美國運通 (AXP) 2003 Q1 法說會逐字稿

Good evening, ladies and gentlemen.

And welcome to the American Express first quarter earnings 2003 release conference call.

At this time, all participants are in a listen-only mode.

Later we will conduct a question and answer session.

I would now like to turn the call over to Mr. Ron Stovall, Senior Vice President of Investor Relations.

Thank you.

Welcome.

I appreciate all of you joining us for today's discussion.

As usual, before we get started, I want to just remind everyone that the discussion today contains certain forward-looking statements about the company's future financial performance and business prospects, which are subject to risks and uncertainties and speak only as of today.

The words believe, expect, anticipate, optimistic, plan, aim, would, should, could likely, and similar expressions are intended to identify forward-looking statements.

Factors that could cause actual results to differ are contained in an 8-K report and in the company's 200210-K report already on file with the Securities and Exchange Commission.

In the first quarter 2003, earnings release and supplement which are now posted on our website at ir.Americanprotection.com and on file with the SEC in an 8-K report, we have provided information that compares and reconciles the managed basis financial measures to be discussed today with the TRS GAAP financial information as well as eight-year phase GAAP and net revenues and explains why these presentations are useful to management and to investors.

We urge you to review that information in conjunction with today's discussion.

Gary Crittenden, Executive Vice President and Chief Financial Officer of American Express will provide some introductory remarks highlighting the key points relating to today's announce.

Once he completes the remarks, we will turn to the moderator who will announce your opportunity to get into the queue for the Q&A period.

Up until then, no one is actually registered to ask questions.

While we will attempt to respond to as many of your questions as possible before we end the call, we do have a limited amount of time and based on this, we ask that your limit yourself to one question at a time during the Q&A.

And with that, let me turn the discussion over to Gary.

Welcome.

Thanks for joining with us today.

As you have already seen, our first quarter diluted EPS is $0.53 representing a record level of first quarter net income.

It increased 15 percent versus 46 cents last year.

In February of 2002, Ken identified five signposts that he would use to assess the performance of the company to make decisions to implement additional growth spendings.

I think that you will find in light of the environment we're performing well against these signposts.

For instance, while margin improvement is not what we would have hoped for because of the difficult revenue environment, expenses are well controlled.

New card product and service launches have benefited metrics and we have performed well versus the competition.

At AEFA, we generated good traction against many aspects of our strategy although real improvement in metrics and earnings clearly requires a more friendly market environment.

Considering the economic and industry events our bill business is growing nicely and credit trends have been growing strong.

Overall, the first quarter results show strong levels of TRS and continue to demonstrate our efforts to design a flexible base and risk profile.

Given the dynamics of the travel and equity market environment today, the impact on the company's results could have been quite negative without the benefits of our efforts to improve our business model.

These improvements include shifting away from our historical reliance on travel and entertainment spending to the more stable everyday activities.

Second, diversifying our revenue stream to incorporate revolving credit revenues in addition to historical spend base revenues.

Third, making aspects of our expense base more variable and creating a dynamic reengineering capability.

And finally, continuingly enhancing our credit management capabilities.

These changes to our business model allowed us to absorb the negative impacts of this environment and deliver solid financial results while investing in the future strength of the business.

Company-wide, our reengineering activities continue to deliver significant benefits.

The net consolidated head count reductions of 8,870, or 11 percent, since the end of Q1 provided substantial cost benefits throughout our businesses.

During the quarter, the consolidated head count level was relatively flat.

In addition, our consolidated balance sheet is strong.

Card coverage -- card reserve coverage of past due accounts is at the high end of historical ranges n addition to a more sophisticated risk management capability surrounding our exposure to travel and entertainment merchant risks, in particular our exposure to airlines, we add to the reserves to further protect us from these exposures and the restructuring of AVIS investment portfolio yielded a better balance and more diversified risk portfolio.

Overall, in the quarter, TRS was characterized by strong, absolute and relative performance versus our competitors.

We reported strong spending volumes driven in part by higher average card member spending, comparatively strong lending balance growth, excellent credit quality, continued interest rate benefits although at a lower level than last year, good expense controls and strong earnings performance.

However, similar to what you have seen from industry peers, AVIS results reflected the persistent market pressure on assets and sales levels and a negative year-over-year earnings comparison, but reflected continued progress on some key initiatives as planned sales grew and 68 percent of our equity assets are now in portfolios that are performing above the industry median on an asset-weighted basis.

Lastly, American Express Bank continued to perform well in light of the difficult global economic environment.

So with that overview, let me now review the details in each one of the businesses and I'll start with TRS.

At TRS, managed revenues increased 7 percent and net income rose 25 percent.

On the revenue side, our successful expansion into everyday spend categories and our decision last year to invest in growth initiatives rather than deliver additional short-term earnings continue to produce benefits in volume, cards in force and lending balance growth.

These benefits allowed to us overcome the effects of further weakening within the travel and entertainment environment.

Business volumes improved versus last year on relatively strong growth in the consumer and small business sectors.

Worldwide build business increased 10 percent on a reported basis and 7 percent on a foreign exchange adjusted basis.

In the US, consumer spending grew at 10 percent on 12 percent higher transaction volume, small business spending rose 11 percent while corporate volumes increased only 1 percent.

In total, US non-T&E related volumes grew 13 percent while P/E related spending was flat.

