UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
--------------------
FORM 10-K
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended 001-12351
DECEMBER 31, 2003 Commission file number
--------------------
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)
Securities registered pursuant to Section 12(b) of the Act:
Common Stock, $.01 Par Value New York Stock Exchange, Inc.
---------------------------- -----------------------------
Title of Each Class Name of Each Exchange
On Which Registered
Securities registered pursuant to Section 12(g) of the Act: None
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 and (2) has been subject to such filing requirements for
the past 90 days. Yes X No
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of Registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K.
Indicate by check mark whether the Registrant is an accelerated filer (as
defined in Exchange Act Rule 12b-2). Yes X No
The aggregate market value of the voting stock held by non-affiliates of the
Registrant as of June 30, 2003 was approximately $321,494,140 based upon the
closing price of $5.55 on the New York Stock Exchange on that date.
As of March 31, 2004, 57,908,052 shares of the Registrant's Common Stock were
outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
Certain portions of the Proxy Statement for the 2004 Annual Meeting of
Stockholders of Metris Companies Inc., which will be filed with the Securities
and Exchange Commission ("SEC") within 120 days after December 31, 2003, are
incorporated by reference in Part III.
TABLE OF CONTENTS
PAGE
----
PART I
Item 1. Business.............................................................. 3
Item 2. Properties............................................................ 39
Item 3. Legal Proceedings..................................................... 39
Item 4. Submission of Matters to a Vote of Security Holders................... 40
PART II
Item 5. Market for Registrant's Common Equity and Related
Stockholder Matters......................................................... 40
Item 6. Selected Financial Data............................................... 41
Item 7. Management's Discussion and Analysis of Financial
Condition and Results of Operations......................................... 43
Item 7a.Quantitative and Qualitative Disclosures
About Market Risk........................................................... 78
Item 8. Financial Statements and Supplementary Data........................... 79
Item 9. Changes in and Disagreements with Accountants on
Accounting and Financial Disclosure......................................... 128
Item 9a. Controls and Procedures.............................................. 128
PART III
Item 10. Directors and Executive Officers of the Registrant................... 128
Item 11. Executive Compensation............................................... 129
Item 12. Security Ownership of Certain Beneficial
Owners and Management....................................................... 129
Item 13. Certain Relationships and Related Transactions....................... 130
Item 14. Controls and Procedures.............................................. 131
PART IV
Item 15. Exhibits, Financial Statement Schedules
and Reports on Form 8-K..................................................... 131
Signatures...................................................................... 132
Exhibit Index................................................................... 134
2
PART I
ITEM 1. BUSINESS
Overview
Metris Companies Inc. ("MCI") and its subsidiaries provide financial
products and services throughout the United States. MCI was incorporated in
Delaware on August 20, 1996, and completed an initial public offering in October
1996. 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 are referred to in
this Report as "we," "us," "our," and the "Company."
We are listed on the New York Stock Exchange under the symbol MXT. All
of our public company filings can be found on our website at
www.metriscompanies.com, including our proxy statements, annual reports on Form
10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and
amendments to these filings. Filings will be available on our website as soon as
reasonably practicable after we electronically file them with, or furnish them
to, the Securities and Exchange Commission.
In the third quarter of 2003, we sold our membership club and warranty
business. As a result, our primary line of business is our credit card business.
Our credit card products are primarily unsecured credit cards issued through
Direct Merchants Bank. These credit cards generate consumer loans, which 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. We target primarily middle market
customers. Direct Merchants Bank obtains information about prospective customers
in the middle market from credit bureau information as well as from other
third-party sources including other companies' customer lists and databases.
Our business requires a high degree of liquidity. Thus, ensuring
adequate liquidity is, and will continue to be, at the forefront of our business
objectives. We rely heavily on the securitization of our credit card loans for
funding, primarily by selling these loans to our proprietary trust, the Metris
Master Trust. We also fund our business through corporate debt issuances.
Because our target market is particularly susceptible to changes in the
economy, the recent economic recession has challenged the Company and reduced
our access to funding. In addition, in 2001 we implemented a program to increase
the credit lines of a large portion of our customers, which put increased
payment pressure on those customers. The delinquency rate on our credit card
loans and the rate at which credit card loans were charged off as uncollectible
increased significantly during 2002 and 2003. Poor performance of loans that had
been securitized resulted in higher required enhancement levels in our
securitizations, which diverted significant amounts of cash that otherwise would
have been available to us. As a result of these factors, our corporate debt
ratings, the Metris Master Trust's debt ratings, and the debt ratings of Direct
Merchants Bank were downgraded. This deterioration in our asset quality, and the
accompanying downgrades in our
3
credit ratings, reduced our access to funding and resulted in higher funding
costs and less favorable transaction terms than previously were available to us.
During 2003, we took a number of significant actions designed to
address our asset quality issues, ensure appropriate liquidity, and return the
Company to profitability, including:
- Sales of Portfolio Receivables. We significantly reduced the size of our
managed receivables portfolio in 2003. This was done using a combination of
decreased marketing efforts, higher account attrition and the sale of
approximately $1.1 billion of credit card receivables in September and
November of 2003. This reduction in the size of our portfolio has
significantly reduced our need for additional bank conduit financing or the
issuance of new asset-backed securities.
- Sale of Membership Club and Warranty Service Business. In July 2003, we
sold our membership club and warranty service business for $45 million in
cash, further focusing our resources on our core consumer lending business.
- Expense Reduction Efforts. We took steps to match our workforce needs with
the size of our managed receivables portfolio by eliminating approximately
1,025 positions in 2003. As a result of this and other expense reduction
efforts, the Company reduced ongoing operating expenses by $191 million
during 2003 as compared to the prior year.
- Efforts to Improve Asset Quality. We took several actions during 2003 to
improve the quality of our receivables. These include strengthening credit
line management strategies, limiting marketing efforts to higher credit
quality consumers, tightening credit authorization criteria, and enhancing
collection strategies.
- Funding Transactions. During the year we obtained funding to replace $1.775
billion of maturing bank conduit financings and warehouse facility
financings that were in existence as of December 31, 2002. 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 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. These conduits also provided for the financing of a term
asset-backed securitization that matured in July 2003. Finally, as required
under one of the conduit facilities, we obtained an amortizing term series
financing of $622.2 million maturing March 2004 to provide for the payment
of a $610 million term asset-backed securitization that began an
accumulation period on November 1, 2003. We also obtained a $125 million
senior secured loan under our Amended and Restated Senior Secured Credit
Agreement, the proceeds of which were used primarily to pay off a $100
million term loan that matured in June 2003.
- Efforts to Improve Collections. In early 2003 we reviewed our collections
operations to determine whether the collections function was operating
effectively. We determined that overall performance of the collections
function could be improved, and as a result, we made significant changes
4
in the operation. We replaced a substantial portion of the senior
management team, updated the technology used by the operation, and
initiated new training programs for all levels of collections personnel. We
also implemented a new collections paradigm that incorporates specific
requirements for staffing, dialer strategies, and a new collections call
model. In addition, reporting and performance standards were enhanced to
ensure management accountability.
As of December 31, 2003 our funding needs for 2004 included $3.1
billion in maturing asset-backed and conduit financing in the Metris Master
Trust, $95.3 million outstanding on our $125 million term loan due in June 2004,
and $100 million of our 10% Senior Notes due in November 2004. We had obtained
and set aside the funds to repay a $500 million asset-backed securitization
scheduled to mature in June 2004 from the Metris Master Trust by entering into a
new conduit financing scheduled to mature in May 2004. Furthermore, we have
received a $1.7 billion, two-year commitment from MBIA Insurance Corporation
("MBIA") to provide financial guaranty insurance policies to refinance maturing
MBIA-guaranteed series from the Metris Master Trust. MBIA has committed to
guarantee three series issued from the Metris Master Trust totaling $1.7 billion
with maturity dates of June 2004, May 2005, and November 2005. We intend to meet
our remaining funding needs in 2004 through a combination of portfolio attrition
(projected to be $1.4 billion in 2004), the renewal or replacement of some of
bank conduit financings, new securitizations, and the sale of receivables, as
necessary.
As mentioned above, 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 transaction terms than
previously were available to us. Any future downgrades in our debt ratings or
those of Direct Merchants Bank, or further deterioration in our asset quality,
could further negatively impact our funding capabilities.
We target customers across the broad middle market segments, focusing
primarily on creditworthy middle market customers who are underserved and
undermarketed by many large, prime and super prime oriented credit card issuers.
We originate new loans by selectively recruiting higher quality customers from
the most attractive parts of each market segment. We believe we can leverage
distinctive competencies in marketing, underwriting, and servicing to better
meet our customers' needs and be competitive in each market segment.
To acquire new customers, we use proprietary targeting and analytics to
identify the most attractive credit card prospects and match them with the most
compelling and profitable product offering. Currently we utilize prescreened
direct mail and telemarketing as the primary new customer acquisition channels,
augmented by partnership and invitation-to-apply direct mail programs. In the
future, we anticipate prudently and deliberately diversifying our distribution
channels to achieve better market penetration within each of the market segments
we serve.
OUR BUSINESS
Our credit card 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. At
5
December 31, 2003, we had approximately 2.8 million credit card accounts with
approximately $8.1 billion in managed credit card receivables. Our products also
include credit protection and insurance products.
When we refer to "managed" loans or other "managed" data, we are using
information that includes securitized loan balances, delinquencies and credit
losses related to those loans, and related finance charge and fee income, even
though those balances, delinquencies, losses, charges and income are not on our
financial statements as a result of the way in which we treat securitizations
under accounting principles generally accepted in the United States ("GAAP").
Although securitized loans have been removed from our balance sheet, we retain
interests in them that affect our financial performance. Therefore, we use
managed financial information, which is not GAAP compliant, to supplement our
GAAP information in analyzing our business. For more information regarding
managed financial information, please see "Management's Discussion and Analysis
of Financial Condition and Results of Operations -- Selected Operating
Data-Managed Basis" at page 73.
We generate income from our consumer lending products through:
- servicing fees and excess spread on credit card loans sold to the Metris
Master Trust;
- interest and other finance charges assessed on outstanding credit card
loans;
- interchange fees (fees paid by the merchant's bank in connection with
credit card transactions) and credit card fees (including annual
membership, cash advance, overlimit and late fees) on outstanding credit
card loans;
- premiums on credit protection products; and
- commissions from third parties for marketing of their products to our
cardholders.
The primary expenses of this business are:
- the costs of funding the loans;
- provisions for loan losses; and
- operating expenses, including employee compensation, account solicitation,
marketing, and data processing expenses.
Profitability is affected by:
- credit quality, including delinquencies, bankruptcies and charge-offs;
- net interest income on loans;
- cost of funds, including enhancement levels on securitizations of loans
sold;
6
- response and approval rates to solicitation efforts;
- the size of our managed loan portfolio;
- credit card usage;
- credit card cancellations;
- fraud losses;
- cardholder servicing expenses; and
- operating expenses.
TARGET MARKET
We primarily target middle market consumers. We target and evaluate
prospective customers in this market by using our proprietary scoring
techniques, together with information obtained from credit bureaus and other
third-party customer lists and databases, to determine a potential customer's
creditworthiness. We also use modeling techniques to evaluate the expected risk,
responsiveness and profitability of each prospective customer, and to offer and
price the products and services we believe to be appropriate for each customer.
Prospects
Our primary sources of prospects for credit card offers are credit
bureau queries and third-party customer lists and databases. Other lists of
non-prescreened names are purchased as well.
Credit Scoring
We use internally and externally developed models to supplement our
evaluation of customers. These models help segment prospects into narrower
ranges within each risk score provided by Fair, Isaac Corporation ("FICO"),
allowing us to better evaluate individual credit risk and to tailor our
risk-based pricing accordingly. We also use this segmentation to exclude certain
individuals from our marketing solicitations.
We believe our methods are effective in further segmenting and
evaluating risk within the FICO risk score bands. We continue to use the results
of our analysis of prospects to adjust the proprietary models to determine the
pricing for various segments and to exclude certain segments from subsequent
direct marketing efforts.
Solicitation
We believe that our proprietary models give us a competitive advantage
in evaluating the credit risk of middle market consumers. We monitor the
performance of the proprietary models and continually re-evaluate the
effectiveness of these models in segmenting credit risk, resulting in further
refinements to our selection criteria for prospects. Over time, we believe that
we will capture additional credit information on the behavioral
7
characteristics of prospects, which will allow us to further increase the
effectiveness of our proprietary models.
Our credit analysts process applications based on policies approved by
the Bank's credit policy committee. We solicit prospects on a nationwide basis
primarily through pre-screened direct mail and telephone solicitations and
direct mail invitations to apply. We receive responses to our solicitations,
obtain new credit bureau reports, perform fraud screening, verify name and
address changes, and obtain any information which may be missing from the
application. We then make the credit decisions and approve, deny or begin
exception processing. We process exceptions for, among other things, missing
credit bureau information and fraud warnings.
Pricing
Through risk-based pricing, we price credit card offers based on a
prospect's risk profile. We evaluate a prospect to determine credit needs,
credit risk and existing credit availability, and then develop a customized
offer that includes the most appropriate product, brand, pricing and credit
line. We have numerous pricing structures on our credit card products. After
credit card accounts are opened, we frequently monitor customers' internal and
external credit performance and recalculate delinquency, profitability and
attrition predictors.
Age of Portfolio
The average age of our credit card portfolio affects the stability of
delinquency and loss rates. Older portfolios are typically more stable. The
following tables set forth, as of December 31, 2003 and 2002, the number of
credit card accounts and the amount of outstanding loans based on the age of the
OWNED accounts(those accounts held by us). (Accounts in acquired portfolios are
presented based on when the account was originated with the previous issuer.)
(Dollars in thousands)
2003
PERCENTAGE OF
AGE SINCE NUMBER PERCENTAGE LOANS LOANS
ORIGINATION OF ACCOUNTS OF ACCOUNTS OUTSTANDING OUTSTANDING
------------ ----------- ----------- ----------- -------------
0-6 MONTHS 41,194 23.7% $ 25,636 20.0%
7-12 MONTHS 5,795 3.4% 1,771 1.4%
13-18 MONTHS 39,843 22.9% 18,286 14.2%
19-24 MONTHS 10,267 5.9% 6,180 4.8%
25-36 MONTHS 16,001 9.2% 12,760 9.9%
37+ MONTHS 60,707 34.9% 63,982 49.7%
------- ----- ----------- -----
TOTAL 173,807 100.0% $ 128,615 100.0%
======= ===== =========== =====
2002
PERCENTAGE OF
AGE SINCE NUMBER PERCENTAGE LOANS LOANS
ORIGINATION OF ACCOUNTS OF ACCOUNTS OUTSTANDING OUTSTANDING
------------ ----------- ----------- ----------- -------------
0-6 MONTHS 258,100 31.1% $ 239,761 28.3%
7-12 MONTHS 114,749 13.8% 145,096 17.1%
8
13-18 MONTHS 45,250 5.4% 19,000 2.3%
19-24 MONTHS 29,304 3.5% 23,489 2.8%
25-36 MONTHS 135,971 16.4% 140,789 16.6%
37+ MONTHS 247,163 29.8% 278,282 32.9%
------- ----- ----------- -----
TOTAL 830,537 100.0% $ 846,417 100.0%
======= ===== =========== =====
The following tables set forth, as of December 31, 2003 and 2002, the
number of credit card accounts and the amount of outstanding loans based on the
age of the MANAGED accounts (includes owned accounts and accounts representing
investors' interests in securitized loans). (Accounts in acquired portfolios are
presented based on when the account was originated with the previous issuer.)
(Dollars in thousands)
2003
PERCENTAGE OF
AGE SINCE NUMBER PERCENTAGE LOANS LOANS
ORIGINATION OF ACCOUNTS OF ACCOUNTS OUTSTANDING OUTSTANDING
------------ ----------- ----------- ----------- -------------
0-6 MONTHS 235,335 8.3% $ 314,477 3.9%
7-12 MONTHS 104,151 3.7% 166,422 2.0%
13-18 MONTHS 196,759 6.9% 381,924 4.7%
19-24 MONTHS 192,573 6.8% 462,675 5.7%
25-36 MONTHS 434,974 15.3% 1,141,664 14.0%
37+ MONTHS 1,673,414 59.0% 5,664,669 69.7%
--------- ----- ----------- -----
TOTAL 2,837,206 100.0% $ 8,131,831 100.0%
========= ===== =========== =====
2002
PERCENTAGE OF
AGE SINCE NUMBER PERCENTAGE LOANS LOANS
ORIGINATION OF ACCOUNTS OF ACCOUNTS OUTSTANDING OUTSTANDING
------------ ----------- ----------- ----------- -------------
0-6 MONTHS 327,959 8.4% $ 363,949 3.2%
7-12 MONTHS 323,314 8.2% 569,547 5.0%
13-18 MONTHS 336,137 8.6% 797,340 7.0%
19-24 MONTHS 310,517 7.9% 779,608 6.8%
25-36 MONTHS 724,112 18.4% 1,850,716 16.2%
37+ MONTHS 1,906,512 48.5% 7,059,026 61.8%
--------- ----- ----------- -----
TOTAL 3,928,551 100.0% $11,420,186 100.0%
========= ===== =========== =====
Historically, we have distributed most internally originated customer
accounts between the owned portfolio and accounts included in the Metris Master
Trust on a random basis. Acquired portfolios were generally included in the
owned credit card portfolio until they could be securitized. Certificates of
deposit served as a primary funding source of owned receivables. Effective with
the sale of deposits out of the Bank, at the end of the third quarter of 2003,
we began assigning the majority of all new accounts to the Metris Master Trust
shortly after the time of origination. Also, during 2003, we sold approximately
$675.3 million of credit card loans from Direct Merchants Bank to the Metris
Master Trust. As of December 31, 2003, the percentage of accounts and percentage
of outstanding balances greater than two years were 44.1% and 59.6% on an owned
basis, versus 74.3% and 83.7% on a MANAGED basis. As of December 31, 2002, the
percentage of accounts and percentage of outstanding balances with an age since
origination of greater than two years were 46.2% and 49.5% on an owned basis,
versus 66.9% and 78.0% on a MANAGED basis.
9
Geographic Distribution
We solicit credit card customers on a national basis and, therefore,
maintain a geographically diversified portfolio. The following tables show the
distribution of MANAGED accounts and amount of managed outstanding loans by
state as of December 31, 2003 and 2002.
(Dollars in thousands)
2003
PERCENTAGE OF
NUMBER PERCENTAGE LOANS LOANS
STATE OF ACCOUNTS OF ACCOUNTS OUTSTANDING OUTSTANDING
------------ ----------- ----------- ----------- -------------
CALIFORNIA 406,436 14.3% $ 1,037,537 12.8%
NEW YORK 259,235 9.1% 704,018 8.7%
TEXAS 230,989 8.1% 670,729 8.2%
FLORIDA 215,004 7.6% 585,629 7.2%
ILLINOIS 116,644 4.1% 328,431 4.0%
NEW JERSEY 103,925 3.7% 263,471 3.2%
OHIO 100,731 3.6% 315,606 3.9%
PENNSYLVANIA 96,250 3.4% 283,187 3.5%
MICHIGAN 73,717 2.6% 224,097 2.8%
GEORGIA 70,902 2.5% 225,409 2.8%
VIRGINIA 70,272 2.5% 211,446 2.6%
ALL OTHERS(1) 1,093,101 38.5% 3,282,271 40.3%
--------- ----- ----------- -----
TOTAL 2,837,206 100.0% $ 8,131,831 100.0%
========= ===== =========== =====
2002
PERCENTAGE OF
NUMBER PERCENTAGE LOANS LOANS
STATE OF ACCOUNTS OF ACCOUNTS OUTSTANDING OUTSTANDING
------------ ----------- ----------- ----------- -------------
CALIFORNIA 558,353 14.2% $ 1,420,177 12.4%
NEW YORK 354,041 9.0% 957,252 8.4%
TEXAS 335,975 8.5% 937,857 8.2%
FLORIDA 297,946 7.6% 821,109 7.2%
ILLINOIS 168,325 4.3% 458,095 4.0%
OHIO 149,153 3.8% 444,954 3.9%
PENNSYLVANIA 138,433 3.5% 395,338 3.5%
NEW JERSEY 137,238 3.5% 353,093 3.1%
MICHIGAN 112,358 2.9% 328,084 2.9%
GEORGIA 100,817 2.6% 308,870 2.7%
VIRGINIA 99,682 2.5% 296,237 2.6%
ALL OTHERS(1) 1,476,230 37.6% 4,699,120 41.1%
--------- ----- ----------- -----
TOTAL 3,928,551 100.0% $11,420,186 100.0%
========= ===== =========== =====
(1) No other state accounts for more than 2.5% of managed loans outstanding.
Credit Lines
When we approve a credit card application, we use automated screening,
modeling and credit-scoring techniques to establish an initial credit line based
on the individual's risk profile. We may, at any time and without prior notice
to a cardholder, prevent or restrict further credit card use by the cardholder,
usually as a result of poor payment performance or our concern over the
creditworthiness of the cardholder. We manage credit lines
10
based on the results of the behavioral scoring analysis, and in accordance with
our internally established criteria. These analytic models automatically and
regularly assign credit line increases and decreases to individual customers, as
well as determine the systematic collection steps to be taken at the various
stages of delinquency. We use these models to manage the authorization of each
transaction, as well as the collections strategies used for non-delinquent
accounts with balances above their assigned credit lines.
The following tables set forth information with respect to credit limit
and account balance ranges of our OWNED credit card loan portfolio as of
December 31, 2003 and 2002.
(Dollars in thousands)
2003
PERCENTAGE
CREDIT LIMIT NUMBER OF LOANS OF LOANS PERCENTAGE
RANGE ACCOUNTS OUTSTANDING OUTSTANDING OPEN TO BUY UTILIZED
--------------- --------- ----------- ----------- ----------- -----------
$1,000 OR LESS 43,411 $ 11,145 8.7% $ 11,607 49.0%
$1,001-$2,000 23,329 14,881 11.6% 21,980 40.4%
$2,001-$3,500 35,187 30,219 23.5% 70,157 30.1%
$3,501-$5,000 32,824 30,890 24.0% 117,522 20.8%
$5,001-$10,000 33,658 34,401 26.7% 216,446 13.7%
OVER $10,000 5,398 7,079 5.5% 63,736 10.0%
------- ----------- ----- -----------
TOTAL 173,807 $ 128,615 100.0% $ 501,448 20.4%
======= =========== ===== ===========
2002
PERCENTAGE
CREDIT LIMIT NUMBER OF LOANS OF LOANS PERCENTAGE
RANGE ACCOUNTS OUTSTANDING OUTSTANDING OPEN TO BUY UTILIZED
--------------- --------- ----------- ----------- ----------- -----------
$1,000 OR LESS 139,884 $ 47,140 5.6% $ 34,572 57.7%
$1,001-$2,000 113,501 78,056 9.2% 104,949 42.7%
$2,001-$3,500 157,637 144,377 17.1% 312,052 31.6%
$3,501-$5,000 145,540 165,726 19.6% 493,234 25.1%
$5,001-$10,000 223,726 333,843 39.4% 1,385,217 19.4%
OVER $10,000 50,249 77,275 9.1% 582,431 11.7%
------- ----------- ----- -----------
TOTAL 830,537 $ 846,417 100.0% $ 2,912,455 22.5%
======= =========== ===== ===========
(Dollars in thousands)
2003
PERCENTAGE
ACCOUNT NUMBER OF LOANS OF LOANS PERCENTAGE
BALANCE RANGE ACCOUNTS OUTSTANDING OUTSTANDING OPEN TO BUY UTILIZED
--------------- --------- ----------- ----------- ----------- -----------
CREDIT BALANCE 3,958 $ (261) (0.2%) $ 13,323 (2.0%)
NO BALANCE 78,170 -- -- 341,258 --
$1,000 OR LESS 52,745 19,477 15.1% 99,856 16.3%
$1,001-$2,000 16,275 23,793 18.5% 24,148 49.6%
$2,001-$3,500 12,872 34,427 26.8% 14,424 70.5%
$3,501-$5,000 5,927 24,898 19.4% 5,365 82.3%
$5,001-$10,000 3,585 22,993 17.9% 2,772 89.2%
OVER $10,000 275 3,288 2.5% 302 91.6%
------- ----------- ----- -----------
TOTAL 173,807 $ 128,615 100.0% $ 501,448 20.4%
======= =========== ===== ===========
11
2002
PERCENTAGE
ACCOUNT NUMBER OF LOANS OF LOANS PERCENTAGE
BALANCE RANGE ACCOUNTS OUTSTANDING OUTSTANDING OPEN TO BUY UTILIZED
--------------- --------- ----------- ----------- ----------- -----------
CREDIT BALANCE 12,188 $ (1,532) (0.2%) $ 36,696 (4.4%)
NO BALANCE 361,513 -- -- 1,869,805 -
$1,000 OR LESS 217,083 92,536 10.9% 583,589 13.7%
$1,001-$2,000 92,070 133,958 15.8% 179,495 42.7%
$2,001-$3,500 73,462 196,383 23.2% 129,697 60.2%
$3,501-$5,000 37,669 158,952 18.8% 60,824 72.3%
$5,001-$10,000 33,734 232,683 27.5% 48,743 82.7%
OVER $10,000 2,818 33,437 4.0% 3,606 90.3%
------- ----------- ----- -----------
TOTAL 830,537 $ 846,417 100.0% $ 2,912,455 22.5%
======= =========== ===== ===========
The following tables set forth information with respect to credit limit
and account balance ranges of our MANAGED loan portfolio (includes investors'
interests in loans securitized) as of December 31, 2003 and 2002.
(Dollars in thousands)
2003
PERCENTAGE
CREDIT LIMIT NUMBER OF LOANS OF LOANS PERCENTAGE
RANGE ACCOUNTS OUTSTANDING OUTSTANDING OPEN TO BUY UTILIZED
--------------- --------- ----------- ----------- ----------- -----------
$1,000 OR LESS 266,970 $ 106,692 1.3% $ 52,579 67.0%
$1,001-$2,000 275,182 292,810 3.6% 139,425 67.8%
$2,001-$3,500 436,683 767,557 9.5% 494,834 60.8%
$3,501-$5,000 486,939 1,098,121 13.5% 1,053,179 51.1%
$5,001-$10,000 989,272 3,604,763 44.3% 3,787,552 48.8%
OVER $10,000 382,160 2,261,888 27.8% 2,459,181 47.9%
--------- ----------- ----- -----------
TOTAL 2,837,206 $ 8,131,831 100.0% $ 7,986,750 50.5%
========= =========== ===== ===========
2002
PERCENTAGE
CREDIT LIMIT NUMBER OF LOANS OF LOANS PERCENTAGE
RANGE ACCOUNTS OUTSTANDING OUTSTANDING OPEN TO BUY UTILIZED
--------------- --------- ----------- ----------- ----------- -----------
$1,000 OR LESS 332,583 $ 135,528 1.2% $ 63,716 68.0%
$1,001-$2,000 396,278 412,759 3.6% 238,865 63.3%
$2,001-$3,500 597,545 1,015,252 8.9% 744,739 57.7%
$3,501-$5,000 635,676 1,412,084 12.4% 1,457,913 49.2%
$5,001-$10,000 1,385,836 4,915,617 43.0% 5,671,671 46.4%
OVER $10,000 580,633 3,528,946 30.9% 3,832,989 47.9%
--------- ----------- ----- -----------
TOTAL 3,928,551 $11,420,186 100.0% $12,009,893 48.7%
========= =========== ===== ===========
(Dollars in thousands)
2003
PERCENTAGE
ACCOUNT NUMBER OF LOANS OF LOANS PERCENTAGE
BALANCE RANGE ACCOUNTS OUTSTANDING OUTSTANDING OPEN TO BUY UTILIZED
--------------- --------- ----------- ----------- ----------- -----------
CREDIT BALANCE 43,712 $ (3,605) -- $ 196,440 (1.9%)
NO BALANCE 481,296 -- -- 2,678,839 --
12
$1,000 OR LESS 619,267 263,923 3.2% 2,325,692 10.2%
$1,001-$2,000 359,726 537,368 6.6% 856,014 38.6%
$2,001-$3,500 413,461 1,134,320 14.0% 794,397 58.8%
$3,501-$5,000 309,349 1,317,428 16.2% 484,164 73.1%
$5,001-$10,000 489,840 3,457,371 42.5% 589,546 85.4%
OVER $10,000 120,555 1,425,026 17.5% 61,658 95.9%
--------- ----------- ----- -----------
TOTAL 2,837,206 $ 8,131,831 100.0% $ 7,986,750 50.5%
========= =========== ===== ===========
2002
PERCENTAGE
ACCOUNT NUMBER OF LOANS OF LOANS PERCENTAGE
BALANCE RANGE ACCOUNTS OUTSTANDING OUTSTANDING OPEN TO BUY UTILIZED
--------------- --------- ----------- ----------- ----------- -----------
CREDIT BALANCE 55,177 $ (5,608) (0.1%) $ 239,405 (2.4%)
NO BALANCE 799,403 -- -- 4,537,646 --
$1,000 OR LESS 810,656 346,158 3.1% 3,122,676 10.0%
$1,001-$2,000 489,361 743,566 6.5% 1,185,350 38.5%
$2,001-$3,500 557,843 1,567,766 13.7% 1,142,500 57.8%
$3,501-$5,000 406,831 1,796,085 15.7% 739,220 70.8%
$5,001-$10,000 647,042 4,840,182 42.4% 941,960 83.7%
OVER $10,000 162,238 2,132,037 18.7% 101,136 95.5%
--------- ----------- ----- -----------
TOTAL 3,928,551 $11,420,186 100.0% $12,009,893 48.7%
========= =========== ===== ===========
In February 2001, the Company initiated a targeted credit line increase
program to a portion of its existing portfolio. The decision to implement the
program was made based upon the following:
- Competitive credit line pressures and the risk of high attrition from the
core customer group; and
- A decision to focus growth and investment on our existing customers as
opposed to prospective customers due to an uncertain external economic
environment and other indicators.
In total, this program generated 1.6 million credit line increases from
February 2001 through September 2001, generating over $5.1 billion in additional
available credit. At its peak in February 2002, approximately $2.0 billion in
additional loan balances were generated from the program. The credit line
increase program was changed in the fourth quarter of 2001, and as of December
31, 2003, $133.9 million of additional loan balances generated remained.
In part because of the slow economic recovery, the credit line increase
program implemented in 2001 to our existing cardholders contributed to our
increased delinquencies and losses during 2002 and 2003. This program resulted
in higher average balances per account as customers utilized the additional
credit line provided. These increased balances per account also resulted in
higher balances per delinquent and charged-off account, causing our charge-offs
and delinquencies to rise during 2002 and stay at or above those levels for much
of 2003. The average balance per charged-off account in 2003 was $5,600,
compared to $4,700 in 2002 and $3,000 in 2001. As a result, significant programs
have been implemented across the managed receivables portfolio that have reduced
the available credit over $6.8 billion during the past two years, including:
13
- the elimination of lines by closing inactive credit card accounts and
reducing credit lines on high risk accounts;
- the limitation of overlimit authorization expansion to only the lowest risk
customers;
- the limitation on issuance of new credit cards and account access to high
risk customers; and
- the implementation of new credit line management strategies across the
portfolio for both credit line increases and decreases.
In addition, the Company has made changes within our collection
operation, including high-level changes to management. In early 2003 we reviewed
our collections operations to determine whether the collections function was
operating effectively. We determined that overall performance of the collections
function could be improved, and as a result we made significant changes in the
operation. We replaced a substantial portion of the senior management team,
updated the technology used by the operation, and initiated new training
programs for all levels of collections personnel. We also implemented a new
collections paradigm that incorporates specific requirements for staffing,
dialer strategies, and a new collections call model. In addition, reporting and
performance standards were enhanced to ensure that management is accountable for
performance in the future. During 2003, we also engaged specialized consultants
to help us create further improvements and efficiencies in recovering delinquent
dollars and reducing credit losses.
As of December 31, 2003, on an OWNED basis, 5.5% of the outstanding
receivable balance relates to cardholders with credit limits in excess of
$10,000, compared to 27.8% on a MANAGED basis. On an OWNED basis, 32.2% was
outstanding to cardholders with credit limits in excess of $5,000, compared to
72.1% on a MANAGED basis. As of December 31, 2002, on an OWNED basis, 9.1% of
the outstanding receivable balance relates to cardholders with credit limits in
excess of $10,000, compared to 30.9% on a MANAGED basis. On an OWNED basis,
48.5% was outstanding to cardholders with credit limits in excess of $5,000,
compared to 73.9% on a MANAGED basis. The difference in the above distributions
between the owned and managed credit card portfolios primarily reflects the
generally younger accounts that are in the owned credit card portfolio, as well
as the fact that the owned credit card portfolio contains the secured card
accounts which generally have lower credit levels.
The FFIEC has issued guidelines to further segregate a credit card
issuer's loan portfolio between subprime loans (loans to consumers who have a
FICO score of 660 or less) and prime loans (loans to consumers with FICO scores
in excess of 660). The banking regulators deem subprime loans to have higher
credit risk and, therefore, require higher levels of capital and allowance for
loan losses. Subprime receivables on an OWNED basis were $83.5 million or 65.7%
of the owned credit card portfolio as of December 31, 2003, compared to $447.3
million or 52.9% of the owned credit card portfolio as of December 31, 2002. The
amount of subprime receivables on a MANAGED basis was $4.9 billion or 61.2% of
the managed credit card portfolio as of December 31, 2003, compared to $7.1
billion or 62.3% of the managed credit card portfolio as of December 31, 2002.
14
Overall, as of December 31, 2003, the Company believes that the credit
quality in the OWNED credit card portfolio is generally worse than the credit
quality of the MANAGED credit card portfolio. Delinquent loans for the OWNED
credit card portfolio were 15.8% and 0.9% as of December 31, 2003 and 2002,
versus 11.1% and 11.0% on a MANAGED basis. Net principal charge-offs in the
OWNED credit card portfolio were 26.4% and 24.9% for the years ended December
31, 2003 and 2002, versus 20.2% and 15.5% respectively on a MANAGED basis.
