美國運通 (AXP) 2003 Q2 法說會逐字稿

Good afternoon, ladies and gentlemen, and welcome to the American Express second quarter earnings release conference call.

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

Later, we will conduct a question-and-answer session.

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

Mr. Stovall you may begin, sir.

Thank you, Courtney, and welcome to everyone.

I appreciate everyone joining us for today's discussion.

Before we get started, it's my job is to remind you that the discussions today contain 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, intend, plan, aim, will, should, could, likely and similar expressions are intended to identify forward-looking statements.

Factors that could cause actual results to differ materially from these forward-looking statements, including the company's financial and other goals, are set forth within today's earnings press release, which was filed in an 8K report and in the company's 2002 10K report and first quarter 2003 10Q report, already on file with the Securities and Exchange Commission.

In the second quarter 2003 earnings release and supplement, which are now posted on our web site at ir.americanexpress.com and on file with the SEC and an 8K report, we've provided information that compares and reconciles the managed basis financial measures to be discussed today with the TRS GAAP financial information as well as AEFA's 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 related to today's announcement.

Once he completes his remarks, we will turn to the moderator, who will announce your opportunity 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.

Based on this, we ask you limit yourself to one question at a time during the Q&A.

With that, let me turn the discussion over to Gary.

Thanks, Ron and welcome, everyone.

Thanks for joining us today.

As you have already seen, our second quarter diluted EPS of 59 cents a share represents a record quarterly level of net income and increased 16% versus 61 cents last year.

In light of the environment, we continue to feel very good about our performance against the five signposts which Ken identified in February of 2002, which we use to assess the performance of the company and to make decisions to implement spending for growth.

For instance, expenses have been well controlled, especially when you factor in the relatively high level of current investment spending.

Also, the benefit of that spending is evidenced within recent card product launches and the solid momentum of our card-related metrics, which have performed well verses the competition.

At AEFA, we've generated good traction against many aspects of our strategy, although real improvement in metrics and earnings truly require a continuation of the current more friendly market environment.

Considering economic and industry trends and compared to competition, our build business continues strong and credit trends have been strong and outperformed our key competitors in recent quarters.

Overall, the second quarter results reflected strong momentum and demonstrated the success of our efforts to create a flexible expense base and well-balanced risk profile.

As many of your know, these efforts include first of all shifting away from our historical reliance on T&E spending to more stable everyday spending activities.

Secondly, diversifying our revenue streams to incorporate revolving credit revenues in addition to our historical spend base revenues.

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

And fourth, continually enhancing our credit management capabilities.

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

The benefits of our investment were highlighted in the recent Business Week survey of the best 100 global brands in 2003, where our brand value was improved and was ranked 15th on the list.

Our business momentum and investment focus also underscore the fact that our future growth will continue to be driven by the substantial organic growth opportunities that we have historically relied upon.

However, there are additional avenues to further supplement and strengthen those organic opportunities as evidenced by two recently-announced Voltan acquisitions: Thread Needle Asset Management, one of the premiere organizations in the UK, with more than $75 billion in assets under management, and Rosenbluth international, a leading global travel management company with over $3 billion in sales.

We also announced co-branded cards with Air Canada and American Airlines during the quarter.

Announcements related to additional partnerships, such as these, are also in the works.

Companywide, our re-engineering activities continue to deliver significant benefits.

Importantly, revenue-related re-engineering activities are driving a growing proportion of our total benefit.

Our consolidated balance sheet remains strong.

Card reserve coverage increased further and remains at the high end of historical ranges.

The restructuring of AEFA's investment portfolio and American Express's bank's loan portfolio yielded a better balance and a more diversified risk portfolio.

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

We reported double-digit spending volume growth, which outdistanced many competitors, driven by a greater number of cards in force and by higher average cardmember spending.

We also reported strong U.S.and non-U.S. spending balance growth.

We had excellent credit quality.

We continued to have year-over-year interest rate benefits although at a lower level than last year.

We evidenced good expense controls and had a strong overall earnings performance.

Similar to what you have seen from industry peers, AEFA results reflected the negative impact on asset and sales levels of the weak equity market comparisons prior to the latter part of the second quarter of this year, but also reflected positive year-over-year earnings comparison and continued progress on key initiatives as planned sales grew 75% -- as plan sales grew and 75% of equity assets in the portfolio performed above the industry median on an asset-weighted basis over the last 18 months.

This is despite a relatively weak second quarter market business performance.

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

With that, let me now review the details of each of these segments.

I will start with TRS.

Managed revenues at TRS increased 6% and net income rose 12%.

On the revenue side, our ongoing successful expansion into everyday spend categories and investments in growth initiatives over the past three quarters continue to produce benefits in volume, cards in force and lending balance growth.

These benefits allowed to us overcome the effects of the continued weak travel and entertainment environment.

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

Worldwide billed business increased 10% on a reported basis and 8% on a foreign exchange adjusted basis.

In the U.S., consumer spending grew at 12% and small business spending rose 14% while corporate volumes decreased 1%.

In total, U.S. non-T&E related volumes grew 15% and T&E-related spending grew 1%.

Outside the U.S., reported volumes were up 11%, which equated to 2% growth on a foreign exchange adjusted basis.

Within our propriety business to get to that 2% on a foreign exchange adjusted basis, our consumer and small business volumes were up 6% while corporate services volume decreased by 7%.

While it is difficult to get too excited about the quarter's T&E-related spending trends, we've recently begun to see an improving trend within the spending categories.

