------- -------- -------- --------
Net excess spread $ 62,770 2.70% $163,188 6.01%
======== ======== ======== ========
(Dollars in thousands) NINE-MONTHS ENDED SEPTEMBER 30,
2003 2002
-------- --------
Gross yield (1) $1,844,344 26.99% $1,895,294 26.44%
Annual principal defaults 1,424,371 20.84% 1,113,041 15.53%
---------- -------- ---------- --------
Net portfolio yield 419,973 6.15% 782,253 10.91%
Annual interest expense and servicing fees 247,996 3.82% 310,360 4.46%
---------- -------- ---------- --------
Net excess spread $ 171,977 2.33% $ 471,893 6.45%
========== ======== ========== ========
(1) Includes cash flows from finance charges, late, overlimit and cash
advance fees, bad debt recoveries, interchange income and debt waiver
fees, less finance charge and fee charge-offs.
The Metris Master Trust and the associated off-balance sheet debt
provide for early amortization if certain events occur. These events are
described in the core transaction documents of each securitization transaction.
Significant events may include (i) three-month average excess spreads below
levels between 0.0% and 1.0%, (ii) negative transferor's interest within the
Metris Master Trust or (iii) failure to fund during an accumulation period for a
maturing term asset-backed securitization. In addition, there are various
provisions ("triggers") within our Series Supplements that, when triggered,
restrict the release of cash to us. The cash is held in spread accounts by the
Metris Master Trust trustee. This restricted cash provides additional security
to the investors in the Metris Master Trust. We reflect cash restricted from
release by the Metris Master Trust in "Retained interests in loans securitized"
in the consolidated balance sheets (see discussion of spread accounts receivable
in Note 2 on page 10). The triggers are primarily related to the performance of
the Metris Master Trust, in particular the average of net excess spread over a
one to three-month period.
The cash restricted from release is limited to the amount of excess
spread generated in the Metris Master Trust on a cash basis. During periods of
lower excess spreads, the required amount of cash to be restricted in the Metris
Master Trust may not be achieved. During those periods, all excess cash normally
released to Metris Receivables, Inc. ("MRI") will be restricted from release.
Once the maximum amount of cash required to be restricted is restricted from
59
release or excess spreads improve, cash can again be released to us. Based on
the performance of the Metris Master Trust, the amount of cash required to be
restricted was $436 million at September 30, 2003, and $304 million at December
31, 2002. As of September 30, 2003, $231.7 million has been restricted from
release due to performance, $21.4 million has been restricted from release due
to corporate debt ratings at the inception of the securitization transactions,
$12.2 million has been restricted from release for defeasance, and $18.6 million
has been restricted from release for maturity reserves. As of December 31, 2002,
$29.1 million had been restricted from release in the Metris Master Trust due to
performance and $21.4 million had been restricted from release due to corporate
debt ratings at the inception of the securitization transactions. The $202.6
million increase in cash restricted due to performance for the period ended
September 30,2003 was funded by approximately $172.0 million of net excess cash
generated by the Metris Master Trust being restricted from release and
approximately $30.6 million that was funded by us as additional enhancement on
new transactions. We expect continued restrictions on the release of a
significant portion of our cash basis excess spread throughout 2004.
On March 17, 2003, we obtained a $425 million extension through March
2004 of an $850 million conduit financing which was scheduled to mature in June
of 2003. We also secured a $425 million conduit financing through March 2004,
which replaced conduits and warehouse facilities that matured during March
through May 2003. Furthermore, these conduits provided for the financing of a
term asset-backed securitization that matured in July 2003. The continued
availability of funding under these facilities is subject to various conditions,
including a minimum three-month average excess spread of 1%. Finally, as
required under one of the conduit facilities, we obtained an amortizing term
series financing of $622.2 million maturing March 2004 to replace a $610 million
term asset-backed securitization that began an accumulation period on November
1, 2003.
On March 31, 2003, Thomas H. Lee Equity Fund IV, L.P. ("THL Fund IV")
committed to provide a term loan to the Company in an aggregate amount of $125
million as a backup financing facility, secured by assets of the Company. On
June 27, 2003, the term loan commitment was terminated and replaced with a $125
million senior secured loan funded by a consortium of lenders. With the
termination of the THL Fund IV commitment, we wrote off $5.1 million of
capitalized commitment fees.