Servicing, Billing and Payment
We have established a relationship with First Data Resources, Inc.
("FDR") for cardholder processing services. FDR is a subsidiary of First Data
Corporation, a provider of information processing and related services,
including cardholder processing (services for financial institutions that issue
credit cards to consumers), and merchant processing (services for financial
institutions that make arrangements with merchants for the acceptance of credit
cards as methods of payment). FDR provides the following services to us:
- data processing;
- credit card reissuance;
- monthly statements;
- interbank settlement; and
- after hours and overflow fraud management.
We handle the following functions internally:
- applications processing; and
- back office support for mail inquiries and most fraud management.
We handle most inbound customer service telephone calls for our
customer base. For a portion of 2003, we outsourced overflow customer service
calls to FDR during peak operation periods. In addition, we process a portion of
our customer payments, including all payments with exceptions. All other
payments are processed by Household Credit Services ("Household").
We generally assess periodic finance charges on an account if the
cardholder has not paid the balance in full from the previous billing cycle. We
base these finance charges on the average daily balance outstanding on the
account during the monthly billing cycle.
We do not impose a finance charge on purchases if cardholders pay the
entire balance on the account by the due date. If we are not paid in full prior
to the due date, which is generally 20 to 25 days after the statement cycle date
and applicable grace period, we impose finance charges on all purchases from the
date the transaction posted to the cardholder's account to the statement cycle
date. We also impose finance charges on each cash
15
advance from the day we make the advance until the cardholder pays the advance
in full.
We assess an annual fee on approximately 25% of the credit card
accounts. We may waive the annual fee, or a portion thereof, depending on the
credit terms offered, which we determine based on the prospect's risk profile
prior to solicitation, or when we determine a waiver to be appropriate
considering the account's overall profitability. In addition to the annual fee,
we charge other fees, including:
- a late fee with respect to any unpaid monthly balance if we do not receive
the required minimum monthly payment by the due date and the account is
less than 120 days contractually past due;
- a cash advance fee for most cash advances;
- a fee with respect to each check submitted by a cardholder in payment of an
account, which the cardholder's bank does not honor; and
- an overlimit charge consistent with the cardholder agreement if, at any
time during the billing cycle, the total amount owed exceeds the
cardholder's credit limit and the account was less than 120 days
contractually past due.
Each cardholder is subject to an agreement governing the terms and
conditions of his or her account. Pursuant to the agreement, we reserve the
right to change or terminate certain terms, conditions, services and features of
the account, including periodic finance charges, late fees, returned check
charges and any other charges, and the minimum payment, subject to the
conditions set forth in the cardholder agreement.
FDR sends monthly billing statements to cardholders on our behalf. When
we establish an account, we assign a billing cycle to that account. Each of
these cycles has a separate monthly billing date based on the business day of
the calendar month on which the cycle begins. Each month, we send a statement to
all cardholders whose accounts have an outstanding balance greater than $1. The
majority of non charged-off cardholders must make a minimum monthly payment,
which is generally the greater of:
- $15;
- 2.5% of the outstanding balance;
- the finance charge; or
- the balance of the account if the balance is less than $15;
plus, in each case, any past due amount.
If we do not receive the minimum payment by the due date, we consider
the account delinquent.
16
Most merchant transactions by cardholders are authorized online. All
authorizations are handled through FDR's adaptive control and fraud detection
systems.
To monitor accounts and authorizations for potential fraudulent
activity, we utilize the Falcon(R) fraud detection neural net system. This
product scores authorizations and allows for development of rules-based
strategies to queue decision authorizations based on a calculated fraud risk.
Accounts suspected of fraud via the scoring model, or rules-based queues, are
blocked or referred until the activity can be verified with the cardholder. This
process targets all main types of fraud, including lost/stolen, non-receipt,
fraudulent application, counterfeit, account takeover, cardholder not present,
and check kiting fraud.
Delinquency, Collections and Charge-offs
We consider an account delinquent if we do not receive the minimum
payment by the payment due date. 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 ("workout re-age") may receive a workout re-age
upon entering the debt management program. 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.
We handle substantially all collections internally, and we determine
the appropriate collection action to take by using FDR's adaptive control
system, which continually monitors all delinquent accounts. We close accounts
that become 60 days contractually delinquent. We charge-off and take accounts as
a loss either:
- within 60 days of formal notification of bankruptcy;
- at the end of the month during which most unsecured accounts become
contractually 180 days past due;
- at the end of the month during which unsecured accounts that have entered
into a credit counseling or other similar program become contractually 120
days past due;
- at the end of the month during which secured accounts become contractually
120 days past due; or
- when identified as fraud losses no later than 90 days from discovery.
We enter into agreements with third parties for the sale of receivables
on a majority of our charged-off accounts. When appropriate, we place delinquent
accounts with external collection agencies or attorneys.
As part of our overall portfolio management, we periodically sell
portfolios of delinquent credit card accounts. These transactions have a
17
direct effect on our charge-off dollars and rates as any reduction in the loan's
value is reflected as a charge-off.
Credit Protection Products
In addition to credit cards, we offer credit protection and insurance
products. These products are sold exclusively to Direct Merchants Bank credit
cardholders and include:
Account Protection Plus(SM) is a program that will waive the balance of
a customer's Direct Merchants Bank credit card account (up to the credit limit)
in the event of the cardholder's death. It further protects the credit card
account holder in the event of involuntary unemployment, disability or the need
to take an employer approved leave-of-absence. In these situations, the
customer's account is "frozen" with no payments due or interest accruing up to
the maximum period of time permissible for each event.
Account Benefit Plan is a program that will waive the balance of a
customer's Direct Merchants Bank credit card account (up to the credit limit) in
the event of the cardholder's death.
Credit Life Insurance offers our credit cardholders traditional life
insurance benefits that will pay the balance of the Direct Merchants Bank credit
card account in the event of the cardholder's death. Additional coverage may be
available on a state-by-state basis that will pay the minimum payment due on the
covered credit card account in the event of unemployment or disability. The
insurance benefits are offered by insurance companies that re-insure those
policies with ICOM Limited, our captive insurance subsidiary.
Third-Party Insurance Products. We cooperate with a variety of
insurance companies to sell their regulated products to Direct Merchants Bank
customers. Our arrangements with these insurance companies generally follow one
of two formats:
- The insurance company pays us a fee for access to a select list of our
cardholders. We provide support during the solicitation and billing
process.
- Our licensed insurance subsidiary, MES Insurance Agency, LLC, manages the
solicitation of customers for the third-party insurance products and pays
the expenses of that solicitation in exchange for a commission.
With lower-risk products, our captive insurance subsidiary, ICOM Limited, may
re-insurance all or a portion of the risk of the third-party insurance policies
that are sold. In that situation, we bear the administrative costs of servicing
the policies.
List Syndication. We cooperate with a variety of third-party partners
to sell their products to Direct Merchants Bank customers. These transactions
may follow different terms. Generally, the partner pays us a fee for access to a
select list of cardholders and the opportunity to leverage Direct Merchants
Bank's name during solicitation and billing processes that we support.
18
Asset Securitizations and Other Funding Vehicles
We securitize credit card loans in order to manage our total cost of
funds. Our securitizations involve packaging and selling pools of both current
and future receivable balances on credit card accounts, in which we retain the
servicing of such receivables. In accordance with GAAP, our securitizations are
generally treated as sales or, in certain circumstances, as collateralized
borrowing transactions. The securitized receivables accounted for as sales are
removed from our balance sheet.
We securitize receivables by selling the receivables to the Metris
Master Trust. The Metris Master Trust issues securities through public
asset-backed securitizations or to multi-seller commercial paper conduits.
Metris Master Trust
The Metris Master Trust was formed in May 1995 pursuant to a pooling
and servicing agreement, as amended. Metris Receivables, Inc. ("MRI"), one of
our special purpose entity subsidiaries, transfers receivables in designated
accounts to the Metris Master Trust. The Metris Master Trust may, and does from
time to time, issue securities that represent undivided interests in the
receivables in the Metris Master Trust. These securities are issued by series
and each series typically has multiple classes of securities. Each series or
class within a series may have different terms. The different classes of an
individual series are structured to obtain specific debt ratings. As of December
31, 2003, 11 series of publicly issued securities were outstanding. MRI
currently retains the most subordinated class of securities in each series and
all other classes are issued to nonaffiliated third parties. These securities
are interests in the Metris Master Trust only and are not obligations of MRI,
MCI, Direct Merchants Bank, or any other subsidiary of the Company. The interest
in the Metris Master Trust not represented by any series of securities issued by
the Metris Master Trust also belongs to MRI and is known as the transferor
interest.
Generally, each series involves an initial reinvestment period,
referred to as the "revolving period," in which principal payments on
receivables allocated to such series are returned to MRI and reinvested in new
principal receivables arising in the accounts. After the revolving period ends,
principal payments allocated to the series are then accumulated and used to
repay the investors. This period is referred to as the "accumulation period,"
and is followed by a "controlled amortization period" wherein investors are
repaid their invested amount. The scheduled accumulation and amortization
periods are set forth in the agreements governing each series. Currently, the
Metris Master Trust does not have any series in an accumulation period or
controlled amortization period. However, all series set forth certain events by
which amortization can be accelerated, referred to as "early amortization."
Reasons an early amortization could occur include:
- the one or three-month average of portfolio collections, less principal and
finance charge charge-offs, financing costs and servicing costs ("excess
spread") drops below certain levels, currently no higher than 1%;
- the existence of negative excess transferors interest within the Metris
Master Trust; or
19
- the failure to obtain funding prior to an accumulation period for a
maturing term asset-backed securitization.
New receivables in designated accounts cannot be funded from a series
that is in early amortization. We currently do not have any series that is in
early amortization.
In addition, there are various provisions within our securitization
agreements that restrict the release of cash to us from the Metris Master Trust.
This restricted cash provides additional security to the investors in the Metris
Master Trust. We reflect cash restricted from release in the Metris Master Trust
as "Retained interests in loans securitized" in the consolidated balance sheet.
The extent to which cash is restricted usually relates to the performance of the
Metris Master Trust, specifically the average net excess spread over a one to
three-month period.
On a monthly basis, each series of securities is allocated its share of
finance charge collections, which is used to pay interest on the series'
securities, pay the series' share of servicing fees and reimburse investors for
the applicable series' share of losses due to charge-offs. Amounts remaining may
be deposited in cash accounts of the Metris Master Trust as additional
protection for future losses. Once each of these obligations is fully met,
remaining finance charge collections, if any, are returned to us.
Bank-Sponsored Conduit Programs
We maintain flexibility in our current funding program by using
primarily bank-sponsored commercial paper conduits within the Metris Master
Trust. These conduits purchase an interest in receivables arising in designated
accounts. These transactions also feature a revolving period in which principal
payments on receivables allocated to the conduits are returned to us and
reinvested in new receivables. These agreements also have early amortization
provisions. (See the above discussion under "Metris Master Trust"). Finance
charge collections are used to pay certain obligations, including servicing
fees, interest on the principal amount of the conduits' investment in the
applicable receivables and recouping charge-offs. After such allocation,
remaining finance charge collections, if any, are returned to us.
Additional information regarding asset securitization is set forth
under "Liquidity, Funding, and Capital Resources" on pages 62-72 of this Report.
COMPETITION
We face intense and increasing competition from numerous financial
services providers, many of which have greater resources and name recognition
than we do. Our credit card business competes with national, regional and local
bankcard issuers, as well as other general purpose and private label credit card
issuers. Some of these issuers are substantially larger, have more seasoned
credit card portfolios and often compete for customers by offering lower
interest rates and/or fee levels than we do. There has been continued focus on
solicitations to middle market consumers, as competitors target this market.
Customers are attracted to credit card issuers largely on the basis of price,
credit limit and other product features. As a result, customer loyalty often is
limited. However, we believe that our strategy of
20
focusing on the middle market sector and our proprietary prospect database,
proprietary models and internal credit scores allow us to compete effectively
for middle market cardholders.
REGULATION
The Company and Direct Merchants Bank
Direct Merchants Bank is a limited purpose credit card bank chartered
as a national banking association. It is a member of the Federal Reserve System.
Its deposits are insured by the Bank Insurance Fund, which is administered by
the Federal Deposit Insurance Corporation ("FDIC"), and it is subject to
comprehensive regulation and periodic examination by the Office of the
Comptroller of the Currency ("OCC"), its primary regulator. It is also subject
to regulation by the FDIC, as a back-up regulator. Direct Merchants Bank is not
a "bank" as defined under the Bank Holding Company Act of 1956 ("BHCA"), as
amended, because it:
- engages only in credit card operations;
- does not accept demand deposits or deposits that the depositor may withdraw
by check or similar means for payment to third parties or others;
- does not accept any savings or time deposits of less than $100,000, except
for deposits pledged as collateral for extensions of credit;
- maintains only one office that accepts deposits; and
- does not engage in the business of making commercial loans.
If Direct Merchants Bank failed to meet the credit card bank criteria
described above, its status as an insured bank would make us subject to the
provisions of the BHCA.
The OCC establishes operating guidelines for national banks, to which
Direct Merchants Bank is subject. On January 31, 2001, the OCC, Federal Reserve
Board, FDIC and Office of Thrift Supervision jointly issued their "Expanded
Guidance for Subprime Lending Programs," which subjects subprime lending
institutions to closer examination scrutiny in order to ensure that their
programs have appropriate risk management controls and capital support. Under
the expanded guidance, the allowance for loan losses required for subprime loans
must be sufficient to absorb at least all estimated credit losses on outstanding
balances over the current operating cycle. Each lender is responsible for
quantifying the amount of capital needed to offset the additional risk inherent
in subprime lending activities, and for fully documenting the methodology and
analysis supporting the amounts specified. As described below, the Bank is
required to maintain capital levels in accordance with the Modified Operating
Agreement that it and MCI have entered into with the OCC.
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
21
accounting policies which are designed to bring consistency in practice between
institutions. Many aspects of the guidance have been implemented by the Bank
with no material impact to our financial statements. We continue testing
alternative approaches to comply with the minimum payment and negative
amortization provisions of the guidance, the results of which are not expected
until the second half of 2004. At this time we are unable to provide assurance
that adoption of the guidance will not have a material adverse effect on our
financial condition.
On March 18, 2003, the Bank and MCI entered into an Operating Agreement
with the OCC. The terms of the Operating Agreement required the Bank and MCI to
enter into a Capital Assurance and Liquidity Maintenance Agreement ("CALMA")
also executed on March 18, 2003. The CALMA requires MCI to make such capital
infusions or provide the Bank with financial assistance so as to permit the Bank
to meet its liquidity requirements.
The Operating Agreement also required Direct Merchants Bank to enter
into a Liquidity Reserve Deposit Agreement under which the 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
short term liquid investments and are classified on the balance sheets as the
"Liquidity reserve deposit." As of December 31, 2003, the balance of the
liquidity reserve deposit was $80 million.
The Operating Agreement was terminated and replaced with a Modified
Operating Agreement effective December 11, 2003. Both the CALMA and the
Liquidity Reserve Deposit Agreement remain in effect. The Modified Operating
Agreement requires, among other things, that:
- The Bank must maintain capital at the dollar amount reported on its
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 required
level.
- The Bank must maintain, at a minimum, liquid assets of not less than $35
million or 100% of the average highest daily funding requirement for
managed receivables.
- The Bank must comply with the terms of the Liquidity Reserve Deposit
Agreement and the CALMA.
- MCI must comply with the terms of the CALMA.
If the OCC were to conclude that the Bank failed to adhere to any
provisions of the Modified Operating Agreement, the OCC could pursue various
enforcement options. If any of these options were to be pursued by the OCC, it
could have a material adverse effect on our operations or capital position.
In July 2003, the OCC requested and Direct Merchants Bank agreed to
eliminate the jumbo certificates of deposit ("CDs") issued by the Bank, and the
risk thereof to the FDIC, by September 30, 2003. The Bank sold $559.3 million of
CDs on September 30, 2003, utilizing a combination of cash on
22
hand, cash generated through the sale of assets to a third-party, and sales of
assets to MCI.
Exportation of Interest Rates and Fees
Under current federal law, national banks such as Direct Merchants Bank
may charge interest at the rate allowed by the laws of the state where the bank
is located and may export those interest rates on loans to borrowers in other
states, without regard to the laws of such other states.
The United States Supreme Court has held that national banks may also
impose late payment fees, overlimit fees, annual fees, cash advance fees and
membership fees allowed by the laws of the state where the national bank is
located on borrowers in other states, without regard to the laws of such other
states. The Supreme Court based its opinion largely on its deference to a
regulation adopted by the OCC that has been interpreted to permit national banks
to export interest rates. As a result, national banks, such as Direct Merchants
Bank, may export such fees.
Dividends and Transfers of Funds
There are various federal law limitations on the extent to which Direct
Merchants Bank can finance or otherwise supply funds to MCI and its affiliates
through dividends, loans or otherwise. These limitations include:
- minimum regulatory capital requirements;
- restrictions concerning the payment of dividends out of net profits or
surplus; and
- Sections 23A and 23B of the Federal Reserve Act governing transactions
between a bank and its affiliates.
In general, federal law prohibits a national bank, such as Direct
Merchants Bank, from making dividend distributions on common stock if the
dividend would exceed currently available undistributed profits. In addition,
Direct Merchants Bank must obtain OCC approval prior to declaring and paying a
dividend, if such distribution would exceed current year net income combined
with retained earnings from the prior two years. Direct Merchants Bank cannot
make a dividend if the distribution would cause it to fail to meet applicable
capital adequacy standards. Finally, although not a regulatory restriction, the
terms of certain of our debt agreements prohibit the payment of dividends in
certain circumstances. See Note 17 to the Consolidated Financial Statements on
page 105.
Capital Adequacy
The Federal Deposit Insurance Corporation Improvement Act of 1991
("FDICIA") requires federal banking regulators to prescribe certain non-capital
standards for safety and soundness relating generally to operations and
management, asset quality and executive compensation. FDICIA also provides that
regulatory action may be taken against a bank that does not meet such standards.
23
The OCC has adopted regulations that define the five capital categories
(well-capitalized, adequately-capitalized, undercapitalized,
significantly-undercapitalized and critically-undercapitalized) identified by
FDICIA, using total risk-based capital, Tier 1 risk-based capital and leveraged
capital ratios as the relevant capital measures. Such regulations establish
various degrees of corrective action to be taken when an institution is
considered undercapitalized. Under the regulations, a "well-capitalized"
institution must have a Tier 1 capital ratio of at least 6%, a total capital
ratio of at least 10%, a leverage ratio of at least 5%, and not be subject to a
capital directive order. Under these guidelines, Direct Merchants Bank is
considered well-capitalized. The Modified Operating Agreement, which is
discussed on page 22, prescribes minimum capital levels as well.
FDICIA requires the FDIC to implement a system of risk-based premiums
for deposit insurance pursuant to which the premiums paid by a depository
institution will be based on the probability that the FDIC will incur a loss
with respect to such institution. The FDIC has adopted a system that imposes
insurance premiums based on a matrix that takes into account a bank's capital
level and supervisory rating.
Under FDICIA, only "well-capitalized" and "adequately-capitalized"
banks may accept brokered deposits. In July 2003, the OCC requested and Direct
Merchants Bank agreed to eliminate federally-insured CDs at the Bank, and the
risk thereof to the FDIC, by September 30, 2003. The Bank sold $559.3 million of
CDs 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. We do not anticipate
issuing certificates of deposit in the foreseeable future.
Lending Activities
Direct Merchants Bank's activities as a credit card lender are also
subject to regulation under various federal consumer protection laws, including
the Truth-in-Lending Act, the Equal Credit Opportunity Act, the Fair Credit
Reporting Act, the Community Reinvestment Act ("CRA") and the Service Member
Civil Relief Act. Regulators are authorized to impose penalties for violations
of these statutes and, in certain cases, to order Direct Merchants Bank to pay
restitution to injured cardholders. Cardholders may also bring actions for
certain alleged violations of such regulations. Federal and state bankruptcy and
debtor relief laws also affect Direct Merchants Bank's ability to collect
outstanding balances owed by cardholders who seek relief under those statutes.
The OCC's CRA regulations subject limited purpose banks, including
Direct Merchants Bank, to a "community development" test for evaluating required
CRA compliance. The community development performance of a limited purpose bank
is evaluated pursuant to various criteria involving community development
lending, qualified investments and community development services.
Legislation; Consumer and Debtor Protection Laws
Congress has passed a financial services law that requires us to
disclose our practices for collection and sharing of non-public customer
information. Changes to this law, or enactment of new laws, could require us
24
to limit or substantially modify our credit card marketing activities and
practices in way that could adversely affect us if these changes result in
additional limits on sharing information. There is such legislation currently
pending or under consideration at the federal and state level.
Additionally, Congress is considering legislation that would amend the
federal bankruptcy laws. Prior legislation, which failed to be signed into law,
was generally considered to be favorable to the credit card industry. However,
any changes to state debtor relief and collection laws could adversely affect us
if such changes result in, among other things, accounts being charged-off as
uncollectible and increased administrative expenses. Congress and the states may
in the future consider other legislation that would materially affect the credit
card and related enhancement services industries.
Various federal and state consumer protection laws limit our ability to
offer and extend credit. In addition, the U.S. Congress and the states may
decide to regulate further the credit card industry by enacting new laws or
amendments to existing laws to reduce finance charges or other fees or charges
applicable to credit card and other consumer revolving loan accounts. These laws
may adversely affect our ability to collect on account balances or maintain
established levels of periodic rate finance charges and other fees and charges
with respect to the accounts.
Investment in the Company and Direct Merchants Bank
Certain acquisitions of capital stock may be subject to regulatory
approval or notice under federal law. Investors are responsible for insuring
that they do not directly or indirectly acquire shares of our capital stock in
excess of the amount that can be acquired without regulatory approval.
Interstate Taxation
Several states have enacted legislation taxing the income from
interstate financial activities, including credit cards, derived from accounts
held by their residents. We believe this legislation will not materially affect
us. Our belief is based upon current interpretations of the enforceability of
this legislation, prior court decisions and the volume of our business in states
that have passed such legislation.
Licensing Requirements
Our captive insurance subsidiary, ICOM Limited, is licensed in Bermuda
under The Insurance Act of 1978 as a Class 2 Insurer. We are restricted from
writing any long-term policies or pursuing any unrelated business in excess of
certain limits under Bermuda law.
Fair Credit Reporting Act
The Fair Credit Reporting Act ("FCRA") regulates consumer reporting
agencies. Under the FCRA, an entity risks becoming a consumer reporting agency
if it furnishes consumer reports to third parties. A consumer report is a
communication of information which bears on a consumer's creditworthiness,
credit capacity, credit standing or certain other characteristics, and which is
collected or used or expected to be used to
25
determine the consumer's eligibility for credit, insurance, employment or
certain other purposes. The FCRA explicitly excludes from the definition of
consumer report a report containing information solely as to transactions or
experiences between the consumer and the entity making the report. An entity may
share consumer reports with any of its affiliates so long as that entity
provides consumers with appropriate disclosure and an opportunity to opt out of
such affiliate sharing.
Our objective is to conduct our operations in a manner that would fall
outside the definition of a consumer reporting agency under the FCRA. If we were
to become a consumer-reporting agency, we would be subject to a number of
complex and burdensome regulatory requirements and restrictions. Such
restrictions could have a material adverse effect on our results of operations,
financial condition and ability to operate.
REGULATORY INVESTIGATIONS
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 our treatment of the "Allowance for loan losses"
in 2001 and subsequent years, our 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 issues, as well as 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. The SEC has informed us that it is reviewing the information and
documents that we have submitted. We anticipate that we will provide additional
information and documents to the SEC in the future. The SEC also may depose
certain of our executive officers and directors in connection with its
investigation. At this time, we cannot predict how long the SEC investigation
will last or what the results of the investigation will be. If the SEC
determines that we or our officers and directors have violated federal
securities laws or the SEC's rules and regulations, we could be subject to SEC
enforcement action, including potential fines and penalties, which could
materially adversely affect our results of operations or financial condition. We
can not assure you the resolution of the SEC investigation will not necessitate
further amendments or restatements to our previously filed reports. We do not
believe, however, that we or our officers or directors have violated any such
laws, rules or regulations.
On August 2, 2003, we received from the OCC correspondence indicating
that we were the subject of an investigation, together with a subpoena requiring
us to produce certain documents. In October 2003, the OCC informally requested
additional documents. On April 1, 2004 we received a second subpoena requiring
us to produce additional documents related primarily to executive compensation
and reimbursement. We do not believe that the OCC's investigation concerns any
of the activities of our current executives.
26
EMPLOYEES
We have approximately 2,900 employees located in Arizona, Florida,
Maryland, Minnesota and Oklahoma. None of our employees are represented by a
collective bargaining agreement.
TRADEMARKS, TRADE NAMES AND SERVICE MARKS
MCI and its subsidiaries have registered and continue to register, when
appropriate, various trademarks, tradenames and service marks used in connection
with our business and for private label marketing of certain of our products. We
consider these trademarks and service marks to be readily identifiable with, and
valuable to, our business.
EXECUTIVE OFFICERS OF THE REGISTRANT
The following table sets forth certain information concerning the
persons who currently serve as our executive officers. Each executive officer
serves at the discretion of our Board of Directors.
NAME AGE POSITION
---- --- --------
David D. Wesselink 61 Chairman and Chief Executive Officer
Richard G. Evans 55 Executive Vice President, General Counsel and Secretary
Matthew S. Melius 38 Executive Vice President, Credit Risk Management; President
of Direct Merchants Bank
Dan N. Piteleski 53 Executive Vice President, Chief Information Officer
John A. Witham 52 Executive Vice President, Chief Financial Officer
Scott R. Fjellman 38 Senior Vice President, Treasurer
Mark P. Wagener 43 Senior Vice President, Controller
David D. Wesselink has been Chairman and Chief Executive Officer of the
Company since December 2002. Mr. Wesselink previously was Vice Chairman of the
Company from September 2000 to December 2002, and Executive Vice President,
Chief Financial Officer of the Company from December 1998 to August 2000. Prior
to joining us, Mr. Wesselink was Senior Vice President and Chief Financial
Officer of Advanta Corporation since 1993. Prior to Advanta Corporation, Mr.
Wesselink held several positions at Household Finance Corp. and Household
International, Inc. from 1971 to 1993, including Senior Vice President from 1986
to 1993, and Chief Financial Officer from 1982 to 1993. Mr. Wesselink is also a
director of MasterCard Incorporated (U.S. Region Board), Saxon Capital, Inc. and
CFC International, Inc.
Richard G. Evans has been Executive Vice President, General Counsel and
Secretary of the Company since June 2001. Prior to joining us, Mr. Evans was
Executive Vice President, General Counsel and Director of Green Tree Financial
Corporation from 1985 to 1999. Prior to Green Tree, Mr. Evans
27
served as Special Assistant Attorney General for the State of Minnesota from
1974 to 1984.
Matthew S. Melius has been Executive Vice President, Credit Risk
Management of the Company since January 2001. Mr. Melius previously was
Executive Vice President, E-Commerce of the Company from September 2000 to
December 2000; Senior Vice President, E-Commerce from January 2000 to August
2000; Senior Vice President, Portfolio Marketing from January 1998 to December
1999; and Vice President, Marketing from September 1995 to December 1997. Prior
to that, Mr. Melius served seven years in the credit card division of the First
National Bank of Omaha, where he advanced from a management trainee to manager
of the portfolio management department, where he directed the account retention
and portfolio profitability operations.
Dan N. Piteleski has been Executive Vice President and Chief
Information Officer of the Company since May 2002. Mr. Piteleski previously was
Senior Vice President, Chief Information Officer of the Company from May 2001 to
April 2002. Prior to joining us, Mr. Piteleski was Vice President, Chief
Information Officer of H.B. Fuller Company for six years. Prior to H.B. Fuller,
Mr. Piteleski served as Vice President, Information Systems at Zenith Data
Systems for two and one-half years. Before Zenith, Mr. Piteleski was Manager,
Information Systems and Technology at Apple Computer for four years. Mr.
Piteleski also has worked in information systems at Equitable Resources Energy
Company, Inc., and American Standard.
John A. Witham has been Executive Vice President and Chief Financial
Officer of the Company since November 2002. Mr. Witham previously was Senior
Vice President, Finance of the Company from June 2002 to October 2002. Prior to
joining us, Mr. Witham was Executive Vice President, Chief Financial Officer of
Bracknell Corp. from November 2000 to October 2001. (In November 2001, Adesta
Communications Inc., a wholly-owned subsidiary of Bracknell Corp. voluntarily
commenced a case under Chapter 11 of the United States Code in the United States
Bankruptcy Court, District of Nebraska. In January 2002, State Group LTD, a
wholly-owned subsidiary of Bracknell Corp., filed bankruptcy in Toronto, Ontario
CANADA.) Before Bracknell Corp., Mr. Witham was Executive Vice President and
Chief Financial Officer for Arcadia Financial Ltd. from February 1994 to June
2000.
Scott R. Fjellman has been Senior Vice President and Treasurer of the
Company since January 2003. Mr. Fjellman previously was Vice President,
Assistant Treasurer of the Company from April 2000 to December 2002. Prior to
joining us, Mr. Fjellman was with Arcadia Financial Ltd. for eight years, most
recently as Vice President of Securitization and Investor Relations. Before
joining Arcadia Financial, Mr. Fjellman spent three years as an auditor with
KPMG LLP.
Mark P. Wagener has been Senior Vice President and Controller of the
Company since October 2001. Mr. Wagener previously was Vice President, Assistant
Controller of the Company from June 2000 to September 2001. Prior to joining us,
Mr. Wagener served for 13 years at Norwest Corporation (now Wells Fargo &
Company), most recently as Director of Corporate Planning and Analysis. Mr.
Wagener began his career with Arthur Andersen & Co. where he worked for five
years as an auditor.
28
Our officers are elected by, and hold office at the will of, our Board
of Directors and do not serve a "term of office" as such.
RISK FACTORS
The factors discussed below, among others, could cause our actual
results to differ materially from those expressed in any forward-looking
statements that we make in this Annual Report on From 10-K. See "Forward Looking
Statements under Item 7 on page 77. Although we have attempted to list
comprehensively these important factors, we caution you that other factors may
in the future prove to be important in affecting our results of operations. New
factors emerge from time to time and it is not possible for us to predict all of
these factors, nor can we assess the impact of each such factor on the business
or the extent to which any factor, or combination of factors, may cause actual
results to differ materially from those contained in any forward-looking
statement.
WE REQUIRE A HIGH DEGREE OF LIQUIDITY TO OPERATE OUR BUSINESS, AND AN
INABILITY TO ACCESS FUNDING AT THE TIMES AND IN THE AMOUNTS THAT WE NEED COULD
ADVERSELY AFFECT OUR ABILITY TO OPERATE OR OUR FINANCIAL RESULTS.
Key elements of our strategy depend on us having adequate available
cash, and we therefore require a high degree of liquidity to operate our
business. See "Management's Discussion and Analysis of Operations - Liquidity
and Capital Resources" for a more detailed discussion of liquidity. Activities
for which we need cash include:
- funding new receivables;
- making interest and principal payments under our credit agreement, existing
senior notes and other indebtedness;
- refinancing maturing series of asset-backed securities issued by the Metris
Master Trust;
- providing credit enhancement with respect to asset-back securities issued
by the Metris Master Trust;
- covering fees and expenses incurred in connection with the securitization
of receivables; and
- meeting other operating expenses.
We anticipate that we will need to enter into financing transactions on
a regular basis, including the securitization of credit card receivables, to
provide cash for these uses. In particular, during the remainder of 2004, we
will need to obtain funding to meet the following maturing obligations:
- $1.75 billion in outstanding term asset-backed securities and $280 million
in outstanding bank conduit financing issued by the Metris Master Trust;
- $95.3 million outstanding under our term loan that is due in June 2004; and
29
- $100 million in senior notes that mature in November 2004.
Since the fourth quarter of 2002, as a result of a deterioration in the
performance of our assets and downgrades in the ratings assigned to our debt
securities, our access to funding has been reduced and the cost and other terms
of the funding that is available to us have been less favorable than had
previously been the case. For example, our securitization transactions completed
in 2003 contained terms that were less favorable than those contained in prior
securitization transactions, including increased subordination levels and
reserve requirements and additional early amortization events. Future downgrades
in our debt ratings or those of Direct Merchants Bank, or resumed deterioration
in our asset quality could result in additional negative impacts on our ability
to access the funding we need and the price of that funding to us. Disruptions
or unfavorable conditions related to one of our financing sources, such as
securitizations, may have similar effects with respect to other financing
sources. In addition, the agreements governing our existing debt financing
contain restrictions that may adversely affect our ability to obtain future
financing. Economic, legal, regulatory, accounting and tax changes could also
make securitization and other sources of funding more difficult, less efficient,
more expensive or unavailable. Finally, many of our competitors have more
capital and higher debt ratings than we do, which may enhance their ability to
obtain funding and reduce their cost of funding compared to ours.
In the past, the sale of brokered certificates of deposit, or CDs, by
Direct Merchants Bank represented a significant source of funding for us.
However, in July 2003, the OCC requested that Direct Merchants Bank eliminate
its federally-insured deposits, or the risk of those deposits to the FDIC, by
September 30, 2003. In response, Direct Merchants Bank sold its insured
certificates of deposit on September 30, 2003. We do not anticipate issuing
certificates of deposit as a source of funding in the foreseeable future, which
may contribute to increased funding costs.