The discount rate declined 1 basis point from the first quarter of 2003 and 6 basis points from the second quarter of last year.

This primarily reflects the continued shift in the mix of spending toward everyday spend categories, which continued to generate stronger than average growth.

Worldwide cards in force rose 5% versus last year as a result of stepped up acquisition efforts within the consumer and small business segments as well as improved customer retention levels.

These results more than offset a decline versus last year in corporate cards in force, resulting from corporate client workforce reductions.

Managed net finance charge revenue grew 9% on 14% growth in average worldwide lending balances.

Quarter end balances were up 16% worldwide, reflecting 14% growth in the U.S. and 32% growth outside the U.S.

Spreads declined in the U.S. as the proportion of the portfolio on introductory rates rose and the mix of products reflected more lower rate offerings.

Travel and TC sales were down as the War in Iraq and concerns regarding SARS exacerbated an already-weak travel environment.

Marketing expenses on a managed basis rose 18%, on top of a similarly large increase last year, as we maintained our most proactive stance toward card acquisition and other initiatives.

The managed provisions for losses declined 8% as overall credit quality improved during the quarter.

Within our charge card business, the loss ratio rose slightly from last quarter, but remained near the record low.

And within the lending business, loss trends continue to improve, reflecting the quality of our target customer segment and the world class credit infrastructure we have built over recent years.

Despite the strong credit indicators, reserve coverage of lending receivables will strengthen in light of continued uncertainty within the credit environment, as evidenced by the recent increase in unemployment.

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

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

Human resource expenses rose 10% as merit increases, higher employee benefits cost and greater management incentive costs outweighed the positive effects of a generally stable employee count.

Other operating expenses rose 10% versus last year due to higher cardmember 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 rose to 32% from 31% last year primarily due to a relatively lower traveler's check income contribution.

Now let me turn to American Express financial advisors where net income increased 8% versus last year and net revenues rose 9%, reflecting improvement in the market environment.

Results also reflect the negative impact of the current low interest rate environment on spread-based products.

Investment income was up 31%, reflecting higher invested assets resulting from strong client demand for the underlying fixed rate products over the last year as well as last year's WorldCom loss.

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

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

On a net basis, we had an investment loss of $16 million versus last year, where we had net losses of $85 million, mostly due to the $78 million pretax loss on WorldCom debt securities.

If you drill down to the underlying components on a gross basis, AEFA recorded $80 million of investment impairments and losses during the quarter.

These losses were partially offset by $64 million worth of realized gains.

Fortunately, as in the past, substantial unrealized gains, approximately $1.5 billion at the end of the quarter within the portfolio, are available to address such issues.

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

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

At the end of the quarter, the portfolio had, as I said, $1.5 billion of net unrealized depreciation.

Management and distribution fees declined 6% on a lower level of average assets under management.

The 3% lower managed asset base at quarter end reflected the negative impact of net asset outflows during the prior three quarters within both our retail and institutional management activities.

During the second quarter, we actually saw net inflows, albeit at a low level for the first time in six quarters.

In additional to lower management fees, distribution fees were flat as the impact of substantially lower mutual fund sales was offset by higher fees from other product activities.

We saw lackluster sales comparisons within the retail and institutional channels.

Branded advisor generated sales decreased 14% on a cash basis and 1% as measured on the internally-used gross dealer concession basis, which weighs the sales of various products to reflect their individual profitability dynamics.

While we have to wait and see how trends develop going forward, we saw improving retail comparisons as investor sales competence strengthened in the last part of the quarter.

Lastly, institutional sales were flat.

Other revenues rose on strong property, casualty and life insurance revenue.

In addition, planning and advice service fees rose 11%.

The provision for losses and benefits increased 15% reflecting higher levels of insurance, annuities and certificates and higher claim costs.

The increases were partially offset by lower crediting rates.

In addition, the impact of appreciation in the S&P 500 on equity indexed annuities on the stock market certificate product added to the provision.

Guaranteed minimum debt benefit expenses declined 3% versus last year.

Human resource expenses increased 3% as merit increases, higher employee benefit expenses and greater management incentive costs were partially offset by lower field force compensation-related costs and the benefit of a 3% reduction in the average home office employee base.

The advisor base rose 3% versus last year and 1% versus last quarter.

Near-term, we expect to continue to carefully manage new advisor additions until the environment becomes more positive on a sustained basis.

Lastly, veteran advisor retention rates remain strong.

Other operating expenses rose 23% versus the second quarter of last year but increased only 2% versus last quarter.

The year-over-year increase means higher expenses resulting from the fewer capitalized costs due to the ongoing impact of the comprehensive review of DAC-related practices, which we completed in the third quarter of 2002, and a higher minority interest expense related to the premium deposits, which is AEFA's joint venture with American Express Bank.

The effective tax rate declined to 25% from 28% last year mostly due to a relatively higher benefit from taxed advantage investments.

Finally at American Express Bank, the bank continued to make solid progress on the strategy shift while delivering solid earnings.

Consumer activities expanded as private banking holdings increased 13% and corporate banking and other loans continued to decrease, now represent 6% of the total loan portfolio or approximately $370 million.

Results benefited from higher fee levels within private banking and the financial institutions group and a provision decline of 28% versus last year.

Due to the continued stabilization of write-offs within the consumer lending portfolio in Hong Kong.