Outside of the U.S., reported volumes were up 15 percent, which equated to 3 percent growth on a foreign exchange adjusted basis.

The discount rate declined two basis points from the fourth quarter of 2002 and six basis points from the first quarter of last year.

Primarily reflecting the continued shift in mix of spending toward everyday spend categories.

Worldwide cards in force rose 4 percent versus last year as the benefits of stepped-up acquisition efforts within our consumer and small business segments more than offset continued declines in corporate cards in force resulting from corporate client work force reductions.

Managed net finance charge revenue grew 10 percent on 11 percent growth in average worldwide lending balances.

Period balances were up 12 percent worldwide reflecting 10 percent growth in the U.S. and 27 percent growth outside of the U.S.

Spreads declined in the U.S. as some of the previously quarterly interest rate benefit diminished.

The introductory rates rose and the mix of products further evolved toward lower-rate offerings.

Travel and traveler's checks sales were down as concerns leading up to and during the war in Iraq exacerbated in already weak travel environment.

Marketing expenses rose 8 percent on a managed basis as we maintained our more pro-active stance toward card acquisition and other business-building initiatives.

The managed provisions for losses declined 7 percent as overall credit quality remains strong.

Within our charge card business, the loss ratio improved to a record quarterly low.

And within our lending business, loss trends continued to reflect the quality of our target customer segments.

Despite the strong credit indicators, reserve coverage of lending receivables was strengthened in light of continued uncertainty within the economic environment.

Coverage of charge card receivables and past due balances also remain strong.

Other provisions declined substantially due to last year's higher reserve additions related to credit exposure to travel related service establishes.

We believe our reserve level, coupled with our risk management activities position us to better manage airline and other merchant bankruptcy related risks.

As expected, interest expense was lower on a lower cost of funds.

Human resource expense rose 2 percent as an 11 percent net reduction in employee count since the end of '01 was offset by merit increases, higher employee benefits costs and greater management incentive costs.

Other operating expenses rose 11 percent versus last year due to higher card member participation in our rewards programs and the impact of technology and service-related outsourcing activities which transferred expenses from human resources, although at a lower, overall cost.

The effective tax rate in the quarter rose to 32 percent from 30 percent last year principally due to a relatively lower contribution to income from the traveler's check business.

Let me now turn to the details at American Express Financial Advisers.

Net income declined 27 percent versus last year as weak market conditions continued to negatively impact our results.

Net revenues declined 6 percent reflecting the difficult market environment and higher provisions.

Investment income was up 5 percent reflecting higher invested assets resulting from the strong client interest in the underlying fixed rate products over the past year.

The portfolio yield continued to decline as cash inflows were invested at relatively lower rates and due to the impact of our portfolio restructuring activities.

The overall credit quality of the portfolio held up relatively well in light of the environment.

On a net basis, we had a modest gain of $5 million versus last year where gains essentially offset losses.

If you drill down to the underlying components on a gross basis, AEFA recorded $182 million of investment impairments and losses during the quarter.

The most significant portions of these related to airline exposures where we felt it was prudent to substantially reduce our carrying values.

These losses were more than offset by 187 million of realized portfolio gains, primarily from the sales of mortgage-backed securities where AEFA repositioned its portfolio to improve its prepayment risk profile.

Fortunately as in the past, substantial unrealized gains within the portfolio are available to address such issues.

That unrealized gains arise during the low-interest rate environment that generally accompanies a weak credit environment, and creates a natural hedge against such losses.

Over time as interest rates rise and the unrealized gains dissipate, credit default rates should also decline.

As of the end of the quarter the portfolio had $1.1 million (ph) of unrealized appreciation.

Management and distribution fees declined 13 percent during the quarter on a lower level of average assets under management.

The 19 percent lower managed asset base reflected the negative impact of market depreciation, and net asset outflows within both our retail and institutional management activities.

In addition to lower management fees, distribution fees declined as the impact of substantially lower mutual funds sales was only partially offset by higher fees from other product activities.

We saw lackluster sales comparisons in both the retail and institutional channels.

Branded advisor generated sales decreased level 11 percent on a cash basis, and 5 percent as measured on the internally used gross dealer concession basis, which weighs the sales of various products to reflect their individual profitability dynamics.

Institutional channel sales decreased 14 percent.

Despite our improved overall equity fund performance, the fact that with our new funds where the style orientations are more consistent with current consumer interest, don't yet have proven multi-year performance records has negatively impacted our fund sales levels.

Other revenues rose on greater property, casualty and life insurance revenues and higher planning and advice service fees.

The provision increased 8 percent, reflecting higher levels of insurance annuities and certificates.

Increased expenses of $6 million related to guaranteed minimum death benefits and higher claim costs.

These increases were partially offset by lower crediting rates, although the fact that some rates are now at minimum contracted amounts, limits our ability to further reduce those crediting rates in the future.

Human resource expenses declined 4 percent as lower field force compensation related costs, and the best of an 8 percent reduction in the average home office employee base were partially offset by merit increases, higher employee benefit expenses, and greater management incentive costs.

The adviser base rose 1 percent versus last year, but declined versus year-end 2002, as has been the typical seasonal pattern.

Near term, we expect to continue to carefully manage new advisor additions until the environment turns more positive.

However, veteran adviser retention rates remained strong.

Other operating expenses rose 17 percent versus the first quarter of last year, but were slightly lower versus the fourth quarter.