If we are unable to access funding at the times and in the amounts that
we need, we would be required to scale back our business operations, may be
unable to refinance maturing series of asset-backed securities issued by the
Metris Master Trust, and may be unable to pay amounts due with respect to our
credit agreement or our existing senior notes. Either an inability to refinance
maturing series of securities issued by the Metris Master Trust or a default in
payment when due of any amounts under our credit agreement or our existing
senior notes could ultimately result in both an early amortization of the
asset-backed securities issued by the Metris Master Trust and an acceleration of
all amounts due under our credit agreement and our existing senior notes. Any
such event could also prevent us from paying our other obligations when due.
Even if we are successful in obtaining the funding that we need, an increase in
the cost of that funding would negatively impact our financial results.
OUR TARGET CONSUMERS GENERALLY HAVE HIGHER DEFAULT RATES AND ARE
IMPACTED MORE BY GENERAL ECONOMIC AND SOCIAL FACTORS THAN HIGHER INCOME
CONSUMERS.
The primary risk associated with secured and unsecured lending to
middle market consumers is that default rates for these consumers are higher
than those for higher income consumers. This results in more accounts being
30
charged off as uncollectable than would be the case with higher income
consumers. If we are not successful in evaluating the creditworthiness of our
target customers or in applying our risk-based pricing system, we could
experience greater levels of delinquencies and losses. In addition, general
economic and social factors, such as the rate of inflation, unemployment levels,
interest rates and the effects of periods of war may have a greater impact on
consumers in our target market than on those with higher incomes. Accordingly,
any general worsening of economic or social conditions may have a
disproportionate effect on our target consumers and, thus, on our delinquency
and charge-off rates.
THE OCCURRENCE OF CERTAIN EVENTS COULD RESULT IN EARLY AMORTIZATION
(REQUIRED REPAYMENT) OF THE SECURITIES ISSUED BY THE METRIS MASTER TRUST AND
ALSO CAUSE ALL AMOUNTS OUTSTANDING UNDER OUR CREDIT AGREEMENT AND OUR EXISTING
SENIOR NOTES TO BECOME DUE AND PAYABLE.
Certain events, such as a deterioration in the performance of our
securitized receivables, deterioration in our financial condition, breaches of
representations, warranties or covenants that we make in the documentation
relating to our securitizations or defaults under our other credit arrangements,
including our credit agreement, could result in early amortization (required
repayment) of the principal amount of the securities issued by the Metris Master
Trust. Early amortization would also cause a default under our credit agreement
which could, in turn, lead to a default with respect to our existing senior
notes, potentially resulting in all amounts due under those arrangements also
becoming due and payable.
IF THE RECENT IMPROVEMENT IN OUR DELINQUENCY AND CHARGE-OFF RATES DOES
NOT CONTINUE, IT COULD NEGATIVELY IMPACT OUR ABILITY TO COMPLETE FUTURE
SECURITIZATION TRANSACTIONS ON ACCEPTABLE TERMS OR AT ALL AND MIGHT RESULT IN
EARLY AMORTIZATION OF OUTSTANDING SECURITIES ISSUED BY THE METRIS MASTER TRUST.
During late 2002 and most of 2003, we experienced significant increases
in the delinquency rate on our credit card loans and the rate at which our
credit card loans were charged off as uncollectable (the "net charge-off rate").
We have taken steps that have resulted since late 2003 in a reversal of these
increases. However, if our responsive steps ultimately are not successful and
the recent improvement in our delinquency and net charge-off rates does not
continue, it could, among other things:
- cause purchasers of securities issued by the Metris Master Trust to require
even higher credit enhancement levels for future securities issued by the
Metris Master Trust, which could divert significant amounts of cash that
otherwise would be available to us;
- jeopardize our ability to complete future securitization transactions on
acceptable terms or at all, thereby decreasing our liquidity and forcing us
to rely on other potentially more expensive funding sources, to the extent
available; and
- cause early amortization (required repayment) of outstanding securities
issued by the Metris Master Trust, with the potential results noted above.
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DIRECT MERCHANTS BANK IS SUBJECT TO REGULATORS WHO COULD IMPOSE
RESTRICTIONS THAT COULD NEGATIVELY IMPACT OUR OPERATIONS OR FINANCIAL RESULTS.
The operations of Direct Merchants Bank and its activities as a credit
card lender are subject to regular review and examination by federal regulators
to assess compliance with federal laws and regulations regarding the safety and
soundness of financial institutions and federal consumer protection laws. These
regulators have broad discretion to issue or revise regulations, and to issue
guidance, that may significantly affect Direct Merchants Bank and the way the
Bank or we conduct business. For example, the banking regulators have issued
guidelines that require financial institutions engaged in subprime lending
(including Direct Merchants Bank) to carry higher levels of capital and credit
loss reserves than other financial institutions. These regulators are also
authorized to impose penalties for violations of the laws and regulations that
they oversee including, in certain cases, ordering Direct Merchants Bank to pay
restitution to cardholders. Any new or more restrictive requirements could
negatively impact our operations or financial results, limit our growth
prospects, reduce our returns on capital or require us to raise additional
capital.
In January 2003, the 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. Many aspects of the guidance have been
implemented by the Bank with no material impact to our financial statements. We
continue testing alternative approaches to comply with the minimum payment and
negative amortization provisions of the guidance, the results of which are not
expected until the second half of 2004. At this time we are unable to provide
assurance that adoption of the guidance will not have a material adverse effect
on our financial condition.
DIRECT MERCHANTS BANK'S ACTIVITIES ARE REGULATED BY THE OCC AND FAILURE
TO OPERATE IN ACCORDANCE WITH ITS RESTRICTIONS, INCLUDING THOSE IN OUR MODIFIED
OPERATING AGREEMENT WITH THE OCC, COULD RESULT IN ADVERSE ACTIONS BY THE OCC.
Direct Merchants Bank's activities are regulated by the OCC. The OCC
has imposed on Direct Merchants Bank the restrictions discussed under
"Management's Discussion and Analysis of Operating Results - Liquidity, Funding
and Capital Resources" and could increase the existing restrictions or impose
new ones. New or more restrictive requirements could include, among others,
restrictions relating to:
- minimum regulatory capital levels;
- extensions of credit;
- strategic acquisitions and asset growth;
- underwriting criteria, account management, account pricing, and accounting
policies and practices;
32
- enhanced scrutiny and consent requirements relating to business plans and
liquidity management;
- submission of special periodic regulatory reports; and
- additional supervisory actions or sanctions under applicable prompt
corrective action guidelines and other applicable laws and regulations.
On December 11, 2003, MCI and Direct Merchants Bank entered into a
Modified Operating Agreement with the OCC described above on page 22 under
"Regulation - The Company and Direct Merchants Bank." Among other things, the
Modified Operating Agreement:
- requires Direct Merchants Bank to maintain minimum capital at the dollar
level reported on its September 30, 2003 Call Report ($213 million), unless
otherwise approved by the OCC;
- requires Direct Merchants Bank to maintain, at a minimum, liquid assets of
not less than $35 million or 100% of the average highest daily funding
requirement for managed receivables;
- requires Direct Merchants Bank to continue to comply with the Liquidity
Reserve Deposit Agreement described above on page 22 under "Regulation -
The Company and Direct Merchants Bank;" and
- requires Director Merchants Bank and MCI to comply with the terms of the
Capital Assurance and Liquidity Maintenance Agreement ("CALMA") described
above on page 22 under "Regulation - The Company and Direct Merchants
Bank."
If we or Direct Merchants Bank fail to adhere to the terms of the
Modified Operating Agreement and our other agreements with regulators, Direct
Merchants Bank could face significant restrictions on growth, payments of
dividends and operating activities. Ultimately, failure to adhere could result
in the regulators ordering Direct Merchants Bank to cease lending activities,
assessing civil money penalties, initiating proceedings to terminate deposit
insurance for Direct Merchants Bank, or assuming control of Direct Merchants
Bank.
WE COULD BE REQUIRED TO PROVIDE SUPPORT TO DIRECT MERCHANTS BANK.
Under our regulatory framework and the CALMA, we could be required to
contribute capital or otherwise provide support to Direct Merchants Bank in
order to maintain or meet Direct Merchants Bank's capital and liquidity needs.
If we had to do this, it could limit our ability to expend funds at the MCI
level or require us to engage in capital raising activities that could adversely
affect our financial results or stock price for a variety of reasons, including
dilution to existing equity holders.
OUR FINANCIAL RESULTS COULD BE NEGATIVELY IMPACTED BY FLUCTUATIONS IN
OUR INTERESTS IN OUR SECURITIZATIONS.
We retain interests in the assets included in Metris Master Trust
securitizations, including retained subordinated interests, spread accounts
33
and other residual interests. The value of and income earned from these
interests will vary over time as a result of many factors not completely within
our control, including the performance of the securitized loans, interest paid
to the holders of securitization securities and transaction expenses. The
performance of the loans included in our securitizations is subject to risks and
uncertainties including, among others, increased delinquencies and credit
losses, economic downturns and social factors, interest rate fluctuations,
changes in government policies and regulations, competition, expenses,
dependence upon third-party vendors, fluctuations in accounts and account
balances, and industry risks. Since we are required to reflect changes in the
value of these interests in our financial statements, decreases in value could
negatively impact our results of operations and financial condition.
CHANGES IN THE INTEREST RATES ON THE FUNDS WE BORROW AND THE AMOUNTS WE
LOAN TO OUR CREDIT CARD CUSTOMERS COULD ADVERSELY AFFECT OUR FINANCIAL RESULTS.
Like other financial institutions, we borrow money from institutions,
which we then lend to our credit card customers. We earn interest on the credit
card loans we make and pay interest on the borrowings we use to fund those
loans. Changes in these two interest rates affect the value of our assets and
liabilities. Generally, our credit card loans are priced at rates indexed from
the prevailing prime rate. The interest we pay on our borrowings is based on
indexes over LIBOR, the London Interbank Offered Rate. If the rate of interest
we pay on our borrowings increases more than the rate of interest we earn on our
loans, our net interest income, and therefore our earnings, could fall. Our
earnings could also be hurt if the rates on our credit card loans fall more
quickly than those on our borrowings. We manage these risks partly by changing
the interest rates we charge on our credit card accounts. The success of
repricing accounts to match an increase or decrease in our borrowing rates
depends on the overall product mix of those accounts, the number of accounts
repriced, the rate at which we are originating new accounts, and our ability to
retain accounts (and the related loan balances) after repricing. For example, if
we increase the interest rate we charge on our credit card accounts and the
cardholders close their accounts as a result, we may not be able to match our
increased borrowing costs as quickly, if at all. Changes in interest rates also
affect the balances our customers carry on their credit cards. When interest
rates fall, there may be more low-rate product alternatives available to our
customers. Consequently, their credit card balances may fall and pre-payment
rates may rise. We can mitigate this risk by reducing the interest rates we
charge. However, these changes can reduce the overall yield on our portfolio.
When interest rates rise, there are fewer low-rate alternatives available to our
customers. Consequently, credit card balances may rise (or fall more slowly). In
this circumstance, we may have to borrow additional amounts at higher interest
rates to fund the increased balances. In our credit card business, we can
mitigate this risk by increasing the interest rates we charge, although doing so
may increase opportunities for our competitors to offer attractive products to
our customers and consequently increase customer attrition from our portfolio.
34
WE FACE INTENSE COMPETITION.
We face intense and increasing competition from numerous financial
services providers, many of which have greater resources and name recognition
than we do. Our credit card business competes with national, regional and local
bankcard issuers, as well as other general purpose and private label credit card
issuers. Some of these issuers are substantially larger, have more seasoned
credit card portfolios and often compete for customers by offering lower
interest rates and/or fee levels than we do. Moreover, the federal
Gramm-Leach-Bliley Act, which permits the affiliation of commercial banks,
securities firms and insurance companies, may increase the number of competitors
in the banking industry and the level of competition for banking products,
including credit cards. There has been continued focus on solicitations to
middle market consumers, as competitors target this market. Our competitors may
take actions such as offering lower interest rates and fees, higher credit
lines, and other incentives to customers to use their credit cards and/or
transfer existing balances. Since customers are attracted to credit card issuers
largely on the basis of price, credit limit and other product features, and
because customer loyalty often is limited, these and other competitive practices
could result in the loss of existing customers, reductions in account balances,
a slowdown in account and balance growth, increased customer acquisition costs
and reductions in the levels of finance charges and fees that we charge.
FAILURE TO COMPLY WITH APPLICABLE LAWS AND REGULATIONS, OR ADVERSE
CHANGES IN THOSE LAWS OR REGULATIONS, COULD HAVE A NEGATIVE IMPACT ON OUR
FINANCIAL RESULTS AND COULD ADVERSELY AFFECT OUR ABILITY TO CONDUCT OUR BUSINESS
IN A PROFITABLE MANNER.
Various federal and state laws and regulations significantly limit the
activities in which we and Direct Merchants Bank are permitted to engage. See
"Business - Regulation." Among other things, these laws and regulations:
- limit the fees and other charges that we are allowed to charge;
- limit or prescribe certain other terms of our products and services;
- require specified disclosures to consumers, including ones regarding our
practices for collection and sharing of non-public customer information;
- require us to treat non-public customer information in certain ways;
- govern the sale and terms of products and services we offer;
- require that we obtain and maintain licenses and qualifications; and
- impose capital requirements.
In some cases, the precise application of these statutes and
regulations is not clear. Our failure to comply with applicable laws and
regulations may result in regulatory action, negative publicity or consumer
class action litigation. Moreover, numerous legislative and regulatory proposals
that would impact aspects of our business are advanced each year. Changes in the
laws and regulations to which our business is subject, including by adoption of
new legislation or by revisions to the interpretation of existing laws and
regulations, could adversely affect our
35
ability to conduct our business in a profitable manner. Finally, changes in
government fiscal or monetary policies, including changes in our rate of
taxation, also could adversely affect our financial results.
LITIGATION INVOLVING US COULD NEGATIVELY AFFECT OUR BUSINESS AND
FINANCIAL RESULTS.
A putative class action lawsuit was filed against us in 2002 alleging
that we violated federal securities laws by failing to timely disclose an OCC
report of examination. In January 2004, a complaint was filed against us by our
former Chairman and Chief Executive Officer alleging breach of contract,
intentional interference with contract, breach of covenant of good faith,
defamation and violation of Minnesota's whistleblower act. We face the risk of
other litigation, including class action lawsuits, challenging our product
terms, rates, disclosures, collections or other practices, under state and
federal consumer protection statutes and other laws, as well as actions relating
to federal securities laws. In particular, state attorneys general and other
government prosecutors have shown an increased interest in the enforcement of
consumer protection laws, including laws relating to subprime lending and
predatory lending practices, and privacy. See "Legal Proceedings" at page 39.
All litigation involves costs, both in terms of money and in terms of diversion
of management's time and attention. In addition, litigation may result in orders
that require us to change specific business practices or adopt business
practices different from our competitors', settlement costs, damages, and in
some cases penalties. Any or all of these could negatively affect our business,
results of operations and financial condition.
WE ARE THE SUBJECT OF AN SEC INVESTIGATION THAT COULD HAVE A MATERIAL
ADVERSE EFFECT ON OUR BUSINESS AND FINANCIAL RESULTS.
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 our treatment of "Allowance for
loan losses" in 2001 and subsequent years, our 2001 credit line increase program
and other related matters. On December 9, 2003, we received notification that
the scope of the investigation had been expanded to include matters related to
our valuation of "Retained interests in loans securitized." We have since has
received additional SEC subpoenas and requests for information on related and
other financial accounting issues, as well as 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 cannot predict the length or outcome of
this investigation, but it could have a material adverse effect on our business
and financial condition.
WE ARE THE SUBJECT OF AN OCC INVESTIGATION THAT COULD NEGATIVELY AFFECT
OUR BUSINESS.
On August 2, 2003, we received from the OCC correspondence indicating
that we were the subject of an investigation, together with a subpoena requiring
us to produce certain documents. In October 2003, the OCC informally requested
additional documents. On April 1, 2004, we received a second subpoena requiring
us to produce additional documents related primarily to executive compensation
and reimbursement. We do not believe
36
that the OCC's investigation concerns any of the activities of our current
executives.
WE ARE THE SUBJECT OF AN INTERNAL REVENUE SERVICE EXAMINATION THAT
COULD HAVE A MATERIAL ADVERSE EFFECT ON OUR LIQUIDITY AND FINANCIAL RESULTS.
In December 2003, an Internal Revenue Service("IRS"), examination team
submitted a request for a Technical Advice Memorandum("TAM"), to its Washington,
D.C. National Office regarding our treatment of certain credit card fees as
original issue discount("OID"). The request covers our tax returns filed for the
years ended December 31, 1998 through December 31, 2001. Although we primarily
report the relevant fees as income when billed for financial reporting purposes,
we believe the fees constitute OID for tax purposes and should, therefore, be
deferred and amortized over the life of the underlying credit card loans for tax
purposes. Cumulatively through December 31, 2001, we had deferred approximately
$210 million in federal income tax under the OID rules. An assessment could
ultimately require us to pay up to this amount of federal tax plus state taxes
and related interest. The rulings in the TAM and the outcome of additional
resolution activities for these years, if necessary, will likely determine our
tax treatment of credit card fees in subsequent years. Based on our federal tax
returns filed for years ending December 31, 2002 and December 31, 2003, we had
deferred approximately $244 million and $179 million in federal income tax,
respectively. We believe that our treatment of these fees, which is consistent
with that of numerous other U.S. credit card issuers, is appropriate and we
continue to work with the IRS to resolve this matter. However, both the final
resolution and its timing are uncertain. A resolution that requires us to pay
immediately any material amount of the taxes we had previously deferred could
have a material adverse effect on our liquidity and financial condition.
OUR RESTATEMENTS OF FINANCIAL RESULTS HAVE HAD, AND MAY IN THE FUTURE
CONTINUE TO HAVE ADVERSE EFFECTS ON US.
We recently have restated our financial results for 1998 through 2002
and for the first three quarters of 2003, in connection with our analysis of our
method of valuing "Retained interests in loans securitized." Included in these
restatements, in addition to changes made as a result of our revised accounting
policies and procedures related to valuing our retained interests, are
corrections to conform with accounting principles generally accepted in the
United States of America 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, and the transfer
of allowance for loan losses that was incorrectly classified as a valuation
reserve. We have also restated certain other prior period amounts to conform
with the current period's presentation. For a more detailed description of the
restatements, see Amendment No. 1 to our Quarterly Report on Form 10-Q for the
quarter ended September 30, 2003. These restatements have resulted in late
filings with the SEC and may have harmed our reputation with investors and
possibly customers. Our restatements and their effects may have additional
adverse effects on us in the future.
37
DISPUTES AFFECTING MASTERCARD AND VISA COULD NEGATIVELY IMPACT OUR
OPERATIONS AND FINANCIAL RESULTS.
We are a member of MasterCard International Incorporated and Visa
U.S.A. Inc. MasterCard(R) and Visa(R) are membership organizations composed of
financial institutions that issue MasterCard or Visa cards. The outcome of
pending or future disputes involving these organizations could, if adversely
decided, affect our operations or result in an increase in the fees we must pay
as a member. In particular, in October 1998, the U.S. Department of Justice, or
DOJ, filed a complaint against MasterCard International Incorporated, Visa
U.S.A. Inc. and Visa International, Inc., asserting that duality (the
overlapping ownership and control of both the MasterCard and Visa associations
by the same group of banks) restrains competition in violation of the antitrust
laws and challenging the rules adopted by both MasterCard and Visa that restrict
member banks from joining American Express, Discover/Novus or other competing
networks. The case was tried in the summer of 2000 and the trial court announced
its decision in October 2001. The trial judge ruled in the associations' favor
on the duality claim, but against the associations on the competing networks
claim. MasterCard and Visa appealed the trial court's ruling, but the appeal was
denied in September 2003. The associations have indicated that they anticipate
seeking further appellate review. We cannot predict the ultimate outcome of this
litigation or its effect on the competitive environment in the credit card
industry. However, it is possible that the outcome of this or any future dispute
involving MasterCard or Visa could negatively impact our operations and
financial results in ways that we cannot currently predict.
OTHER INDUSTRY-WIDE RISKS COULD ADVERSELY AFFECT OUR FINANCIAL
PERFORMANCE.
We face many industry-wide risks that could negatively affect our
financial performance. For example, all businesses in the credit card industry
face the risk of fraud by cardholders and third parties, as well as the risk
that increased criticism from consumer advocates and the media could hurt
consumer acceptance of our products. In addition we face risks related to:
- rapidly changing technologies, including in particular, technological
challenges in the developing online credit card and financial services
market;
- the possibility that system disruptions and failures may interrupt or delay
our ability to provide services to our customers;
- potential claims relating to the proprietary nature of widely used
technology, such as "smart cards" and call center technology; and
- the ability to provide and safeguard the secure transmission of
confidential information over the Internet in the face of security
breaches, acts of vandalism and developments in computer capabilities that
could result in a compromise or breach of the technology used to protect
customer transaction data.
AVAILABLE INFORMATION
You can find additional information regarding our executive officers
and Board of Directors in the Proxy Statement relating to our 2004 Annual
38
Meeting of Stockholders. In addition, we periodically file reports and other
information with the SEC under the Securities Exchange Act of 1934. You can read
and copy this information at SEC offices in Washington, D.C., New York City, and
Chicago; obtain copies of this information by mail from the Public Reference
Section of the SEC, 450 Fifth Street, N.W., Room 1024, Washington, D.C. 20549,
at prescribed rates; obtain copies from the SEC's website (http://www.sec.gov);
inspect information at the offices of the New York Stock Exchange, Inc., 20
Broad Street, New York, New York, 10005; request copies of documents by calling
our Investor Relations Department at (952) 593-4874; and visiting our website.
Our Internet website is http://www.metriscompanies.com. We make
available, free of charge, through the Investor Relations portion of our website
our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports
on Form 8-K, and amendments to such reports filed or furnished pursuant to
Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, as
soon as reasonably practicable after we electronically file such material with,
or furnish it to, the SEC.
ITEM 2. PROPERTIES
We currently lease our principal executive office space in Minnetonka,
Minnesota, consisting of leases for approximately 300,000 and 19,000 square
feet. These leases expire in December 2011 and March 2005, respectively.
Subsequent to year-end 2003, we entered into a letter of intent with a
third-party to lease 131,000 square feet of space at our Minnetonka
headquarters. Although the letter of intent is non-binding, management believes
it is highly probable that the Company will be released from a portion of our
obligations under the original lease agreement as a result of the terms outlined
in the letter of intent. We previously entered into sublease agreements for the
remaining 19,000 square foot lease obligation noted above.
In addition, Direct Merchants Bank leases 54,000 square feet in
Phoenix, Arizona, which serves as the Bank's operation center. This lease
expires in 2009. We also lease 7,500 square feet in Scottsdale, Arizona to
support the Company's data center. In addition, we lease facilities in Tulsa,
Oklahoma, White Marsh, Maryland, Jacksonville, Florida and Duluth, Minnesota,
consisting of approximately 100,000, 115,000, 160,000 and 20,000 square feet,
respectively. These leases expire in December 2010, September 2007, May 2005 and
September 2006, respectively. We have entered into sublease agreements for
approximately 101,000 square feet of our lease obligation in Jacksonville. We
have entered into sublease agreements for approximately 50,000 square feet of
our lease obligation in Maryland. The leased properties in Oklahoma, Maryland,
Florida and Duluth, Minnesota support our collections, customer service and back
office operations. We also own our Hispanic operations center in Orlando,
Florida, which consists of approximately 45,000 square feet. We believe our
facilities are suitable for our businesses and that we will be able to lease or
purchase additional facilities as needed.
ITEM 3. LEGAL PROCEEDINGS
In September 2002, a shareholder lawsuit was filed in the United States
District Court for the District of Minnesota, naming MCI, Ronald N. Zebeck and
David D. Wesselink as defendants. The plaintiffs seek to represent a
39
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 timely disclose the existence of an impact of an OCC Report of
Examination. The lawsuit is currently in the discovery phase. We believe the
lawsuit is without merit and are vigorously defending against the claim.
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 by a Direct Merchants Bank cardholder in Middlesex County Superior
Court in Cambridge, Massachusetts, against the Bank and MCI alleging certain
unfair business practices. The complaint purported to be a class action lawsuit;
however, it was never certified as a class action, and the matter has been
settled and the complaint will be dismissed with prejudice.
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.
For a discussion of current regulatory investigations to which we are
subject, see "Regulatory Investigations" under Item 1 on page 26.
Because we are unable to estimate damages at this time, these matters
may have a material adverse affect on our results of operations, financial
condition or ability to operate our business in the event of a negative outcome
on one or more of these matters.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matter was submitted to a vote of security holders during the fourth
quarter of our fiscal year ended December 31, 2003.
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The information required by Item 201 of Regulation S-K is set forth in
the "Summary of Consolidated Quarterly Financial Information and Stock Data" on
pages 123-125 of this Report.
40
ITEM 6. TABLE 1: SELECTED FINANCIAL DATA
FOUR-
YEAR
(In thousands, except COMPOUND
EPS, dividends and stock GROWTH
prices) 2003 2002 2001 2000 1999 RATE
----------- ----------- ----------- ----------- ----------- --------
INCOME STATEMENT DATA:
Net interest income $ 16,109 $ 125,886 $ 202,861 $ (12,608) $ 27,428 (12.5)
Provision for loan losses 126,648 219,804 461,106 164,800 122,322 0.9
Other operating income 505,020 835,421 1,273,444 1,080,270 794,857 (10.7)
Other operating expense 611,746 741,220 727,284 599,139 437,984 8.7
----------- ----------- ----------- ----------- ----------- -----
Tax rate(1) 32.0% 659.7% 39.5% 38.6% 48.1% --
Net (loss) income $ (147,739) $ (1,584) $ 160,029 $ 185,902 $ 109,555 N/A
----------- ----------- ----------- ----------- ----------- -----
PER COMMON SHARE STATISTICS:
(Loss) earnings per
share - diluted $ (3.27) $ (0.66) $ 1.61 $ 2.01 $ 1.44 N/A
Stock price 4.44 2.47 25.71 26.31 23.79 (34.3)
Dividends paid -- 0.040 0.040 0.033 0.017
Book value per common
share equivalent(2) 8.85 11.53 12.00 9.68 7.38 4.7
Shares outstanding
(year-end) 57,807 57,168 63,419 62,243 57,919
Shares used to compute
earnings (loss) per
share (diluted) 57,471 59,782 99,366 92,582 76,324
----------- ----------- ----------- ----------- -----------
41
(TABLE 1: SELECTED FINANCIAL DATA CONT.)
FOUR-YEAR
COMPOUND
GROWTH
2003 2002 2001 2000 1999 RATE
------------ ----------- ------------ ------------ ------------ ---------
SELECTED OPERATING DATA:
Year-end credit card
loans $ 128,615 $ 846,417 $ 2,756,763 $ 1,184,269 $ 150,200
Year-end assets 1,392,396 2,590,392 4,165,975 3,738,307 2,041,862 (9.1)
Average credit card loans 518,705 1,305,127 1,709,989 614,991 78,036
Average interest-earning assets 1,023,577 1,889,768 2,060,191 838,468 1,485,094 (8.9)
Average assets 2,211,348 3,334,850 3,903,846 2,826,653 193,926 84.0
Average total equity 1,038,190 1,116,578 1,011,573 759,653 564,288 16.5
Year-end deposits 6,262 892,754 2,058,008 2,106,199 775,381 (70.0)
Year-end debt 350,448 357,649 647,904 356,066 345,012 0.4
Year-end preferred stock 470,728 430,642 393,970 360,421 329,729 9.3
Return on average assets N/A N/A 4.1% 6.6% 56.5%
Return on average total equity N/A N/A 15.8% 24.5% 19.4%
Net interest margin 1.6% 6.7% 9.8% (1.5)% 1.9%
Allowance for loan losses $ 45,492 $ 90,315 $ 460,159 $ 123,123 $ 12,175
Allowance for loan losses
as a percent of 30-day
plus delinquent
receivables 224.0% 1,146.7% 165.7% 138.1% 351.1%
Delinquency ratio(3) 15.8% 0.9% 10.1% 7.5% 2.3%
Allowance for loan losses
as a percent of credit
card loans 35.4% 10.7% 16.7% 10.4% 8.1%
Net charge-off ratio(4) 26.4% 24.9% 12.3% 9.7% 52.7%
(1) 1999 results include a permanent nondeductible tax difference of $50.8
million due to the extinguishment of the Series B Preferred Stock and 12%
Senior Notes, and the cancellation of warrants in June 1999 with the
issuance of the Company's Series C Preferred Stock.
(2) "Book value" is calculated assuming conversion of preferred stock.
(3) "Delinquency ratio" represents credit card loans that were at least 30 days
contractually past due at year-end as a percentage of year-end owned credit
card loans. The decrease in delinquencies as of December 31, 2002 versus
December 31, 2001 primarily reflects the sale of approximately $120 million
of delinquent receivables during September and December 2002.
(4) The "Net charge-off ratio" in 2002 reflects actual principal amounts
charged-off, less recoveries, as a percentage of average credit card loans.
The net charge-off ratio also includes a $101.5 million charge-off of loans
transferred to "held for sale."
42
ITEM 7. 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 our
consolidated financial statements and related notes thereto for the period ended
December 31, 2003.
We provide financial products and services to middle market 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. These credit card loans generate income and cash flow from principal,
interest and fee payments. Additional cash flow is generated through the sale of
our other consumer financial products, such as credit protection.
Our target market is particularly susceptible to changes in the
economy. Over the past few years, the status of the economy 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 middle market consumer loan industry. In addition, in 2001, we
implemented a program to increase the credit lines to a large portion of our
existing customers, which put increased payment pressure on those customers. We
continued to experience the residual effects of the economic downturn and the
2001 credit line increase program in 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 11.11% as of December 31,
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 December 31, 2003 was 3.62% compared to 2.70% for
the quarter ended September 30, 2003, 1.93% for the quarter ended June 30, 2003,
and 2.37% for the quarter ended March 31, 2003. The three-month average excess
spread was 4.30% as of February 29, 2004.
We continue to evaluate and modify our marketing programs to improve
the overall credit quality of the managed portfolio. Beginning late in 2002 and
continuing throughout 2003, we tested pricing and line assignments for new
customers. These actions were in response to a lower interest rate environment,
increased competition in the middle market sector and overall tightening of our
underwriting. The early results of these initiatives indicate improved credit
quality from our most recent marketing campaigns.
We took several steps during 2003 to right-size our business in order
to properly position ourselves to execute our strategic plan. We sold our
43
membership club and warranty business in order to focus our resources on our
core credit card loans business. 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 accounts in September and November 2003. We
also have taken steps to match our workforce needs with the size of our
portfolio by eliminating approximately 1,025 positions.
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. As of
December 31, 2003, our funding needs for 2004 included $3.1 billion in maturing
asset-backed financing and conduits in the Metris Master Trust, $101.7 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 or replacement 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 previously were available to us. Future downgrades in our debt
ratings or those of Direct Merchants Bank, or further deterioration in our asset
quality, could continue to negatively impact our funding capabilities.
CRITICAL ACCOUNTING ESTIMATES
The Company's significant accounting policies are identified on pages
85-93 of this Report, the most critical of which are our determination of the
"Allowance for loan losses" and the valuation of our "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 of future charge-offs for subprime receivables and 13
months of 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 other
differentiating receivable pools. 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 in
other programs as deemed necessary. We separately analyze the reserve
requirement on each of these groups or portfolios.
44
We continually evaluate the individual liquidating risk pools employing
a roll-rate model which uses historical delinquency levels and pay-down levels
(12 months of historical data, with emphasis 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
also consider several subjective factors which may be overlaid into the credit
risk roll-rate model in determining the necessary loan loss reserve, including:
- national and economic trends and business conditions, including the
condition of various market segments;
- changes in lending policies and procedures, including those for
underwriting, collection, charge-off and recovery, as well as the
experience, ability and depth of our lending management staff;
- trends in volume and the product pricing of accounts, including any
concentrations of credit; and
- impact 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. Each of these components is described below. 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
45
range based on historical trends (weighted heavily toward the low end of the
range), adjusted, as appropriate, for portfolio forecast information.
The contractual retained interests represent the subordinated
securities held by us. There is no stated interest rate associated with these
securities, and these securities are not rated. They are subordinated 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.
The 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 interests; thus they are included, instead, in the
value of the interest-only strip receivable.
Spread accounts receivable balances represent cash held by the Metris
Master Trust trustee as reserves required by certain series. These balances earn
interest and the fair value is determined in the same manner as the contractual
retained interests.
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 our competition
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
consolidated financial statements do not include an adjustment to the fair value
of "Retained interests in loans
46
securitized" that might result from the inability to finance future receivables.
RESULTS OF OPERATIONS
YEAR ENDED DECEMBER 31, 2003 COMPARED TO YEAR ENDED DECEMBER 31, 2002
"Net loss" for the year ended December 31, 2003 was $147.7 million, or
$3.27 per diluted common share, compared to a "Net loss" of $1.6 million, or
$0.66 per diluted common share in 2002. The increase in "Net loss" of $146.2
million is primarily due to a $109.8 million reduction in "Net interest income"
and a $330.4 million reduction in "Other operating income," offset by a $93.2
million decrease in "Provision for loan losses" and a $129.5 million reduction
in other operating expense. Included in the 2003 results is a $93.5 million
after-tax net loss consisting of special items associated with the impacts from
the sale of our membership club and warranty business, two credit card loan
portfolio sales totaling $1.1 billion, a workforce reduction, the sale of
certificates of deposit by Direct Merchants Bank, and the write-down of certain
fixed assets and leases. Included in the same period of 2002 are $27.7 million
of pre-tax special items associated with the write-downs of excess property,
equipment, and operating leases and a write-down of a portfolio of charged-off
loans purchased in 2001 and 2000.
Net Interest Income
"Net interest income" consists primarily of interest earned on our
"Credit card loans," less interest expense on borrowings to fund loans and
operations. Table 2 provides an analysis of interest income and expense, net
interest spread, net interest margin and average balance sheet data for the
years ended December 31, 2003, 2002 and 2001.