The $125 million senior secured loan was issued pursuant to an Amended
and Restated Senior Secured Credit Agreement dated as of June 18, 2003, as
amended, and effective as of June 27, 2003(the "Credit Agreement"). The loan
matures June 27, 2004, and carries a fixed interest rate of 12% plus a monthly
performance payment, which is indexed to the monthly excess spread in the Metris
Master Trust. The funds were primarily used to pay off a $100 million term loan
that matured in June of 2003. The terms of the Credit Agreement under which the
loan was issued require mandatory prepayment of a portion of the principal if
the Company receives funds due to the sale of certain Company assets. During the
third quarter of 2003 we were required to make a $22.5 million principal
repayment from the proceeds of the sale of our membership club and warranty
business. Since that time we have made additional principal paydowns of
approximately $6 million. We are bound by certain covenants under the Credit
Agreement, as amended. As of September 30, 2003, we were in compliance with all
covenants under the Credit Agreement, as amended. In addition, under that
agreement dividends declared and paid by Direct Merchants Bank indirectly to MCI
are limited to the Bank's earnings not to exceed $20 million per calendar
quarter.
The Internal Revenue Service ("IRS") has completed its examination of
the Company's tax returns through December 31, 1998. The IRS has proposed
adjustments to increase the Company's federal income tax by $42.9 million, plus
interest of more than $16 million, pertaining to the Company's treatment of
certain credit card fees as original issue discount ("OID"). Although these fees
are primarily reported as income when billed for financial reporting purposes,
we believe the fees constitute OID and must be deferred and amortized over the
life of the underlying "Credit card loans" for tax purposes. Cumulatively
through September 30, 2003, the Company has deferred approximately $200 million
in federal income tax under the OID rules. Any assessment similar to what has
been proposed by the IRS may ultimately require payment by the Company of the
federal tax plus state taxes and related interest.
60
The Company believes its treatment of these fees is appropriate and
continues to work with the IRS to resolve the proposed adjustments. The
Company's position on the treatment of credit card fees is consistent with that
of many other U.S. credit card issuers. We do not expect final settlement or
additional tax to be paid over the next twelve months. However, both the timing
and amount of the final resolution of this matter are uncertain.
In July of 2003, the OCC requested and Direct Merchants Bank agreed to
eliminate federally insured "Deposits" at the Bank, or the risk thereof to the
FDIC, by September 30, 2003. The Bank sold $559.3 million of insured
certificates of deposit on September 30, 2003, utilizing a combination of cash
on hand, cash generated through the sale of assets to a third-party, and sales
of assets to MCI, in order to fully comply with the OCC's request. The sale of
the certificates of deposit resulted in a loss of approximately $33 million.
DIRECT MERCHANTS BANK CAPITAL ADEQUACY
In the normal course of business, Direct Merchants Bank enters into
agreements, or is subject to regulatory requirements, that result in cash, debt,
dividend or other capital restrictions.
The Federal Reserve Act imposes various legal limitations on the extent
to which banks can finance or otherwise supply funds to their affiliates. In
particular, Direct Merchants Bank is subject to certain restrictions on
transactions with MCI and its affiliates including any extensions of credit or
other covered transactions, such as certain purchases of assets. Bank regulatory
laws limit or prohibit Direct Merchants Bank's ability to lend or provide credit
support to MCI and its affiliates. Additionally, Direct Merchants Bank is
limited in its ability to declare dividends indirectly to MCI in accordance with
the National Bank Act dividend provisions.
Direct Merchants Bank is subject to certain capital adequacy guidelines
adopted by the OCC. At September 30, 2003, and December 31, 2002, Direct
Merchants Bank's Tier 1 risk-based capital ratio, risk-based total capital ratio
and Tier 1 leverage ratio exceeded the minimum required capital levels, as
illustrated in Table 9.
The Bank is also subject to capital requirements under its December 11,
2003 Modified Operating Agreement with the OCC discussed below under "Regulatory
Matters." In accordance with the Modified Operating Agreement, in future
quarters the Bank must maintain capital at the dollar level as reported on the
September 30, 2003 Call Report unless otherwise approved by the OCC. Direct
Merchants Bank's capital ratio as of September 30, 2003, was 156.4% and the Bank
was considered a "well-capitalized" depository institution under regulations of
the OCC (including FFIEC subprime guidelines).
Under capital adequacy guidelines and the regulatory framework for
prompt corrective action, Direct Merchants Bank must meet specific capital
guidelines that involve quantitative measures of assets, liabilities and certain
off-balance-sheet items as calculated under regulatory accounting practices. The
Bank's capital amounts and classification are also subject to qualitative
judgments by the regulators about components, risk weightings and other factors.
Quantitative measures established by regulation to ensure capital
adequacy require Direct Merchants Bank to maintain minimum amounts and ratios
(set forth in Table 9) of total and Tier 1 capital (as defined in the
regulations) to risk-weighted assets (as defined), and of Tier 1 leverage
capital (as defined) to average assets (as defined). Failure to meet minimum
capital requirements can result in certain mandatory and/or discretionary
actions by regulators that, if undertaken, could have a direct material adverse
effect on our financial statements.