The increase versus last year reflects higher expenses resulting from fewer capitalized costs due to the ongoing impact of the comprehensive review of DAC-related practices in the third quarter of 2002, the impact of technology and service-related outsourcing activities, and the higher minority interest expense related to premium deposits, which comes from AEFA's joint venture with American Express Bank.

The effective tax rate at AEFA declined to 25 percent from 28 percent last year on a relatively higher benefit from tax-advantaged investments.

Let me now go through the detail on American Express Bank.

The Bank continued to make solid progress on its strategy shift while delivering solid earnings.

Consumer activities expanded as private banking client holdings increased 12 percent, and personal financial services client volumes rose 4 percent versus last year.

And corporate banking and other loans continued to decrease, and now represent 8 percent of the total loan portfolio, or approximately $460 million.

Results continue to benefit from lower funding costs.

In addition, provisions declined 17 percent versus last year.

While provision declined, they remained at a fairly high absolute level strong level on continued consumer losses in Hong Kong.

So that's a quick review of our results from the quarter.

Let me now conclude with a few comments on our outlook.

Despite the uncertainty, our results for the quarter and last year show that we are better able to operate in a difficult environment.

Notwithstanding the challenges within the travel and entertainment sector, our payments business has delivered solid results, with business metrics and credit indicators that compare very well to key industry participants.

The quality of our customer base, the benefits of our reward based spend-oriented business model, our everyday spending initiatives, and our improved revolving credit capabilities combined to create a competitive advantage which is being leveraged effectively.

Within our financial services activities, the progress we are making at AEFA is clouded by impact of the volatile equity markets.

The first quarter comparisons were particularly difficult due to the relatively high level of the equity markets at the beginning of at the beginning of 2002.

However, we are confident that the foundations put in place through new products and better investment performance position us for stronger results when market conditions improve.

Fortunately, we entered 2003 with a business plan that took a cautious approach, with no exceptions -- with no expectation that economic conditions would significantly improve.

Our reengineering activities are on track to deliver the additional $1 billion of benefits targeted for the year.

Nonetheless, we are dealing with a difficult environment.

Equity markets continue to be volatile.

The global economy remains weak.

And the travel industry weakness has been further exacerbated by the war in Iraq, and fears related to SARS, particularly within the Asia-Pacific region.

Questions still exist about the likely direction of the environment over the near term -- and in particular, how long the current weakness in the travel sector will last.

Given this uncertainty, we've prepared contingency plans for each of our business which provide for short-term cost benefits versus our fundamental expense reengineering initiatives.

In light of recent trends within the travel sector and persistent market weakness, we have begun to implement some of these plans.

For instance, we are utilizing furloughs within our travel business.

We are delaying hiring related to open positions in some areas.

We're delaying certain non-critical technology expenditures.

And we're containing various consulting and other discretionary spending initiatives.

With regard to SARS in particular, billings from markets primarily effected thus far in Asia are a relatively small portion of our worldwide total.

In those markets we have put in place additional expense reduction initiatives, and, importantly, we are shifting our growth-oriented spending to markets which have not yet been impacted.

Fortunately, the global breadth of our business provides opportunities to manage this situation.

Additional actions related to SARS and broad economic and market uncertainties will be implemented dynamically based on our continued review of our business risks and opportunities.

Our goal is to utilize our flexibility in a manner that best preserves our ability to perform well in an environment like this, and continue our growth-oriented investments.

While we are not prepared for every possible business scenario, these actions do position us better to manage expense levels through these uncertain times.

We continue to believe our financial targets of 12 percent to 15 percent EPS growth, 8 percent revenue growth, and 18 percent to 20 percent return on average -- return on equity on average and over time are appropriate.

In the first quarter, TRS's volume growth of 10 percent was at the high end of the 6 percent 10 percent industry growth we've indicated underlies our ability to meet the targets.

Still environmental risk does clearly exist as evidenced by the weakening travel and entertainment-related spending in March and in April.

At AEFA we've indicated that an 8 percent equity market appreciation level is needed for us to achieve our targeted growth.

Unfortunately, they are in a tougher spot in light of where the market is today compared to last year.

But those comparisons do get easier as the year progresses.

As I indicated at the beginning of my comments, we are tracking well the signposts Ken identified earlier -- identified earlier this year.

On balance, we feel good about the quarter's result.

But as always, we will carefully monitor the performance of the economy and markets to endeavor to make the appropriate trade-offs as we move through the year.

Thanks very much for listening.

And I think, Marcelle, we are now ready to take your questions.

Thank you, sir.

We will now begin the question and answer session.

If you have a question, you will now need to press the one on your touch-tone phone.

Remember, if anyone presses one at the beginning of the call, you must -- I'm sorry -- the request has not been recognized by the system.

You will hear an acknowledgment that you have been placed in queue.

If your question has been answered and you wish to be removed from the queue, please press the pound sign.

Your questions will be queued in the order that they are received.

If you are using a speaker phone, please pick up your handset before pressing the numbers.

Once again, if there are any questions, please press the one on your touch-tone phone.

Thank you.

Our first question comes from Brad Paul (ph) from Prudential.

Please state your question,

Thanks.

Hi, Gary.

Hi, Brad.

Can you give us -- you mentioned that you're on track for the $1 billion of reengineering-related benefits.

Can you give us a sense -- does that mean you're a quarter of the way through that?