TABLE 2: ANALYSIS OF AVERAGE DAILY BALANCES, INTEREST AND AVERAGE YIELDS AND
RATES
YEAR ENDED DECEMBER 31,
-----------------------
2003 2002
---- ----
AVERAGE YIELD/ AVERAGE YIELD/
(Dollars in thousands) BALANCE INTEREST RATE BALANCE INTEREST RATE
------- -------- ---- ------- -------- ----
ASSETS:
Interest-earning assets:
Federal funds sold $ 74,589 $ 838 1.1% $ 23,750 $ 403 1.7%
Short-term investments 352,847 4,556 1.3% 560,891 10,121 1.8%
Liquidity reserve deposit 77,436 761 1.0% -- -- --
Credit card loans 518,705 84,375 16.3% 1,305,127 218,878 16.8%
----------- ----------- ----------- -----------
Total interest-earning assets $ 1,023,577 $ 90,530 8.8% $ 1,889,768 $ 229,402 12.1%
Other assets 1,282,137 -- -- 1,696,174 -- --
Allowance for loan losses (94,366) -- -- (251,092) -- --
----------- -----------
Total assets $ 2,211,348 -- -- $ 3,334,850 -- --
=========== ===========
LIABILITIES AND EQUITY:
Interest-bearing liabilities:
Deposits $ 542,953 $ 28,421 5.2% $ 1,406,022 $ 68,740 4.9%
Debt 366,368 46,000 12.6% 380,728 34,776 9.1%
----------- ----------- ----------- -----------
47
Total interest-bearing liabilities $ 909,321 $ 74,421 8.2% $ 1,786,750 $ 103,516 5.8%
Other liabilities 263,837 -- -- 431,522 -- --
----------- -----------
Total liabilities 1,173,158 -- -- 2,218,272 -- --
Stockholders' equity 1,038,190 -- -- 1,116,578 -- --
----------- -----------
Total liabilities and equity $ 2,211,348 -- -- $ 3,334,850 -- --
=========== ===========
Net interest income and interest margin(1)
-- $ 16,109 1.6% -- $ 125,886 6.7%
Net interest rate spread(2)
-- -- 0.6% -- -- 6.3%
(1) We compute "Net interest margin" by dividing net interest income by average
total interest-earning assets.
(2) The "Net interest rate spread" is the yield on average interest-earning
assets minus the funding rate on average interest-bearing liabilities.
TABLE 2: ANALYSIS OF AVERAGE DAILY BALANCES, INTEREST AND AVERAGE YIELDS AND
RATES (CONTINUED)
YEAR ENDED DECEMBER 31,
-----------------------
2001
----
Average Yield/
(Dollars in thousands) Balance Interest Rate
------- -------- ----
ASSETS:
Interest-earning assets:
Federal funds sold $ 63,981 $ 3,115 4.9%
Short-term investments 286,221 12,373 4.3%
Credit card loans 1,709,989 353,650 20.7%
--------------------------- ---------------------
Total interest-earning assets $ 2,060,191 $ 369,138 17.9%
Other assets 2,089,242 -- --
Allowance for loan losses (245,587) -- --
---------------------------
Total assets $ 3,903,846 -- --
===========================
LIABILITIES AND EQUITY:
Interest-bearing liabilities:
Deposits $ 2,110,967 $ 127,916 6.1%
Debt 379,159 38,361 10.1%
--------------------------- ---------------------
Total interest-bearing liabilities $ 2,490,126 $ 166,277 6.7%
Other liabilities 402,147 -- --
--------------------------- ---------------------
Total liabilities 2,892,273 -- --
Stockholders' equity 1,011,573 -- --
---------------------------
Total liabilities and equity $ 3,903,846 -- --
===========================
Net interest income and interest
Margin(1) -- $ 202,861 9.8%
Net interest rate spread(2) -- -- 11.2%
48
"Net interest income" decreased from $125.9 million for the year ended
December 31, 2002, to $16.1 million for year ended December 31, 2003. The
decrease is due to a decrease in average interest-earning assets of $900 million
and a 510 basis point reduction in net interest margin. The decrease in margin
is primarily due to a 330 basis point decrease in yield on interest earning
assets resulting from a $786.4 million reduction in average "Credit card loans"
and a 240 basis point increase in the costs of funds due to higher interest
expense incurred on the term debt instruments outstanding during the respective
periods. As of December 31, 2003, 50.7% of our average interest-earning assets
were in "Credit card loans," compared to 69.1% as of December 31, 2002. The
overall yield decrease is primarily due to the shift in the mix of interest
earning assets to lower yielding assets.
Net interest income is affected by changes in the average interest rate
earned on interest-earning assets and the average interest rate paid on
interest-bearing liabilities, in addition to changes in the volume of
interest-earning assets and interest-bearing liabilities. Table 3 presents the
effects of changes in average volume and interest rates on individual financial
statement line items on an owned basis.
TABLE 3: CHANGES IN NET INTEREST INCOME
YEAR ENDED DECEMBER 31, YEAR ENDED DECEMBER 31,
2003 VS. 2002 2002 VS. 2001
--------------------------------- ----------------------------------
INCREASE CHANGE DUE TO INCREASE CHANGE DUE TO
(Dollars in thousands) (DECREASE) VOLUME RATE (DECREASE) VOLUME RATE
---------- ------ ---- ---------- ------ ----
INTEREST INCOME:
Federal funds sold $ 435 $ 859 $ (424) $ (2,712) $ (1,959) $ (753)
Short-term investments (4,804) (2,334) (2,470) (2,252) 11,874 (14,126)
Credit card loans (134,503) (142,269) 7,766 (134,772) (83,731) (51,041)
--------- --------- --------- --------- --------- ---------
Total interest income (138,872) (143,744) 4,872 (139,736) (73,816) (65,920)
Interest bearing
deposits (40,319) (42,195) 1,876 (59,176) (42,717) (16,459)
Other interest expense 11,224 (1,314) 12,538 (3,585) 159 (3,744)
--------- --------- --------- --------- --------- ---------
Total interest expense (29,095) (43,509) 14,414 (62,761) (42,558) (20,203)
--------- --------- --------- --------- --------- ---------
Net interest income $(109,777) $(100,235) $ (9,542) $ (76,975) $ (31,258) $ (45,717)
========= ========= ========= ========= ========= =========
Credit Card Loans
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
49
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
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.
In accordance with FFIEC guidance, workout re-ages can only occur once in five
years. Table 4 presents the delinquency trends of our credit card loan
portfolio.
TABLE 4: LOAN DELINQUENCY
DECEMBER 31, % OF DECEMBER 31, % OF DECEMBER 31, % OF
(Dollars in thousands) 2003 TOTAL 2002 TOTAL 2001 TOTAL
---- ----- ---- ----- ---- -----
Loans outstanding $ 128,615 100% $ 846,417 100% $ 2,756,763 100%
Loans contractually
delinquent:
30 to 59 days 5,015 3.9% 1,673 0.2% 87,603 3.2%
60 to 89 days 4,888 3.8% 2,121 0.2% 66,647 2.4%
90 or more days 10,406 8.1% 4,082 0.5% 123,528 4.5%
------------- ---- --------------- --- ------------- ----
Total $ 20,309 15.8% $ 7,876 0.9% $ 277,778 10.1%
============= ==== =============== === ============= ====
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 $72.5 million of 2-cycle plus delinquent receivables in
December 2002, the delinquency ratio would have been 8.7 percent as of December
31, 2002. There was no sale of delinquent receivables during the fourth quarter
of 2003. The increase in delinquencies as of December 31, 2003 versus December
31, 2002 primarily reflects the overall credit quality of the remaining
receivables in the OWNED portfolio.
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
50
which unsecured accounts that have entered into a credit counseling or other
similar debt forbearance program 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. Beginning in the fourth quarter of 2003 we changed our policy for
recognizing credit losses on accounts that enter into a settlement payment
arrangement. Under the new policy, the portion of the balance that has been
forgiven is charged-off upon entering into the settlement arrangement with the
customer. The previous policy recognized these losses after the completion of
the settlement arrangement. We charge-off accounts that are identified as fraud
losses no later than 90 days after discovery.
We enter into agreements with third parties for the sale of a majority
of charged-off accounts. We also refer 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.
Charge-offs due to bankruptcies were $32.6 million, representing 42.5%
of total gross charge-offs, as of December 31, 2003, and $61.5 million,
representing 17.8% of total gross charge-offs, as of December 31, 2002. Table 5
presents our net charge-offs for the periods indicated as reported in the
consolidated financial statements.
TABLE 5: NET CHARGE-OFFS
YEAR ENDED DECEMBER 31,
-----------------------
(Dollars in thousands) 2003 2002 2001
---- ---- ----
Average credit card loans $ 518,705 $ 1,305,127 $ 1,709,989
Net charge-offs 137,015 325,351 209,779
Net charge-off ratio 26.4% 24.9% 12.3%
============== ============= ==============
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. During 2003, we sold two portfolios of delinquent
accounts approximating $69.0 million in receivables, resulting in a $62.3
million charge-off. During 2002, we sold two portfolios of delinquent accounts
approximating $120 million in receivables, resulting in a $101.5 million
charge-off.
Provision and Allowance for Loan Losses
We record provisions for loan losses in amounts necessary to maintain
the allowance at a level sufficient to absorb anticipated 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. We also utilize debt forbearance programs and credit counseling
services for qualifying cardholders that are experiencing payment difficulties.
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 $6.2 million, or 4.8%
of total credit card loans, as of December
51
31, 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 4.
The provision for loan losses for the year ended December 31, 2003,
totaled $126.6 million compared to a provision of $219.8 million in 2002. The
decrease in the provision for loan losses in 2003 compared to 2002 primarily
reflects the decrease in "Credit card loans" during the year, primarily offset
by the increased delinquency rate as of December 31, 2003 discussed above. The
"Allowance for loan losses" was $45.5 million, or 35.4% of credit card loans, as
of December 31, 2003, versus $90.3 million, or 10.7% of credit card loans, as of
December 31, 2002.
Our roll-rate models, including management contingency, indicated our
required "Allowance for loan losses" was $46 million as of December 31, 2003,
compared to a range of $75 million to $90 million as of December 31, 2002. We
believe the allowance for loan losses is adequate to cover probable future
losses inherent in the loan portfolio under current conditions.
Retained Interests in Loans Securitized
Our credit card receivables are primarily funded by asset
securitizations through the Metris Master Trust. 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 may be 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 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 include 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 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
52
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 December 31, 2003 and December 31, 2002.
TABLE 6: RETAINED INTERESTS IN LOANS SECURITIZED
DECEMBER 31, DECEMBER 31,
(In thousands) 2003 2002
---- ----
Contractual retained interests $ 542,014 $ 685,197
Excess transferor's interests 48,775 57,447
Interest-only strip receivable 16,039 13,882
Spread accounts receivable 230,073 51,500
------------- -----------
Retained interests in loans securitized 836,901 808,026
============= ===========
"Retained interests in loans securitized" increased by $28.9 million
between December 31, 2002 and December 31, 2003, to $836.9 million. The increase
is primarily due to a $178.6 million increase in spread accounts receivable
partially offset by a $143.2 million decrease in contractual retained interests.
The contractual retained interests decreased $143.2 million from
December 31, 2002 to December 31, 2003, primarily due to the sale of receivables
to a third-party in the third and fourth quarters of 2003, and attrition in the
securitized loan portfolio. The decrease in contractual retained interests was
partially offset by higher enhancement levels required by recent securitization
agreements. Spread accounts receivable increased over December 31, 2002 as all
excess spread earned on receivables held in the Metris Master Trust was 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 Resources" section of Management's Discussion and Analysis
of Financial Condition and Results of Operations on pages 62-72.
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 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 fair value. (See "Critical Accounting Estimates" on pages
44-47 for more information on the valuation of the "Retained interests in loans
securitized").
The significant assumptions used for estimating the fair value of the
"Retained interests in loans securitized" are as follows:
53
AT DECEMBER 31,
--------------------
2003 2002
---- ----
Monthly payment rate 6.7% 6.7%
Gross yield(1) 25.4% 26.0%
Annual interest expense and servicing fees 4.2% 4.0%
Annual gross principal default rate 20.7% 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(2) 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.
(2) Beginning in 2003, the discount rate on spread account balances have
been reduced by interest income expected to be earned.
The decrease in the gross yield assumption reflects lower Libor rates
and an improvement in credit quality in the Metris Master Trust during 2003,
which has resulted in lower yields. The lower default rate assumption also
reflects the improved credit quality in the Metris Master Trust.
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 the Bank's 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. The sale was necessary to create additional liquidity, reduce 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 liquidity position and financing market
conditions at that time. We do not believe the 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.
At December 31, 2003, the sensitivity of the current fair value of the
"Retained interests in loans securitized" to immediate 10% and 20% adverse
changes are as follows (in millions):
54
ADVERSE IMPACT ON FAIR VALUE
----------------------------
10% ADVERSE CHANGE 20% ADVERSE CHANGE
------------------ ------------------
Annual discount rate $ 22.6 $ 44.3
Monthly payment rate 139.7 331.4
Gross yield 132.8 285.4
Annual interest expense and servicing fees 21.3 48.1
Annual gross principal default rate 99.3 209.4
As the sensitivity indicates, the fair value of the Company's "Retained
interests in loans securitized" on its balance sheet, as well as reported
earnings, could vary significantly if different assumptions or conditions
prevail.
"Securitization income" was $173.4 million and $323.5 million for the
years ended December 31, 2003 and 2002, respectively. The following table
details "Securitization income" for the years ended December 31, 2003, 2002, and
2001 respectively.
YEAR ENDED DECEMBER 31,
-----------------------
(In thousands) 2003 2002 2001
---- ---- ----
Loss on new securitization of
receivables to the Metris Master Trust $ (55,214) $ (70,578) $ (60,574)
(Loss) gain on replenishment of
receivables to the Metris Master Trust (161,743) 28,706 (34,672)
Discount accretion 308,912 305,327 221,670
Change in fair value (71,669) (342,080) 28,069
Interest-only revenue 221,331 452,268 510,806
Transaction and other costs (68,250) (50,126) (14,899)
--------- --------- ---------
Securitization income $ 173,367 $ 323,517 $ 650,400
========= ========= =========
The decrease of $150.2 million in "Securitization income" for the year
ended December 31, 2003 compared to 2002, is primarily due to a $230.9 million
decrease in interest-only revenue and a $190.5 million adverse change in the
loss/gain on replenishment of receivables to the Metris Master Trust, partially
offset by a $270.4 million improvement in the change in fair market value of
"Retained interests in loans securitized." Interest-only revenue decreased from
$452.3 million in 2002 to $221.3 million in 2003, due to a $2.6 billion
reduction in receivables held in the Metris Master Trust and a 311 basis-point
decrease in excess spread in the Metris Master Trust. The $190.5 million adverse
change in the loss/gain on replenishment of receivables to the Metris Master
Trust from 2002 to 2003 is primarily due to a reduction in the benefit from
receivables purchased from the Bank at a $14.5 million net discount in 2003, as
compared to a $151.5 million net discount in 2002. The $270.4 million
improvement in the change in fair market value of "Retained interests in loans
securitized" is primarily due to a stabilization of the interest-only asset
resulting from the flattening of excess spreads in the Metris Master Trust. The
$71.7 million reduction in fair value in 2003 is primarily due to a discount on
the increasing spread accounts receivable balance.
Other Operating Income
Other operating income was $505.0 million in 2003, a decrease of $330.4
million or 39.5% from $835.4 million in 2002. "Securitization income" decreased
$150.1 million during the year as discussed more fully above.
55
"Servicing income on securitized/sold receivables" was $176.6 million
and $195.2 million for the years ended December 31, 2003 and 2002, respectively.
The decrease in servicing income was caused by a $900 million reduction in
average principal receivables held by the Metris Master Trust during 2003.
"Credit card fees, interchange, credit protection and other credit card income"
was $79.5 million for the year ended December 31, 2003, compared to $163.2
million for the year ended December 31, 2002. The decrease is primarily due to a
decrease in average "Credit card loans" of $786.4 million over the twelve-month
period. Furthering this decline was an amendment to the core transaction
documents of the Metris Master Trust agreement, 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 as of May 2002.
During the third quarter of 2003, we sold our membership club and
warranty business. The "Gain on sale of membership club and warranty business"
was $84.8 million. As a result of the sale, "Enhancement services revenue"
decreased to $107.9 million for the year ended December 31, 2003, compared to
$153.5 million for the year ended December 31, 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." As of December 31, 2003
we had $7.3 million of "Deferred income," and $1.9 million in deferred costs,
associated with the sold business, which will expire throughout 2004.
Other Operating Expense
Other operating expenses were $611.7 million for the year ended
December 31, 2003, a decrease of $129.5 million from the year ended December 31,
2002. This decrease resulted primarily from a shrinking of the core business and
the sale of our membership club and warranty business.
"Credit card account and other product solicitation and marketing
expenses" were $93.3 million and $173.3 million for the years ended December 31,
2003 and 2002, respectively. The decrease of $80.0 million over 2002 is the
result of the Company's decisions to decrease the size of our managed credit
card portfolio through lower account acquisitions and to exit the membership
club and warranty business. "Employee compensation" decreased $35.3 million for
the year ended December 31, 2003 to $175.5 million primarily as a result of the
elimination of 1,025 positions during the year and the sale of our membership
club and warranty business during the third quarter of 2003.
"Data processing services and communications" expense decreased $15.2
million to $68.7 million for the year ended December 31, 2003, primarily due to
the reduction in our managed credit card portfolio. "Credit protection claims
expense" decreased $13.7 million for the year ended December 31, 2003, primarily
due to a decrease in receivable balances covered by our debt waiver products.
"Occupancy and equipment" expense decreased $11.4 million to $36.6 million for
the year ended December 31, 2003 due to the reduction in facilities as a result
of decreased staffing levels.
"Asset impairments, lease write-offs and severance" were $56.2 million
and $27.7 million for the years ended December 31, 2003 and 2002, respectively.
During 2003, we recorded $8.3 million for workforce
56
reductions, approximately $20.8 million in write-downs of excess property,
equipment, and operating leases, a $22.0 million write-off of purchased
portfolio premium on "Credit card loans" sold in the third and fourth quarters
of 2003, and a $5.1 million write-off of commitment fees related to a backup
financing facility entered into in March 2003, with Thomas H. Lee Equity Fund
IV, L.P. Comparatively, in 2002, we recorded a write-down of $10.6 million for
portfolios of charged-off loans purchased in 2001 and 2000, a $17.1 million
write-down of excess property, equipment, operating leases, and the then pending
sale of our Arizona facility.
"Other" expense was $79.4 million compared to $100.2 million for the
years ended December 31, 2003 and 2002, respectively. The $20.8 million decrease
compared to the prior year was primarily due to a write-off of $7 million in
marketing and origination costs on our retail note program during 2002, a $7
million reduction from the write-off of certain uncollectible receivables during
2002, and an overall shrinking of the core business during 2003.
Derivative Activities
We use derivative financial instruments for the purpose of managing our
exposure to interest rate risk.
MRI enters into interest rate cap transactions related to each
asset-backed securitization transaction. MRI assigns all of its right, title and
interest under the interest rate cap agreements to the trustee of the Metris
Master Trust for the benefit of the holders of securities issued by the Metris
Master Trust. The purpose of the interest rate cap is to effectively limit the
interest exposure of the Metris Master Trust for each individual series to a
maximum amount based on the LIBOR rate.
The interest rate caps do not meet the criteria for hedge accounting
treatment. The change in the fair value of the caps is included in the
consolidated income statement under "Securitization income." We recognized
expense of $5.3 million and $22.6 million from the mark-to-market adjustments on
the interest rate caps for the years ended December 31, 2003 and 2002,
respectively.
Prior to 2003, we entered into interest rate swap transactions through
Direct Merchants Bank. The swaps were used to convert a portion of the fixed
rate certificates of deposit issued by the Bank ("CDs") to variable rate CDs,
and thus hedge the fair market value of the CDs. The CDs exposed us to
variability in the fair value in rising or declining interest rate environments.
By converting the fixed payment to a variable payment, the interest rate swaps
reduced the variability of the fair market value of the CDs.
Consistent with SFAS No. 133, all swaps are designated as fair value
hedges. Changes in the value of the swaps are recognized in income, in the
period in which the change in value occurred. In addition, changes in the value
of the CDs, to the extent they are attributable to the risk being hedged, were
simultaneously recognized in income. Any difference between the fair value
change in the swaps versus the fair value change in the related hedged CDs was
considered to be the "ineffective" portion of the hedge. The
57
ineffective portion of the swap was recorded as an increase or decrease in
income.
During 2002 and 2001, all swaps were sold. At the date of sale, the
swap and the related CDs were valued, and a gain or loss was recognized on the
difference between the change in fair value of the swap and the change in fair
value of the CDs. The cumulative amount recorded as an adjustment to the value
of the CDs was amortized over the life of the CDs as an adjustment to interest
expense.
YEAR ENDED DECEMBER 31, 2002 COMPARED TO YEAR ENDED DECEMBER 31, 2001
Net loss for the year ended December 31, 2002 was $1.6 million, or
$0.66 per diluted share, down from net income of $160.0 million, or $1.61 per
diluted share in 2001.
Net interest income decreased from $202.9 million for the year ended
December 31, 2001 to $125.9 million for year ended December 31, 2002. The
decrease is due to a decrease in average interest-earning assets of $170.4
million and a 310 basis point reduction in net interest margin. The decrease in
margin is primarily due to a 580 basis point decrease in yield resulting from a
$404.9 million reduction in average credit card loans and a 50 basis point
reduction in the prime rate. Additionally, there was a shift in the mix of
assets from higher yielding credit card loans to lower yielding investments. For
the year ended December 31, 2002, 69.1% of our average interest-earning assets
were in credit card loans, compared to 83.0% for the year ended December 31,
2001.
The provision for loan losses was $219.8 million in 2002 compared to
$461.1 million in 2001. The decrease relates to the estimated required balance
in the allowance for loan losses to cover probable losses inherent in our loan
portfolio under applicable conditions. The size of the credit card loan
portfolio, net principal charge-offs, recent delinquency and collection trends,
and economic conditions were factors considered by management in determining the
necessary balance in the allowance for loan losses. Average credit card loans
decreased to $1.3 billion in 2002 from $1.7 billion in 2001.
The net principal charge-off rate was 24.9% in 2002 compared to 12.3%
in 2001. The increase in the net principal charge-off rate is partially due to
the sale of approximately $120 million of delinquent receivables in 2002. The
sale resulted in a charge-off of $101.5 million. The weak economic environment
and the effects of the Company's 2001 credit line increase program on the
severity of credit losses also adversely affected the net charge-off rate.
Charge-offs due to bankruptcies were $61.5 million, representing 17.8% of total
gross charge-offs as of December 31, 2002 and $76.3 million, representing 27.8%
of total gross charge-offs as of December 31, 2001.
Other operating income decreased $438.0 million, or 34%, to $835.4
million for the year ended December 31, 2002. This decrease was primarily due to
a $326.9 million decrease in "Securitization income" to $323.5 million in 2002.
The decrease in "Securitization income" was primarily due to an unfavorable
change in the market value adjustment of $370.1 million and a reduction of $58.5
million in interest-only revenue based on the performance
58
of the underlying assets. These changes were partially offset by an increase of
$63.4 million in gains on asset replenishment and an $83.7 million increase in
discount accretion income. Servicing income on securitized/sold receivables of
$195.2 million increased $36.1 million over 2001. The increase in servicing
income was due to the increase in securitized credit card receivables due to the
transfer of approximately $2.3 billion of receivables from Direct Merchants Bank
to the Metris Master Trust. Credit card fees, interchange and other credit card
income decreased to $163.2 million in 2002, compared to $322.0 million in 2001.
The decrease in credit card fees, interchange and other credit card income is
due to the reduction of our owned credit card portfolio. In addition, we also
amended the Metris Master Trust core transaction documents, which resulted in
interchange income earned on receivables held by the Metris Master Trust to be
recorded as contribution to the excess spread earned, effective May 2002. In
2002, $44.3 million of interchange income was earned by the Metris Master Trust.
Enhancement services revenue increased 8.2% to $153.5 million due primarily to
increased active enrollments in various membership products. These increases
were partially offset by a decrease in ServiceEdge(R) revenue due to the run-off
of the ServiceEdge(R) portfolio and a decrease in PurchaseShield(R) revenue due
to decreased enrollments.
Total other operating expenses for the year ended December 31, 2002
increased $13.9 million over 2001. Credit card account and other product
solicitation and marketing expenses decreased $14.7 million over 2001. Credit
protection claims expense increased $14.1 million, reflecting higher claims paid
on debt waiver death benefits and interest forgiven, as well as an increase in
our estimate of unreported claims as of the balance sheet date. As of December
31, 2002, we had a debt waiver total covered balance of $2.4 billion, compared
to $2.8 billion as of December 31, 2001. Employee compensation decreased $14.6
million for the year ended December 31, 2002, due to decreased staffing needs
and fringe benefits. Other expenses increased $10.5 million.
During 2002, we recorded approximately $17.1 million of write-downs of
excess property, equipment, operating leases, and the pending sale of our
Arizona building. In addition, we recorded a $10.6 million write-down on
portfolios of charged-off loans purchased in 2001 and 2000. The book value of
these portfolios was $3.4 million as of December 31, 2002, compared to $20.1
million as of December 31, 2001.
BALANCE SHEET ANALYSIS
Cash and Cash Equivalents
Cash and cash equivalents decreased $401.7 million to $178.5 million as
of December 31, 2003 compared to $580.2 million as of December 31, 2002. The
decrease was primarily due to the $559.3 million of cash used to fund the sale
of CDs during the third quarter of 2003, offset by sales of receivables from
Direct Merchants Bank to the Metris Master Trust and other third parties.
59
Liquidity Reserve Deposit
During 2003, in compliance with our Operating Agreement with the OCC,
Direct Merchants Bank established restricted deposits with a third-party
depository bank for the purpose of supporting Direct Merchant Bank's funding
needs. These deposits are invested in short-term liquid investments. As of
December 31, 2003, the balance of these deposits was $80.2 million.
Credit Card Loans
Credit card loans were $128.6 million as of December 31, 2003, compared
to $846.4 million as of December 31, 2002. The $717.8 million decrease is
primarily a result of the sale of $708.5 million in "Credit card loans" from
Direct Merchants Bank to the Metris Master Trust. In addition, $213.3 million in
"Credit card loans" were sold to third-parties in September 2003.
Property and Equipment
"Property and equipment, net" decreased to $33.7 million at December
31, 2003, primarily due to the sale of our Arizona facility in the second
quarter of 2003 and the third quarter sale of other assets. Additional decreases
occurred from the write-down of excess leasehold improvements, furniture and
fixtures.
Purchased Portfolio Premium
"Purchased portfolio premium" decreased to $17.6 million at December
31, 2003, from $64.6 million at December 31, 2002. The $47.0 million decrease
was due to the write-down of "Purchased portfolio premium" associated with the
sales of credit card loans to third parties during the second half of 2003, and
the $25.0 million amortization expense recorded in 2003.
Other Assets
"Other assets" decreased from $187.2 million at December 31, 2002 to
$81.8 million at December 31, 2003. The decrease was due to the $66.8 million
reduction in deferred marketing costs from the membership club and warranty
business that was sold in July 2003, and a decrease of $23.6 million in deferred
tax assets at December 31, 2003.
Deposits
Deposits decreased $886.5 million to $6.3 million as of December 31,
2003, from $892.8 million as of December 31, 2002. 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. The Bank sold $559.3
million of insured CDs on September 30, 2003, utilizing a combination of cash on
hand, cash generated through the sale of credit card receivables to a
third-party, and sales of credit card receivables to MCI, in order to fully
comply with the OCC's request. The sale of the CDs resulted in a loss of
approximately $33.0 million. We do not anticipate issuing CDs in the foreseeable
future.
60
Deferred Income
Deferred income decreased to $18.1 million as of December 31, 2003
compared to $143.1 million as of December 31, 2002. The decrease primarily
relates to the sale of our membership club and warranty business in July 2003.
Stockholders' Equity
Stockholders' equity was $909.2 million as of December 31, 2003, a
decrease of $145.5 million from $1,054.7 million as of December 31, 2002. The
decrease primarily results from a net loss of $147.7 million partially offset by
$2.0 million of stock issuances under employee benefit plans.
OFF-BALANCE SHEET ARRANGEMENTS
Our operations are funded primarily through asset securitizations of
our credit card receivable principal balances. We rely heavily on this method of
funding and any negative effect on our ability to securitize assets would have a
material impact on our business. We securitize consumer loans in order to manage
our total cost of funds. Our securitizations involve packaging and selling pools
of both current and future principal receivable balances on credit card
accounts, in which we retain the servicing of such receivables. Our
securitizations are treated as sales under accounting principles generally
accepted in the United States of America and are removed from our balance sheet.
We primarily securitize receivables by selling the receivables to the Metris
Master Trust, a proprietary, non-consolidated trust, which issues securities
through public and private asset-backed securitizations or to multi-seller
commercial paper conduits.
The Metris Master Trust was formed in May 1995 pursuant to a pooling
and servicing agreement, as amended. Metris Receivables, Inc. ("MRI"), one of
our special purpose entity subsidiaries, transfers receivables in designated
accounts to the Metris Master Trust. The Metris Master Trust may, and does from
time to time, issue securities that represent undivided interests in the
receivables in the Metris Master Trust. These securities are issued by series
and each series typically has multiple classes of securities. Each series or
class within a series may have different terms. The different classes of an
individual series are structured to obtain specific debt ratings. As of December
31, 2003, 11 series of publicly issued securities were outstanding. MRI
currently retains the most subordinated class of securities in each series and
all other classes are issued to nonaffiliated third parties. These securities
are interests in the Metris Master Trust only and are not obligations of MRI,
MCI, Direct Merchants Bank, or any other subsidiary of the Company. The interest
in the Metris Master Trust not represented by any series of securities issued by
the Metris Master Trust also belongs to MRI and is known as the transferor's
interest.
Generally, each series involves an initial reinvestment period,
referred to as the "revolving period," in which principal payments on
receivables allocated to such series are returned to MRI and reinvested in new
principal receivables arising in the accounts. After the revolving period ends,
principal payments allocated to the series are then accumulated and used to
repay the investors. This period is referred to as the "accumulation period,"
61
and is followed by a "controlled amortization period" wherein investors are
repaid their invested amount. Currently, the Metris Master Trust does not have
any series in an accumulation period or controlled amortization period. The
scheduled accumulation and amortization periods are set forth in the agreements
governing each series. However, all series set forth certain events by which
amortization can be accelerated, referred to as "early amortization." Reasons an
early amortization could occur include: (i) one or three-month average of
portfolio collections, less principal and finance charge charge-offs, financing
costs and servicing costs, would drop below certain levels; (ii) negative
transferor's interest within the Metris Master Trust; or (iii) failure to obtain
funding during an accumulation period for a maturing term asset-backed
securitization. New receivables in designated accounts cannot be funded from a
series that is in early amortization. We currently do not have any series that
are in early amortization.
In addition, there are various triggers within our securitization
agreements that, if broken, would restrict the release of cash to us from the
Metris Master Trust. This restricted cash provides additional security to the
investors in the Metris Master Trust. We reflect cash restricted from release in
the Metris Master Trust at its fair value as "Retained interests in loans
securitized" in the consolidated balance sheet. The triggers are usually related
to the performance of the Metris Master Trust, specifically the average of net
excess spread over a one to three-month period.
On a monthly basis, each series is allocated its share of finance
charge and fee collections which are used to pay investors interest on their
securities, pay their share of servicing fees, and reimburse investors for their
share of losses due to charge-offs. Amounts remaining may be deposited in cash
accounts of the Metris Master Trust as additional protection for future losses.
Once each of these obligations is fully met, remaining finance charge
collections, if any, are returned to us. Principal receivables held by the
Metris Master Trust were $7.5 billion and $9.8 billion as of December 31, 2003
and 2002, respectively.
Revenues and expenses generated from the Metris Master Trust are found
in the "Securitization income" and "Servicing income on securitized/sold
receivables" lines in the consolidated statements of income. Our interests
retained in credit card receivables sold to the Metris Master Trust are recorded
at fair value in "Retained interests in loans securitized" on the consolidated
balance sheets. The cash flows generated from the Metris Master Trust are
presented in Note 6 to the consolidated financial statements on page 96 of this
Report.
Maintaining adequate liquidity in the Metris Master Trust is, and will
continue to be, at the forefront of our business objectives. Additional
information regarding asset securitization is set forth under "Liquidity,
Funding, and Capital Resources" below. Additional information regarding the
accounting for our "Retained interests in loans securitized" can be found in
"Note 2 - Significant Accounting Policies" on pages 85-93 of this Report.
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
62
of our assets and liabilities and short- and long-term interest rates, and by
the capital markets. We use a variety of financing sources to manage liquidity,
funding, and interest rate risks. Table 9 summarizes our funding and liquidity
as of December 31, 2003 and 2002, respectively.