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

Before I conclude with a few comments on the outlook, I want to address our third quarter adoption of FASB interpretation No. 46, most people refer to it as FIN 46, consolidation of [INAUDIBLE] which became effective July 1.

We addressed this rule in last year's 10K and in the first quarter 10Q.

Although our analysis is still under way, we thought it would be appropriate to provide a preview of the impact of adopting this rule as a change in accounting principles as of July 1.

Industry participants have been studying the rule over recent quarters to gauge its impact.

Industrywide interpretations are being refined, but we have a preliminary view of where we're likely to come out.

As most of your know, the new rule addresses the consolidation of variable interest entities not previously consolidated, although our direct economic exposures related to the activities have already been fully reflected on our balance sheet.

Based on our current interpretation of the rule, we estimate that the third quarter net income would be reduced by a below the line noncash charge of approximately $150 million as we consolidate up to $2 billion of high-yield loans and bonds underlying collateralized debt obligations and the cash collateral related to the secured loan trust that AEFA manages and invests in.

The unusual nature of the rule is evident within the fact that while all of the charge relates to certain management CDOs, the ultimate economic loss potential is only $18 million, the current underlying carrying value of those investments.

But based our position as manager or investor, we take interim responsibility for the underlying assets on our balance sheet until the structures holding them eventually mature.

It's important note that the charge will have no cash flow effect on the company.

Future valuation adjustments specifically related to the application of FIN 46 to the CDOs are also noncash items and will be reflected in the company's quarterly results until maturity.

As such, we expect that the aggregate gains or losses related to the CDOs, including the charge, to reverse themselves over time as the structures mature.

This reversal will take place through future operating earnings, we intend to highlight any significant quarterly impacts going forward.

While the adoption of FIN 46 will potentially add volatility to the quarterly results, it doesn't change the economics around the rest of our holdings.

We don't expect it to cause a revision in the capital requirements or credit rating agency review of the company.

With that completed, let me now conclude with a few comments on our outlook.

Our results for the quarter further illustrate the benefits of the fundamental changes we've made in the last two years to the business model and the strong momentum resulting from the business building investments over recent quarters.

Notwithstanding the challenges within the travel and entertainment sector, our payments business continued to deliver strong results with business metrics and credit indicators that compare well to key industry participants.

The quality of our customer base, the breadth of our product portfolio, the benefits of our reward base spend-oriented business model, our spend activities, and our improved revolving credit capabilities create a competitive advantage, which is being leveraged effectively and which has delivered one of TRS's strongest quarters in years.

Despite the T&E challenges in the second quarter, we were at the high end of the 6 to 10% industry growth which underlies our ability to meet the target.

Within our financial services activities, the progress we're making at AEFA continues to be clouded by the weak impact -- by the impact of weak equity markets prior to the second quarter.

However, we are confident that the foundations being put in place through new products and enhanced investment management capabilities, position us for stronger results if market conditions continue to improve.

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

Fortunately, the market's tone increased in recent months, and comparisons do get easier as the year progresses.

In addition, our re-engineering activities are on track to deliver the additional $1 billion of benefits targeted for the year.

To date, they've provided substantial expense comparison benefits.

However, revenue-related re-engineering activities are starting to drive a grower portion of the benefits.

We've shown an opportunity adapt to business volatility and weakness through contingency plans within each of our businesses, which provide for short-term cost benefits versus the fundamental expense re-engineering initiatives.

In light of the broad strength in momentum we're seeing in the underlying business and the opportunity to gain further competitive advantage within them, we plan to invest more in business building initiatives during the second half of the year rather than allow the additional benefits to fall to the bottom line.

We expect EPS to exceed the current 2003 Wall Street consensus of $2.26, in light of our plans to increase investment spending, it is unlikely that our full-year EPS, before the impact of accounting changes, will exceed $2.29.

This decision is consistent with our belief that we will maximize shareholder value by working to meet all three of our financial targets, a 12 to 15% EPS growth, 8% revenue growth and 18 to 20% return on equity on average and over time.

During the first six months, we're tracking well verses the EPS growth and return on equity targets, but didn't meet our revenue growth target of 8%.

Therefore, investing more in order to build on the growth-oriented spending in recent quarters appears to be an appropriate trade-off, especially in light of the opportunity to take advantage of the current competitive environment.

On balance, we feel very good about the quarter's results and our prospects for continued growth.

However, while we are seeing encouraging signs in the environment, we plan to maintain our flexibility when it comes to controlling expenses, driving re-engineering and setting the pace at which we invest in the business.

Thanks very much for listening.

Courtney, we are now ready to take some questions.

Thank you.

We will now begin the question and answer session.

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If there are any questions, please press the 1 on your touch-tone phone.

And your first question comes from Brad Ball from Prudential.

Please state your question.

Thanks.

Hi, Gary.

Hi, Brad.

On the AEFA business, can you talk about the margins, they're looking still, you know, a little less than where we'd like them to be.

You know, what's the outlook there for the margins in the business?

And where are there further opportunities to pare costs?

And also, you mentioned in the Thread Needle deal, you called it a VOLTAN acquisition.

Can you elaborate what you mean on that?

Are there opportunities to gain synergies on Thread Needle?

First on the margin question, in the -- in terms of the -- for example, the net revenue margin, let me begin there if I could.

Obviously we've been under some pressure, particularly as we came to the first quarter and now into the second quarter of this year as our crediting rates remain relatively fixed on some of our annuity products and our reinvestment rates declined.

It depends what happens with the yield curve going forward.