And also the additional short term cost benefits that you referred to -- the furloughs and other delays -- is that in addition to the one billion that Ken referred to back in February?

Let me answer the second one fist.

Es.

It is in addition to.

I mentioned in the comments here -- but it might not have been totally clear -- that a series of contingency initiatives that we've implemented that are not permanent cost reductions, but that are things that are just done in reaction to the environment that will be in addition to the reengineering saves.

The -- on a -- as you think about the reengineering savings for the year, a portion of what the benefit is in the early part of the year is always the carry over from last year.

Since we were well over $1 billion last year in terms of our total, as you might guess, that carry over benefit does help the early part of the year.

So we are actually pretty well along towards our targets.

And I think we're quite comfortable that where we stand now will allow us to achieve the $1 billion on a full-year basis.

OK.

And just a quick follow-up.

In terms of the Asian billings, you said it's small.

International billings are about a quarter of total worldwide billings, so how much -- how small is Asia?

Well, we didn't want to specifically get into that.

But it obviously has an impact in our overall total calculation.

But it is a relatively small portion of the total.

We're stronger obviously in Europe.

Our largest markets are in Europe.

We're very strong in Mexico.

And, obviously we have strength in Australia and Japan.

But Australia and Japan have not been significantly impacted by this whole event at the point.

Sot he markets that are primarily affected happen to be the markets in Asia that are not the largest markets in Asia.

And Asia as a percentage of the total is relatively small.

OK.

Thanks.

Thank you.

Our next question comes from Michael Hughes from Merrill Lynch.

Please state your question.

Hi, guys.

I'm looking at your expenses for this quarter vis-a-vis what you said, and it seemed to me like you almost had a lot of wiggle room to maybe get ahead on bonus accruals or take care of more of getting your pension situation a little better placed.

Am I right on that, or is it all just kind of that's the number?

I'm confused by the question.

You got to --

you guys are obviously going to have bonuses at the end of the year.

You could divide up what you need by four, or you could when you have quarters where you're a little more flush, you can throw a little extra away, and similarly, you guys are a little behind on your pension accruals, if I'm not mistaken, and you probably could get a little caught up if you had a better quarter.

It seems like your personal expense number was unusually high vis-a-vis where you've been even relative to the comments it that you guys made in the supplements.

Well, first of all, we're not behind on our pension accruals.

We did end last year with an unfunded pension amount which, you know, on a cash basis, which actually during the course of the last month we made a significant contribution to cover.

We made a $350 million contribution in the course of the last month to essentially top up that cash portion that was unfunded in the pension.

But from a pension accrual standpoint, we obviously have accounted for that in the appropriate way and we're not behind on those accruals.

From a human resource cost perspective, you know, the numbers are relatively attractive for two reasons.

I guess in spite of what you might have just suggested, we've had a head count reduction versus this quarter last year that is substantial, and the accruals that we have taken for bonuses, we've taken given our current expectation for what our results are for the year, and we don't have a lot of wiggle room with that.

I mean, we have a current forecast for what our results are going to be for the year.

Our bonus accruals are set based on expectation of business line, and we don't do a lot of wiggling, as you might have termed it, with those numbers when we put them together.

OK.

Thanks.

Thank you.

Our next question comes from David Hochstim from Bear Stearns.

Please state your question.

Thanks, hi.

Could you just -- two questions really.

There was a $30 million sequential increase in the HR expenses at AEFA this quarter.

I wonder is that what's referred to on the merit increases and higher employee benefits and management incentive comps, or is there something else going on there?

Or is that a normal run rate?

I think it's normal.

It's the things you mentioned.

We have the higher incentive in the plan at this point than we did last year.

You know, we still have expectations for the year at AEFA that include the fact that the comparisons toward the end of this year get easier from an equity market perspective and so as you might guess, that's kind of clocked into our thinking on what that expense will be on a full-year basis, but there were the merit increases that you had referenced there.

That would be more of a normal run rate, or we should see that kind of sequential increase as we go through the year?

I think the way you should think about that is as we mentioned, we have a series of contingent actions that we're taking across the company and depending on the environment there, that number could, you know, be influenced, you know, so it would be lower, but there's nothing unusual about the number in the first quarter, David, if that's the specific question.

OK.

And then can you just remind us what's in other operating expense at PRS and is there a sizable change in the quarter?

I guess I like asking you about membership rewards reservings practices.

Yes.

In the other operating expense line, TRS, our total rewards cost is found in that category, and that's the largest single component of that line item.

You know, it includes things like professional fees, you know, card member services, those types of items tend to be toward the larger end of the California, our occupancy and equipment costs.

But there's two primary drivers of increase here.

One is the overall higher level of reward spending and secondly, we did have the shift that I mentioned in the supplement out of HR costs and into other expenses as we now pay for the people who support our IBM contract and some of our other outsourcing agreements in this other operating expense category.

So it's really that shift that is taking place.

And on the reserving methodology, you want me to spend a minute talking about the methodology on rewards?

Yes.

Maybe you can tell us how it changed the last couple of quarters in dollars.

Well, we don't split it out in dollars.

What I can tell you is it's really a function of two things.

It's kind of the cost per point and that number has remained essentially the same for the last couple of quarters and the ultimate redemption rate and the ultimate redemption rate worldwide has remained the same, as well, so there's been no change the estimating factors over the past two quarters.