Additional information about Direct Merchants Bank's actual capital
amounts and ratios are presented in the following table:
61
TABLE 9: CAPITAL RATIOS
(Dollars in thousands) TO BE
ADEQUATELY TO BE WELL
ACTUAL CAPITALIZED CAPITALIZED
------ ----------- -----------
As of September 30, 2003 AMOUNT RATIO AMOUNT RATIO AMOUNT RATIO
-------- ----- -------- ----- -------- -----
Total Capital $211,557 156.4% $ 10,821 8.0% $ 13,527 10.0%
(to risk-weighted assets)
Tier 1 Capital 209,392 154.8% 5,411 4.0% 8,116 6.0%
(to risk-weighted assets)
Tier 1 Capital 209,392 20.7% 40,373 4.0% 50,466 5.0%
(to average assets)
(Dollars in thousands) TO BE
ADEQUATELY TO BE WELL
ACTUAL CAPITALIZED CAPITALIZED
------ ----------- -----------
As of December 31, 2002 AMOUNT RATIO AMOUNT RATIO AMOUNT RATIO
-------- ----- -------- ----- -------- -----
Total Capital $402,721 30.8% $104,516 8.0% $130,645 10.0%
(to risk-weighted assets)
Tier 1 Capital 385,480 29.5% 52,258 4.0% 78,387 6.0%
(to risk-weighted assets)
Tier 1 Capital 385,480 24.7% 63,381 4.0% 79,977 5.0%
(to average assets)
REGULATORY MATTERS
On March 18, 2003, we entered into an Operating Agreement with the OCC.
The terms of the Operating Agreement required Direct Merchants Bank and MCI to
enter into a Capital Assurance and Liquidity Maintenance Agreement ("CALMA")
which also was executed on March 18, 2003. The effect of the CALMA is to
potentially require MCI to make such capital infusions or provide Direct
Merchants Bank with financial assistance so as to permit Direct Merchants Bank
to meet its liquidity requirements. Although the Operating Agreement was
terminated and replaced with a Modified Operating Agreement, effective December
11, 2003, the CALMA is still in place and effective between Direct Merchants
Bank and MCI.
In compliance with the Operating Agreement, Direct Merchants Bank, has
established restricted deposits with third-party depository banks for the
purpose of supporting Direct Merchants Bank's funding needs. These deposits are
invested in cash and cash equivalents. As of September 30, 2003, the balance of
these deposits was $83.9 million and is classified on the balance sheets as
"Liquidity reserve deposit."
On December 11, 2003, we entered into a Modified Operating Agreement
with the OCC, which replaced the original Operating Agreement dated March 18,
2003. The Modified Operating Agreement requires, among other things, the
following:
o The Bank must maintain capital at the dollar level reported on
the September 30, 2003, Call Report, unless otherwise approved
by the OCC. The Bank may continue to pay dividends in
accordance with applicable statutory and regulatory
requirements, provided capital remains at the aforementioned
level.
o The Bank shall maintain, at a minimum, liquid assets of not
less than $35 million or 100% of the average highest daily
funding requirement for managed receivables.
o The Bank is required to continue to comply with the terms of
the Liquidity Reserve Deposit Agreement and the CALMA.
o The Bank and MCI are required to comply with the terms of the
CALMA.
62
If the OCC were to conclude that the Bank failed to adhere to any
provision of the Modified Operating Agreement, the OCC could pursue various
enforcement options.
In July 2003, the OCC requested and Direct Merchants Bank agreed to
eliminate federally insured "Deposits" at the Bank, or the risk thereof to the
FDIC, by September 30, 2003. The Bank eliminated $559.3 million of insured
"Deposits" on September 30, 2003, utilizing a combination of cash on hand, cash
generated through the sale of assets to a third-party, and sales of assets to
MCI.
On August 5, 2003, we received notification from the SEC that we are
the subject of a formal, nonpublic investigation. We believe that this
investigation initially related primarily to the Company's treatment of its
"Allowance for loan losses" in 2001, and subsequent years, the Company's 2001
credit line increase program and other related matters. On December 9, 2003, we
received notification that the scope of the investigation was expanded to
include matters related to our valuation of "Retained interests in loans
securitized." The Company subsequently has received additional SEC subpoenas and
requests for information on related and other financial accounting and the above
matters. The SEC has advised us that this is a fact-finding inquiry and that it
has not reached any conclusions related to this matter. We are responding fully
to the SEC in its investigation.
FORWARD-LOOKING STATEMENTS
This Quarterly Report on Form 10-Q contains certain forward-looking
statements within the meaning of Section 27A of the Securities Act of 1933, as
amended, and Section 21E of the Securities Exchange Act of 1934, as amended,
which are subject to the "safe harbor" created by those sections.