If you take today's yield curve as example, our expectation is that the reinvestment rate opportunities are going to be improving going into the third and fourth quarter.

From that perspective, I will we will see an opportunity for further relief.

On an expense basis in the quarter, we had, I think a 3% increase in, you know, operating expenses, human resource costs, for example, and that is giving us pretty good leverage against the -- the revenue growth rate that we experienced.

Now, a big piece of the revenue growth rate came off the equity market depreciation, it's hard to know how it's going to continue into the third and fourth quarters, but the comparisons versus last year are relatively easier than in the first half of the year.

The opportunity is potentially there.

From an other operating expense perspective, you saw the number was up very substantially, it's driven very much by this DAC revision that we did in the third quarter of last year and that's unlikely to change.

So, off the top of my head, those are kind of key ins and outs, Brad, I'd expect to see going forward.

Do you have a target margin for the business long-term? 14% today?

We certainly do, you know, as I have said, we continue to target companywide, which is the only thing we've discussed publicly, the kind of 96 margin levels.

You can assume we've got the pressure, obviously, across the entire company, to try to make continued improvements.

On the Thread Needle acquisition, when we say bold on, these are very complementary kinds of acquisitions.

That is we're acquiring companies in the same business we're in, that conduct basically the same activities that we have, but we had a very small -- relatively small, international investment activity going on in London.

And so the cost synergy impact of doing this deal is relatively small.

The real benefit here is provided by the opportunity of having -- our having the chance to sell, you know, high quality international products through the advisor network in the United States, to a lesser extent to sell the domestic product through the third party built by Thread Needle in Europe, in particular.

So we think there are some excellent opportunities to do that.

That was the key driver behind our decision to do the deal.

The cost synergies are relatively small and relate to the relatively small office we operated in London.

Great, thanks.

Your next question comes from Michael Freudenstein from JP Morgan, please state your question.

Hey, good afternoon.

Hey, Michael.

Just wanted to first get a sense, in the last call, you talked about how things slowed down on a billed business front; that was helpful color.

I wonder if you could give us some sense of how the second quarter went given sort of the events early on and as they sort of fade away, maybe some of the improvement, hopefully?

You know, the quarter was quite consistent.

If you look at the first quarter and the second quarter, you know, both quarters were strong.

I think during the second quarter, you know, we had pretty consistent strength in all three months.

If there was any pattern, I think we saw a slight improvement our corporate business as we came through the quarter, and exited with more momentum in the corporate business than we started the quarter with.

That would be the only thing I would characterize as dramatically different over the three months.

And does that, in part, explain your interest of the timing around the Rosenbluth acquisition, or was that relevant of what was going on in terms of the trends you were seeing there?

It's opportunistic, it's an excellent business, as you know, with a tremendous history and a terrific customer base.

And it provides us an opportunity to provide even broader services to our customers than we have been able to in the past.

For them it adds the opportunity to access a global network for their customers, which they've had difficulty assembling in the past, so, for us it just felt like a very, very nice tuck-in acquisition depending how you want to refer to it.

That's what drove our thinking as opposed to an underlying economic situation.

Okay, and Gary.

In the past, also, you were able to give us some sense of how some of your new products are doing as a percentage of your overall new account bookings, for example, built-in rewards and cash rebate, if I recall, were over half of new accounts booked in the second half of last year.

I'm not sure if I'm remembering that 100% correctly, but can you give us a sense of what the new products have had on your success to date?

The -- if you remember that, you remember something that I'd -- I don't know that we disclosed, but what we are going to do is do a very comprehensive review of this in the analyst meeting coming up next week.

Al Kelly will be doing the detailed drill-down and I think is going to go through specifically some of the products you just mentioned and talk about the impact those have had on our results this year.

I won't steal Al's thunder, but there will be some more information available next week.

You know, I don't know if you spoke about specific products, but I thought you had talked about new products, overall, as being big drivers of your account growth in the second half of last year.

I think -- -- I'm getting feedback on the line here.

I think you might be referring to what we mentioned about the new -- the reward charge combination product.

Which we said was key to our success some the charge business as we exited last year.

That's absolutely true.

And Al's going to talk more about that.

We're pleased with the overall economic results of that product.

The -- the outcome in that product line is different than what we had anticipated going in.

We've actually had fewer accounts sign up than what we had anticipated on when we initially launched the product, but the rewards usage of the product is higher.

The billings are higher.

Net-net, it's better than we anticipated.

That's the flavor you will be able to get from the presentations next week.

Okay.

And last question is just on the inflows.

Can you tell us which products, specifically, we're seeing the inflows at AEFA?

Well, we continue to see a pretty good -- pretty good strength on our fixed products during the quarter, but are you referring particularly to the managed inflows?

Yeah.

You know, what I'm trying to get a sense of is are you having positive flows in equity specifically?

You know, I think it's -- it's very much annuity-related in the quarter still, Michael.

Okay, thank you, Gary.

You bet.

Your next question comes from Eric Wasserstrom from UBS.

Please state your question.

Thanks, good afternoon.

The -- Gary, could you give us a sense of -- of what -- sort of what determined your margin behavior in the credit card business this quarter?

And also perhaps some sense of how it might behave in an environment in which presumably your funding costs might be higher than they are today.

Sure.

You know, one determinant of this is what's going on in terms of the percentage of the portfolio on introductory rates.

In the quarter the percentage of the portfolio intro rates was just over 22%, 22.5% or so, which is very much in line with where it has been historically.