TABLE 9: LIQUIDITY, FUNDING AND CAPITAL RESOURCES
DECEMBER 31, 2003 DECEMBER 31, 2002
----------------- -----------------
(In thousands) DMCCB OTHER CONSOLIDATED DMCCB OTHER CONSOLIDATED
-------- -------- ------------ -------- -------- ------------
Cash and due
from banks $ 29,399 $ 2,677 $ 32,076 $ 58,399 $ 4,414 $ 62,813
Federal funds
sold 25,300 -- 25,300 88,000 -- 88,000
Short-term
investments 71,829 49,280 121,109 322,039 107,380 429,419
-------- -------- -------- -------- -------- --------
Total cash
and cash
equivalents $126,528 $ 51,957 $178,485 $468,438 $111,794 $580,232
======== ======== ======== ======== ======== ========
DECEMBER 31, 2003 DECEMBER 31, 2002
--------------------- ----------------------
(In thousands) UNUSED UNUSED
ON-BALANCE SHEET FUNDING OUTSTANDING CAPACITY OUTSTANDING CAPACITY
------------------------ ---------- -------- ----------- --------
Revolving credit line -
July 2003 $ N/A $ N/A $ -- $162,696
Term loan - expired in
June 2003 N/A 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 147,724 N/A 146,824 N/A
Term loan - June 2004 101,679 N/A -- N/A
Other 1,045 N/A 10,825 N/A
Deposits 6,262 N/A 892,754 N/A
---------- -----------
Subtotal 356,710 N/A 1,250,403 162,696
OFF-BALANCE SHEET FUNDING
Metris Master Trust:
Term asset back
securitizations -
various maturities
through January 2009 6,400,000 -- 7,610,000 --
Conduits - matured
March 2004 196,000 654,000 1,177,957 422,043
Amortizing term series -
matured February 2004 99,200 -- -- --
Metris facility -
expired in March 2003 -- -- 48,900 26,100
---------- -------- ----------- --------
Subtotal 6,695,200 654,000 8,836,857 448,143
---------- -------- ----------- --------
Total $7,051,910 $654,000 $10,087,260 $610,839
========== ======== =========== ========
63
The following table presents the amounts, as of December 31, 2003, of
off-balance sheet funding outstanding in the Metris Master Trust scheduled to
amortize in future years. We base the amortization amounts on estimated
amortization periods, which are subject to change based on the Metris Master
Trust performance.
(In thousands)
2004 $ 1,945,200
2005 2,300,000
2006 1,250,000
2007 600,000
2008 --
Thereafter 600,000
--------------
Total $ 6,695,200
==============
The effective weighted-average interest rate on the Company's
outstanding funding as of December 31, 2003 and 2002 was as follows:
DECEMBER 31, 2003 DECEMBER 31, 2002
----------------- -----------------
Term loan-2003 -- 4.7%
Senior Secured Credit
Agreement - 2004 27.6% --
Senior notes-2004 10.0% 10.0%
Senior notes-2006 11.4% 11.4%
Other 12.3% 8.7%
Deposits 2.2% 5.1%
Metris Master Trust 1.9% 2.1%
Metris facility -- 1.9%
The term loan matured in 2003. The 20 basis point decrease in the
weighted-average interest rate on the Metris Master Trust was primarily due to
the decrease in LIBOR, which is the base rate for these funding vehicles, and
the maturity of the Series 1997-1 asset-backed securitization, which had fixed
rate funding at 6.9%, in April 2002. As the base rate, the 30-day LIBOR
decreased from 1.4% as of December 31, 2002, to 1.1% as of December 31, 2003.
During 2003 and 2002, we had net proceeds of approximately $700 million
and $900 million, respectively, from sales of credit card loans to the Metris
Master Trust and the Metris facility referred to in the above table. We used
cash generated from these transactions to reduce borrowings and to fund the
credit card loan portfolio.
64
Our contractual cash obligations as of December 31, 2003 were as
follows:
LESS THAN ONE TO FOUR TO OVER FIVE
(In thousands) ONE YEAR THREE YEARS FIVE YEARS YEARS TOTAL
-------- ----------- ---------- --------- --------
Long-term debt $202,254 $ 147,975 $ 23 $ 196 $350,448
Operating leases 13,374 21,593 5,663 13,167 53,797
Contractual purchase
obligations(1) 63,704 146,206 32,416 -- 242,326
Deposits 6,262 -- -- -- 6,262
-------- ----------- ---------- --------- --------
Total $285,594 $ 315,774 $ 38,102 $ 13,363 $652,833
======== =========== ========== ========= ========
(1) Includes purchase obligations for goods and services covered by
noncancellable contracts and contracts including cancellation fees.
In addition to contractual cash obligations, open-to-buy on credit card
accounts as of December 31, 2003 was $8.0 billion. While this amount represents
the total lines of credit available to our customers, we have not experienced
and do not anticipate that all of our customers will exercise their entire
available line at any given point in time. We also have the right to increase,
reduce, cancel, alter or amend the terms for these available lines of credit at
any time. See the tables on pages 11-13 of this Report for further information.
As of December 31, 2003, we had twelve-month contractual cash
obligations of $285.6 million and off-balance sheet funding scheduled to
amortize of $1.9 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. During the next
twelve months we intend to reduce outstanding receivables 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. The Company will need to obtain conduit
warehouse funding arrangements to meet other maturing obligations in the Metris
Master Trust and is currently reviewing its alternatives in the conduit market.
We believe that we will be able to obtain the requisite funding that
will provide us with adequate liquidity to meet anticipated cash needs through a
variety of funding options. As an example, on March 2, 2004, the Company secured
an amortizing term series financing of $500 million maturing May 3, 2004, and
defeased a $500 million term asset-backed securitization (Series 1999-1) that
began an accumulation period on March 1, 2004. At this time, the conduit
financing proposals received to date may require us to refinance existing
corporate debt that matures in 2004.
The Metris Master Trust has three surety-wrapped asset-backed term
securitization series that mature over the next two years totaling $1.7 billion
with maturity dates of June 2004, May 2005, and November 2005, respectively. On
March 2, 2004, MRI received a $1.7 billion, two-year
65
commitment from MBIA Insurance Corporation ("MBIA") to provide financial
guaranty insurance policies to refinance these maturing MBIA-guaranteed series
from the Metris Master Trust. This commitment from MBIA will provide financial
guaranty insurance capacity to wrap newly issued series from the Metris Master
Trust.
We are currently reviewing alternatives to refinance the $95.3 million
outstanding (as of March 31, 2004) of the $125.0 million term loan due June
2004, and the $100.0 million of 10% senior notes due in November 2004. Subject
to the condition to refinance existing corporate debt discussed above, we
believe we will have sufficient cash on hand to allow us to retire both of these
loans in 2004 without incurring any additional corporate debt, if necessary. We
are also reviewing alternatives to refinance the current outstanding amount of
$280 million from the $500 million amortizing Metris Master Trust series due on
May 3, 2004. If we are unable to obtain funding from a third party, we would be
able to fund the accumulation account for a maturing asset-backed term
securitization with operating cash for a period of approximately two weeks.
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. 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 previously were available to us.
Future downgrades in our debt ratings or those of Direct Merchants Bank, as well
as further deterioration in our asset quality, could continue to negatively
impact our funding capabilities.
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 or individual series 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 excess
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 Metris
Master Trust trustee holds the cash in spread accounts. 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. 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 following table shows the annualized yields, defaults, costs and
excess spreads for the Metris Master Trust on a cash basis.
66
Year Ended December 31,
------------------------------------------------------------------------------------
(Dollars in thousands) 2003 2002 2001
--------------------------- --------------------------- ----------------------
Gross yield(1) $ 2,367,452 26.84% $ 2,564,009 26.46% $ 2,035,113 27.58%
Annual principal
defaults 1,803,022 20.44% 1,587,095 16.38% 972,348 13.18%
------------- ---------- ------------- ---------- ------------- -----
Net portfolio
yield 564,430 6.40% 976,914 10.08% 1,062,765 14.40%
Annual interest
expense and
servicing fees 316,992 3.78% 406,826 4.35% 451,061 6.62%
------------- ---------- ------------- ---------- ------------- -----
Net excess
spread $ 247,438 2.62% $ 570,088 5.73% $ 611,704 7.78%
============= ========== ============= ========== ============= =====
(1) Includes cash flows from finance charges, late, overlimit and cash
advance fees, bad debt recoveries, interchange income (effective May
2002), and debt waiver fees, less finance charge and fee charge-offs.
The following table illustrates the maximum amount of cash (as a
percentage of outstanding securitized principal receivables) that could be held
by the Metris Master Trust trustee as additional collateral if the one-month and
three-month average excess spread of the Metris Master Trust was within various
ranges.
Cash Basis Net Maximum
Excess Spread Restricted
----------------- ------------
greater than 5.5% --
5.0% - 5.5% 0.5% - 1.0%
4.5% - 5.0% 0.5% - 1.5%
4.0% - 4.5% 2.0% - 2.5%
3.5% - 4.0% 2.5% - 3.0%
3.0% - 3.5% 2.5% - 4.0%
less than 3.0% 4.0% - 5.0%
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 MRI will be restricted from release. Once the maximum amount of cash
required to be restricted is restricted from release or excess spreads improve,
cash again can be released to us. Based on the performance of the Metris Master
Trust, the amount of cash required to be restricted was $294 million at December
31, 2003, and $304 million at December 31, 2002. As of December 31, 2003, $255.4
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, and $16.9 million has been restricted from
release for maturity reserves. In addition, $12.2 million has been restricted
from release for defeasance of the Series 2001-1. 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 $226.3
million increase in cash restricted due to performance for the period ended
December 31, 2003
67
consisted of approximately $194.1 million of net excess cash generated by the
Metris Master Trust that was restricted from release, and approximately $32.2
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
2003. We also secured a $425 million conduit financing through March 2004, which
replaced bank conduit financing and warehouse facilities that matured during
March through May 2003. Finally, 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 June 18, 2003, and effective
as of June 27, 2003, as amended ("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 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 year-end 2003, we have made additional principal payments of approximately
$6.4 million. We are bound by certain covenants under the Credit Agreement. As
of December 31, 2003, we were in compliance with all covenants under the Credit
Agreement. 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.
In the fourth quarter of 2003, the Internal Revenue Service ("IRS")
examination team submitted a request for a Technical Advice Memorandum ("TAM")
to its Washington, D.C. National Office regarding our treatment of certain
credit card fees as original issue discount ("OID"). The request for a TAM
covers tax returns filed for the years ended December 31, 1998 through December
31, 2001. 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 December 31, 2001, the Company had deferred
approximately $210 million in federal income tax under the OID rules. An
assessment ultimately could require the Company to pay up to that amount of
federal tax plus state taxes and related interest.
68
The Company believes its treatment of these fees is appropriate and
continues to work with the IRS to resolve this matter. The Company's position is
consistent with that of numerous other U.S. credit card issuers. While both the
timing and amount of the final resolution are uncertain, we do not expect any
additional tax to be paid over the next twelve months.
The Company has $470.7 million of Series C Perpetual Convertible
Preferred Stock outstanding, which is held by affiliates of Thomas H. Lee
Partners, L.P. (formerly, Thomas H. Lee Company) ("THL Partners"), a private
equity firm, and is convertible into common stock at a conversion price of
$12.42 per common share subject to adjustment in certain circumstances. The
Series C Preferred Stock has a 9% dividend payable in additional shares of
Series C Preferred Stock and will also receive any cash dividends paid on the
Company's common stock on a converted basis. One share of Series C Preferred
Stock is convertible into 30 shares of common stock, plus a premium amount
designed to guarantee a portion of seven years' worth of dividends at a 9%
annual rate. For conversions in 2003, the premium amount would be equal to
approximately 76.5% of those future dividends. Assuming conversion of the Series
C Preferred Stock into common stock, THL Partners would own approximately 42.5%
of the Company on a diluted basis at December 31, 2003. So long as affiliates of
THL Partners own at least 25% of the originally issued Series C Preferred Stock
(or any shares of Common Stock issued upon conversion thereof), the holders of a
majority of the then-outstanding shares of the Series C Preferred Stock are
entitled to elect four members to MCI's Board of Directors. The Series C
Preferred Stock may be redeemed by us in certain circumstances by paying 103% of
the redemption price of $372.50 and all accrued dividends at the time of
redemption. We also have the option to redeem the Series C Preferred Stock after
December 9, 2008, without restriction by paying the redemption price of $372.50
and all accrued dividends at the time of redemption.
The Federal Reserve Act imposes various legal limitations on the extent
to which banks that are members of the Federal Reserve System can finance or
otherwise supply funds to certain of their affiliates. In particular, Direct
Merchants Bank is subject to certain restrictions on any extensions of credit to
MCI or its subsidiaries. Additionally, Direct Merchants Bank is limited in its
ability to declare dividends to MCI or its subsidiaries. Therefore, Direct
Merchants Bank's investments in federal funds sold are generally not available
for the general liquidity needs of the Company or its subsidiaries.
Our secured/unsecured debt is rated by Moody's Investor Services
("Moody's"), Standard & Poor's Rating Services ("S&P") and Fitch, Inc.
("Fitch"). Factors affecting the various ratings include the overall health of
the global/national economy, specific economic conditions impacting the subprime
consumer finance industry, and the overall financial performance of the Company,
including earnings, credit losses, delinquencies, excess spreads in the Metris
Master Trust and our overall liquidity. Furthermore, certain of our term
asset-backed securitizations require the restriction of cash if our corporate
debt ratings go below certain levels. The table below illustrates the current
debt ratings of MCI.
69
MOODY'S S&P FITCH
------- --- -----
METRIS COMPANIES INC.
Senior unsecured debt Caa2 CCC- CCC
Moody's, S&P and Fitch have a "negative outlook" for our debt ratings
and the Company. The rating agencies cited concerns about our funding and
liquidity challenges, earnings and asset quality.
Since the later part of 2002, our corporate debt ratings, the Metris
Master Trust ratings and the ratings of Direct Merchants Bank have been
downgraded. These downgrades reflect the continuing losses we have experienced
in 2003, as well as deteriorating performance in the Metris Master Trust. These
downgrades and any future downgrades will have a negative effect on our ability
to obtain funding. In addition, access to funding may be at a higher cost and on
terms less favorable to us than those previously available as a result of the
deterioration in our financial performance and asset quality.
On March 18, 2003, we entered into an Operating Agreement with the OCC.
On December 11, 2003, the Operating Agreement was modified. For discussion on
the Modified Operating Agreement, and the related capital and liquidity
requirements, see page 22 of this Report.
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 pages 109-111 of this Report. 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 pages 70-72 of this Report.
During 2003, Direct Merchants Bank declared and indirectly paid $190.8
million of dividends to MCI.
As of December 31, 2003 and 2002, we had $5.9 and $7.3 million,
respectively, of letters of credit issued. We hold 110% cash collateral against
our letters of credit. Under our Credit Agreement, we need to maintain, among
other items, minimum equity plus reserves to managed accounts receivable of 15%,
a minimum three-month average excess spread of 1% (on each individual series of
securities issued under the Metris Master Trust), minimum equity of $750
million, and a ratio of equity plus allowance for loan losses and discount on
gross "Retained interests in loans securitized" to managed 90-day plus
delinquencies of 2.25%. Furthermore, the Company has pledged certain assets as
collateral on the Credit Agreement.
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
70
particular, Direct Merchants Bank is subject to certain restrictions on any
extensions of credit to, or other covered transactions such as certain purchases
of assets with, MCI and its affiliates. Bank regulatory laws limit or prohibit
Direct Merchants Bank's ability to lend 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.
We have approximately $241.3 million of equity and $126.5 million of
cash, cash equivalents and marketable securities at Direct Merchants Bank as of
December 31, 2003. A portion of this cash is available, upon approval of
regulatory authorities, to assist in the Company's financing needs.
Direct Merchants Bank is subject to certain capital adequacy guidelines
adopted by the OCC. At December 31, 2003 and 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 the table
below.
In addition to the statutory minimums, according to the Modified
Operating Agreement, the Bank must maintain minimum capital at a dollar level as
reported on the September 30, 2003 Call Report ($213 million). Nothing in the
Modified Operating Agreement shall prevent the Bank from reducing its capital
should circumstances permit so long as the Bank first requests and obtains the
OCC's supervisory non-objection to such reduction.
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 in the regulations), and of
Tier 1 leverage capital (as defined in the regulations) to average assets (as
defined in the regulations). 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.
71
Additional information about Direct Merchants Bank's actual capital
amounts and ratios are presented in the following table:
TO BE
ADEQUATELY TO BE WELL
ACTUAL CAPITALIZED CAPITALIZED
------------------ ------------------ ------------------
AS OF DECEMBER 31, 2003 AMOUNT RATIO AMOUNT RATIO AMOUNT RATIO
--------- ----- --------- ----- --------- -----
Total capital $ 240,868 140.0% $ 13,760 8.0% $ 17,200 10.0%
(to risk-weighted assets)
Tier 1 capital 238,328 138.6% 6,880 4.0% 10,320 6.0%
(to risk-weighted assets)
Tier 1 capital 238,328 70.2% 13,589 4.0% 16,987 5.0%
(to average assets)
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% 62,381 4.0% 77,977 5.0%
(to average assets)
FFIEC guidelines indicate that an institution with a concentration in
subprime lending should hold one and one-half to three times the normal minimum
capital required.
NEWLY ISSUED PRONOUNCEMENTS
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, the 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. Many aspects of the guidance have been
implemented by the Bank with no material impact to our financial
72
statements. We continue testing alternative approaches to comply with the
minimum payment and negative amortization provisions of the guidance, the
results of which are not expected until the second half of 2004. At this time we
are unable to provide assurance that adoption of the guidance will not have a
material adverse effect on our financial condition.
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." Our
non-consolidated entity, the Metris Master Trust, is a Qualified Special Purpose
Entity under the definition in SFAS No. 140. The adoption of this Interpretation
did not have a material impact on our financial statements.
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.
SELECTED OPERATING DATA - MANAGED BASIS
In addition to analyzing our performance on an owned basis, we analyze
our financial performance on a managed loan portfolio basis. On a managed
73
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
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 our overall financial
condition and results of operations.
74
TABLE 10: SELECTED OPERATING DATA - MANAGED BASIS
YEAR ENDED DECEMBER 31,
FOUR-YEAR
COMPOUND
(In thousands) 2003 2002 2001 2000 1999 GROWTH RATE
----------- ------------ ------------ ------------ ----------- -----------
SELECTED OPERATING DATA:
Total credit card accounts 2,837 3,929 4,929 4,464 3,680 (6.3%)
Year-end loans $ 8,131,831 $ 11,420,186 $ 11,991,784 $ 9,345,631 $ 7,343,272 2.6%
Year-end assets 8,098,524 11,431,203 12,124,528 9,806,249 7,563,394 1.7%
Average loans 10,047,580 11,850,927 10,419,280 8,081,638 6,053,811 13.5%
Average interest-earning assets 10,552,452 12,435,568 10,769,482 8,305,115 6,190,267 14.3%
Average assets 10,023,893 11,972,958 10,656,156 8,332,500 6,269,760 12.5%
Return on average assets N/A N/A 2.3% 2.3% 1.0%
Equity to managed assets 11.2% 9.3% 9.4% 9.0% 8.2%
Delinquency ratio(1) 11.1% 11.0% 9.4% 8.2% 7.6%
Net charge-off ratio(2) 20.2% 15.5% 10.9% 9.6% 9.0%
(1) Delinquency ratio represents credit card loans that were at least 30
days contractually past due at year-end as a percentage of year-end
managed loans.
(2) Net charge-off ratio reflects actual principal amounts charged-off,
less recoveries, as a percentage of average managed credit card loans.
75
TABLE 11: MANAGED LOAN PORTFOLIO
(Dollars in thousands)
DECEMBER 31,
% OF % OF % OF
2003 TOTAL 2002 TOTAL 2001 TOTAL
------------ --------- ------------ --------- ------------ ---------
Credit card loans $ 128,615 $ 846,417 $ 2,756,763
Receivables held by
the Metris
Master Trust 8,003,216 10,573,769 9,235,021
------------ ------------ ------------
Total managed loan
portfolio $ 8,131,831 $ 11,420,186 $ 11,991,784
============ ============ ============
Loans contractually
Delinquent:
30 to 59 days 242,571 3.0% 359,223 3.1% 375,887 3.1%
60 to 89 days 204,621 2.5% 285,448 2.5% 274,278 2.3%
90 or more days 454,884 5.6% 615,278 5.4% 473,003 4.0%
------------ --------- ------------ --------- ------------ ---------
Total $ 902,076 11.1% $ 1,259,949 11.0% $ 1,123,168 9.4%
============ ========= ============ ========= ============ =========
AVERAGE BALANCES:
Credit card loans $ 518,705 $ 1,305,127 $ 1,709,989
Receivables held by
the Metris
Master Trust 9,528,875 10,545,800 8,709,291
------------ ------------ ------------
Total managed loan portfolio
$ 10,047,580 $ 11,850,927 $ 10,419,280
============ ============ ============
Net charge-offs $ 2,033,852 20.2% $ 1,840,786 15.5% $ 1,140,151 10.9%
============ ========= ============ ========= ============ =========
The increase in the managed delinquency rates as of December 31, 2003,
over December 31, 2002 and 2001, primarily reflects the sale of $72.5 million of
2-cycle plus delinquent assets in December 2002. Excluding the sale, the managed
delinquency ratio would have been 11.6 percent as of December 31, 2002. The
December 31, 2002 increase in delinquency rates over December 31, 2001 reflects
the 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
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.
Managed net charge-offs at December 31, 2003, increased 470 and 930
basis points over December 31, 2002 and 2001, respectively, primarily due to the
impact of the 2001 credit line increase program and the residual effect of the
past deterioration in the economy. 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 $72.5 million of 2-cycle plus
delinquent assets in December 2002. The effect of this transaction is included
in the delinquency and net charge-off rates presented in Table 11.
76
We charge-off bankrupt accounts within 60 days of formal notification.
Charge-offs due to bankruptcies were $681.1 million, representing 28.1% of total
managed gross charge-offs as of December 31, 2003 and $654.5 million,
representing 33.7% of total managed gross charge-offs as of December 31, 2002.
In addition to those bankrupt accounts that were charged-off, we received formal
notification of $65.8 million and $106.3 million of managed bankrupt accounts as
of December 31, 2003 and 2002, respectively.
Total managed loans decreased $3.3 billion to $8.1 billion as of
December 31, 2003, compared to $11.4 billion as of December 31, 2002, and $12.0
billion at December 31, 2001. This was primarily due to a reduction in credit
lines and 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 $695.4 million, or 8.6% of total managed loans, as of December 31, 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
11.
FORWARD-LOOKING STATEMENTS
This Annual Report on Form 10-K 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 are described under the heading "Risk
Factors" in pages 29-38 of this Report, and are also discussed in other parts of
this Report, including "Legal Proceedings" (pages 39-40), "Management's
Discussion and Analysis of Financial Condition and Results of Operations" (pages
43-77) and "Quantitative and Qualitative Disclosures About Market Risk (page
78). 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 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.
77
ITEM 7a. 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, as 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 balance
sheet 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 assets are "Credit card loans," and "Retained interests in
loans securitized." Our receivables and receivables held by the Metris Master
Trust 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,
bank loans, long-term debt and equity issuances. Our securitized loans are held
by the Metris Master Trust and bank-sponsored multi-seller receivables conduits
and investors in term series securities 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 December 31, 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 floating rate debt are not allowed to decrease below zero percent. Assuming
that we take no counteractive measures, as of December 31, 2003, a
200-basis-point increase in interest rates affecting our floating rate financial
instruments, including both debt obligations and receivables, would result in a
decrease in net income of approximately $23 million relative to a base case over
the next 12 months, compared to an approximate $11 million increase 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
$37 million as of December 31, 2003, and an increase of approximately $55
million as of December 31, 2002.
The change in sensitivity for the 200 basis point decrease is primarily
due to the decreased impact on interest expense as interest expense cannot fall
below zero. The change in sensitivity for the 200 basis point increase is
primarily due to a lower percentage of receivables that will be impacted by a
rate increase.
78
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
METRIS COMPANIES INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(DOLLARS IN THOUSANDS, EXCEPT PER-SHARE DATA)
DECEMBER 31,
------------
2003 2002
---- ----
ASSETS:
Cash and due from banks $ 32,076 $ 62,813
Federal funds sold 25,300 88,000
Short-term investments 121,109 429,419
----------------- -----------------
Cash and cash equivalents 178,485 580,232
----------------- -----------------
Liquidity reserve deposit 80,158 --
Credit card loans 128,615 846,417
Less: Allowance for loan losses 45,492 90,315
----------------- -----------------
Net credit card loans 83,123 756,102
----------------- -----------------
Retained interests in loans securitized 836,901 808,026
Property and equipment, net 33,680 83,831
Purchased portfolio premium, net 17,561 64,579
Other receivables due from credit card
securitizations, net 80,714 110,471
Other assets 81,774 187,151
----------------- -----------------
TOTAL ASSETS $ 1,392,396 $ 2,590,392
================= =================
LIABILITIES:
Deposits $ 6,262 $ 892,754
Debt 350,448 357,649
Accounts payable 32,397 53,589
Deferred income 18,060 143,148
Accrued expenses and other liabilities 76,036 88,579
----------------- -----------------
TOTAL LIABILITIES 483,203 1,535,719
----------------- -----------------
STOCKHOLDERS' EQUITY:
Convertible preferred stock - Series C, par value $.01 per share; 10,000,000
shares authorized, 1,263,699 and 1,156,086 shares
issued and outstanding, respectively 470,728 430,642
Common stock, par value $.01 per share;
300,000,000 shares authorized, 64,862,314
and 64,223,231 shares issued, respectively 649 642
Paid-in capital 229,655 227,376
Unearned compensation (27) --
Treasury stock - 7,055,300 shares (58,308) (58,308)
Retained earnings 266,496 454,321
----------------- -----------------
TOTAL STOCKHOLDERS' EQUITY 909,193 1,054,673
----------------- -----------------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 1,392,396 $ 2,590,392
================= =================
See accompanying Notes to Consolidated Financial Statements.
79
METRIS COMPANIES INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(DOLLARS IN THOUSANDS, EXCEPT PER-SHARE DATA)
YEAR ENDED DECEMBER 31,
-----------------------
2003 2002 2001
---- ---- ----
INTEREST INCOME:
Credit card loans $ 84,375 $ 218,878 $ 353,650
Federal funds sold 838 403 3,115
Other 5,317 10,121 12,373
----------------- ------------------- -----------------
Total interest income 90,530 229,402 369,138
----------------- ------------------- -----------------
Deposit interest expense 28,421 68,740 127,916
Other interest expense 46,000 34,776 38,361
----------------- ------------------- -----------------
Total interest expense 74,421 103,516 166,277
----------------- ------------------- -----------------
NET INTEREST INCOME 16,109 125,886 202,861
Provision for loan losses 126,648 219,804 461,106
----------------- ------------------- -----------------
NET INTEREST EXPENSE
AFTER PROVISION FOR LOAN LOSSES (110,539) (93,918) (258,245)
----------------- ------------------- -----------------
OTHER OPERATING INCOME:
Securitization income 173,367 323,517 650,400
Servicing income on securitized / sold receivables 176,627 195,214 159,074
Credit card fees, interchange and other credit card income 79,492 163,174 322,048
Enhancement services revenue 107,930 153,516 141,922
Loss on sale of credit card loans (117,183) -- --
Gain on sale of membership club and warranty business 84,787 -- --
----------------- ------------------- -----------------
505,020 835,421 1,273,444
----------------- ------------------- -----------------
OTHER OPERATING EXPENSE:
Credit card account and other product solicitation and
marketing expenses 93,349 173,269 188,009
Employee compensation 175,539 210,826 225,463
Data processing services and communications 68,715 83,874 90,222
Credit protection claims expense 30,882 44,550 30,457
Occupancy and equipment 36,564 48,013 47,572
Purchased portfolio premium amortization 25,000 30,220 30,277
Mastercard/Visa assessment and fees 9,243 13,869 16,522
Credit card fraud losses 3,821 8,647 9,068
Asset impairments, lease write-offs and severance 56,222 27,736 --
Loss on sale of deposits 32,963 -- --
Other 79,448 100,216 89,694
----------------- ------------------- -----------------
611,746 741,220 727,284
----------------- ------------------- -----------------
(LOSS) INCOME BEFORE INCOME TAXES AND CUMULATIVE EFFECT OF
ACCOUNTING CHANGE (217,265) 283 287,915
Income tax (benefit) expense (69,526) 1,867 113,660
----------------- ------------------- -----------------
(LOSS) INCOME BEFORE CUMULATIVE EFFECT OF ACCOUNTING CHANGE (147,739) (1,584) 174,255
Cumulative effect of accounting change
(net of income taxes of $9,273) -- -- 14,226
----------------- ------------------- -----------------
NET (LOSS) INCOME (147,739) (1,584) 160,029
Convertible preferred stock dividends 40,086 38,009 34,771
----------------- ------------------- -----------------
NET (LOSS) INCOME APPLICABLE TO COMMON STOCKHOLDERS $ (187,825) $ (39,593) $ 125,258
================= =================== =================
80
YEAR ENDED DECEMBER 31,
-----------------------
2003 2002 2001
---- ---- ----
(LOSS) EARNINGS PER SHARE:
Basic - (loss) income before
cumulative effect of
accounting change $ (3.27) $ (0.66) $ 1.79
Basic - cumulative effect of
accounting change -- -- (0.15)
------------- ------------- -------------
Basic-net (loss) income $ (3.27) $ (0.66) $ 1.64
============= ============= =============
Diluted - (loss) income before
cumulative effect of
accounting change $ (3.27) $ (0.66) $ 1.75
Diluted-cumulative effect of
accounting change -- -- (0.14)
------------- ------------- -------------
Diluted-net (loss) income $ (3.27) $ (0.66) $ 1.61
============== ============= =============
SHARES USED TO COMPUTE EARNINGS
(LOSS) PER SHARE:
Basic 57,471 59,782 97,641
Diluted 57,471 59,782 99,366
DIVIDENDS DECLARED AND PAID PER
COMMON SHARE $ -- $ 0.040 $ 0.040
See accompanying Notes to Consolidated Financial Statements.
81
METRIS COMPANIES INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
(DOLLARS AND SHARES IN THOUSANDS)
NUMBER OF SHARES TOTAL
OUTSTANDING PREFERRED COMMON PAID-IN UNEARNED TREASURY RETAINED STOCKHOLDERS'
PREFERRED COMMON STOCK STOCK CAPITAL COMPENSATION STOCK EARNINGS EQUITY
BALANCE, DECEMBER 31, 2000 968 62,243 $ 360,421 $ 622 $198,077 $ -- $ -- $ 373,577 $ 932,697
========= ====== ========= ====== ======== =========== ======== ========= ===========
Net income -- -- -- -- -- -- -- 160,029 160,029
Cash dividends -- -- -- -- -- -- -- (3,752) (3,752)
Common stock repurchased -- (806) -- -- -- -- (13,014) -- (13,014)
Preferred dividends in kind 90 -- 33,549 -- -- -- -- (33,549) --
Issuance of common stock
under employee benefit plans -- 1,518 -- 15 27,927 -- -- -- 27,942
Deferred compensation -- 464 -- 5 6,409 (8,108) -- -- (1,694)
Amortization of restricted
stock -- -- -- -- -- 3,128 -- -- 3,128
--------- ------ --------- ------ -------- ----------- -------- --------- -----------
BALANCE, DECEMBER 31, 2001 1,058 63,419 $ 393,970 $ 642 $232,413 $ (4,980) $(13,014) $ 496,305 $ 1,105,336
========= ====== ========= ====== ======== =========== ======== ========= ===========
Net loss -- -- -- -- -- -- -- (1,584) (1,584)
Cash dividends -- -- -- -- -- -- -- (3,728) (3,728)
Common stock repurchased -- (6,249) -- -- -- -- (45,294) -- (45,294)
Preferred dividends in kind 98 -- 36,672 -- -- -- -- (36,672) --
Issuance of common stock
under employee benefit plans -- 462 -- 4 2,975 -- -- -- 2,979
Deferred compensation -- 76 -- 1 967 (968) -- -- --
Amortization of restricted
stock -- -- -- -- -- 1,808 -- -- 1,808
Forfeiture of restricted stock -- (540) -- (5) (8,979) 4,140 -- -- (4,844)
--------- ------ --------- ------ -------- ----------- -------- --------- -----------
BALANCE, DECEMBER 31, 2002 1,156 57,168 $ 430,642 $ 642 $227,376 $ -- $(58,308) $ 454,321 $ 1,054,673
========= ====== ========= ====== ======== =========== ======== ========= ===========
Net loss -- -- -- -- -- -- -- (147,739) (147,739)
Preferred dividends in
kind 108 -- 40,086 -- -- -- -- (40,086) --
Issuance of common stock
under employee benefit plans -- 461 -- 5 1,961 -- -- -- 1,966
Deferred compensation -- 303 -- 3 546 (549) -- -- --
Restricted stock forfeitures -- (125) -- (1) (228) 229 -- -- --
Amortization of restricted
stock -- -- -- -- -- 293 -- -- 293
--------- ------ --------- ------ -------- ----------- -------- --------- -----------
BALANCE, DECEMBER 31, 2003 1,264 57,807 $ 470,728 $ 649 $229,655 $ (27) $(58,308) $ 266,496 $ 909,193
========= ====== ========= ====== ======== =========== ======== ========= ===========
See accompanying notes to Consolidated Financial Statements
82
METRIS COMPANIES INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(DOLLARS IN THOUSANDS)
YEAR ENDED DECEMBER 31,
-----------------------
2003 2002 2001
----------- ----------- -----------
OPERATING ACTIVITIES:
Net(loss)income $ (147,739) $ (1,584) $ 160,029
Adjustments to reconcile net income (loss) to net cash
provided by (used in) operating activities:
Cumulative effect of accounting change -- -- 14,226
Depreciation, amortization and accretion (175,252) (175,314) (125,096)
Provision for loan losses 126,648 219,804 461,106
(Gain) loss from credit card securitization 216,957 (41,872) 95,246
Gain on sale of membership club and warranty business (84,787) -- --
Asset impairments, lease write-offs, and severance 56,222 27,736 --
Market (gain) loss on derivative financial instruments 5,303 22,562 (10,128)
Loss on sale of deposits 32,963 -- --
Changes in operating assets and liabilities, net:
Fair value of retained interests in loans securitized 71,669 342,080 (28,069)
Spread accounts receivable (268,805) (39,785) 6,570
Other receivables due from credit card securitizations 29,757 29,362 (132,177)
Accounts payable and accrued expenses (62,398) (27,163) 32,370
Liquidity reserve deposit (80,158) -- --
Deferred income (34,299) (45,587) (23,306)
Other (25,312) (1,728) 26,990
----------- ----------- -----------
Net cash (used in) provided by operating activities (339,231) 308,511 477,761
----------- ----------- -----------
INVESTING ACTIVITIES:
Proceeds from transfers of portfolios to the Metris Master Trust 695,459 2,087,097 553,180
Net cash from loan originations and principal collections on
loans receivable (794,033) (704,614) (1,127,389)
Proceeds from sales of credit card portfolios to third-parties 891,256 16,278 --
Proceeds from sale of membership club and warranty business 45,000 -- --
Credit card portfolio acquisitions -- -- (290,774)
Disposal of property and equipment, net 25,942 -- --
Additions to property and equipment, net -- (6,159) (5,708)
----------- ----------- -----------
Net cash provided by (used in) investing activities 863,624 1,392,602 (870,691)
----------- ----------- -----------
FINANCING ACTIVITIES:
Proceeds from issuance of debt 125,606 51,745 387,000
Repayment of debt (133,707) (342,000) (95,162)
Sale of deposits (559,282) -- --
Net decrease in deposits (327,210) (1,165,254) (48,191)
Premium paid and transaction costs on sale of deposits (32,963) -- --
83
Cash dividends paid -- (3,728) (3,752)
Proceeds from issuance of common stock 1,416 2,011 26,248
Repurchase of common stock -- (45,294) (13,014)
----------- ----------- -----------
Net cash provided by (used in) financing activities (926,140) (1,502,520) 253,129
----------- ----------- -----------
Net decrease in cash and cash equivalents (401,747) 198,593 (139,801)
Cash and cash equivalents at beginning of year 580,232 381,639 521,440
----------- ----------- -----------
Cash and cash equivalents at end of year $ 178,485 $ 580,232 $ 381,639
=========== =========== ===========
YEAR ENDED DECEMBER 31,
-----------------------
2003 2002 2001
----------- ----------- -----------
SUPPLEMENTAL DISCLOSURES AND CASH FLOW INFORMATION:
Cash paid (received) during the year for:
Interest 67,519 $ 106,394 $ 165,241
Income taxes (78,601) (32,996) 25,718
Tax benefit from employee stock option exercises 1 174 8,989
See accompanying Notes to Consolidated Financial Statements.