Forward-looking statements include, without limitation: expressions of the
"belief," "anticipation," "intent," or "expectations" of management; statements
and information as to our strategies and objectives; return on equity; changes
in our managed loan portfolio; net interest margins; funding costs; liquidity;
cash flow; operating costs and marketing expenses; delinquencies and charge-offs
and industry comparisons or projections; statements as to industry trends or
future results of operations of the Company and its subsidiaries; and other
statements that are not historical fact. Forward-looking statements may be
identified by the use of terminology such as "may," "will," "believes," "does
not believe," "no reason to believe," "expects," "plans," "intends,"
"estimates," "anticipated," or "anticipates" and similar expressions, as they
relate to the Company or our management. Forward-looking statements are based on
certain assumptions by management and are subject to risks and uncertainties
that could cause actual results to differ materially from those in the
forward-looking statements.
These risks and uncertainties include, but are not limited to, our high
liquidity requirement; our higher delinquency rate, credit loss rates and
charge-off rates of our "Credit card loans;" the higher charge-off and
bankruptcy rates of the Company's target market of moderate-income consumers;
the success and impact of our existing or modified strategic initiatives; the
effect of the restatement of the Company's financial statements discussed
herein, risks associated with Direct Merchants Bank's ability to comply with its
agreement with regulators regarding the safety and soundness of its operations;
interest rate risks; risks associated with acquired portfolios; dependence on
the securitization markets and other funding sources to fund our business,
including the refinancing of existing indebtedness; the effects of the
previously announced SEC investigation, government policy and regulation,
whether of general applicability or specific to us, including restrictions
and/or limitations relating to our minimum capital requirements, reserving
methodologies, dividend policies and payments, growth, and/or underwriting
criteria; reduced funding availability and increased funding costs; privacy laws
that could result in lower revenue generated from fewer marketing campaigns
and/or penalties for non-compliance; and general economic conditions that can
have a negative impact on the performance of loans and marketing of credit
protection and other enhancement services.
These and other risks and uncertainties are discussed in "Legal
Proceedings" (page 67), "Management's Discussion and Analysis of Financial
Condition and Results of Operations" (pages 42-65) and "Quantitative and
Qualitative Disclosures About Market Risk" (page 66). Although we have attempted
to list comprehensively the major risks and uncertainties, other factors may in
the future prove to be important in causing actual results to differ materially
from those contained in any forward-looking statement. Readers are cautioned not
to place undue reliance on any forward-looking statement, which speaks only as
63
of the date thereof, and are reminded that they are not guarantees of future
performance of the Company. We undertake no obligation to update any
forward-looking statements, whether as a result of new information, future
events or otherwise.
SELECTED OPERATING DATA - MANAGED BASIS
In addition to analyzing the Company's performance on an owned basis,
we analyze the Company's financial performance on a managed loan portfolio
basis. On a managed basis, the balance sheets and income statements include
other investors' interests in securitized loans that are not assets of the
Company, thereby reversing the effects of sale accounting under SFAS No. 140,
"Accounting for Transfers and Servicing of Financial Assets and Extinguishments
of Liabilities." We believe this information is meaningful to the reader of the
financial statements. We service the receivables that have been securitized and
sold, and we own the right to the cash flows from those receivables sold in
excess of amounts owed to security holders.
The following information is NOT in conformity with accounting
principles generally accepted in the United States of America; however, we
believe the information is relevant to understanding the overall financial
condition and results of operations of the Company.
TABLE 10: MANAGED LOAN PORTFOLIO
(Dollars in thousands) SEPTEMBER 30, % OF DECEMBER 31, % OF SEPTEMBER 30, % OF
2003 TOTAL 2002 TOTAL 2002 TOTAL
------------- ----- ------------ ----- ------------- -----
PERIOD-END BALANCES:
Credit card loans $ 110,922 $ 846,417 $ 761,297
Receivables held in the
Metris Master Trust 8,880,214 10,573,769 10,915,438
------------- ------------ -------------
Managed $ 8,991,136 $ 11,420,186 $ 11,676,735
============= ============ =============
Loans contractually delinquent:
Credit card loans 16,746 15.1% 7,876 0.9% 47,322 6.2%
Receivables held in the
Metris Master Trust 980,930 11.0% 1,252,073 11.8% 1,201,849 11.0%
------------- ------------ -------------
Managed $ 997,676 11.1% $ 1,259,949 11.0% $ 1,249,171 10.7%
============= ============ =============
(Dollars in thousands) THREE-MONTHS ENDED NINE-MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------- -------------
2003 2002 2003 2002
------------ ------------ ----------- ------------
AVERAGE BALANCES:
Credit card loans $ 512,710 $ 874,955 $ 650,887 $ 1,699,445
Receivables held in the Metris Master
Trust 9,417,277 11,032,628 9,903,679 10,285,621
------------ ------------ ----------- ------------
Managed $ 9,929,987 $ 11,907,583 $10,554,566 $ 11,985,066
============ ============ =========== ============
NET CHARGE-OFFS:
Credit card loans $ 66,995 51.8% $ 85,037 38.6% $ 118,986 24.4% $ 253,814 20.0%
Receivables held in the Metris Master
Trust 505,856 21.4% 402,608 14.5% 1,447,256 19.6% 1,061,008 13.8%
------------ ------------ ----------- ------------
Managed $ 572,851 23.0% $ 487,645 16.2% $ 1,566,242 19.9% $ 1,314,822 14.7%
============ ============ =========== ===========
The increase in the managed delinquency rates as of September 30, 2003,
over December 31, 2002, and September 30, 2002, reflects various factors,
including declining credit card loan balances, the residual effect of the past
deterioration in the economy and the impact of our 2001 credit line increase
program. The 2001 credit line increase program added payment pressure to our
customers due to increased average outstanding balances, which require higher
monthly payments. These factors have made our collections efforts more
difficult, resulting in higher delinquencies. In addition, as part of our
overall portfolio management, we sell portfolios of delinquent credit card
accounts. These transactions have a direct effect on delinquency dollars and
rates. Excluding the sale of $39.9 million of 2-cycle plus delinquent assets and
the portfolio sale of $590.9 million on a managed basis in September 2003, the
managed delinquency ratio would have been 11.4 percent as of September 30, 2003.