If you go back from say the third quarter of '99 through to today, it's bounced between about that level and 25%.

So, somewhere in that range.

And -- so, you know, one of the factors is the percentage of the portfolio that's on introductory range.

So, it's up from where it has been the past couple of quarters, but pretty much in the range of the last three or four years.

The second is obviously what the net interest yield is on that.

In the quarter, the net interest yield was 8.9% and again, that's pretty consistent with the range that we've been in over the last four years, which has ranged from a low of about 8% to a high of about 10% or so.

And -- so, at any one point in time, depending on the product mix, the introductory rates and what the interest rates are in the market, we will see some of that impact on our underlying spreads that we have.

Now, generally for our fixed rate products, as I've said a few times in the past, we are probably, I guess more hedged or have longer maturities than we typically might have.

That has happened because we have had, you know, a relatively long period of time are low interest rates and in particular over the last three or four months, we've had flat yield curves, up until the last few weeks.

We've taken advantage of that to lock in more funding than we might typically do.

I think you will see, for at least the foreseeable future, that the exposure we have to rising rates is less than it might have been at other periods in time.

Now, obviously that doesn't last forever and eventually that benefit bleeds off, but for the time being, that's what we see.

And as I say, you will see this -- the spreads vary up and down with the -- with the other elements that I talked about.

And -- but I think primarily within the ranges I just described to you.

And one follow you that, Gary.

Of that, you know, 20, 22% that's -- that's going to reprice over, you know, over the next quarter or two, are the teasers -- I'm sorry, are the go-to rates that they're replacing to, how do those compare to where you've been historically?

You know, we've consistently had a policy that says we don't offer uneconomic products.

We really do not offer products that don't make economic sense for us.

And so that's been our policy it continues to be our policy and our acceptance in the marketplace is driven by the quality of our offering, the rewards that we have and other features, not by the introductory pricing.

They just haven't changed substantially.

Just to be clear, is that pricing, given the current funding benefit with that just on an absolute interest rate, APR basis be below where it's been in the past?

I would say marginally below where it's been in the past, but I wouldn't take that as a significant difference from what our pricing strategy has been.

Okay, thanks very much.

You bet.

Your next question comes from Bruce Harting from Lehman Brothers.

Please state your question.

Hi, Gary.

Can you add a little more detail to the sort of the combination on the one hand of cost shifting into the other operating expense line?

And outsourcing, yet the significant jump in human resources costs?

And, you know, both what happened in the quarter and then from a forward-looking, you know, perspective, in terms of what we can expect in those two areas and in the other expense, you know, given that it's, you know, I don't know, about 40% of total expense, will we see any further breaking down of that line item going forward?

Thanks.

Sure.

The -- I assume you're referring to the increase in the TRS human resources.

Yes, thank you.

Thank you.

The -- there's a number of factors that go into that.

Obviously, our head count was relatively flat in the quarter, we had merit increases and as you know, we have significantly changed our mix of stock options, and although the option grants in and of themselves are not significant to our financial results, the replacement expenses that we had are important things.

So, as we reduced or eliminated stock options, we increased incentive payouts, for example, we did selective increases in merit and so I think what you're seeing in that line item is -- is those kinds of effects playing through and causing a higher human resource expense.

Now, some of the expense, obviously, has been transferred out of HR and into the other operating expense line, but we're pretty much annualized now on the IBM contract.

As you will recall, it was just about this time last year when that deal was finalized.

We should'nt see that kind of transference between those two categories going forward.

Both of these line items continue to be subjected to the same kind of re-engineering we're doing across the entire company and will continue to play a role in leveraging our overall expense structure, but we do have, you know, this expense particularly related to, you know, higher merit, as I say, higher incentive pay, that's higher in this quarter.

Also, you know, our results are good this year, and so our incentive pay out plans for the year, at least as we stand today, are a little higher than they were last year at the same time.

So, all the factors taken together bring to us that spot.

In terms of splitting out the detail of other operating expense, that's something we review every November with our audit committee and we may make some changes in that line item to provide a little bit more detail around the rewards expense in particular.

A lot of people have interest in that and it's something we're seriously considering doing.

Your next question comes from Michael Cohen from CIBC World Markets.

Please state your question.

Hi, guys, could you talk about the dynamics underlying the 1% decline in the corporate volume, was sort of large business down by more?

And how did middle market fare, you know,the context of things, did that sort of pick up the slack?

Thank you.

Yes, you -- you got it exactly right.

That's what happened.

The large business was down by more.

What is happening there is obviously our clients have also been affected by the reduction in head count and as the head count goes down, the number of cards they have goes down.

Large corporate business is down more than 1%.

That's being offset by significant improvement in our middle market business.

We've put in a sales force in the middle market in the United States and a sales force in the middle market in Europe.

The combination is driving very nice increases in our middle market business, but the blend rate that you see is the minus 1, now.

As I said, we did see improvement in that number as we went through the quarter, you know who knows how it will proceed in the quarter we're in now, but we saw clear improvement in the number in the quarter.

Is it something you will breakdown further as you, you know, look at things in November?

You know, I don't know.

We already provide so much detail, when you get to very fine levels like that, it's hard to, you know, commit to it.

I think whenever it -- we believe it t would illustrate something that could be particularly important, you know,a quarter we might disclose it in a particular quarter, but I doubt we'd want to do it on a quarter after quarter basis.

Great, thank you.