Would more airline bankruptcies cause the average cost per point to decline since the customer will be forced to redeem on other less costly rewards?

Well, generally, what we have seen is a pattern of customers increasing their redeeming on, you know, lower-cost alternatives and you know on retail types of alternatives, but that's not an unmitigated loss.

Some of those alternatives are higher and some of those are lower than our average, so it's a little bit difficult to say, but generally, your point is true.

If someone chooses to redeem at a retail channel that generally lowers our cost and we're seeing more redemptions in retail types of channel than we did a couple years ago.

Following up on Brad's question, it seems in the past there was some mention in split in TRS, build business volume Asia relative to the rest of the world, and I think it was something like a third.

It's not nearly that -- not nearly that large.

OK.

Great.

Thanks.

Thank you.

Our next question comes from Robert Hottensen from Goldman Sachs.

Please state your question.

Your marketing expenses dipped below 10 percent of TRS for the first time in a while.

Is that an aberration?

Or are we going to see a fairly reduced level of marketing expense growth?

And the second one is on the head count reductions or contingency reductions and expenses that you cited, kind of Asia related and so forth, is that enough to move the needle on further head count reductions?

Or will we see that in the income statement or is that just not enough to move the needle on that?

Bob, on the first question about marketing expense growth, seasonally, typically the first quarter is not our largest year-over-year increase quarter, you know, in prior years.

And so although I don't want to forecast out obviously what's going to happen with our marketing expenditures because that is one of the things we moderate up and down with the business a bit.

This pattern is not atypical for percent (ph) be taken as a signal that our appetite for spending on growth opportunities is less than it was before.

We feel like this was a solid quarter and it positioned us nicely for the things that we're planning to do in the coming quarters from the marketing standpoint.

The primary lever that we have pulled so far related to contingency is this furlough program that I mentioned, primarily in our travel business.

That doesn't reduce our head count because those people still remain as employees to the company for up to a six-month time period.

It varies -- the implementation of that program varies depending on the location and the specific business that is involved.

You won't see much impact from that, and we currently have no plans, obviously, for wholesale kinds of head count reductions, you know, of the kind that happened back post 9/11 in 2001.

But as always, we very carefully monitor, you know, the environment and are careful not to, you know, certainly add head count in weak situations like this.

As I mentioned, we've essentially frozen all head count additions that are not essential to the business and my guess is you'll see some impact to that.

But it won't be the kinds of reductions we have seen in the past.

Thank you.

Our next question comes from Matt Vetto from Salomon Smith Barney.

Please state your question.

Hi.

Good afternoon.

Hi, Matt.

The question for you -- you sort of alluded to this a little bit in your comments and in the supplement.

It seemed like the billing growth trends got progressively weaker through the quarter, particularly so in March.

And I think you mentioned in passing maybe April, too.

I'm wondering if you attribute any of that to sort of short-term war phenomena, or is that trend kind of continuing into April?

What can you tell us about the real-time trends there?

My April comment that you referred to related to travel spending in the industry in general, I wasn't talking about American Express specifically, but you know, it's obviously well known from the popular press that travel spending is down in April, as well.

But this trend that you see that has taken place over the course of the quarter clearly reflects, in part, the impact of the war, you know, both the kind of run-up to the war and the actual starting of the war in the latter part of March and then it's clear that there is an impact associated with SARS that is taking place in -- particularly in certain markets in Asia, and so -- and since both of those effects continue somewhat, I think it's fair to say that one could assume that that impact is going to carry over into April.

I think, you know, as we think about the war, we clearly had a relatively pessimistic view of this.

Essentially we had a view that the war impact would be similar to the impact that we had seen back in the early '90s.

And at this point, I think we'd say it's not going to be as large as what we had anticipated originally.

That being said, we obviously weren't thinking about SARS at the time we had put together our thinking around that topic.

And so in some ways, the impact of SARS supplements what is a better expectation on the -- from the impact of the war.

So you know, obviously, I wish I can give you a little better guidance than that.

But I think you've got your finger on the right elements that influence that trend in the month of March.

And clearly, those same underlying factors will have an influence in April.

OK.

And you talk a little bit about a higher tax rate, and also some benefit from foreign exchange rates.

If you stack those two up against each other, which was the dominant driver?

Well, the tax rate would have impacted us more because, you know, that's obviously is a real change in expense.

We basically hedge virtually all of our foreign exchange exposure back into dollars since we report in dollars.

And so any benefit that we would have seen basically gets washed out from, you know, hedging expense that took place as an offset during the quarter.

And the real financial impact would have been on the tax rate at TRS.

OK.

Great.

Thanks a lot.

You bet

Thank you.

Our next question comes from Bruce Harting from Lehman Brothers.

Please state your question.

Yes.

Gary, the -- can you talk about the mix between -- for the relative advantage of funding unbalance sheet versus off-balance sheet and relative funding costs between the two and you know the interplay between, you know, capital dynamics and whether you do more securitization as you buy back more stock, where you are on that calculation given that your RAO is back up so high within TRS to 30 percent plus?

Does that impact the decision, or is it purely a decision based on, you know, the mix between securitization and funding on balance sheet?

Is it simply a relative cost of funds between the two?

And you know, is there any more room for, you know, margin expansion through the balance of the year?

Thanks.

OK.

Let's get all of these points.

You know, the finances in funding, using securitization and the other ways that we fund commercial paper or medium term notes, in general, is not a material difference.