Excluding the sale of $72.5 million of 2-cycle plus delinquent assets in
December 2002, the managed delinquency ratio would have been 11.6 percent as of
64
December 31, 2002. Excluding the sale of $47.6 million of 2-cycle plus
delinquent assets in September 2002, the managed delinquency ratio would have
been 11.0 percent as of September 30, 2002.
Total managed loans decreased $2.4 billion to $9.0 billion as of
September 30, 2003, compared to $11.4 billion as of December 31, 2002. This was
primarily due to a reduction in credit lines, tighter underwriting standards
implemented in 2002, fewer new accounts, increased charged-off receivables and
the sale of credit card loans to third-parties. The amount of credit card loans
in debt forbearance programs was $769.3 million or 8.6% of total managed loans
as of September 30, 2003, compared with $860.1 million or 7.5% of managed loans
as of December 31, 2002. All delinquent receivables in debt forbearance programs
are included in Table 10.
Managed net charge-offs increased $85.2 million and $251.4 million for
the three- and nine-month periods ended September 30, 2003, compared to the same
periods in 2002, primarily due to the impact of the 2001 credit line increase
program and the residual effect of the past deterioration in the economy. In
addition, as part of our overall portfolio management, we sell portfolios of
delinquent credit card accounts. These transactions have a direct effect on
charge-off dollars and rates as any reduction in the loan's value is reflected
as a charge-off. We sold $39.9 million of 2-cycle plus delinquent assets in
September 2003 and $47.6 million of 2-cycle plus delinquent assets in September
2002. The effects of these transactions as well as the sale on September 16,
2003 of $590.9 million of receivables from Direct Merchants Bank and the Metris
Master Trust are included in the delinquency and net charge-off rates presented
in Table 10.
We charge-off bankrupt accounts within 60 days following formal
notification. Charge-offs due to bankruptcies were $171.9 million, representing
28.6% of total managed gross charge-offs for the three-months ended September
30, 2003, and $177.5 million, representing 34.1% of total managed gross
charge-offs for the three-months ended September 30, 2002. Charge-offs due to
bankruptcies were $539.1 million, representing 32.7% of total managed gross
charge-offs for the nine-months ended September 30, 2003, and $463.3 million,
representing 33.3% of total managed gross charge-offs for the nine-months ended
September 30, 2002. In addition to those bankrupt accounts that were
charged-off, we received formal notification of $80.3 million and $102.1 million
of managed bankrupt accounts as of September 30, 2003, and 2002, respectively.
Net Interest Income
TABLE 11: ANALYSIS OF AVERAGE BALANCES, INTEREST AND AVERAGE YIELDS AND RATES
(Dollars in thousands) THREE-MONTHS ENDED NINE-MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
2003 2002 2003 2002
----------- ----------- ----------- -----------
Average interest-earning assets:
Owned $ 1,098,535 $ 1,785,855 $ 1,232,248 $ 2,273,957
Receivables held in the Metris Master Trust 9,417,277 11,032,628 9,903,679 10,285,621
----------- ----------- ----------- -----------
Managed $10,515,812 $12,818,483 $11,135,927 $12,559,578
=========== =========== =========== ===========
Net interest income:
Owned $ 2,360 $ 8,164 $ 27,896 $ 107,680
Receivables held in the Metris Master Trust 361,986 446,172 1,148,737 1,213,804
----------- ----------- ----------- -----------
Managed $ 364,346 $ 454,336 $ 1,176,633 $ 1,321,484
=========== =========== =========== ===========
Net interest margin (1):
Owned 0.9% 1.8% 3.0% 6.3%
Receivables held in the Metris Master Trust 15.3% 16.0% 15.5% 15.8%
Managed 13.7% 14.1% 14.1% 14.1%
(1) We compute net interest margin by dividing annualized net interest income by
average total interest-earning assets.