You bet, Michael.

Your next question comes from Chris Brendler from Legg Mason.

Please state your question.

Hi, good evening, guys.

How you doing?

Good.

A little bit more on the card business, if you could.

I was -- maybe I was one of the only ones, I thought maybe we'd see a little better number on the card acquisition side U.S.

Can you give us a little more color on what you're seeing domestically in the card business?

I thought maybe -- you know, the spending you're indicating you've been pushing that, the new products, I know it's a net number, but it's hard to see how many accounts were at it.

I want to see if you're pleased with the growth or are still thinking that there's, you know, could do a little better?

And also maybe relate that to the pressure on the margin, I'm just wondering why you feel that you really should be pressing that the introductory rates so hard.

It seems to me that your advantage is really outside of the lending business and given all the commentary we've heard from other lenders how difficult this competitive environment is, why do you feel it necessary to push that lending business so hard?

The -- you know, it's interesting.

We think about our growth rate always in the context of our competition and we feel terrific about our performance this quarter.

You know, if you look at virtually any of the measures that I talked about, whether you're talking about card growth, growth in transactions, growth in spending, growth in AR, on virtually every one of those measures, we at the top of the pack over the last three month.

And so it is, I think generally still, a pretty difficult environment, as evidenced by the performance of many of our competitors.

So, on these measures we really feel like we just had an excellent quarter.

And -- and honestly feel like the excellent quarter came as a result of the decisions we made late last year to increase our marketing spending.

As a result of that, both because we think there's a competitive opportunity that's opened up here as our competitors seem to be, you know, somewhat weakened and we seem to be gaining strength, there's an opportunity for to us turn up the heat even further.

So, as you see other people reporting, you know, middle of the pack types of earnings improvement and yet cutting their marketing expenditures, we're taking every opportunity we can to increase marking by mid-double digits numbers last year, the same kind of increase this year and obviously we hope for the same kind of compounding and building effect in next year's results.

So, overall we feel very, very good about that.

I think, you know, the important thing to think about our business is we are primarily a spend-based company.

The spending is the key factor that drives our results.

That being said, we have developed over time, a very nice lending business, as well.

And have managed that business extremely well.

And if we can be effective there as we have been in penetrating customer segments or parts of customer spending that we would not be able to get without our lending portfolio, I think you're going to ton see us push on that.

That being said, we have very clear parameters.

As I said, the portion of our portfolio that's currently on introductory rates, very much in line with our four-year history and reflects, frankly, the recent growth rate we've seen in products, like, you know, our blue cash program, for example, new introductory products that are being accepted in the market and therefore driving up the proportion of our portfolio on introductory rates.

And -- and our pricing again, falls very much within the band that we've had over the last four years or so and reflects our commitment to not do this in the marketplace.

So we're going to compete very tough competitively.

We have a better capital structure and a better cost of funds than most of our direct competitors do.

That really opens up a window for us in conjunction with the rewards program that we have to really take advantage of this opportunity to pick up some market share and we're really -- we're going to do it.

We're going to continue to have, I think, the same drive to garner momentum that we've had.

One quick follow-up, given the results of this quarter and how much they really contrast to your competitors, would you now consider the credit to be one of your core competencies and strategic advantages now?

Yes, I think Ash and his team have done a superb job.

The numbers are truly outstanding.

Certainly on the charge card, it's hard to imagine numbers that could be better than these, particularly given the new charge launches we've done over the last year or so.

And, you know, on the lending side we've had significant improvement in our ratios as you look over the course of the last, you know, five or six quarters.

And, you know, we think there are many reasons for that.

You know, we've got rewards is now a significant portion of our total billing and that's driving our credit results.

As well as our customer retention and top line.

We continue to improve the quality of our underwriting capabilities and our ability both facilitate customer transactions while we at the same time, you know, use dynamic underwriting to assure our losses stay rightfully check.

I think we've got kind of best in class capability in that general area now.

Great, thanks.

Your next question comes from Joel Houck from Wachovia Securities, please state your question.

Good afternoon.

Hi, Joel.

I wondered if you could provide a little bit more color on the competitive landscape in -- in -- and I guess more specifically what's changed in the last three or six months that gets you more excited in order to spend more money?

And kind of a follow-on on to that is who do you plan on taking market share from?

Is it banks, mile lines, a combination of both?

I assume you're not going to name specific companies, but anyway, that's the question.

Okay.

Well, you know, if you just -- if you look at some of the, you know, the unique factors of the last few months, clearly the funding environment has gotten tougher for some competitors.

And they have been forced either to slow their growth rate or to go to other types of funding that might be a little higher cost for them than we've needed to do.

Because of the huge cash generation that we have each year and the strong credit position that we're in, our capital structure provides an advantage to us.

Secondly, we've seen that in order to, you know, have reasonable numbers, a number of our competitors have actually cut back on their marketing expenditures, so, you see competitor after competitor actually reducing marketing expenditure at a time when we see substantial marketing opportunities and so there -- and, you know, the interesting thing about the payments business is you don't start and stop that overnight.

As you slow down spending, it takes a while of the impact for that to be seen, as you ramp it up, it takes a while to be seen.

We're in a period right now of gathering momentum, we have, you know, beginning in the early part of last year, substantially increased our marketing expense and now year-over-year we continue to increase our marking expense and we see that as a real -- a real window of -- of opportunities for us.

You know, we also have seen some credit quality deterioration among some of our competitors, certainly not universal, but there are some competitors that are struggling with credit quality.