It obviously depends on whether you're talking about a longer maturity MNT or whether you're talking about commercial paper.

Generally, the cost of those programs is not the primary driver.

The reason why we have multiple programs is it allows us to diversify our funding sources and we don't want to become overreliant on any one funding source to make, you know, things happen from a liquidity standpoint.

So we obviously still have capacity to securitize more.

Were we to choose to do that, I think the pattern you have seen from us over the past few quarters is the pattern we're likely to follow.

We're relatively comfortable with the level of securitizations that we're at, you know.

We'll continue to do, I believe, roughly the same amounts that we have done historically, barring any major change in the capital markets that would cause us to think otherwise.

That overall has very little to do with what our share buyback program is.

The way we calibrate the share buyback program is we look at the capital that's required on the risk-adjusted basis to support our asset growth.

We then add to that a cushion to ensure that we can absorb a fairly significant hit in the environment without taking a credit rating downgrade and then generally because our return on equity is so strong, we have excess capital above that every year which we plow back into share buybacks, and we've had a good appetite for that in the first quarter, as you saw in the earnings supplement.

My guess is our appetite for that will continue strong as long as our performance stays at the level that it's been at right now.

And so we feel, you know, we feel good about what that's going to contribute to the bottom line EPS growth going forward much as it has for the last few years.

From a margin standpoint, you know, there are obviously many factors that go into the calculation of the bottom line margin.

I would say that we are as committed as we have been to have our operating expense to revenue ratio perform as described it historically, to move back toward the '96 level of operating expense to revenue over the next few years and clearly, the revenue weakness that we experienced at AEFA in this quarter hurt us in that regard.

But like I said, you know, if you look at the comparisons as you go through the rest of the year, these revenue comparisons get somewhat easier assuming the equity market doesn't fall precipitously from where we are here today and so we have, you know, ongoing intention to continue to improve that particular measure of margin.

The overall margin is a little bit harder to say because you've got other factors in there like provision and interest that, you know, are swing factors.

Thank you.

Thank you.

You are next question comes from Vincent Daniel from Keefe Bruyette & Woods.

Please state your question.

My questions have been answered already.

Thanks, guys.

Thank you.

Our next question comes from Eric Wasserstrom from UBS.

Thanks.

I have two quick questions, please.

The first is in terms of credit losses.

If you could comment on your outlook specifically?

And if, Gary, you don't want to do that, you know, in the past several days, several other credit card companies, both Bank One and (inaudible) have given the perception that we're seeing a turn in the credit cycle.

Is that also your view?

And I guess that's the first issue.

You know, frankly, as we look at this topic, we're letting the record speak for itself.

We've had absolutely outstanding performance over the last, I guess, six quarters or so, from kind of the high point where we had reached as the lending portfolio began to kind of fully mature down to the level where we are today and we're obviously delighted with the success of the risk management team and the contribution that it's made to our overall results.

We obviously increased our reserve coverage in the quarter and added to our lending reserve in the quarter by about, you know, by not a trivial amount.

And we did that because the environment in which we are operating is an uncertain environment.

And as I said in my comments, we continue to take a very cautious approach to the full year.

That being said, we have enormous confidence in the risk management team that has got us where we are today.

We have absolutely no reason to think that the capabilities they've brought to our results are going to be any different in the coming quarters that we've seen over the last few.

And we're very pleased with the position we're in from a reserve standpoint right now.

Great.

Thanks.

Just the second question.

In terms of these contingency plans that you put in place on the expense side, you can give us -- do I understand that this is sort of -- you have a series of stages of this?

Can you give us a sense of what the next phase might include?

Yes.

What we did is we entered the year with what we've actually called internally a flexibility plan that basically had spaced out by month different levers that we would pull that would kind of bring us home to our overall financial targets assuming the environment did not get, you know, really ugly.

And we have implemented kind of the first phase of those.

And by the way, we implement these differently by business.

So for example, if the consumer business in the United States, we have implemented virtually none of these contingency plans owe other than the most limited.

In our travel business, we have obviously taken significant actions.

And at AEFA, we've taken significant actions.

So it varies a lot from business to business how it actually gets implemented.

The components of this include the things that I've mentioned -- so things like salary freezes, the furlough program.

The next tranche that we haven't dug into deeply but still have the capability would be to reduce spending initiatives that we had planned for this year.

And we have a lot of flexibility around that still for the remainder of the year.

These are things that we would like to do.

And they actually help us competitively if we can execute on them this year.

But if we don't, particularly given the environment, we don't think we're at any disadvantage as a result of not doing them.

And we still have a lot of capability to kind of manage that.

And then finally, we have marketing expenditures which we would moderate as a last resort.

What we're tying to do is make sure that we can continue to keep our foot on the growth pedal and continue to show the same kind of good, relative comparisons to our competitors as we go through the rest of the year, while we at the same time kind of manage our way through the difficult financial environment.

So what you've seen so far is some businesses taking action on each of those levers, I would say, with the exception of the marketing lever.

And some of the businesses have taken none of the actions yet.

And depending on how the environment goes, we'll pull more or less of those as we go through the year.

Now, it goes without saying that the opportunity to execute on these gets less as you go through the year.

So if you haven't pulled the trigger now, the magnitude of your ability to respond gets less if there's a shock that happens later in the year.

So our flexibility is highest at this early point in the year.

And the amount of flexibility declines as we go through the year.