84
METRIS COMPANIES INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(DOLLARS IN THOUSANDS, EXCEPT AS NOTED)
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. ("MRI"). MCI
and its subsidiaries, as applicable, may be referred to as "we," "us," "our", or
the "Company." We are an information-based direct marketer of consumer lending
products.
All dollar amounts are presented as pre-tax amounts unless otherwise
noted. We have eliminated all significant intercompany balances and transactions
in consolidation.
PERVASIVENESS OF ESTIMATES
We have prepared the consolidated financial statements in accordance
with accounting principles generally accepted accounting in the United States of
America ("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 credit card loan portfolio and the fair
value of our "Retained interests in loans securitized" as of December 31, 2003,
and December 31, 2002, could materially differ from these estimates. The
accompanying consolidated financial statements do not include an adjustment to
the fair value of "Retained interests in loans securitized" that might result
from the possible 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 of consumer lending products, 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.
NOTE 2 - SIGNIFICANT ACCOUNTING POLICIES
The following is a summary of the significant accounting and reporting
policies used in preparing the consolidated financial statements.
85
FEDERAL FUNDS SOLD AND SHORT-TERM INVESTMENTS
"Federal funds sold" are short-term loans made to banks through the
Federal Reserve System. It is our policy to make such loans only to banks that
are considered to be in compliance with their regulatory capital requirements.
Short-term investments are investments in money market mutual funds, Treasuries,
other Government Agency Obligations, and commercial paper with maturities less
than three months. We invest in certain certificates of deposit and Housing
Bonds in order to meet the Bank's obligations under the Community Reinvestment
Act, and fulfill the credit needs of the Bank's local community.
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 assets and are
classified on the consolidated balance sheets as "Liquidity reserve deposit."
CREDIT CARD LOANS
"Credit card loans" presented on our consolidated balance sheets are
receivables from cardholders that we have not sold via securitizations or
third-party conduit warehousing arrangements, and are recorded at the amount
outstanding plus related deferred acquisition costs, net of related deferred
revenue. "Interest income" on "Credit card loans" is earned and accrued based on
the amount of the loans outstanding. Accrued interest and fees, which have been
billed to the cardholder but not yet received, are classified on the
consolidated balance sheets with the related "Credit card loans". Accrued
interest that has not yet been billed to the cardholder is estimated and
classified on the consolidated balance sheets in "Other assets." "Interest
income" and fees are generally recognized until a loan is charged-off. Upon
charge-off, any unpaid principal is applied to the "Allowance for loan losses"
and any unpaid finance charges and fees are netted against the applicable income
statement line items. Interest charges are reduced or eliminated and fee
billings are eliminated if a cardholder is placed in a credit counseling or debt
forbearance program. Effective November 2002, we suspended the billing of late
fees after an account becomes 120 days contractually delinquent. Effective March
2003, we stopped billing overlimit fees once an account became 120 days
contractually delinquent.
When we decide to sell a portion of our "Credit card loans", the loans
are specifically identified and transferred to the held-for-sale account. The
loans are transferred into the account at the lower of cost or fair value at the
date the decision to sell is made. Any reduction in the loan's value is
reflected as a charge-off of the recorded investment in the loan with a
corresponding reduction in the "Allowance for loan losses". All deferred costs
and fees are written off upon the decision to sell. At the time of sale we
record the difference between the carrying value and sales price as an increase
or decrease in the "Provision for loan losses." Any "Purchased portfolio
premium" would also be written off unless we retain ownership of the cardholder
account. To the extent that the loan's carrying value at the time of transfer
does not reflect fair value, an additional "Provision for loan losses" is
recorded. Any loans in the held-for-sale account are revalued to the lower of
cost or fair value at each
86
subsequent reporting date. We had no loans in the held-for-sale account as of
December 31, 2003 and 2002.
ALLOWANCE FOR LOAN LOSSES
We maintain an "Allowance for loan losses" sufficient to absorb
anticipated probable loan losses inherent in the credit card loan portfolio as
of the balance sheet date. The allowance is based on management's consideration
of all relevant factors including management's assessment of applicable economic
and seasonal trends. In addition, we have incorporated updated regulatory
guidance regarding analysis and documentation for the allowance for loan losses.
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 ultimately
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 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 "Allowance for loan
losses," we consider several subjective factors which may be overlaid into the
credit risk roll-rate model in determining the necessary loan loss reserve,
including:
- national and economic trends and business conditions, including the
condition of various market segments;
- changes in lending policies and procedures, including those for
underwriting, collection, charge-off and recovery, as well as in the
experience, ability and depth of lending management and staff;
- trends in volume and the product pricing of accounts, including any
concentrations of credit; and
- 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."
Various regulatory agencies, as an integral part of their examination
process, periodically review our allowance for loan losses maintained at Direct
Merchants Bank. Such agencies may require that we recognize additions to the
allowance based on their judgment on information available to them at the time
of their examination. In our opinion, the allowance for loan losses is adequate
to cover probable losses inherent in the loan portfolio under current
conditions.
87
We charge-off unsecured credit card accounts at the end of the month
during which the loan becomes contractually 180 days past due except as follows.
We charge-off all secured credit card accounts and accounts which enter into
credit counseling or other similar programs and later become delinquent at the
end of the month during which the loan becomes contractually 120 days past due
after first reducing the loss by the security deposit. Bankrupt accounts are
charged-off within 60 days of formal notification of bankruptcy. Accounts of
deceased accountholders without a surviving, contractually liable individual, or
an estate large enough to pay the debt in full are charged-off immediately upon
notification.
CREDIT CARD FEES AND ORIGINATION COSTS
Credit card fees include annual membership, late payment, overlimit,
returned check, cash advance transaction and other miscellaneous fees. We assess
these fees according to the terms of the related cardholder agreements and,
except for annual membership fees, we recognize the fees as revenue when charged
to the cardholder's account.
In accordance with Statement of Financial Accounting Standards ("SFAS")
No. 91, "Accounting for Nonrefundable Fees and Costs Associated with Originating
or Acquiring Loans and Initial Direct Costs of Leases," we defer certain direct
credit card origination costs associated with successful credit card
solicitations. These costs are capitalized and amortized to "Interest income" on
a straight-line basis over the cardholder's privilege period, generally 12
months. These net deferred costs are included in "Credit card loans." If
deferred direct credit card acquisition costs were to exceed forecasted future
cash flows, we would make an appropriate adjustment for impairment. All other
costs of credit card solicitation are expensed as incurred.
CREDIT CARD FRAUD LOSSES
We experience "Credit card fraud losses" from the unauthorized use of
credit cards. We expense these fraudulent transactions when identified, through
the establishment of a reserve for the transactions. We charge-off these amounts
through "Credit card fraud losses" no later than 90 days from discovery, after
all attempts to recover the amounts from these transactions, including
chargebacks to merchants and claims against cardholders, are exhausted.
RETAINED INTERESTS IN LOANS SECURITIZED AND SECURITIZATION INCOME
Upon securitization, the Company removes the applicable Credit card
receivables 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 may be sold to the Metris Master Trust at the
inception of a securitization series. We also sell credit card receivables daily
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 income." At the same time, the Company
recognizes the "Retained interests in loans securitized."
88
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 include 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 represent 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 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 in
"Securitization 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 in loans securitized" using the effective yield method in accordance
with Emerging Issues Task Force ("EITF") 99-20 "Recognition of Interest Income
and Impairment on Purchased and Retained Beneficial Interests in Securitized
Financial Assets." Accordingly, "Securitization 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.
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 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.
89
DEBT ISSUANCE COSTS
Debt issuance costs (upfront fees) are the costs related to issuing new
on-balance-sheet debt securities. We capitalize these costs and amortize them to
expense over the term of the new on-balance sheet debt security.
PROPERTY AND EQUIPMENT
We record "Property and equipment" at cost and depreciate it on a
straight-line basis over its estimated economic useful lives, which range from
one to 25 years. We capitalize software developed for internal use that
represents major enhancements or replacements of operating and management
information systems. We begin amortization of such capitalized software when the
systems are fully developed and ready for implementation. We expense repair and
maintenance costs as incurred. We review "Property and equipment" for impairment
whenever events or changes in circumstances indicate that the carrying amount of
an asset may not be recoverable. Any impairment is recorded in "Asset
impairments, lease write-offs and severance." Upon the decision to sell
"Property and equipment," we adjust the carrying value to the lower of cost or
market and transfer the assets to a held for sale account. No depreciation is
recognized on held for sale assets.
PURCHASED PORTFOLIO PREMIUM
The "Purchased portfolio premium" represents the excess of amounts paid
for portfolio acquisitions over the related "Credit card loans," net of reserves
and discounts. The premium is amortized over the estimated account life,
generally seven years, based on expected account attrition. The recoverability
of the premium is evaluated quarterly.
DEBT WAIVER PRODUCTS
Direct Merchants Bank offers various debt waiver products on
receivables it owns as well as securitized receivables. The Bank records
"Deferred Revenue" on receivables owned by the Bank when the debt waiver
customer is billed. Revenue on receivables it owns is recognized in the month
following the completion of the cancellation period, which is one-month.
Revenues recorded for debt waiver products on receivables owned by the Bank are
included in the consolidated statements of income under "Credit card fees,
interchanges and other credit card income." Unearned revenues on receivables
owned by the Bank are recorded in the consolidated balance sheets in "Deferred
income."
Cash flows from debt waiver products on receivables sold to the Metris
Master Trust are included in the valuation of the interest-only strip
receivable.
The Bank incurs the related claims and marketing expenses for all debt
waiver products. A reserve is maintained for future death and finance charge
claims based on experience with settlement of such claims. Reserves for pending
and incurred but not reported claims are recorded in the consolidated balance
sheets in "Accrued expenses and other liabilities." Expenses related to these
claims are included in "Credit protection claims expense" on the consolidated
statements of income.
90
Qualifying membership acquisition costs for all debt waiver products
are deferred and charged to expense as debt waiver product fees are recognized.
We amortize these costs using an accelerated methodology, which approximates our
historical cancellation experience for the debt waiver products. Amortization of
debt waiver acquisition costs is included on the consolidated statements of
income in "Credit card account and other product solicitation expenses." All
other debt waiver acquisition costs are expensed as incurred.
INTEREST RATE RISK MANAGEMENT CONTRACTS
From time to time we enter into interest rate risk management contracts
such as interest rate swap, floor and cap agreements with highly rated
counterparties in order to hedge our interest rate exposure on securitized loans
and deposits. We account for these contracts in accordance with SFAS 133,
"Accounting for Derivative Instruments and Hedging Activities," as amended by
SFAS 138. We recognize all derivatives as either assets or liabilities on the
balance sheet and measure those instruments at fair value. The change in fair
value of the derivatives is recognized currently in earnings unless specific
hedge accounting criteria are met. If the derivative qualifies as a hedge, the
accounting treatment for the change in fair value varies based on the type of
risk being hedged. The monthly interest rate differential to be paid or received
on these contracts is accrued and included in "Net securitization and credit
card servicing income" or "Deposit interest expense," as appropriate, on the
consolidated statements of income. Interest payable or receivable under these
contracts is classified under "Other receivables due from credit card
securitization, net" or "Other assets," as appropriate on the consolidated
balance sheets.
INCOME TAXES
Deferred taxes are based on the temporary differences between the
financial statements and the tax bases of assets and liabilities that will
result in future taxable or deductible amounts. The deferred taxes are based on
the enacted rate that is expected to apply when the temporary differences
reverse. A valuation allowance is recognized if it is more likely than not that
all or some portion of the deferred tax asset will not be realized.
EARNINGS PER SHARE
The following table presents the computation of basic and diluted
weighted-average shares used in the per-share calculations:
YEAR ENDED DECEMBER 31,
-----------------------
(In thousands) 2003 2002 2001
---- ---- ----
(Loss) income before cumulative effect of accounting change $ (147,739) $ (1,584) $ 174,255
Preferred dividends 40,086 38,009 34,771
Net (loss) income applicable to common stockholders before cumulative effect
of accounting change, net (187,825) (39,593) 139,484
Cumulative effect of accounting change, net -- -- 14,226
-------------- --------------- -------------
Net (loss) income applicable to common Stockholders $ (187,825) $ (39,593) $ 125,258
============== ================ =============
91
Weighted average common shares outstanding 57,471 59,782 62,962
Adjustment for:
Assumed conversion of convertible preferred stock(1) -- -- 34,679
-------------- --------------- -------------
Basic common shares 57,471 59,782 97,641
Assumed exercise of outstanding stock options(1) -- -- 1,725
-------------- --------------- -------------
Diluted common shares 57,471 59,782 99,366
============== =============== =============
(1) The earnings per share calculation for the year ended December 31, 2003
and 2002 excludes the assumed conversion of the Convertible Preferred
Stock and the outstanding stock options, as they are anti-dilutive.
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 (loss) 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 the 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)
earnings 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) income" and "(Loss) earnings per
share" would have been recorded to the pro forma amounts indicated below:
YEAR ENDED DECEMBER 31,
-----------------------
(In thousands except per share data) 2003 2002 2001
---- ---- ----
Net (loss)income, as reported $ (147,739) $ (1,584) $ 160,029
Add: Stock-based employee compensation expense included in reported
net (loss) income, net of related tax effects 192 1,152 1,930
Deduct: Annual stock-based employee compensation (benefit) expense
determined based on the fair value for all awards, net of
related tax effects (20,609) 19,293 18,777
------------------ ----------------- ----------------
Pro forma net (loss)income (126,938) (19,725) 143,182
================== ================= ================
(Loss) earnings per share:
Basic-as reported (3.27) (0.66) 1.64
================== ================= ================
Basic-pro forma (2.91) (0.97) 1.47
================== ================= ================
Diluted-as reported (3.27) (0.66) 1.61
================== ================= ================
Diluted-pro forma (2.91) (0.97) 1.44
================== ================= ================
Weighted-average assumptions in option valuation:
Risk-free interest rates 1.5% 3.7% 4.9%
Dividend yields -- 1.6% 0.2%
Stock volatility factor 111.4% 92.9% 52.2%
Expected life of options (in years) 3.7 6.0 6.0
92
The above pro forma amounts may not be representative of the effects on
reported net earnings for future years. In February 2003, we granted 303,000
shares of restricted stock totaling $0.5 million of unearned compensation, which
amortized into "Compensation expense" over the twelve month vesting period.
During 2003 we had $0.3 million in amortization expense and $0.2 million in
forfeiture benefits related to this restricted stock.
NOTE 3 - ALLOWANCE FOR LOAN LOSSES
Activity in the "Allowance for loan losses" is as follows:
YEAR ENDED DECEMBER 31,
-----------------------
(In thousands) 2003 2002 2001
---- ---- ----
Balance at beginning of year $ 90,315 $ 460,159 $ 123,123
Allowance related to assets acquired -- -- 14,106
Allowance related to assets transferred to the Metris Master Trust
(34,456) (264,297) 71,603
Provision for loan losses 126,648 219,804 461,106
Principal receivables charged-off(1) (141,164) (345,785) (235,197)
Recoveries 4,149 20,434 25,418
---------------- ---------------- ----------------
Net loans charged-off (137,015) (325,351) (209,779)
---------------- ---------------- ----------------
Balance at end of year $ 45,492 $ 90,315 $ 460,159
================ ================ ================
(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 for the
years ended December 31, 2003, 2002 and 2001 were $20.3 million, $7.9 million,
and $277.8 million, respectively.
NOTE 4 - RETAINED INTERESTS IN LOANS SECURITIZED
Our "Credit card loans" 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, excess transferor's interests
maintained above the contractual retained interests, an interest-only strip
receivable, 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 December 31, 2003 and 2002,
respectively.
AT DECEMBER 31,
---------------
(In thousands) 2003 2002
---- ----
Contractual retained interests $ 542,014 $ 685,197
Excess transferor's interests 48,775 57,447
Interest-only strip receivable 16,039 13,882
Spread accounts receivable 230,073 51,500
-------------------- -------------------
Retained interests in loans securitized $ 836,901 $ 808,026
==================== ===================
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The following table illustrates the significant assumptions used in
estimating the fair value of retained interests as of December 31, 2003 and
2002, respectively.
AT DECEMBER 31,
---------------
2003 2002
---- ----
Monthly payment rate 6.7% 6.7%
Gross yield(1) 25.4% 26.0%
Annual interest expense and servicing fees 4.2% 4.0%
Annual gross principal default rate 20.7% 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 December 31, 2003, the sensitivity of the current fair value of the
retained interests to immediate 10% and 20% adverse changes are as follows:
ADVERSE IMPACT ON FAIR VALUE
----------------------------
(In millions) 10% ADVERSE CHANGE 20% ADVERSE CHANGE
------------------ ------------------
Annual discount rate $ 22.6 $ 44.3
Monthly payment rate 139.7 331.4
Gross yield 132.8 285.4
Annual interest expense and servicing fees 21.3 48.1
Annual gross principal default rate 99.3 209.4
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.
The actual rates for loans securitized are as follows:
AT DECEMBER 31,
---------------
2003 2002
---- ----
Annual gross principal default rate 20.4% 16.4%
Monthly payment rate 6.8% 6.6%
Gross yield(1) 26.8% 26.5%
(1) Includes finance charges, late and overlimit fees, debt waiver premiums,
interchange income, cash advance fees, and bad debt recoveries, net of
finance charge and fee charge-offs.
94
NOTE 5 - SECURITIZATION INCOME
The following summarizes "Securitization income" for the years ended
December 31, 2003, 2002 and 2001, respectively.
YEAR ENDED DECEMBER 31,
-----------------------
(In thousands) 2003 2002 2001
---- ---- ----
Loss on new securitization of receivables to the Metris Master
Trust $ (55,214) $ (70,578) $ (60,574)
(Loss) gain on replenishment of receivables to the Metris Master
Trust (161,743) 28,706 (34,672)
Discount accretion 308,912 305,327 221,670
Change in fair value (71,669) (342,080) 28,069
Interest-only revenue 221,331 452,268 510,806
Transaction and other costs (68,250) (50,126) (14,899)
--------------- --------------- ---------------
Securitization income $ 173,367 $ 323,517 $ 650,400
=============== =============== ===============
95
NOTE 6 - SECURITIZATION ACTIVITY
Securitization activity for the years ended December 31, 2003 and 2002,
is as follows:
DECEMBER 31,
------------
(In thousands) 2003 2002
---- ----
Credit card loans $ 128,615 $ 846,417
Receivables held in the Metris Master
Trust 8,003,216 10,573,769
------------------- -------------------
Total managed loans $ 8,131,831 $ 11,420,186
=================== ===================
Managed loans more than 30-days contractually delinquent $ 902,075 $ 1,259,949
Managed loans charged-off, net of recoveries $ 2,033,852 $ 1,840,786
YEAR ENDED DECEMBER 31,
-----------------------
(In thousands) 2003 2002
---- ----
Cash flow to/from the Company:
Proceeds from transfers of portfolios to the Metris Master Trust $ 1,077,200 $ 2,087,097
Net proceeds from sales and repayments of securitized loans (3,218,857) (1,145,947)
Proceeds from principal receivables collections reinvested in
revolving credit card securitizations 5,306,757 5,490,499
Servicing fees received 174,964 192,325
Cash flows received from net excess spread 247,438 570,088
----------- -----------
Total $ 3,587,502 $ 7,194,062
=========== ===========
NOTE 7 - PROPERTY AND EQUIPMENT
The carrying value of property and equipment is as follows:
AT DECEMBER 31,
---------------
2003 2002
---- ----
Furniture and equipment $ 36,363 $ 40,870
Computer software and equipment 68,923 71,640
Buildings and land 4,604 24,143
Leasehold improvements 12,638 16,389
-------- --------
Total $122,528 $153,042
Less: Accumulated depreciation and amortization 88,848 69,211
-------- --------
Balance at end of year $ 33,680 $ 83,831
======== ========
Depreciation and amortization expense for the years ended December 31,
2003, 2002, and 2001, was $18.2 million, $25.6 million, and $24.7 million,
respectively.
NOTE 8 - PURCHASED PORTFOLIO PREMIUM
The carrying value of the "Purchased portfolio premium" was $17.6
million and $64.6 million as of December 31, 2003 and 2002, net of accumulated
amortization of
96
$136.6 million and $124.2 million, respectively. Amortization expense for the
years ended December 31, 2003, 2002, and 2001, was $25.0 million, $30.2 million,
and $30.3 million, respectively. During 2003, $22.0 million of "Purchased
portfolio premium" was written off due to asset sales. "Purchased portfolio
premium" is amortized based on account attrition. On a quarterly basis,
"Purchased portfolio premium" is analyzed for impairment by comparing the
expected account attrition to actual account attrition.
NOTE 9 - PORTFOLIO ACQUISITIONS AND SALES
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 held by the Metris Master Trust prior to the sale.
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. 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 2003, we sold two portfolios of delinquent accounts
approximating $69.0 million in receivables. Upon the decision to sell, $62.3
million of receivables were charged-off.
During 2002, we sold two portfolios of delinquent accounts
approximating $120 million in receivables. Upon the decision to sell, $101.5
million of the receivables were charged off.
NOTE 10 - CONVERTIBLE PREFERRED STOCK
Affiliates of Thomas H. Lee Partners, L.P. ("THL Partners"), a
Boston-based investment firm, and its predecessor, Thomas H. Lee Company, hold
100% of the outstanding shares of our Series C Perpetual Convertible Preferred
Stock. The Series C Preferred Stock has a 9% dividend payable in additional
shares of Series C Preferred Stock and also receives any cash dividends paid on
our common stock based on the number of shares of common stock into which the
Preferred Stock would convert on the record date of the dividend. Each share of
Series C Preferred Stock is convertible into 30 shares of common stock plus, if
converted at the option of the holder before January 1, 2004, a premium amount
designed to guarantee a portion of seven years worth of dividends at the 9%
annual rate. The premium amount would have been equal to 76.5% of those future
dividends for conversions in 2003 and would have been 54.4% of those dividends
in 2002.
The Series C Preferred Stock is normally fully convertible into common
stock. This would mean that upon conversion of their Preferred Stock, our
Preferred Stockholders could have received 42,616,367 shares, or approximately
42.5%, of the outstanding common stock on a diluted basis as of December 31,
2003. However, the indenture that governs our 10% Senior Notes due 2004 requires
us to offer to purchase those notes in the event that such a conversion would
result in a shareholder or group (within the meaning of Rules 13d-3 and 13d-5 of
the Securities Exchange Act of 1934) obtaining 35% or more of our outstanding
97
voting stock. Therefore, we included a provision in the terms of our Series C
Preferred Stock that sets the maximum percentage of outstanding voting stock
that any shareholder or group, such as the affiliates of THL Partners, could
obtain while any of our 10% Notes remain outstanding at 34.9%. Accordingly, as
of December 31, 2003, the Series C Preferred Stock could have been converted
into 30,894,763 shares, or 34.9%, of our common stock on a diluted basis, with
the excess Series C Preferred Stock converting into 11,721,604 shares of
nonvoting Series D Preferred Stock. The Series D Preferred Stock automatically
converts into common stock on a share-for-share basis at the time that the
conversion will not exceed the ownership limitations described above. The terms
of our Series D Preferred Stock are essentially the same as the terms of our
common stock, except that
- the Series D Preferred Stock has a liquidation preference of $.01 per
share, and
- is non-voting, except as required by law to preserve the powers,
preferences or other rights of that class of stock.
So long as they or their affiliates own at least 25% of the originally
issued Series C Preferred Stock (or any shares of common stock issued upon
conversion thereof), the holders of a majority of the shares of Series C
Preferred Stock are entitled to elect four of 11 directors of the Board. So long
as they or their affiliates: (a) own any shares of Series C Preferred Stock (or
any shares of common stock issued upon conversion thereof); and (b) are entitled
to elect four directors, Thomas H. Lee Equity Fund IV, L.P., which owns
approximately 85% of our outstanding Series C Preferred Stock, has the right to
appoint one of the four directors. So long as they or their affiliates own at
least 10% but less than 25% of the originally issued Series C Preferred Stock
(or any shares of common stock issued upon conversion thereof), the holders of a
majority of the shares of Series C Preferred Stock are entitled to elect one
director. The four directors who have been elected by the holders of our Series
C Preferred Stock are all affiliates of THL Partners and, through such
affiliation as well as actual ownership of Series C Preferred Stock, may be
deemed to be the beneficial owners of approximately 97% of the common stock that
would be issued upon conversion of our Series C and D Preferred Stock, both
individually and in the aggregate.
The Series C Preferred Stock may be redeemed by us in certain
circumstances by paying 103% of the redemption price of $372.50 and any accrued
dividends at the time of redemption. We also have the option to redeem the
Series C Preferred Stock after December 9, 2008, without restriction by paying
the redemption price of $372.50 and any accrued dividends at the time of
redemption.
NOTE 11 - STOCK OPTIONS
We provide the Metris Companies Inc. Long-Term Incentive and Stock
Option Plan, which permits a variety of stock-based grants and awards and gives
us flexibility in tailoring our long-term compensation programs. As of December
31, 2003, 8.3 million shares were available for grant. We do not provide loans
to employees for the purchase of stock or the exercise of stock options.
The Compensation Committee of the Board has the authority to determine
the exercise prices, vesting dates or conditions, expiration dates and other
material conditions upon which options or awards may be exercised, except that
the option
98
price for Incentive Stock Options ("ISOs") may not be less than 100%
of the fair market value of the common stock on the date of grant (and not less
than 110% of the fair market value in the case of an ISO granted to any employee
owning more than 10% of the common stock) and the terms of nonqualified stock
options may not exceed 15 years from the date of grant (not more than ten years
for ISOs and five years for ISOs granted to any employee owning more than 10% of
the common stock). Full- or part-time employees, consultants or independent
contractors are eligible to receive nonqualified options and awards. Only full-
or part-time employees are eligible to receive ISOs. Our stock options expire
ten years from the date of grant and vest over periods ranging from one to six
years with some options vesting at 25% to 33.3% per year.
We also issue restricted stock grants under the stock option plan.
During 2003, a total of 305,600 shares were issued to various employees with an
approximate aggregate market value of $0.5 million at the time of the grant. As
of the date restricted stock is granted, deferred compensation is recorded as a
reduction of equity for the fair value of the shares granted. The deferred
compensation is amortized to compensation expense on a straight-line basis over
the vesting period.
In prior years we issued restricted stock to our former Chairman and
Chief Executive Officer. Upon his termination, he forfeited all the restricted
stock previously granted to him. All previously recognized expense was reversed
and the related deferred compensation was added back to stockholders' equity.
The amount of compensation reversed in 2002 that had been recognized in previous
years was $3.0 million.
We also provide the Metris Companies Inc. Non-Employee Director Stock
Option Plan, which provides up to 750,000 shares of common stock for awards of
options, subject to adjustments in certain circumstances. During 2003, 2002 and
2001, we granted 105,000, 100,000 and 89,000 options, respectively. At December
31, 2003, 81,000 shares were available for grant.
Information regarding our stock option plans for 2003, 2002, and 2001,
is as follows:
YEAR ENDED DECEMBER 31,
-----------------------
2003 2002 2001
---- ---- ----
WEIGHTED- WEIGHTED- WEIGHTED-
AVERAGE AVERAGE AVERAGE
EXERCISE EXERCISE EXERCISE
SHARES PRICE SHARES PRICE SHARES PRICE
------ ----- ------ ----- ------ -----
Options outstanding,
beginning of year 11,729,444 $19.05 10,604,136 $19.73 9,907,062 $17.67
Options exercised 2,500 5.33 49,899 13.67 1,383,358 11.81
Options granted 1,622,794 1.83 2,180,885 12.09 2,832,838 25.01
Options canceled/
forfeited 7,522,495 17.99 1,005,678 11.45 752,406 27.01
--------- --------- ----------
Options outstanding,
end of year 5,827,243 15.53 11,729,444 19.05 10,604,136 19.73
========= ========== ==========
Weighted-average fair value
of options granted
during the year - $ 1.34 - $ 8.19 - $13.57
99
The following table summarizes information about stock options
outstanding at December 31, 2003:
OPTIONS OUTSTANDING OPTIONS EXERCISABLE
------------------- -------------------
WEIGHTED-
AVERAGE WEIGHTED- WEIGHTED-
NUMBER REMAINING AVERAGE NUMBER AVERAGE
OUTSTANDING CONTRACTUAL EXERCISE EXERCISABLE EXERCISE
EXERCISE PRICE AT 12/31/03 LIFE PRICE AT 12/31/03 PRICE
-------------- ----------- ----------- -------- ------------ ---------
$0-$16.77 3,209,942 7.4 $ 8.22 1,695,059 $ 10.50
$17.10-$24.42 1,660,841 6.3 22.01 1,313,756 21.94
$24.67-$38.88 956,460 7.0 28.79 633,601 28.29
--------- --- ----- --------- -----
5,827,243 7.0 15.53 3,642,416 17.72
EMPLOYEE STOCK PURCHASE PLAN
We provide the Metris Companies Inc. Employee Stock Purchase Plan
("ESPP"), whereby eligible employees may authorize payroll deductions of the
lesser of up to 15% of their salary or $25,000 to purchase shares of our common
stock. Under the plan, shares of our common stock may be purchased at the end of
each monthly offering period at 85% of the lower of the fair market value on the
first or last day of the monthly offering period. Employees contributed $0.8
million and $1.8 million to purchase 387,828 and 374,166 shares of common stock
under the ESPP during 2003 and 2002, respectively. We are authorized to issue up
to 2.5 million shares of common stock to employees under the plan, and as of
December 31, 2003, there were approximately 1.9 million shares available for
future issuance.
We offer certain employees the Non-Qualified Employees Stock Purchase
Plan ("NQ ESPP"). Eligible employees may purchase shares of our common stock at
100% of the fair market value of common shares on the last day of the monthly
offering period. Employees contributed $0.09 million and $0.1 million to
purchase 30,024 and 27,946 shares of common stock under the NQ ESPP during 2003
and 2002, respectively. We are authorized to issue up to 0.5 million shares of
common stock to employees under the plan, and as of December 31, 2003, there
were approximately 0.5 million shares available for future issuance.
MANAGEMENT STOCK PURCHASE PLANS
We provide a management stock purchase plan, whereby any employee who
is a Senior Vice President level or above, excluding corporate officers
designated by the Board of Directors, who participates in the Metris Management
Incentive Bonus Plan is eligible to participate. Participants may elect to defer
up to 50% of their bonus received under the Management Bonus Plan, which is
credited to a stock purchase account as restricted stock units. We will match $1
for every $3 contributed by the participant. The participant's contributions are
vested immediately and our matching contributions vest after three years. During
2003, employees contributed $6,750 to purchase 1,502 restricted stock units
under the plan. The restricted stock units convert to common stock when
distributed from the plan. No contributions were made to the plan during 2002.
The restricted stock units convert to common stock when distributed from the
plans. We are
100
authorized to issue up to 450,000 shares of common stock to employees under the
plans, and as of December 31, 2003, approximately 287,359 of the authorized
shares were available for future issuance.
We provided an additional management stock purchase plan, whereby
officers designated by the Board of Directors, who participate in the Metris
Annual Incentive Bonus Plan for Designated Corporate Officers were eligible to
participate. Participants elected to defer up to 50% of their bonus received
under the Management Bonus Plan, which was credited to a stock purchase account
as restricted stock units. We matched $1 for every $3 contributed by the
participant. The participant's contributions were vested immediately and our
matching contributions vest after three years. No contributions were made to the
plan during 2003 or 2002. The restricted stock units convert to common stock
when distributed from the plan. This plan terminated on December 31, 2003.
NOTE 12 - EMPLOYEE BENEFIT PLANS
We offer a defined contribution plan that is intended to qualify under
section 401(k) of the Internal Revenue Code. The 401(k) Plan provides retirement
benefits for eligible employees. Eligible employees may elect to contribute to
the 401(k) Plan, and we match a portion of employee contributions and make
discretionary contributions based upon our financial performance. For the years
ended December 31, 2003, 2002, and 2001, we contributed $3.3 million, $2.6
million and $2.0 million to the 401(k) Plan, respectively.