And, again, finding it more difficult to price competitively and -- and therefore there are, you know, they've got what appears to be some adverse selection in their portfolio base.

And so each one of these issues are somewhat unique to, you know, different companies, but taken as a whole, we think opens up a unique opportunity for us to continue to gain market share.

And -- and we intend to gain market share on all fronts.

So, we intend to gain market share of spending, as you've seen in the last quarter.

We intend to gain market share of overall lending balances as you've seen in the quarter.

And we think there's opportunities to take it from competitors of all the kinds that you described.

So, we feel good about our position right now, feel good about where the business is positioned in and the way, you know, the market is responding to us.

And would there be anything that perhaps might cause you to change that viewpoint?

Or does the window of opportunity look pretty good for the foreseeable future?

There's always things that could cause it to change.

I wish I could say there's not.

One of the reasons why I make comments at the end of my introduction here, that we retain this fixation on flexibility, is that if there's anything we've learned over the last two years is that you can't really count on things from one quarter to the next.

So, we continue to have a very clear posture of a flexible cost structure that allows us to, on relatively short notice and I mean over say an 8 to 12-week time period, make significant changes in our level of competences that allow us to throttle back or to push forward in response to the market environment.

And I think this is a perfect example of how we're thinking about, you know, running the business.

When we had the conference call three months ago, I talked about our contingency plans, our flexibility in response to SARS.

The concerns about the War in Iraq and how it would carry over into the year and how we had developed clear plans.

We've obviously moved through that phase now and are on the other side of that equation and talking about how we can increase investment spending and drive our business in the next few months.

So, I don't think, you know, and, you know, who knows, but there -- I hope there's not, but there might not be another event three or four months from today.

So, you know, the key theme here is flexibility, our ability to have a flexible business model and respond to whatever the market is and to do it in a way that hopefully over time really builds the total value of the company.

Okay, thank you.

Your next question comes from Robert Hottensen from Goldman Sachs.

Please state your question.

Hi, Gary.

Could you elaborate a little bit on the re-engineering benefits, you know, the billion dollars still remaining, including the 25% in benefit from revenue re-engineering.

Specifically, is there anything beyond membership rewards, you know, on the revenue side and how should we think about this beyond 2003 into 2004?

On the revenue re-engineering side, there is a number of things we have under way.

There is a couple that people with well familiar with and you mentioned one of them.

We've talked in the past about re-engineering on the corporate services side to move our corporate travel business onto the Internet and although it hurt us from a revenue standpoint it helped us from a margin standpoint.

Other kinds of examples are reductions in the point of sale disruptions.

When a customer goes at point of sale, they're using their charge card, we underwrite virtually every one of those transactions.

We check to see if the customer's credit is adequate to support the transaction.

We have worked hard in the last couple of years to have a capability that allows to us authorize more and more of those transactions to actually provide better customer service but actually a allowing people to spend more on the card.

And we've seen a significant reduction in the number of disruptions we've had because of the time and effort we've spent in improving our underwriting capabilities at the point of sale.

We have -- we're engaged right now in a strong effort on early customer engagement to encourage customers when they get the card to actually utilize the card.

We have a new series of processes that have been developed by one of our Six Sigma teams to encourage early customer engagement when they get the card in their hand, and we're continuing to press on the revenue re-engineering front, driving more dollars of billings out of the same number of transactions because it's critical, obviously to our overall accomplishment of our billion dollars.

As I think we said in the notes, it's roughly 25% of the total now.

It's an increasing percentage of the total and will be an increasing percentage of the total next year, but -- but I don't think you should take away that that means that we have any less enthusiasm about what we need to do on the cost side, as well.

We really do have a clear focus on where we need to be from a long-term margin perspective and are focused on continuing to make improvements in our cost to get us to that level.

From quarter-to-quarter, you're going to see movements around that number because, you know, there are times when we're investing harder, you know, in a number of different categories, but the long-term trend here has to be absolutely clear for us to achieve our financial targets and I think, you know, that's where we're targeting from both a revenue and expense re-engineering perspective.

Okay, thank you.

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

Please state your question.

Hi, good afternoon.

Hi, Matt.

Just want to follow-up, the release has, and I guess you eluded to it a little bit, seeing the early signs of an economic pickup.

I assume that refers to the strengthening or the strengthening trends in the corporate spending, is that correct?

And could you remind us of the cyclical relationship between the small business and corporate?

I heard you talk about it in the past, to maybe the small business is more of a leading indicator?

Is that right?

And is that what we're seeing this time around?

What you mentioned, Matt, is correct.

There are probably a few other things that I would add to the list that you mentioned.

Clearly the corporate spending and the improving corporate spending we saw during the quarter is one of the elements we've looked at.

Although, traveler spending continues to be negative, it's less negative than it was.

So, the trend we're seeing in travel spending is moving in the right direction from our perspective.

As you said, small business spending has been robust now for a number of months.

So, if you go back into last quarter, we were in the mid-double digits range on small business spending.

We've continued to see that be very strong for us during the second quarter, and although we don't have any economic analysis here that would prove that our small business spending leads our corporate spending, I think if Terry Hatch were here, she'd say what she learns from her customers is they have to respond to the environment immediately.

So, when there's demand for the product, they need to be able to spend.

We need to have a product available for them.

When there's no demand for the product, they have to cut back.

So, we're clearly seeing strengthening within the small business sector that gives us some encouragement.