But generally, we think we've got a very dynamic capability to respond to the environment, to allow us to deal with reasonable changes in the business and still come in where we'd hope to come in on a full-year basis.

Great.

Thanks very much.

And just to make sure I understand, did you say that none of these have been implemented within the U.S. yet?

No.

What I said is in the consumer and small business, we've only done very limited actions.

So we have restrained our travel spending a little bit.

We've done a little bit of hiring freeze.

But no significant actions at this point.

Great.

Thanks very much.

Thank you.

Our next question comes from Caren Mayer from Banc of America Securities.

Pleas estate your question.

Hi, Gary and Ron.

Just one quick follow-up question to all the questions that have been asked.

I recognize you didn't hedge your charge card cost of funds this year.

But we did see more improvement than I had thought.

Could you just kind of give us qualitatively -- I mean, should we continue to see it move down?

I know some of it was just lower -- seasonally lower balances.

But what should the direction look like for the rest of the year?

How much more benefit could you get there?

Well we do have an opportunity -- if the rates were to stay at this exact same level, we would continue to see benefit through the year.

It is not anything like the benefit we saw last year, obviously.

But it is still beneficial to us if rates stay at this level.

What I've said, I think, in the past is we have to see very significant deterioration in the rate to have a negative comparison to last career.

And if rates stay where they are, we will have a positive comparison going forward.

OK.

But in order of magnitude, I mean you're just saying less benefit than we saw last year, but still -- I mean have you told us how much?

I'm afraid we haven't disclosed that.

And the reason is not that we don't want to say it.

It's because it, obviously, depends upon exactly on how we fund this remaining amount that is not locked on a quarter by quarter basis as we go through the rest of the year.

Got you.

It's just very hard to forecast the exact amount.

OK.

Thank you.

Thank you.

Our next question comes from Phil Marriott (ph) from Arnold Fly Schroeder (ph).

Please state your question.

Good evening.

Just with respect to HR, I know a bunch of people asked about that line item.

But I was wondering if you could at least address whether or not the company -- and I would assume that this is the case -- that you would be poised to show kind of sequential absolute dollar improvement throughout the year, as you showed last year.

Is that a reasonable assumption?

Yes.

That's a reasonable assumption.

The thing to think about is that kind of pattern of head count reduction that we saw as we came through the year last year.

If you think about it, compared to the end of '01, we're down to about 9,000 employees today and obviously saw the benefit associated with that.

As we go into the second quarter that comparison will be less.

And as we also said in the note, sequentially from a head count perspective we're essentially flat versus last quarter.

As you kind of play through the year the benefit that we'll see from that should be less and less.

Now there's some of these other items that we've talked about.

We have a certain expectation for what will happen from an inventive payout perspective that is kind of a wildcard here depending on exactly what the business performance is.

We have the potential impact of this furlough program.

So there are a few items like that that can have an influence on a quarter-to-quarter basis.

But directionally I think your comment, I think, is correct.

OK.

And then one other question.

You know, I've heard from a couple of other travel-related companies that at least recently -- like let's say the last couple of weeks, two or three weeks in April and at least in the United States -- there's been more activity, you know, post-war and so forth.

And I was just wondering if you could comment on whether or not you're seeing that kind of activity, as well?

Well, I think what we can say is clearly the war impact appears to be less than what we initially anticipated it would be.

So that's clearly a positive, particularly if you're focused on the U.S. market.

If you now factor into that the SARS impact, the SARS impact is something that we did not expect and certainly is another factor that we have to deal with outside of the United States right now.

OK.

Thanks very much.

Thank you.

Our next question comes from Chris Brindler (ph) from Legg Mason.

Please state your question.

Good afternoon, Gary.

Hi, Chris.

Hi.

A couple quick ones, if I might -- maybe ask real quick.

First, on the charge card credit losses.

If I was an outsider -- mostly because I am -- and just had to look at the environment that we're in and had to guess where your charge card credit losses would be, I would never have guessed you would be hitting an all-time low.

Can you give us any color there on what's driving that?

Is it all internal risk management driven that's offset what would seem to be economic weakness and corporate weakness?

Is there anything else that's driving that improvement?

And then I have a second question.

On the charge card, there's, I guess, a couple of things.

We really have continued to make significant improvements in terms of our underwriting capability in the management of our risk generally within that portfolio.

I point out too that we've done without coming at a cost to our authorizations performance, Our authorizations performance has actually improved significantly at the same time that our credit performance has been good.

So that one piece of it is just real improvement on the part of the risk management team.

The other factor is that we've had low growth in that portfolio now for the last couple of years.

And as that portfolio seasons, obviously the people who are in that portfolio are better and better credit risks.

And you have much more history with those people.

And so the risk of loss is simply less.

You can make, you mow, ongoing underwriting decisions that take into account a longer history.

And we underwrite virtually every transaction that one may have in the charge card.

So I think that's part of the factor.

The other thing I would say is we see the rapid growth rate and the rewards line on the income statement.

And I think many people view that as a negative.

Obviously internally, we view that as a positive because the higher proportion of our customer base that is on rewards programs, the -- you know, the better their provision performance tends to be, the loss performance tends to be.

And so if you kind of wrap all of those things together, it really does take us to an historic low level.

And I think the important thing about that is also to recognize that in spite of that, our coverage rates, you know, I think we're at 159% of past dues in this quarter, really stand in stark distinction to where we were a year ago, at say 135% of coverage.