The Company also offered a Non-Qualified Deferred Compensation Plan for
a select group of management or highly compensated employees. The plan provided
saving and investment opportunities to those individuals who elected to defer a
portion of their salary. The Company matched a portion of the employee
contribution and made discretionary contributions based on the Company's
financial performance. We contributed $0.4 million and $0.3 million to the plan
for the years ended December 31, 2002 and 2001, respectively.
During 2003, the Non-Qualified Deferred Compensation Plan was
discontinued and all vested balances were distributed to participants.
SUPPLEMENTAL EXECUTIVE RETIREMENT PLAN
Our Supplemental Executive Retirement Plan ("SERP") provides officers
and other members of senior management with supplemental retirement benefits in
excess of limits imposed on qualified plans by federal tax law. The SERP is an
account balance plan to which we will make annual contributions targeted to
provide 40%-60% of the average of the participant's final three years of salary
and bonus with us. These benefits will be paid in 15 annual installments
beginning the year after they become eligible to receive benefits. Participants
are eligible to receive benefits upon leaving our employment if they are at
least 65 years of age or at least age 55 with five years of plan participation,
if a change of control occurs or in the event of death. We recognized $3.4
million, $0.9 million, and $0.7 million of expense in 2003, 2002, and 2001,
respectively, related to the SERP. Our liability was $7.1 million and $3.8
million at December 31, 2003 and 2002, respectively, for future payments under
this plan. We calculate this expense and liability based on actuarial
assumptions regarding
101
years of participation, future investment returns and participants continuing in
the SERP until age 65.
NOTE 13 - INCOME TAXES
The components of the (benefit) expense for income taxes consisted of
the following:
YEAR ENDED DECEMBER 31,
-----------------------
2003 2002 2001
---- ---- ----
Current:
Federal $ (93,725) $ (28,893) $ 63,865
State 557 138 6,381
---------- ---------- -----------
(93,168) (28,755) 70,246
Deferred:
Federal 22,940 29,840 41,445
State 702 782 1,969
---------- ---------- -----------
23,642 30,622 43,414
Total $ (69,526) $ 1,867 $ 113,660
========== ========== ===========
A reconciliation of our effective income tax rate compared to the
statutory federal income tax rate is as follows:
YEAR ENDED
DECEMBER 31,
------------
2003 2002 2001
---- ---- ----
Statutory federal income tax rate 35.0% 35.0% 35.0%
State income taxes, net of federal benefit (0.4) 211.3 1.9
Valuation allowance (1.1) - -
Other, net (1.5) 413.4 2.6
---- ----- ----
Effective income tax rate 32.0% 659.7% 39.5%
==== ====== =====
The 2002 effective income tax rate is high relative to statutory rates
primarily due to the effect of nondeductible expenses, minimum state income
taxes, and low pre-tax income.
Our deferred tax assets and liabilities are as follows:
AT 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 $ 122,852 $ 172,299
Intangibles 30,343 31,635
Net operating loss and credit carry forwards 28,200 -
Deferred revenues 8,730 59,042
Other 23,639 36,508
Valuation allowance (2,427) -
--------- ---------
Total deferred tax assets $ 211,337 299,484
102
Deferred income tax liabilities resulting from future taxable and deductible
temporary differences:
Accrued interest on credit card loans 194,766 207,984
Deferred marketing costs 3,034 35,689
Other 16,354 34,986
--------- ---------
Total deferred tax liabilities 214,154 278,659
--------- ---------
Net deferred tax (liabilities) assets $ (2,817) $ 20,825
========= =========
During 2003, the Company recorded a $2.4 million valuation allowance
against its deferred tax assets due to uncertainties related to their
realization. We believe, based on our operating earnings in prior years,
expected reversal of taxable temporary differences, and to a lesser degree,
reliance on future earnings, the remaining deferred tax assets are fully
realizable.
In the fourth quarter of 2003, the Internal Revenue Service ("IRS")
examination team submitted a request for a Technical Advice Memorandum ("TAM")
to its Washington, D.C. National Office regarding the Company's treatment of
certain credit card fees as original issue discount ("OID"). With this
submission, the examination team has effectively withdrawn its 2002 proposed
adjustment for returns filed through December 31, 1998. The request for a TAM
covers tax returns filed through December 31, 2001. 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
December 31, 2001, the Company had deferred approximately $210 million in
federal income tax under the OID rules. An assessment could ultimately require
the Company to pay up to this amount of 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 this matter. The Company's position is
consistent with that of numerous other U.S. credit card issuers. While both the
timing and amount of the final resolution are uncertain, we do not expect any
additional tax to be paid over the next twelve months.
NOTE 14 - STOCKHOLDERS' EQUITY
During the years ended December 31, 2003 and 2002, we paid cash
dividends of $0 and $3.7 million. Under our credit facility agreement we can not
make dividend payments that exceed either $.01 per share of total shares and
options outstanding stock or $1.0 million per quarter.
Upon our termination of our former Chairman and Chief Executive Officer
in December 2002, he forfeited 540,029 shares of restricted stock. As a result,
$4.8 million of deferred compensation and common stock was added back to
stockholders' equity.
NOTE 15 - RELATED PARTY TRANSACTIONS
In the ordinary course of business, our executive officers may have
credit card loans issued by us. Pursuant to our policy, such loans are issued on
the same terms as those prevailing at the time for comparable loans with
unrelated persons and do not involve more than the normal risk of
collectibility.
103
On May 7, 1999 we entered into a loan agreement with our former
Chairman and Chief Executive Officer, Ronald N. Zebeck. The loan's original and
current principal balance is $5 million. The loan is unsecured and bears
interest at a rate of 6.25% per annum. Mr. Zebeck was terminated effective
December 15, 2002.
On January 23, 2004, a complaint was filed in Hennepin County District
Court in Minneapolis, Minnesota, against Metris, certain members of its board of
directors and a number of other entities, by Mr. Zebeck. On February 1, 2004,
defendants filed an answer in which they denied the allegations in the
complaint, and MCI filed counterclaims against Mr. Zebeck seeking a declaratory
judgment against Mr. Zebeck for the principal amount of the loan made by MCI in
1999, plus interest.
NOTE 16 - COMMITMENTS AND CONTINGENCIES
Commitments to extend credit to consumers represent the unused credit
limits on open credit card accounts. These commitments were $8.0 billion and $12
billion as of December 31, 2003 and 2002, respectively. While these amounts
represent the total lines of credit available to our customers, we have not
experienced and do not anticipate that all of our customers will exercise their
entire available line at any given point in time. We also have the right to
increase, reduce, cancel, alter or amend the terms of these available lines of
credit at any time.
We lease certain office facilities and equipment under various
cancelable and non-cancelable operating lease agreements that provide for the
payment of a proportionate share of property taxes, insurance and other
maintenance expenses. These leases also may include scheduled rent increases and
renewal options. Rental expense for these operating leases for the years ended
December 31, 2003, 2002, and 2001, was $11.5 million, $23.8 million and $21.8
million, respectively. In 2003, 2002, and 2001 we recognized $14.1, $6.4, and $0
million, respectively, of expense due to excess capacity related to certain
operating leases.
Future minimum lease commitments at December 31, 2003, under cancelable
and non-cancelable operating leases are as follows:
2004 $ 13,373
2005 8,100
2006 7,037
2007 6,456
2008 5,663
Thereafter 13,167
------
Total minimum lease payments 53,796
======
We are a party to various legal proceedings resulting from the ordinary
business activities relating to our operations.
In September 2002, a shareholder lawsuit was filed in the United States
District Court for the District of Minnesota, naming MCI, Ronald N. Zebeck and
David D. Wesselink as defendants. The plaintiffs seek 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 that
defendants violated the federal securities laws when MCI failed to disclose the
existence of the OCC Report of Examination until April 17, 2002. We believe the
lawsuit is without merit.
104
Our activities as a credit card lender are subject to regular review
and examination by federal regulators to assess compliance with various federal
consumer protection laws. Regulators are authorized to impose penalties for
violations of these laws and, in certain cases, to order us to pay restitution
to injured cardholders.
On May 3, 2001, Direct Merchants Bank entered into a consent order with
the OCC. The consent order required us to pay approximately $3.2 million in
restitution to approximately 62,000 credit card customers who applied for and
received a credit card in connection with a series of limited test marketing
campaigns from March 1999 to June 2000. Under the terms of the consent order, we
made no admission or agreement on the merits of the OCC's assertions. The
restitution as required by the OCC consent order was paid and is reflected in
our December 31, 2001 financial statements. In October 2002, the OCC advised
that Direct Merchants Bank is in full compliance with the consent order.
Furthermore, the OCC made a determination not to assess civil money penalties.
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:
- 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.
- 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.
- The Bank is required to continue to comply with the terms of the Liquidity
Reserve Deposit Agreement.
- 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 17 - CAPITAL REQUIREMENTS AND RESTRICTED PAYMENTS
In the normal course of business, we enter into agreements, or are
subject to regulatory requirements, that result in cash, debt, and 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 any
extensions of credit to or other covered transactions, such as certain purchases
of assets, with us and our affiliates. Such restrictions limit Direct Merchants
Bank's ability to lend to us and our affiliates. Additionally, Direct Merchants
Bank is limited in its ability to declare dividends to us and our affiliates in
105
accordance with the national bank dividend rules and the Modified Operating
Agreement.
Direct Merchants Bank is subject to certain capital adequacy guidelines
adopted by the OCC. At December 31, 2003 and 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, and Direct Merchants Bank
was considered a "well-capitalized" depository institution under regulations of
the OCC.
We are also bound by restrictions set forth in the indentures related
to the Senior Notes dated November 7, 1997, and July 15, 1999. Pursuant to those
indentures, we may not make dividend payments in the event of a default or if
all such restricted payments would exceed 25% of our aggregate cumulative "Net
income." Furthermore, our senior secured credit agreement limits payments of
quarterly dividends to $.01 per share.
NOTE 18 - CONCENTRATIONS OF CREDIT RISK
A concentration of credit risk is defined as significant credit
exposure with an individual or group engaged in similar activities or affected
similarly by economic conditions. We are active in originating "Credit card
loans" throughout the United States, and no individual or group had a
significant concentration of credit risk at December 31, 2003 or 2002.
We target our consumer lending products primarily to middle consumers.
Primary risks associated with lending to this market are that they may be more
sensitive to future economic downturn, which may make them more likely to
default on their obligations.
The banking regulators have issued guidelines to further segregate a
credit card issuer's loan portfolio between subprime loans (loans to consumers
who have a FICO credit score of 660 or less) and prime loans (loans to consumers
with FICO scores in excess of 660). The banking regulators deem subprime loans
to have higher credit risk. Subprime receivables were $83.5 million or 65.7% of
the credit card portfolio as of December 31, 2003, compared to $447.3 million or
52.9% of the credit card portfolio as of December 31, 2002.
NOTE 19 - FAIR VALUE OF FINANCIAL INSTRUMENTS
We have estimated the fair value of our financial instruments in
accordance with SFAS No. 107, "Disclosures About Fair Value of Financial
Instruments." Financial instruments include both assets and liabilities, whether
or not recognized in our consolidated balance sheets, for which it is
practicable to estimate fair value. The fair value of an asset is the amount at
which the asset could be bought or sold in a current transaction between willing
parties, that is, other than in a forced or liquidation sale. Additionally,
certain intangible assets recorded on the consolidated balance sheets, such as
purchased credit card relationships, and other intangible assets not recorded on
the consolidated balance sheets (such as the value of the credit card
relationships for originated loans and the franchise values of our various lines
of business) are not considered financial instruments and, accordingly, are not
valued for purposes of this disclosure. Accordingly, the aggregate estimated
fair value amounts presented do not represent the entire underlying value of the
Company.
106
Quoted market prices generally are not available for all of our
financial instruments. Accordingly, in cases where quoted market prices are not
available, fair values were estimated using present value and other valuation
techniques that are significantly affected by the assumptions used, including
the discount rate and estimated future cash flows. These assumptions are based
on historical experience and assessments regarding the ultimate collectibility
of assets and related interest, and estimates of product lives and repricing
characteristics used in our asset/liability management process. These
assumptions involve uncertainties and matters of judgment, and therefore, cannot
be determined with precision. Thus, changes in these assumptions could
significantly affect the fair-value estimates.
A description of the methods and assumptions used to estimate the fair
value of each class of our financial instruments is as follows:
Cash and cash equivalents and Liquidity reserve deposit
The carrying amounts approximate fair value due to the short-term
nature of these instruments.
Net credit card loans
"Credit card loans" are originated with variable rates of interest that
adjust with changing market interest rates. Thus, the carrying value of the
"Credit card loans," less the "Allowance for loan losses," approximates fair
value. This valuation does not include the value that relates to estimated cash
flows generated from new loans from existing cardholders over the life of the
cardholder relationship. Accordingly, the aggregate fair value of the "Credit
card loans" does not represent the underlying value of the established
cardholder relationships.
Retained interests and other securitization related assets
The fair value of the "Retained interests in loans securitized" and
other securitization related assets are estimated by discounting the expected
future cash flows from the Metris Master Trust and each of the conduits at
rates, which we believe to be consistent with those that would be used by an
independent third party. However, because there is no active market for the
"Retained interests in loans securitized," the fair values presented may not be
indicative of the value negotiated in an actual sale. The future cash flows used
to estimate fair value are limited to the securitized receivables that exist at
year end and do not reflect the value associated with future receivables
generated by accountholder activity.
Interest rate caps
We enter into interest rate cap transactions related to most series of
securities issued from the Metris Master Trust. We mark these assets to market
based on third-party and counter party valuations, and as such carrying value
approximates fair value.
Debt
We make short-term borrowings with variable rates of interest that
adjust with changing market interest rates. Thus, carrying value approximates
fair value.
107
We obtain the fair value of long-term debt from quoted market yields,
when available.
Deposits
The fair value for fixed rate certificates of deposit are estimated
based on quoted market prices of comparable instruments.
The estimated fair values of our financial instruments are summarized
as follows:
AT DECEMBER 31,
---------------
2003 2002
---- ----
CARRYING ESTIMATED CARRYING ESTIMATED
AMOUNT FAIR VALUE AMOUNT FAIR VALUE
(In thousands) ------ ---------- ------ ----------
Cash and cash equivalents $ 178,485 $ 178,485 $ 580,232 $ 580,232
Liquidity reserve deposit 80,158 80,158 - -
Credit card loans, net 83,123 83,123 756,102 756,102
Retained interests in loans securitized and other
receivables due from
credit card securitizations, net
917,615 917,615 918,497 918,497
Interest rate caps 9,787 9,787 12,711 12,711
Debt 350,448 274,849 357,649 341,580
Deposits 6,262 6,262 892,754 911,141
NOTE 20 - DERIVATIVE FINANCIAL INSTRUMENTS
We use derivative financial instruments for the purpose of managing our
exposure to interest rate risks.
MRI enters into interest rate cap transactions related to most
asset-backed securitization transaction. MRI assigns all of its right, title,
and interest under the interest rate cap agreement to the Trustee of the Metris
Master Trust for the benefit of the holders of securities issued by the Metris
Master Trust. The purpose of the interest rate cap is to effectively limit the
interest exposure of the Metris Master Trust for each individual series to a
maximum based upon the LIBOR rate.
The interest rate caps do not meet the criteria for hedge accounting
treatment. The change in the fair value of the caps is included in the
consolidated income statement under "Securitization income." We recognized
expense of $5.3 million and $22.6 million from the mark-to-market adjustments on
the interest rate caps for the years ended December 31, 2003 and 2002,
respectively.
We entered into interest rate swap transactions through Direct
Merchants Bank. The swaps were used to convert a portion of the fixed rate
certificates of deposit ("CDs") to variable rate CDs, and thus hedge the fair
market value of the CDs. The CDs expose us to variability in the fair value in
rising or declining interest rate environments. By converting the fixed payment
to a variable payment, the interest rate swaps reduce the variability of the
fair market value of the CDs.
108
As of the adoption of SFAS No. 133 or their inception, all swaps were
designated as fair value hedges. Changes in the value of the swaps are
recognized in income, in the period in which the change in value occurred. In
addition, changes in the value of the CDs, to the extent they are attributable
to the risk being hedged, are simultaneously recognized in income. Any
difference between the fair value change in the swaps versus the fair value
change in the related hedged CDs was considered to be the "ineffective" portion
of the hedge. The ineffective portion of the swap is recorded as an increase or
decrease in income.
During 2002 and 2001, all swaps were sold. At the date of sale, the
swap and the related CDs were valued, and a gain or loss was recognized for the
difference between the change in fair value of the swap and the change in fair
value of the CDs. The cumulative amount recorded as an adjustment to the value
of the CDs was being amortized over the life of the CDs as an adjustment to
interest expense. This amount was written off by the third quarter of 2003 at
the time of the certificates of deposit sale.
Prior to SFAS No. 133, we amortized the costs of interest rate
contracts on a straight-line basis over the expected life of the contract. The
adoption of SFAS No. 133 resulted in a one-time, non-cash, after-tax charge to
earnings of $14.2 million, reflected as a "Cumulative effect of accounting
change" in the consolidated statements of income for the year ended December 31,
2001.
NOTE 21 - 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 $84.8 million. Included in the gain was the recognition of $90.8
million of "Deferred income" and the write-off of $45.4 million of deferred
costs, which are included in "Other assets." As of December 31, 2003, we have
$7.3 million of "Deferred income", $1.9 million in deferred costs, and $0.7
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 22 - ASSET IMPAIRMENTS, LEASE WRITE-OFFS AND SEVERANCE
During 2003, we recorded $8.3 million for workforce reductions,
approximately $20.8 million in write-downs of excess property, equipment, and
operating leases, a $22.0 million write-off of purchased portfolio premium on
"Credit card loans" sold in the third and fourth quarters of 2003, and a $5.1
million write-off of commitment fees related to a backup financing facility
entered into in March of 2003, with Thomas H. lee Equity Fund IV, L.P. In 2002,
we recorded a write-down of $10.6 million for portfolios of charged-off loans
purchased in 2001 and 2000, a $17.1 million write-down of excess property,
equipment, operating leases, and the then pending sale of our Arizona facility.
NOTE 23 - DEBT AND DEPOSITS
A $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
109
that matured in June 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
2003 we were required to make $23.3 million in principal repayments from the
proceeds of the sale of our membership club and warranty business and proceeds
from the sale of office equipment. At December 31, 2003, we had outstanding
borrowings of $101.7 million under the Credit Agreement with an effective
weighted average interest rate of 27.6%. Since year-end we have made additional
principal pre-payments of approximately $6.4 million. We are bound by certain
covenants and as of December 31, 2003 and 2002, we were in compliance with all
financial covenants under the Credit Agreement. 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.
As of December 31, 2003, we had $150.0 million of 10.125% Senior Notes
due 2006 outstanding. The carrying value of these Senior Notes is $148.0 million
as of December 31, 2003. These Senior Notes were issued at a discount of $6.3
million to yield an effective interest rate of 11%.
The Senior Notes due 2004 and 2006 and the Senior Secured Credit
Agreement are unconditionally guaranteed on a senior basis, jointly and
severally, by Metris Direct, Inc., magnUS Services, Inc. (formerly Metris
Recovery Services, Inc.), Crescent Ridge Aviation, Inc., Metris Financial
Services, Inc., Metris Card Services, LLC and Metris Credit Card Services, Inc.
(the "Guarantors"). Any subsidiaries we form in the future may provide a
guarantee of this indebtedness. The guarantee is an unsecured obligation of the
Guarantors and ranks equally with all existing and future unsubordinated
indebtedness.
We also have $100 million of 10% Senior Notes due 2004 outstanding with
terms and conditions substantially similar to the Senior Notes due 2006.
During third quarter 2003, we prepaid a $10.0 million 9.19% term loan
that was due 2005 associated with a sale of certain Company assets. Subsequent
to December 31, 2003, we redeemed all notes and prepaid all interest and
principal amounts of approximately $1.0 million due under our Renewable
Unsecured Subordinated Note Program. The redeemed notes were originally issued
with terms ranging from two to ten years. There are currently no outstanding
notes under this program and the program has been terminated.
Our debt outstanding as of December 31, 2003, matures as follows:
2004 $ 202,254
2005 127
2006 147,769
2007 79
2008 23
Thereafter 196
---------
Total debt outstanding 350,448
=========
The Bank has established deposit accounts related to its secured card
product. These accounts do not have a set maturity date and pay a fixed interest
rate of 2%. As of December 31, 2003 and 2002, $6.3 million and $6.4 million
secured card deposits were outstanding, respectively.
110
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 OCC to eliminate the deposit risk to the FDIC.
We have various indirect subsidiaries, which do not guarantee Company
debt. We have prepared condensed consolidating financial statements of the
Company, which follow. the detail Guarantor subsidiaries and the non-guarantor
subsidiaries for purposes of complying with SEC reporting requirements. Separate
financial statements of the guaranteeing subsidiaries and the non-guaranteeing
subsidiaries are not presented because we have determined that the subsidiaries
financial information would not be material to investors.
111
METRIS COMPANIES INC.
SUPPLEMENTAL CONSOLIDATING BALANCE SHEETS
DECEMBER 31, 2003
(DOLLARS IN THOUSANDS)
METRIS GUARANTOR NON-GUARANTOR
COMPANIES INC. SUBSIDIARIES SUBSIDIARIES ELIMINATIONS CONSOLIDATED
-------------- ------------ ------------ ------------ ------------
ASSETS:
Cash and cash equivalents $ (1,081) $ 3,034 $ 176,532 $ - $ 178,485
Liquidity reserve deposit - - 80,158 - 80,158
Net credit card loans 15,203 - 67,920 - 83,123
Retained interests in loans
securitized - - 822,900 14,001 836,901
Property and equipment, net - 33,663 17 - 33,680
Purchased portfolio premium 80 - 17,481 - 17,561
Other receivables due from
credit card
securitizations, net 5 - 80,709 - 80,714
Other assets 21,242 30,934 54,917 (25,319) 81,774
Investment in subsidiaries 1,296,461 878,810 - (2,175,271) -
---------- ---------- ---------- ----------- ----------
TOTAL ASSETS $1,331,910 $ 946,441 $1,300,634 $(2,186,589) $1,392,396
========== ========== ========== =========== ==========
LIABILITIES:
Deposits $ (1,000) $ - $ 7,262 $ - $ 6,262
Debt 384,684 (413,842) 422,606 (43,000) 350,448
Accounts payable 489 15,406 16,805 (303) 32,397
Deferred income - - 18,060 - 18,060
Accrued expenses and other
liabilities 38,544 48,416 (42,909) 31,985 76,036
---------- ---------- ----------- ----------- ----------
TOTAL LIABILITIES 422,717 (350,020) 421,824 (11,318) 483,203
---------- ----------- ---------- ----------- ----------
TOTAL STOCKHOLDERS' EQUITY 909,193 1,296,461 878,810 (2,175,271) 909,193
---------- ---------- ---------- ----------- ----------
TOTAL LIABILITIES AND
STOCKHOLDERS' EQUITY $1,331,910 $ 946,441 $1,300,634 $(2,186,589) $1,392,396
========== ========== ========== =========== ==========
112
METRIS COMPANIES INC.
SUPPLEMENTAL CONSOLIDATING BALANCE SHEETS
DECEMBER 31, 2002
(DOLLARS IN THOUSANDS)
METRIS GUARANTOR NON-GUARANTOR
COMPANIES 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 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
========== ========== ========== ============ ==========
113
METRIS COMPANIES INC.
SUPPLEMENTAL CONSOLIDATING STATEMENTS OF INCOME
YEAR ENDED DECEMBER 31, 2003
(DOLLARS IN THOUSANDS)
METRIS
COMPANIES GUARANTOR NON-GUARANTOR
INC. SUBSIDIARIES SUBSIDIARIES ELIMINATIONS CONSOLIDATED
--------- ------------ ------------- ------------ ------------
NET INTEREST (EXPENSE) INCOME $ (45,265) $ 4,873 $ 56,501 $ -- $ 16,109
Provision for loan losses 2,568 -- 124,182 (102) 126,648
--------- --------- --------- --------- ---------
NET INTEREST (EXPENSE) INCOME
AFTER PROVISION FOR LOAN LOSSES (47,833) 4,873 (67,681) 102 (110,539)
--------- --------- --------- --------- ---------
OTHER OPERATING INCOME:
Securitization (expense) income (158) -- 174,976 (1,451) 173,367
Servicing income on securitized /
sold receivables -- -- 176,627 -- 176,627
Credit card fees, interchange and
other credit card income (expense) 2,535 66,153 89,383 (78,579) 79,492
Enhancement services revenue -- -- 107,930 -- 107,930
Loss on sale of credit card loans -- -- (117,183) -- (117,183)
(Loss) gain on sale of membership club
and warranty business (624) 28,011 45,787 11,613 84,787
Intercompany allocations 2,375 243,873 22,520 (268,768) --
--------- --------- --------- --------- ---------
4,128 338,037 500,040 (337,185) 505,020
OTHER OPERATING EXPENSE:
Credit card account and other product
solicitation and marketing expenses -- 50,144 101,137 (57,932) 93,349
Employee compensation -- 170,597 4,942 -- 175,539
Data processing services and communications 18 (78,471) 161,584 (14,416) 68,715
Credit protection claims expense -- -- 30,882 -- 30,882
Occupancy and equipment -- -- 36,564 -- 36,564
Purchased portfolio premium amortization 48 -- 28,457 (3,505) 25,000
Mastercard/Visa assessment and fees -- -- 9,243 -- 9,243
Credit card fraud losses 51 -- 3,770 -- 3,821
Asset impairments, lease write-offs and severance -- -- 56,222 -- 56,222
Loss on sale of deposits -- -- 32,963 -- 32,963
114
Other 2,863 124,418 (30,442) (17,391) 79,448
Intercompany allocations 90 80,690 187,988 (268,768) --
--------- --------- --------- --------- ---------
3,070 347,378 623,310 (362,012) 611,746
LOSS BEFORE INCOME TAX BENEFIT AND EQUITY IN
(LOSS) INCOME OF SUBSIDIARIES (46,775) (4,468) (190,951) 24,929 (217,265)
Income tax (benefit) expense (14,969) (6,791) (53,256) 5,490 (69,526)
Equity in loss of subsidiaries (115,933) (130,400) -- 246,333 --
--------- --------- --------- --------- ---------
NET (LOSS) INCOME $(147,739) $(128,077) $(137,695) $ 265,772 $(147,739)
========= ========= ========= ========= =========
115
METRIS COMPANIES INC.
SUPPLEMENTAL CONSOLIDATING STATEMENTS OF INCOME
YEAR ENDED DECEMBER 31, 2002
(DOLLARS IN THOUSANDS)
METRIS GUARANTOR NON-GUARANTOR
COMPANIES INC. SUBSIDIARIES SUBSIDIARIES ELIMINATIONS CONSOLIDATED
-------------- ------------ ------------- ------------ ------------
NET INTEREST (EXPENSE) INCOME $ (30,584) $ (389) $ 156,859 $ -- $ 125,886
Provision for loan losses (603) -- 220,305 102 219,804
--------- --------- --------- --------- ---------
NET INTEREST EXPENSE AFTER PROVISION FOR
LOAN LOSSES (29,981) (389) (63,446) (102) (93,918)
--------- --------- --------- --------- ---------
OTHER OPERATING INCOME:
Securitization income(expense) 3,168 -- 324,872 (4,523) 323,517
Servicing income on securitized/sold
receivables -- -- 195,214 -- 195,214
Credit card fees, interchange and other
credit card income (expense) 1,748 94,941 166,747 (100,262) 163,174
Enhancement services revenue (expense) -- 58,664 154,519 (59,667) 153,516
Intercompany allocations 166 266,604 45,742 (312,512) --
--------- --------- --------- --------- ---------
5,082 420,209 887,094 (476,964) 835,421
OTHER OPERATING EXPENSE:
Credit card account and other product
solicitation and marketing expenses 16 112,249 181,196 (120,192) 173,269
Employee compensation (1,101) 183,701 28,226 -- 210,826
Data processing services and communications 52 (92,080) 184,702 (8,800) 83,874
Credit protection claims expense -- 1,334 43,216 -- 44,550
Occupancy and equipment -- -- 48,013 -- 48,013
Purchased portfolio premium amortization 119 -- 33,727 (3,626) 30,220
Mastercard/Visa assessment and fees -- -- 13,869 -- 13,869
Credit card fraud losses 177 -- 8,470 -- 8,647
Asset impairments, lease write-offs and severance -- -- 27,736 -- 27,736
Other 7,037 143,488 (40,918) (9,391) 100,216
116
Intercompany allocations 80 92,814 219,618 (312,512) --
--------- --------- --------- --------- ---------
6,380 441,506 747,855 (454,521) 741,220
(LOSS) INCOME BEFORE INCOME TAXES AND EQUITY IN
INCOME OF SUBSIDIARIES (31,279) (21,686) 75,793 (22,545) 283
Income tax (benefit) expense (9,377) (20,107) 38,110 (6,759) 1,867
Equity in income (loss) of subsidiaries 20,318 37,683 -- (58,001) --
--------- --------- --------- --------- ---------
NET (LOSS) INCOME $ (1,584) $ 36,104 $ 37,683 $ (73,787) $ (1,584)
========= ========= ========= ========= =========
117
METRIS COMPANIES INC.
SUPPLEMENTAL CONSOLIDATING STATEMENTS OF INCOME
YEAR ENDED DECEMBER 31, 2001
(DOLLARS IN THOUSANDS)
METRIS NON-
COMPANIES GUARANTOR GUARANTOR
INC. SUBSIDIARIES SUBSIDIARIES ELIMINATIONS CONSOLIDATED
------------ ------------ ------------ ------------ ------------
NET INTEREST INCOME (EXPENSE) $ 8,579 $ (8,437) $ 202,719 $ -- $ 202,861
Provision for loan losses 1,393 -- 459,713 -- 461,106
----------- ----------- ----------- ----------- -----------
NET INTEREST INCOME (EXPENSE)
AFTER PROVISION FOR LOAN
LOSSES 7,186 (8,437) (256,994) -- (258,245)
----------- ----------- ----------- ----------- -----------
OTHER OPERATING INCOME:
Securitization
income 67 -- 650,333 -- 650,400
Servicing income on
securitized/sold
receivables -- -- 159,074 -- 159,074
Credit card fees, interchange
and other credit card
income (expense) 2,890 31,507 318,718 (31,067) 322,048
Enhancement services revenues -- 57,836 84,086 -- 141,922
Intercompany allocations 152 229,643 34,807 (264,602) --
----------- ----------- ----------- ----------- -----------
3,109 318,986 1,247,018 (295,669) 1,273,444
OTHER OPERATING EXPENSE:
Credit card account and other
product solicitation and
marketing expenses
-- 12,869 175,140 -- 188,009
Employee compensation 1,101 197,646 26,716 -- 225,463
Data processing services and
communications 3 (90,538) 198,876 (18,119) 90,222
Credit protection claims
expense -- 877 29,580 -- 30,457
Credit card fraud losses 1 5 9,062 -- 9,068
Purchased portfolio
premium amortization -- -- 32,116 (1,839) 30,277
Occupancy and equipment -- -- 47,572 -- 47,572
Mastercard/Visa assessment and
fees -- -- 16,522 -- 16,522
Other (392) 127,304 (34,366) (2,852) 89,694
Intercompany allocations 127 57,355 207,120 (264,602) --
----------- ----------- ----------- ----------- -----------
840 305,518 708,338 (287,412) 727,284
118
INCOME BEFORE INCOME TAXES,
EQUITY IN INCOME OF
SUBSIDIARIES, AND
CUMULATIVE EFFECT OF
ACCOUNTING CHANGE 9,455 5,031 281,686 (8,257) 287,915
Income tax expense (benefit) 3,646 1,168 111,875 (3,029) 113,660
Equity in income (loss) of
subsidiaries 154,220 155,585 -- (309,805) --
----------- ----------- ----------- ----------- -----------
INCOME (LOSS) BEFORE
CUMULATIVE EFFECT OF
ACCOUNTING CHANGE 160,029 159,448 169,811 (315,033) 174,255
Cumulative effect of
accounting change, net -- -- 14,226 -- 14,226
----------- ----------- ----------- ----------- -----------
NET INCOME (LOSS) $ 160,029 $ 159,448 $ 155,585 $ (315,033) $ 160,029
=========== =========== =========== =========== ===========
119
METRIS COMPANIES INC.
SUPPLEMENTAL CONDENSED CONSOLIDATING STATEMENTS OF CASH FLOWS
YEAR ENDED DECEMBER 31,2003
(DOLLARS IN THOUSANDS)
METRIS NON-
COMPANIES GUARANTOR GUARANTOR
INC. SUBSIDIARIES SUBSIDIARIES ELIMINATIONS CONSOLIDATED
------------ ------------ ------------ ------------ ------------
OPERATING ACTIVITIES:
Net cash (used in) provided by operating
activities $ (166,479) $ (114,182) $ (330,567) $ 271,997 $ (339,231)
----------- ----------- ----------- ----------- -----------
INVESTING ACTIVITIES:
Proceeds from transfers of portfolios to
the Metris Master Trust -- -- 695,459 -- 695,459
Net cash from loan originations and
principal collections on loans
receivable (13,962) -- (766,070) (14,001) (794,033)
Proceeds from sales of credit card
portfolios to third-parties -- -- 891,256 -- 891,256
Proceeds from sale of membership club and
warranty business -- 8,100 36,900 -- 45,000
Disposal of property and equipment, net -- 5,717 20,225 -- 25,942
Investment in subsidiaries 180,419 275,006 512,963 (968,388) --
----------- ----------- ----------- ----------- -----------
Net cash provided by (used in) investing
activities 166,457 288,823 1,390,733 (982,389) 863,624
----------- ----------- ----------- ----------- -----------
FINANCING ACTIVITIES:
Net increase (decrease) in debt 1,320 (9,421) -- -- (8,101)
Sale of deposits -- -- (559,282) -- (559,282)
Net decrease in deposits -- -- (327,210) -- (327,210)
Premium paid and transaction costs on
deposits sold -- -- (32,963) -- (32,963)
Proceeds from issuance of common stock 1,416 -- -- -- 1,416
Repurchase of common stock -- (170,295) (540,097) 710,392 --
----------- ----------- ----------- ----------- -----------
Net cash provided by (used in) financing
activities 2,736 (179,716) (1,459,552) 710,392 (926,140)
----------- ----------- ----------- ----------- -----------
Net increase (decrease) in cash and cash
equivalents 2,714 (5,075) (399,386) -- (401,747)
Cash and cash equivalents at beginning of
year (3,795) 8,109 575,918 -- 580,232
----------- ----------- ----------- ----------- -----------
Cash and cash equivalents
at end of year $ (1,081) $ 3,034 $ 176,532 $ -- $ 178,485
=========== =========== =========== =========== ===========
120
METRIS COMPANIES INC.