Now, that being said, there is a lot of mixed signals out there and -- and as we say, this is the first real time that we have seen some encouraging signs of improvement, but there still are other macroeconomic factors that are mixed.

Unemployment numbers still don't look terrific.

Positive news on the manufacturing front over the last week or so, so, we're kind of cautiously optimistic at this stage.

We feel like there has been some improvement in the tone of the environment as we see it, but we're not out the woods yet.

Okay.

And then one quick follow-up, you talk about tailing off the pace of stock buyback in the second half of the year.

Barring similar types of moves, should we see it climb back to what it has been in the first half of next year?

Yes, I think the way to think about it is that the guidance we've given is we will return approximately 65% of our total capital generated on average and over time.

It's been higher in the first half of the year.

I think around 75% or so.

In the first half of the year.

We won't sustain that pace in the second half.

But we will in the full year basis meet the target this year, barring some event we don't foresee today.

On average, and over time going forward, that's our plan, to return to that level of total return to shareholders.

Great.

Thanks a lot.

Your next question comes from Caren Mayer from Banc of America.

Please state your question.

Hi, Gary.

Hi, Caren.

I have a follow you a couple of questions that have been asked.

Your discount rate is going down because of an increase in everyday spend, which is great because volume is up, but your yield is under pressure.

As you look at some of these initiatives to enhance revenue and get you back on the 8% trajectory, can you give us a sense of the initiatives?

And how much, would you rehashing the data you've given us, but how should we think about the discount rate and the yield in terms of what portion of it is cyclical?

I assume when T&E picks back up we will see the discount rate start to improve a little bit, despite the move toward everyday spending.

Is that right?

And on the yield side, can you us a sense of trends there?

Yeah.

From a discount rate perspective, you know, what we have said, I think historically, is true.

That we expect a gradual reduction in discount rates that reflects the broadening into the everyday expense categories.

The rather large reduction that we've seen relative to last year, I think has been exacerbated by everything you said, T&E has been weaker and as we see a change in T&E, because it has the higher average discount rate, it's likely it wouldn't have the same kind of reduction as the six basis point reduction would have implied year-over-year.

I think you also correctly said that we do think this was the right trade-off, that we feel good about the change and -- and because it is a reflection of, you know, the execution of our strategy, essentially.

So, I think you're likely to see a continuation in the discount rate, but really reflecting the success of our everyday strategy.

On the yield, you know, numbers, I wish I could give you a -- you know, a accurate forecast for it.

It's something that obviously we forecast.

I decided about the best I can do is kind of give you a sense of the parameters that we work in and as I said, we think the parameters on the proportion of the introductory rates to be kind of in the range we're in now, somewhere maybe a low of, you know, 20% and maybe a high of 25%, we're in the middle of that range right now.

When we are growing the business, obviously you see a bigger piece of the portfolio on introductory rates than when we're in a period when we're holding back.

And because we're growing now more strongly than we did a year ago and investing even more, because we're growing all of the aspects of our business, the charge card and credit card business, you know, you're going to see an increase in the number, but it will get to a certain level and then -- and then, you know, but we have parameters around that.

Likewise on the net interest yield, at times when the portfolio is -- is at a higher percentage on introductory rates, you're going to see a lower net interest yield, but that's not as a result of our significantly reducing the pricing that we, you know, have on the products, the go-to rates that we have on the products.

There has been some modest reduction in that reflecting underlying reduction in fixed rates and how we could hedge going forward, but it's really been very modest.

And so, you know, without giving you a point estimate, I think I've given you a sense of the parameters here and that's likely to be the range we will manage going forward.

Thank you, Gary.

Your next question comes from Michael Hughes from Merrill Lynch.

Please state your question.

I'm covered, thank you.

We will take one more question.

Your last question comes from Matthew Park from AG Edwards.

Please state your question, sir.

Lucky me!

I have two questions on credit quality.

What is your outlook on credit quality?

And given your kind of accelerating growth rate on the receivables, are you comfortable with the current reserve ratio?

Yeah, I think we are.

I mean if you look in the supplement at the -- at the current coverage ratios that we have, our coverage ratios are really at very attractive levels.

You know, on the charge side, we're now at 171% of 90-day past dues.

On the lending side we are at 136% of 30-day past dues.

So, we stand really at historically high rates and this, at the same time, that, you know, the benefits that we're getting from our improved underwriting capabilities and, you know, the benefit we get from a higher percentage penetration of membership rewards, is really improving our ability to manage these, you know, these losses.

So, in spite of the growth we've seen, I think we feel very comfortable with where we are from a credit perspective.

There are things like unemployment out there that -- that are a bit of a concern, but unemployment has now bounced around in the 6% level for quite some time and -- and so even though it deteriorated a bit from where it was earlier in '01 and in 2000, we really didn't see much deterioration in credit.

Again, because I think there were a lot of other factors that have offset that deterioration.

So, I think, you know, we feel like we're appropriately and comfortably reserved for the -- you know, the risks that we currently have in the portfolio.

So, just a follow-up, given your growth projections in '04, do you feel you might see -- we might see some kind of a backing up into terms of excess provision you may have to put in, to keep up with the reserve ratio?

No, no I do not.

As I said, right now we are at historically very high rates of coverage.

And so we don't anticipate that being an issue.

Great, thank you.

Thank you.

And thank you, operator, we appreciate your help.

You're welcome, sir.

Thank you for your participation.

You may disconnect at this time.