65
Managed net interest income decreased $90.0 million and $144.9 million
for the three- and nine-month periods ended September 30, 2003, compared to the
same periods in 2002. Net interest income consists primarily of interest earned
on "Credit card loans" less interest expense on borrowing to fund the loans. The
decrease is primarily due to a $2.3 billion and $1.4 billion decrease in managed
average interest-earning assets, for the three- and nine-month periods ended
September 30, 2003, compared to the same periods in 2002.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Market risk is the risk of loss from adverse changes in market prices
and rates. Our principal market risk is due to changes in interest rates. This
affects us directly in our lending and borrowing activities, as well as
indirectly, since interest rates may impact the payment performance of our
cardholders.
To manage our direct risk to market interest rates, management actively
monitors the interest rates and the interest sensitive components of our owned
and managed balance sheets to minimize the impact that changes in interest rates
have on the fair value of assets, net income and cash flow. We seek to minimize
that impact primarily by matching asset and liability re-pricings.
Our primary managed assets are "Credit card loans," which are virtually
all priced at rates indexed to the variable Prime Rate. We fund "Credit card
loans" through a combination of cash flows from operations, asset
securitizations, bank loans, long-term debt and equity issuances. Our
securitized loans are owned by the Metris Master Trust and bank-sponsored
multi-seller receivables conduits within the Metris Master Trust, which have
committed funding primarily indexed to variable commercial paper rates and
LIBOR. The long-term debt is at fixed interest rates. At September 30, 2003, and
2002, none of the securities issued out of the Metris Master Trust and conduit
funding of securitized receivables was funded with fixed rate securities.
In an interest rate environment with rates significantly above current
rates, the potential negative impact on earnings of higher interest expense is
partially mitigated by fixed rate funding and interest rate cap contracts.
The approach we use to quantify interest rate risk is a sensitivity
analysis, which we believe best reflects the risk inherent in our business. This
approach calculates the impact on net income from an instantaneous and sustained
change in interest rates of 200 basis points. In this analysis, interest rates
on our floating rate debt are not allowed to decrease below zero percent.
Assuming that we take no counteractive measures, as of September 30, 2003, a
200-basis-point increase in interest rates affecting our floating rate financial
instruments, including both debt obligations and loans, would result in a
decrease in net income of approximately $14.6 million relative to a base case
over the next 12 months, compared to an approximate $11.0 million decrease as of
December 31, 2002, relative to a base case over the next 12 months. A decrease
of 200 basis points would result in an increase in net income of approximately
$28.5 million as of September 30, 2003, and an increase of $55.0 million as of
December 31, 2002.
The change in the 12-month sensitivity to both a 200-basis-point
increase and decrease in the market interest rate is mainly due to an increase
in loan balances in the third quarter of 2003 where the interest rate charged on
customer loan balances is below the floor rate and a continued decrease in the
forecasted future loan balances. Our use of this methodology to quantify the
market risk of financial instruments should not be construed as an endorsement
of its accuracy or the accuracy of the related assumptions. In addition, this
methodology does not take into account the indirect impact interest rates may
have on the payment performance of our cardholders, or the fact that LIBOR and
Prime Rates may not move in tandem in an increasing or decreasing rate
environment. The quantitative information about market risk is necessarily
limited because it does not take into account operating transactions or other
costs associated with managing immediate changes in interest rates.
66
ITEM 4 CONTROLS AND PROCEDURES
Under the supervision and with the participation of the Company's
management, including the Chairman and Chief Executive Officer ("CEO") and the
Chief Financial Officer ("CFO"), we evaluated the effectiveness of the design
and operation of the Company's disclosure controls and procedures (as defined in
Rule 13a-14(c) or 15d-14(c) under the Exchange Act). Based on that evaluation,
the Company's management, including the CEO and CFO, have concluded that, as of
September 30, 2003, our disclosure controls and procedures were not effective in
ensuring that information required to be disclosed in the reports we file under
the Securities Exchange Act of 1934, as amended ("Exchange Act") are recorded,
processed, summarized and reported within the time periods specified in SEC
rules and forms.
On November 17, 2003, our external auditors, KPMG LLP, issued a
material weakness report noting a material weakness in our policies and
procedures for estimating the fair value of our "Retained interests in loans
securitized" and associated revenue recognition. During the past several months
we have taken steps to revise our valuation model and related policies,
procedures and assumptions to address the issues in the material weakness
report. During the period, the Company also identified and changed its
accounting policies to conform with accounting principles generally accepted in
the United States of America associated with the accounting for securitization
transaction costs, credit card solicitation costs, and debt waiver revenue
associated with receivables sold to the Metris Master Trust (See Note 2 of the
unaudited consolidated financial statements on page 9 for further discussion).