SUPPLEMENTAL CONDENSED CONSOLIDATING STATEMENTS OF CASH FLOWS
YEAR ENDED DECEMBER 31, 2002
(DOLLARS IN THOUSANDS)
METRIS NON-
COMPANIES GUARANTOR GUARANTOR
INC. SUBSIDIARIES SUBSIDIARIES ELIMINATIONS CONSOLIDATED
--------- ------------ ------------ ------------ ------------
OPERATING ACTIVITIES:
Net cash provided by (used in) operating
activities $ 78,331 $ 51,110 $ 209,857 $ (30,787) $ 308,511
----------- ----------- ----------- ----------- -----------
INVESTING ACTIVITIES:
Proceeds from sales and repayments of
securitized loans -- -- 2,087,097 -- 2,087,097
Net cash from loan originations and
principal collections on loans
receivable (1,554) -- (703,060) -- (704,614)
Proceeds from sales of credit card
portfolios to third-parties -- -- 16,278 -- 16,278
Additions to property and equipment, net -- (5,161) (998) -- (6,159)
Investment in subsidiaries (96,479) 248,588 243,969 (396,078) --
----------- ----------- ----------- ----------- -----------
Net cash (used in) provided by investing
activities (98,033) 243,427 1,643,286 (396,078) 1,392,602
----------- ----------- ----------- ----------- -----------
FINANCING ACTIVITIES:
Net increase (decrease) in debt 45,304 (559) (292,000) (43,000) (290,255)
Net decrease in deposits -- -- (1,165,254) -- (1,165,254)
Cash dividends paid (3,728) -- -- -- (3,728)
Proceeds from issuance of common stock 2,011 -- -- -- 2,011
Capital contributions -- (287,374) (182,491) 469,865 --
Repurchase of common stock (45,294) -- -- -- (45,294)
----------- ----------- ----------- ----------- -----------
Net cash (used in) provided by financing
activities (1,707) (287,933) (1,639,745) 426,865 (1,502,520)
----------- ----------- ----------- ----------- -----------
Net (decrease) increase in cash and
cash equivalents (21,409) 6,604 213,398 -- 198,593
Cash and cash equivalents at beginning of
year 17,614 1,505 362,520 -- 381,639
----------- ----------- ----------- ----------- -----------
Cash and cash equivalents at end of year $ (3,795) $ 8,109 $ 575,918 $ -- $ 580,232
=========== =========== =========== =========== ===========
121
METRIS COMPANIES INC.
SUPPLEMENTAL CONDENSED CONSOLIDATING STATEMENTS OF CASH FLOWS
YEAR ENDED DECEMBER 31, 2001
(DOLLARS IN THOUSANDS)
METRIS NON-
COMPANIES GUARANTOR GUARANTOR
INC. SUBSIDIARIES SUBSIDIARIES ELIMINATIONS CONSOLIDATED
----------- ------------ ------------ ------------ ------------
OPERATING ACTIVITIES:
Net cash provided by (used in) operating
activities $ 161,612 $ 132,930 $ 498,252 $ (315,033) $ 477,761
----------- ----------- ----------- ----------- -----------
INVESTING ACTIVITIES:
Proceeds from transfers of portfolios to
the Metris Master Trust -- -- 553,180 -- 553,180
Net cash from loan originations and
principle collections on loans
receivable (503) -- (1,126,886) -- (1,127,389)
Credit card portfolio acquisitions -- -- (290,774) -- (290,774)
(Additions to) disposal of property and
equipment, net -- (18,257) 12,549 -- (5,708)
Investments in subsidiaries (218,746) (170,922) 2,238 387,430 --
----------- ----------- ----------- ----------- -----------
Net increase (decrease) in debt (219,249) (189,179) (849,693) 387,430 (870,691)
----------- ----------- ----------- ----------- -----------
FINANCING ACTIVITIES:
Net increase (decrease) in debt 900 (1,062) 292,000 -- 291,838
Net decrease in deposits -- -- (48,191) -- (48,191)
Cash dividends paid (3,752) -- -- -- (3,752)
Proceeds from issuance of common stock 26,248 -- -- -- 26,248
Capital contributions -- 48,156 24,241 (72,397) --
Repurchase of common stock (13,014) -- -- -- (13,014)
----------- ----------- ----------- ----------- -----------
Net cash provided by (used in) financing
activities 10,382 47,094 268,050 (72,397) 253,129
----------- ----------- ----------- ----------- -----------
Net (decrease) increase in cash
and cash equivalents (47,255) (9,155) (83,391) -- (139,801)
Cash and cash equivalents at beginning
of year 64,869 10,660 445,911 -- 521,440
----------- ----------- ----------- ----------- -----------
Cash and cash equivalents at end of year $ 17,614 $ 1,505 $ 362,250 $ -- $ 381,639
=========== =========== =========== =========== ===========
122
METRIS COMPANIES INC. AND SUBSIDIARIES
SUMMARY OF CONSOLIDATED QUARTERLY FINANCIAL INFORMATION AND STOCK DATA
(Dollars in thousands, except per-share data) (unaudited)
2003
------------------------------------------------------
FOURTH THIRD SECOND FIRST
QUARTER QUARTER QUARTER QUARTER
--------- --------- --------- ---------
SUMMARY OF OPERATIONS:
Interest income $ 2,281 $ 24,656 $ 31,432 $ 32,161
Interest expense 14,068 22,296 18,716 19,341
--------- --------- --------- ---------
Net Interest Income (11,787) 2,360 12,716 12,820
Provision for loan losses 18,810 33,019 30,033 44,786
Other Operating Income 163,838 135,319 126,192 79,671
Other Operating Expense(1) 93,290 196,836 146,474 175,146
--------- --------- --------- ---------
Income (Loss) Before Income Taxes 39,951 (92,176) (37,599) (127,441)
Income taxes 5,134 (17,198) (12,851) (44,611)
--------- --------- --------- ---------
Net Income (Loss) 34,817 (74,978) (24,748) (82,830)
Preferred Stock Dividends 10,358 10,131 9,908 9,689
--------- --------- --------- ---------
Net Income (Loss) Applicable to Common Stockholders $ 24,459 $ (85,109) $ (34,656) $ (92,519)
========= ========= ========= =========
PER COMMON SHARE:
Earnings (Loss) per Share:
Basic $ 0.39 $ (1.48) $ (0.60) $ (1.62)
Diluted 0.39 (1.48) (0.60) (1.62)
Shares used to Compute EPS (000's):
Basic 88,580 57,546 57,462 57,257
Diluted 88,750 57,546 57,462 57,257
Cash Dividends: $ -- $ -- $ -- $ --
Market Prices:
High $ 5.06 $ 6.68 $ 6.87 $ 2.92
Low 3.80 2.78 2.11 1.25
Close 4.44 4.12 5.55 2.35
123
METRIS COMPANIES INC. AND SUBSIDIARIES
SUMMARY OF CONSOLIDATED QUARTERLY FINANCIAL INFORMATION AND STOCK DATA
(Dollars in thousands, except per-share data) (unaudited)
2002
------------------------------------------------------
FOURTH THIRD SECOND FIRST
QUARTER QUARTER QUARTER QUARTER
--------- --------- --------- ---------
SUMMARY OF OPERATIONS:
Interest income $ 39,350 $ 31,416 $ 68,792 $ 89,844
Interest expense 21,144 23,252 26,955 32,165
--------- --------- --------- ---------
Net Interest Income 18,206 8,164 41,837 57,679
Provision for loan Losses 40,987 26,340 90,601 61,876
Other Operating Income 147,480 262,967 167,556 257,418
Other Operating Expense(1) 186,636 174,540 198,954 181,090
--------- --------- -------- ---------
Income (Loss) Before Income Taxes (61,937) 70,251 (80,162) 72,131
Income taxes (21,145) 25,201 (30,040) 27,851
--------- --------- -------- ---------
Net Income (Loss) (40,792) 45,050 (50,122) 44,280
Preferred Stock Dividends 9,822 9,605 9,394 9,188
--------- --------- --------- ---------
Net Income (Loss) Applicable to Common Stockholders $ (50,614) $ 35,445 $ (59,516) $ 35,092
========= ========= ========= =========
PER COMMON SHARE:
Earnings (Loss) per Share:
Basic $ (0.88) $ 0.50 $ (0.97) $ 0.46
Diluted (0.88) 0.50 (0.97) 0.46
Shares used to Compute EPS (000's):
Basic 57,199 89,574 61,503 96,032
Diluted 57,199 89,579 61,503 96,973
Cash Dividends: $ 0.010 $ 0.010 $ 0.010 $ 0.010
Market Prices:
High $ 4.70 $ 8.40 $ 22.75 $ 27.49
Low 1.45 1.61 7.39 12.35
Close 2.47 2.31 8.31 20.00
124
STOCK DATA
Our common stock, which is traded under the symbol "MXT," has been
listed on the New York Stock Exchange since May 7, 1999. Prior to its listing on
the New York Stock Exchange, our common stock traded under the symbol "MTRS" on
the Nasdaq Stock Market since its initial public offering on October 25, 1996.
As of March 8, 2004, there were approximately 800 holders of record and
approximately 18,500 beneficial holders of our common stock.
We are also bound by restrictions set forth in the indentures related
to the Senior Notes dated November 7, 1997, and July 15, 1999. Pursuant to those
indentures, we may not make dividend payments in the event of a default or if
all such restricted payments would exceed 25% of our aggregate cumulative "Net
income." Furthermore, our Amended and Restated Senior Secured Credit Agreement
limits payments of quarterly dividends to $.01 per share.
125
MANAGEMENT'S REPORT ON CONSOLIDATED FINANCIAL STATEMENTS
AND INTERNAL CONTROL
The accompanying consolidated financial statements, related financial
data, and other information in this annual report were prepared by the
management of Metris Companies Inc. Management is responsible for the integrity
and objectivity of the data presented, including amounts that must necessarily
be based on judgments and estimates. The consolidated financial statements were
prepared in conformity with accounting principles generally accepted in the
United States of America.
Management of Metris Companies Inc. depends on its accounting systems
and internal control structures in meeting its responsibilities for reliable
consolidated financial statements. In management's opinion, these systems and
structures provide reasonable assurance that assets are safeguarded and that
transactions are properly recorded and executed in accordance with management's
authorizations. As an integral part of these systems and structures, the Company
employs a professional staff of internal auditors who conduct operational and
special audits and coordinate audit coverage with Company management and the
independent auditors.
The consolidated financial statements have been audited by the
Company's independent auditors, KPMG LLP, whose opinion appears separately.
Their opinion on the consolidated financial statements is based on auditing
procedures that include performing selected tests of transactions and records as
they deem appropriate. These auditing procedures are designed to provide
reasonable assurance that the consolidated financial statements are free of
material misstatement.
The Audit Committee of the Company's Board of Directors, composed
solely of outside directors, meets quarterly with the internal auditors, the
independent auditors and management to review the work of each and ensure that
each is properly discharging its responsibilities. The internal and independent
auditors have free access to the Audit Committee to discuss the results of their
audit work and their findings.
/s/ David D. Wesselink /s/ John A. Witham
----------------------------- ----------------------------
David D. Wesselink John A. Witham
Chairman and Executive Vice President and
Chief Executive Officer Chief Financial Officer
126
INDEPENDENT AUDITORS' REPORT
The Board of Directors and Stockholders
Metris Companies Inc.:
We have audited the accompanying consolidated balance sheets of Metris
Companies Inc. and subsidiaries as of December 31, 2003 and 2002, and the
related consolidated statements of income, changes in stockholders' equity and
cash flows for each of the years in the three-year period ended December 31,
2003. These consolidated financial statements are the responsibility of the
Company's management. Our responsibility is to express an opinion on these
consolidated financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally
accepted in the United States of America. Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of Metris
Companies Inc. and subsidiaries as of December 31, 2003 and 2002, and the
results of their operations and their cash flows for each of the years in the
three-year period ended December 31, 2003, in conformity with accounting
principles generally accepted in the United States of America.
As discussed in Note 20 to the consolidated financial statements, the
Company changed its method of accounting for derivative financial instruments in
2001.
/s/ KPMG LLP
-----------------------------
KPMG LLP
Minneapolis, Minnesota
April 9, 2004
127
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None
ITEM 9a. 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-15(e)or 15d-15(e) under the Exchange Act). Based on that evaluation,
the Company's management, including the CEO and CFO, have concluded that, as of
December 31, 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") is recorded,
processed, summarized and reported within the time periods specified in SEC
rules and forms. During the quarter ended December 31, 2003, except as described
below, there were no changes in our internal controls over financial reporting
(as defined in Rule 13a-15(f) or 15d-15(f) under the Exchange Act) that have
materially affected, or are reasonably likely to materially affect, our internal
controls over financial reporting.
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.
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 is effective in ensuring that
information required to be disclosed in the reports we file under the Exchange
Act is 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 III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information required by this item with respect to directors is set
forth under "Proposal One: Election of Directors," in the Company's Proxy
Statement for the 2004 Annual Meeting of Stockholders, which will be filed
within 120 days of December 31, 2003 and is incorporated herein by reference.
The information required by this item with respect to executive officers is,
pursuant to instruction 3 of Item 401(b) of Regulation S-K, set forth in Part I
of this Form
128
10-K under "Executive Officers of the Registrant." The information required by
this item with respect to reports required to be filed under Section 16(a) of
the Securities Exchange Act of 1934 is set forth under "Section 16(a) Beneficial
Ownership Reporting Compliance" in the Proxy Statement and is incorporated
herein by reference.
Metris has adopted a code of ethics applicable to its executive
officers, including its principal executive officer, principal financial officer
and principal accounting officer. The code of ethics is posted on our web site
at www.metriscompanies.com.
ITEM 11. EXECUTIVE COMPENSATION
The information required by this item is set forth under "Compensation
Tables and Compensation Matters" in the Proxy Statement and is incorporated
herein by reference.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required by this item is set forth under "Company Stock
Owned by Officers and Directors" and "Persons Owning More Than Five Percent of
Company's Common Stock" in the Proxy Statement and is incorporated herein by
reference.
129
The following table provides information as of December 31, 2003 with respect to
our common stock issuable under equity compensation plans approved by security
holders:
Number of Number of securities
securities to be remaining available for
issued upon Weighted-average future issuance under
exercise of exercise price of equity compensation
outstanding outstanding plans (excluding
options, warrants options, warrants securities reflected in
Plan Category and rights and rights column (a))
---------------------------- ----------------- ----------------- -----------------------
(a) (b) (c)
EQUITY COMPENSATION PLANS APPROVED BY SECURITY HOLDERS
Metris Companies Inc.
Amended and Restated
Long-Term Incentive and
Stock Option Plan(1) 5,238,243 $15.34 8,265,838
Metris Companies Inc.
Non-Employee Directors Stock
Option Plan 589,000 $17.22 81,000
Management Stock Purchase
Plan(2) 18,415 $11.09 287,359
Annual Incentive Plan for
Designated Corporate
Officers(3) 7,851 $10.13 --
Employee Stock Purchase 1,535,359
Plan(2) -- $ 0.00
Non-qualified Employee Stock
Purchase Plan -- $ 0.00 432,144
--------- ----------
TOTAL 5,853,509 10,601,700
========= ==========
(1) The Long-Term incentive Plan permits the issuance of restricted stock
awards and performance awards.
(2) Shares are issued based on the participations' elections to participate in
the plan.
(3) The Annual Incentive Plan for Designated Corporate Officers terminated on
December 31, 2003. There are no securities remaining available for future
issuance under the plan.
We do not have any equity compensation plans that have not been approved by
security holders as of December 31, 2003.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by this item is set forth under "Corporate
Governance" in the Proxy Statement and is incorporated herein by reference.
With the exception of the information incorporated by reference in
Items 10-13, the Proxy Statement is not to be deemed filed as part of this Form
10-K.
130
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
The information required by this item is set forth under "Information
Regarding Independent Auditor" in the Proxy Statement and is incorporated herein
by reference.
PART IV
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a) The following documents are made part of this Report:
1. Consolidated Financial Statements - See Item 8 above.
2. Financial Statement Schedules
All schedules to the consolidated financial
statements normally required by Form 10-K are omitted
since they are either not applicable or the required
information is shown in the financial statements or
the notes thereto.
3. Exhibits. See Exhibit Index on page 134 of this
Report.
(b) Reports on Form 8-K: During the three months ended December
31, 2003, through the date of this Report, the Company filed
the following Current Reports on Form 8-K:
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.
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.
On March 15, 2004, we filed a Current Report on Form 8-K to
report under Items 7, 9 and 12, the filing of a press release
announcing (a) financial results for our fourth quarter ended
December 31, 2003, (b) the receipt of a commitment from MBIA
Insurance Corporation to provide financial guaranty insurance
policies to refinance a portion of the Company's maturing
asset-backed securitization transactions in 2004 and 2005, and
(c) the late filing of our Annual Report on Form 10-K.
(c) Exhibits: See Exhibit Index on page 134 of this Report.
131
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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 on the 9th day of April,
2004.
METRIS COMPANIES INC.
(Registrant)
By /s/ David D. Wesselink
---------------------------------
David D. Wesselink
Chairman and
Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this Report
has been signed below by the following persons on behalf of Metris Companies
Inc., the Registrant, and in the capacities and on the dates indicated.
Signature Title Date
--------- ----- ----
Principal executive officer: Chairman of the Board, April 9, 2004
Chief Executive Officer
/s/ David D. Wesselink
------------------------------
David D. Wesselink
Principal financial officer: Executive Vice President, April 9, 2004
Chief Financial Officer
/s/ John A. Witham
------------------------------
John A. Witham
Principal accounting officer: Senior Vice President, April 9, 2004
Controller
/s/ Mark P. Wagener
------------------------------
Mark P. Wagener
132
DIRECTORS:
/s/ Lee R. Anderson, Sr. Director April 9, 2004
---------------------------
Lee R. Anderson, Sr.
/s/ C. Hunter Boll Director April 9, 2004
---------------------------
C. Hunter Boll
/s/ John A. Cleary Director April 9, 2004
---------------------------
John A. Cleary
/s/ Thomas M. Hagerty Director April 9, 2004
---------------------------
Thomas M. Hagerty
/s/ David V. Harkins Director April 9, 2004
---------------------------
David V. Harkins
/s/ Walter M. Hoff Director April 9, 2004
---------------------------
Walter M. Hoff
/s/ Thomas H. Lee Director April 9, 2004
---------------------------
Thomas H. Lee
/s/ Edward B. Speno Director April 9, 2004
---------------------------
Edward B. Speno
/s/ Frank D. Trestman Director April 9, 2004
---------------------------
Frank D. Trestman
133
EXHIBIT INDEX
Exhibit
Number Description of Exhibit
------ ----------------------
Charter Documents:
3.1 Amended and Restated Certificate of Incorporation of the
Company (incorporated by reference to Exhibit 3.1 to the Company's
Registration Statement on Form 8-A (File No. 1-12351)).
(a) Certificate of Amendment to articles of incorporation
dated June 4, 2003.
3.2 Amended and Restated Bylaws of the Company (incorporated by
reference to Exhibit 3.1 to the Company's Quarterly Report on Form 10-Q
for the period ended June 30, 1999 (File No. 1-12351)).
Instruments Defining Rights:
4.1 Indenture, dated as of November 7, 1997, among MCI, Metris
Direct, Inc., as Guarantor, and the First National Bank of Chicago, as
Trustee, including form of 10% Senior Note due 2004 and form of
Guarantee by Metris Direct, Inc. (incorporated by reference to Exhibit
4.a to MCI's Registration Statement on Form S-4 (File No. 333-43771)).
(a) First Supplemental Indenture, dated as of June 25,
1999, among MCI, the Guarantors named therein and the First
National Bank of Chicago (incorporated by reference to Exhibit
4.4 to MCI's Registration Statement on Form S-4 (File No.
333-86695)).
(b) Second Supplemental Indenture, dated as of February
28, 2000, among MCI, the Guarantors named therein and Bank One
Trust Company, N.A., as Trustee, successor in interest to the
First National Bank of Chicago (incorporated by reference to
Exhibit 4.2 to MCI's Quarterly Report on Form 10-Q for the
period ended March 31, 2000 (File No. 1-12351)).
(c) Third Supplemental Indenture, dated as of January 2,
2001, among MCI, the guarantors named therein and Bank One
Trust Company, N.A. (incorporated by reference to Exhibit
4.1(c) to MCI's Annual Report on Form 10-K for the year ended
December 31, 2001 (File No. 1-12351)).
(d) Agreement of Resignation, Appointment and Acceptance,
dated as of November 14, 2001, among MCI, Bank One Trust
Company, N.A., as Prior Trustee, and US Bank National
Association, as Successor Trustee (incorporated by reference
to Exhibit 4.1(d) to MCI's Annual Report on Form 10-K for the
year ended December 31, 2001 (File No. 1-12351)).
4.2 Certificate of Designation of Series C Perpetual Preferred
Stock (incorporated by reference to Exhibit 4.2 of MCI's Current Report
on Form 8-K dated December 22, 1998 (File No. 1-12351)).
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(a) Amended Certificate of Designation of Series C
Perpetual Convertible Preferred Stock (incorporated by
reference to Exhibit 3.3 to MCI's Registration Statement on
Form S-3 (File No. 333-82007)).
4.3 Certificate of Designation of Series D Junior Participating
Convertible Preferred Stock (incorporated by reference to Exhibit 4.3
of MCI's Current Report on Form 8-K dated December 22, 1998 (File No.
1-12351)).
4.4 Registration Rights Agreement, dated as of December 9, 1998,
between MCI and the Investors named therein (incorporated by reference
to Exhibit 10.3 to MCI's Current Report on Form 8-K dated December 22,
1998 (File No. 1-12351)).
4.5 Form of common stock certificate of MCI (incorporated by
reference to Exhibit 4.3 to MCI's Registration Statement on Form S-8
(File No. 333-91917)).
4.6 Indenture, dated as of July 13, 1999, by and among MCI, Metris
Direct, Inc. and The Bank of New York, including Form of 10 1/8% Senior
Notes due 2006 and Form of Guarantee (incorporated by reference to
Exhibit 4.1 to MCI's Registration Statement on Form S-4 (File No.
333-86695)).
(a) First Supplemental Indenture, dated as of February
28, 2000, among MCI, the Guarantors named therein and The Bank
of New York, (incorporated by reference to Exhibit 4.1 to
MCI's Quarterly Report on Form 10-Q for the period ended March
31, 2000 (File No. 1-12351)).
(b) Second Supplemental Indenture, dated as of February
2, 2001, among MCI, the Guarantors named therein and The Bank
of New York (incorporated by reference to Exhibit 4.7(b) to
MCI's Annual Report on Form 10-K for the year ended December
31, 2001 (File No. 1-12351)).
(c) Agreement of Resignation, Appointment and Acceptance,
dated as of February 20, 2002, among MCI, The Bank of New
York, as Prior Trustee, and US Bank National Association, as
Successor Trustee (incorporated by reference to Exhibit 4.7(c)
to MCI's Annual Report on Form 10-K for the year ended
December 31, 2002 (File No. 1-12351)).
4.7 Exchange and Registration Rights Agreement, dated as of July
13, 1999, by and among MCI, Bear, Stearns & Co. Inc., Chase Securities
Inc., Salomon Smith Barney Inc. and Barclays Capital Inc., relating to
the new notes (incorporated by reference to Exhibit 4.2 to MCI's
Registration Statement on Form S-4 (File No. 333-86695)).
Material Contracts
10.1 Second Amended and Restated Pooling and Servicing Agreement,
dated as of January 22, 2002, among Metris Receivables, Inc. ("MRI"),
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as Transferor, Direct Merchants Credit Card Bank, National Association
("Direct Merchants Bank"), as Servicer, and U.S. Bank National
Association, as Trustee (incorporated by reference to Exhibit 4.3 to
MRI's Current Report on Form 8-K dated January 24, 2002 (File No.
0-23961)).
(a) Amendment No. 1 to the Second Amended and Restated
Bank Receivables Purchase Agreement, dated as of June 14,
2002, between Metris Companies Inc., as Buyer, and Direct
Merchants Credit Card Bank, National Association, as Seller
(incorporated by reference to Exhibit 4.1 to MRI's Current
Report on Form 8-K dated June 18, 2002 (File No. 0-23961).
10.2 Second Amended and Restated Bank Receivables Purchase
Agreement, dated as of January 22, 2002, between Direct Merchants Bank
and MCI (incorporated by reference to Exhibit 4.1 to MRI's Current
Report on Form 8-K dated January 24, 2002 (File No. 0-23961)).
(a) Amendment No. 1 to the Second Amended and Restated
Purchase Agreement, dated as of June 14, 2002, between Metris
Receivables, Inc., as Buyer, and Metris Companies Inc., as
Seller (incorporated by reference to Exhibit 4.2 to MRI's
Current Report on Form 8-K dated June 18, 2002 (File No.
0-23961).
10.3 Second Amended and Restated Bank Receivables Purchase
Agreement, dated as of January 22, 2002, between MCI and MRI
(incorporated by reference to Exhibit 4.2 to MRI's Current Report on
Form 8-K dated January 24, 2002 (File No. 0-23961)).
(a) Amendment No. 1 to the Metris Master Trust
Second Amended and Restated Pooling and Servicing Agreement, dated as
of June 14, 2002, among Metris Receivables, Inc., as Transferor, Direct
Merchants Credit Card Bank, National Association, as Servicer, and U.S.
Bank National Association, as Trustee (incorporated by reference to
Exhibit 4.3 to MRI's Current Report on Form 8-K dated June 18, 2002
(File No. 0-23961).
10.4* Change of Control Severance Agreement, dated as of May 15,
1998, by and between MCI and Ronald N. Zebeck and a schedule of
executive officers of the Company also having such an agreement with
MCI, indicating the differences from the version of agreement filed (as
permitted by Instruction 2 to Item 601 of Regulation S-K) (incorporated
by reference to Exhibit 10.2 to MCI's Quarterly Report on Form 10-Q for
the quarter ended September 30, 1998 (File No. 1-12351)).
(a) Amendment to Ronald N. Zebeck's Change of
Control Severance Agreement, dated as of December 9, 1998
(incorporated by reference to Exhibit 10.7(i) to MCI's Annual
Report on Form 10-K for the year ended December 31, 1998 (File
No. 1-12351)).
(b) Amended Schedule of Executive Officers with
Change of Control Severance Agreements (incorporated by
reference to Exhibit 10.4(b) to MCI's Annual Report on Form
10-K for the year ended December 31, 2001 (File No. 1-12351)).
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10.5* Retention Agreement, dated May 17, 1999, between Ronald N.
Zebeck and MCI (incorporated by reference to Exhibit 10.2 to MCI's
Quarterly Report on Form 10-Q for the quarter ended June 30, 1999 (File
No. 1-12351)).
10.6 Capital Assurance and Liquidity Maintenance Agreement, dated
as of March 18, 2003, between Direct Merchants Bank, and MCI
(Incorporated by reference to Exhibit 99.3 to MCI's Current Report on
Form 8-K dated March 19, 2003 (File No. 1-12351)).
10.7 Liquidity Reserve Deposit Agreement, dated as of March 18,
2003, among Direct Merchants Bank, JPMorgan Chase Bank, and the Office
of the Comptroller of the Currency (Incorporated by reference to
Exhibit 99.4 to MCI's Current Report on Form 8-K dated March 19, 2003
(File No. 1-12351)).
10.8 Amended and Restated Senior Secured Credit Agreement, dated as
of June 18, 2003, among Metris Companies Inc., the Lenders from time to
time parties thereto, Goldman Sachs Credit Partners L.P. as
Administrative Agent, and Deutsche Bank Trust Companies America as
Collateral Agent (Incorporated by reference to Exhibit 10 to MCI's
Current Report on Form 8-K dated July 11, 2003 (File No. 1-12351)).
(a) First Amendment to the Amended and Restated Senior
Secured Credit Agreement and to credit Agreement Reserve
Securities Account Control Agreement, dated as of July 29,
2003 among Metris Companies Inc., the Lenders from time to
time parties to the Senior Secured Credit Agreement, Goldman
Sachs Credit Partners L.P. as Administrative Agent, and
Deutsche Bank Trust Companies America as Collateral Agent
(Incorporated by reference to Exhibit 10.2 to MCI's Current
Report on Form 10-Q dated August 14, 2003 (File No. 1-12351)).
(b) 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. (Incorporated
by reference to Exhibit 10.1 to MCI's Current Report on Form
10-Q dated March 2, 2003 (File No. 1-12351)).
(c) 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
(Incorporated by reference to Exhibit 10.2 to MCI's Current
Report on Form 10-Q dated March 2, 2003 (File No. 1-12351)).
(d) 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
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America as Administrative Agent and Collateral Agent
(Incorporated by reference to Exhibit 10.3 to MCI's Current
Report on Form 10-Q dated March 2, 2003 (File No. 1-12351)).
(e) 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
(Incorporated by reference to Exhibit 10.4 to MCI's Current
Report on Form 10-Q dated March 2, 2003 (File No. 1-12351)).
(f) 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
(Incorporated by reference to Exhibit 10.5 to MCI's Current
Report on Form 10-Q dated March 2, 2003 (File No. 1-12351)).
10.9 Asset Purchase Agreement Dated July 29, 2003 by and among
Metris Companies Inc., Metris Direct, Inc., Metris Direct Services,
Inc., Metris Travel Services Inc., Metris Club Services, Inc., Metris
Warranty Services, Inc., and Metris Warranty Services of Florida, Inc.,
CPP Holdings Limited and CPP US Operations Group, LLC (Incorporated by
reference to Exhibit 10.3 to MCI's Current Report on Form 8-K dated
August 14, 2003 (File No. 1-12351)).
10.10 Transition Services Agreement dated July 29, 2003 by and among
CPP Holdings Limited and CPP US Operations Group, LLC and Metris
Companies Inc. and MES Insurance Agency, LLC (Incorporated by reference
to Exhibit 10.4 to MCI's Current Report on Form 8-K dated August 14,
2003 (File No. 1-12351)).
10.11 Employee Leasing Agreement dated July 29, 2003, by and between
CPP Holdings Limited and CPP US Operations Group, LLC and Metris
Companies Inc. (Incorporated by reference to Exhibit 10.5 to MCI's
Current Report on Form 8-K dated August 14, 2003 (File No. 1-12351)).
10.12 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 (Incorporated by reference
to Exhibit 10.6 to MCI's Current Report on Form 10-Q dated March 2,
2003 (File No. 1-12351)).
(a) 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
(Incorporated by reference to Exhibit 10.7 to MCI's Current
Report on Form 10-Q dated March 2, 2003 (File No. 1-12351)).
10.13 Modified Operating Agreement effective as of December 11, 2003,
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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)).
10.14* MCI Non-Employee Director Stock Option Plan (incorporated by reference
to Exhibit 10.3 to MCI's Registration Statement on Form S-4/A (File No.
333-86695)).
10.15* MCI Management Stock Purchase Plan (incorporated by reference
to Exhibit 10.4 to MCI's Registration Statement on Form S-4/A (File No.
333-86695)).
10.17* MCI Amended and Restated Long-Term Incentive and Stock Option Plan
(incorporated by reference to Exhibit 10.6 to MCI's Registration Statement on
Form S-4/A (File No. 333-86695)).
(a) Form of Non-Qualified Stock Option Agreement
(incorporated by reference to Exhibit 10.8 to MCI's Annual
Report on Form 10-K for the year ended December 31, 1998 (File
No. 1-12351)).
(b) Form of Non-Qualified Performance Accelerated Stock
Option Agreement (incorporated by reference to Exhibit
10.10(b) to MCI's Annual Report on Form 10-K for the year
ended December 31, 2001 (File No. 1-12351)).
(c) Form of Restricted Stock Award Agreement
(incorporated by reference to Exhibit 10.10(c) to MCI's Annual
Report on Form 10-K for the year ended December 31, 2001 (File
No. 1-12351)).
Other Exhibits
11 Computation of Earnings Per Share.
12 (a) Computation of Ratio of Earnings to Fixed Charges.
12 (b) Computation of Ratio of Earnings to Fixed Charges and
Preferred Dividends.
21 Subsidiaries of MCI.
23 Independent Auditors' Consent.
31.1 Certification of Chief Executive Officer Pursuant to Section
302 of the Sarbanes Oxley Act of 2002.
31.2 Certification of Chief Financial Officer Pursuant to Section
302 of the Sarbanes Oxley Act of 2002.
32.1 Certification of Chief Executive Officer Pursuant to Section
1350 of Chapter 63 of Title 18 of the United States Code.
32.2 Certification of Chief Financial Officer Pursuant to Section
1350 of Chapter 63 of Title 18 of the United States Code.
* Management contract or compensatory plan or arrangement required to be filed
as an exhibit pursuant to Item 14(c) of Form 10-K
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