And so we're well covered for the environment should there be a discontinuity here.

But the progress has really been great.

I would agree.

The second question is also a little surprised to see your lending balance growth.

Can you give us a little bit of a strategic view of how you view the lending business?

I know you said it's a good offset to reduce the volatility associated with the volume-related business.

But from my perspective is the U.S. lending market is extremely competitive.

Your own, I think, financial margins have been (ph) about 40 basis points this quarter.

Give us your take on the competitive environment in the U.S. card business.

Well, it is very competitive.

What you see, I think is -- and you can observe it externally -- with our marketing programs, we tend to kind of pulse (ph) various marketing programs.

So at the end of last year, you saw us doing a lot with the new charge card product that had embedded rewards as part of that product.

The area that we had real focus on as we came into the early part of this year was Blue.

And you've seen a lot of -- hopefully, you've seen a lot of our advertising surrounding Blue this year.

We've made great progress with that and feel good about that.

We've got some very attractive balance transfer programs that we rolled out during the course of the first quarter and feel very good about the impact that they have had.

And so taken in aggregate, we think about our lending program as part and parcel of our core strategy, but that there are different points in time.

Sometimes we're pushing it very hard.

Other times we've got our foot a little bit off that pedal when we might be pushing the charge card ahead.

It doesn't make sense for us to kind of keep the pedal, you know, all the way to the floor on a product for an extended period of time because the advertising impact loses its effectiveness somewhat.

And so -- but we do I have obviously a marketing plan laid out with various products that come into the marketing plan as we go through the year.

And I think you're seeing some of the impact of that in the growth of the balances.

As far as the competitive nature, the one thing I can make an absolute commitment on is that, first of all, we never target low FICA score customers.

So we're totally out of the subprime market.

But more importantly, we just don't price anything in the market that doesn't earn a return that is acceptable for us given all the alternatives that we have for spending that money.

And so, although one can see this kind of a movement in our yield, you know, obviously over the course of a year, it's not an unusual amount of movement from our perspective, particularly given what's happened with -- how dramatic the decline in interest rates were a year or so ago.

But we're still pricing product at levels as long as our models are achieved that deliver returns that are very attractive for all of us.

Great.

Thanks.

Thank you.

Our next question comes from Ed Groshans from Prudential.

Please state your question.

I'm with Morse and Cabbott (ph).

But hi, Gary.

Hi, Ed.

I wanted to just talk about, the -- you mentioned some impairments regarding some of the airline exposure.

Yes.

Was that in the investment portfolio with some of the aircraft leases?

Or was it other types of exposure?

No.

It's essentially what you just said.

We have in the directly owned asset portfolio up at AEFA an exposure, obviously to airlines.

It's a part of our portfolio.

Given the weakness that has taken place in the sector there, we took some, what I think are very significant steps, to strengthen our position there.

And we feel good about the remaining credits that we have in the portfolio.

We're on a very sound basis in terms of having marked those securities relative to their market value.

And that was the biggest piece of the reductions that we took at AEFA in the directly owned portfolio.

Excellent.

Thank you.

Thank you.

Our next question comes from Bob Napoli from U.S.

Bancorp Piper Jaffray.

Please state your question.

Good morning.

Most of my questions -- good evening.

Earnings season, I guess.

Most of my questions have been answered.

But on the -- at AEFA, your management distribution fees as a percentage of your assets under management has come down quite a bit, I mean, even from the fourth quarter to the first quarter.

And I know it's been a -- is that all a shifting away from equities into fixed income?

Well, not entirely.

There's also obviously a shift from proprietary to non-proprietary funds that have an impact on that, as well.

Do you expect to see a continued negative impact on that metric as we move through the year as part of your plan?

Well, what we would expect to happen is some stabilization in the prop to non-prop ratio.

We've kind of seen that happen as we went through the back half of last year.

And you know, we'd hope to see some stabilization in that measure.

The fixed income thing is a little bit hard to call right now.

It obviously depends a lot on what happens to equity markets as we go forward.

But that's -- you know, again, it's hard to call.

But we certainly would hope for some stabilization in the prop to non-prop ratio as we've seen over the last couple of quarters.

Ron, I don't know if you have anything to contribute to ...

No.

The other thing that -- management fees, obviously, kind of move along with the managed asset base.

The other influence that is kind of volatile in there is distribution fees which are kind of a function that tails at any point in time.

So in any quarter there is this one component that doesn't really kind of move in conjunction with the asset base.

OK.

And on -- just on the card growth, one other question related to that.

The cash back card is something you talked a lot about.

But you didn't mention it in your key products a little earlier, which surprised me.

Only because it was launched -- that was kind of a -- it's actually a good cue because that's the program that we did before the embedded charge program.

And we've met our internal objectives with that we just finished a review of that project, and we've met our internal objectives with that product for its launch.

So we feel pretty good about its start.

I mean five percent cash back.

It seems like you should be able to take every Discover customer you want.

Maybe we will make you our marketing spokesman, Bob.

I think we have time for probably one more question.

Thank you.

Once again, if there are any questions, please press the one on your touch-tone phone.

Sir, at this time, we show no further questions.

Thank you, Marcelle.

And thanks, everybody, for joining.

Thank you, Ladies and gentlemen.

This concludes today's conference for today.

You may all disconnect at this time.

Thank you for participating.