The Company, as of February 24, 2004 has re-evaluated the effectiveness
of the design of the Company's disclosure controls and procedures (as defined in
Rule 13a-14(c) or 15d-14(c) under the Exchange Act). Based on that evaluation,
the Company's management, including the CEO and CFO, have concluded that the
design of our disclosure controls and procedures were effective in ensuring that
information required to be disclosed in the reports we file under the Exchange
Act are recorded, processed, summarized and reported within the time periods
specified in SEC rules and forms. The Company has not yet evaluated (tested) the
operating effectiveness of such controls.
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
In September and October 2002, three shareholder lawsuits were filed in
the United States District Court for the District of Minnesota, naming MCI,
Ronald N. Zebeck and David Wesselink as defendants. Two of the lawsuits have
been dismissed. The plaintiff in the remaining lawsuit seeks to represent a
class of purchasers of MCI common stock between November 5, 2001 and July 17,
2002. The lawsuit seeks damages in an unspecified amount. The complaint alleges,
among other things, that defendants violated the federal securities laws when
MCI failed to disclose the existence of an OCC Report of Examination until April
17, 2002. The lawsuit is currently in the discovery phase. We believe the
lawsuit is without merit.
We are a party to various legal proceedings resulting from the ordinary
business activities relating to our operations. On January 23, 2004, a complaint
was filed in Middlesex County Superior Court in Cambridge, Massachusetts,
against Direct Merchants Bank and MCI. The complaint purports to be a class
action complaint covering the period January 1, 2000 through December 31, 2004
(sic) and alleges, among other things, that defendants employed overly
aggressive, sharp and often unlawful business practices, inappropriately
assessed late fees and other charges against cardholders, and violated
Massachusetts' restrictions on maximum interest charges. The complaint seeks
declaratory relief, rescission and damages, and alleges civil conspiracy, breach
of fiduciary duty, breach of contract, breach of covenant of good faith and fair
dealing, negligence, unfair trade practices and violations of the federal
Truth-in-Lending Act and Regulation Z. The complaint has not been certified as a
class action, and we believe we have numerous substantive legal defenses to all
claims and intend to vigorously defend the case.
67
Also on January 23, 2004, a complaint was filed in Hennepin County
District Court in Minneapolis, Minnesota, against MCI, certain members of its
board of directors and a number of other entities, by Ronald N. Zebeck, MCI's
former Chairman and Chief Executive Officer. The complaint alleges breach of
contract, intentional interference with contract, breach of covenant of good
faith, defamation, and violation of Minnesota's whistleblower act. On February
1, 2004, defendants filed an answer in which they denied the allegations in the
complaint, and MCI filed counterclaims against Mr. Zebeck alleging breach of
fiduciary duty and duty of loyalty, unjust enrichment, breach of covenant not to
compete, requesting an accounting, and seeking declaratory judgment against Mr.
Zebeck for the principal amount ($5 million) of a loan made by MCI in 1999, plus
interest. We believe Mr. Zebeck's claims are without factual and legal support,
and we have numerous substantive legal defenses to his claims. We intend to
vigorously defend against Mr. Zebeck's claims and will aggressively prosecute
our case against him.
Because we are unable to estimate damages at this time, there can be no
assurance that defense or resolution of these matters will not have a material
adverse effect on our financial position.
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
Under the terms of our $125 million Credit Agreement, we are restricted as
to the timing and amount and circumstances under which we may declare and pay
dividends to shareholders. We may make, declare, and pay dividends any time
after December 31, 2003, provided that the aggregate amount of such dividend
shall be allowed under existing law, shall not cause a default or event of
default under our Senior Note Indenture (as defined) or any other material
Indebtedness (as defined), and shall not exceed $0.01 per share of our Capital
Stock (as defined) and in no event to exceed $1,000,000 in any fiscal quarter.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None
ITEM 5. OTHER INFORMATION
None
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) EXHIBITS:
10.1 Agreement of Resignation, Appointment and Acceptance, dated as of
September 15, 2003, by and among Metris Companies Inc., the lenders
from time to time parties to the Senior Secured Credit Agreement,
Deutsche Bank Trust Company Americas as Successor Administrative Agent
and Goldman Sachs Credit Partners L.P. as Resigning Administrative
Agent.
10.2 Second Amendment to the Amended and Restated Senior Secured Credit
Agreement dated as of September 30, 2003, among Metris Companies Inc.,
the Lenders from time to time parties to the Senior Secured Credit
Agreement, Deutsche Bank Trust Companies America as Administrative
Agent and Collateral Agent.
10.3 Third Amendment to the Amended and Restated Senior Secured Credit
Agreement dated as of November 19, 2003, among Metris Companies Inc.,
the Lenders from time to time parties to the Senior Secured Credit
Agreement, Deutsche Bank Trust Companies America as Administrative
Agent and Collateral Agent.
10.4 Fourth Amendment to the Amended and Restated Senior Secured Credit
Agreement dated as of December 19, 2003, among Metris Companies Inc.,
the Lenders from time to time parties to the Senior Secured Credit
Agreement, Deutsche Bank Trust Companies America as Administrative
Agent and Collateral Agent.
68
10.5 Fifth Amendment to the Amended and Restated Senior Secured Credit
Agreement dated as of January 26, 2004, among Metris Companies Inc.,
the Lenders from time to time parties to the Senior Secured Credit
Agreement, Deutsche Bank Trust Companies America as Administrative
Agent and Collateral Agent.
10.6 Deposit Accounts Purchase and Assumption Agreement dated as of
September 26, 2003, by and between Direct Merchants Credit Card Bank,
National Association, a national banking association as Seller and
First National Bank of Omaha, as Purchaser.
10.7 Amendment to Deposit Accounts Purchase and Assumption Agreement dated
as of September 30, 2003, by and between Direct Merchants Credit Card
Bank, National Association as Seller and first National Bank of Omaha
as Purchaser.
10.8 Modified Operating Agreement effective as of December 11, 2003, by and
between Direct Merchants Bank, Metris Companies Inc., and the Office of
the Comptroller of the Currency. (Incorporated by reference to Exhibit
99-1 to MCI's Current Report on Form 8-K dated December 12, 2003 (File
No. 1-12351)).
31.1 Certification of Principal Executive Officer Pursuant to Section 1350
of Chapter 63 of Title 18 of the United States Code.
31.2 Certification of Principal Financial Officer Pursuant to Section 1350
of Chapter 63 of Title 18 of the United States Code.
32.1 Certification of Principal Executive Officer Pursuant to Rule
13a-14(a)/15d-14(a).
32.2 Certification of Principal Financial Officer Pursuant to Rule
13a-14(a)/15d 14(a).
(b) REPORTS ON FORM 8-K:
On July 11, 2003, we filed a Current Report on Form 8-K to report under
Items 5 and 7 that we had entered into an Amended and Restated Senior
Secured Credit Agreement, dated as of June 18, 2003, among us as
Borrower, the parties identified therein as Lenders, Goldman Sachs
Credit Partners L.P., as Administrative Agent for the Lenders, and
Deutsche Bank Trust Company Americas as the Collateral Agent for the
Lenders.
On July 24, 2003, we filed a Current Report on Form 8-K to report under
Items 5 and 7 our financial results for the second quarter ended June
30, 2003.
On July 30, 2003, we filed a Current Report on Form 8-K to report under
Item 5 and 7 the sale of the membership club and warranty products and
operations of our enhancement services business.
On September 18, 2003, we filed a Current Report on Form 8-k, to report
under Items 5 and 7, the filing of two press releases. One reporting
the sale of a portfolio of approximately 160,000 credit card accounts
and $590 million in receivables and the second announcing the
replacement of the $610 million Series 2001-1 asset-backed
securitization from the Metris Master Trust.
On September 30, 2003, we filed a Current Report on Form 8-K to report
under Items 5 and 7 a workforce reduction, and an agreement to sell the
federally insured "Deposits" at Direct Merchants Bank, N.A.
On October 2, 2003, we filed a Current Report on Form 8-K to report
under Items 5 and 7 the closing of our sale of federally insured
"Deposits" from Direct Merchants Bank, N.A.
On October 23, 2003, we filed a Current Report on Form 8-K, and an
amendment on Form 8-K/A, to report under Items 5 and 7 our financial
results for the third quarter ended September 30, 2003.
On November 17, 2003, we filed a Current Report on Form 8-K, to report
under Items 5 and 7 a press release announcing our delay in filing the
10-Q for the third quarter pending resolution of valuation issues.
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On November 17, 2003, we filed a Current Report on Form 8-K, to report
under Items 5 and 7, the filing of a press release announcing our sale
of credit card accounts and related receivables.
On December 12, 2003, we filed a Current Report on Form 8-K, to report
under Item 5 that we entered into a new Modified Operating Agreement
with the Office of the Comptroller of Currency that supersedes the
existing agreement dated March 18, 2003.
On December 19, 2003, we filed a Current Report on Form 8-K to report
under Item 5 the notification received from the SEC, expanding its
investigation to include the valuation of our retained interests in
securitized loans.
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SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934,
the Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
METRIS COMPANIES INC.
(Registrant)
Date: April 9, 2004 By: /s/ John A. Witham
---------------------------------
John A. Witham
Executive Vice President and
Chief Financial Officer
(Principal Financial Officer and
Authorized Officer of Registrant)
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