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American Express Company (NYSE:AXP)

Q2 2008 Earnings Call

July 21, 2008 5:00 pm ET

Executives

Ron Stovall – Senior Vice President of Investor Relations

Kenneth Chenault – Chairman and Chief Executive Officer

Daniel T. Henry – Chief Financial Officer & Executive Vice President

Analysts

Meredith Whitney – Oppenheimer & Co.

Christopher Brendler – Stifel Nicolaus & Co.

Robert Napoli – Piper Jaffray

David Hochstim – Bear Stearns

Sanjay Sakhrani – Keefe, Bruyette & Woods

Brad Ball – Citigroup

[Unidentified Analyst]

Mike Taiano – Sandler O’Neill & Partners L.P.

Eric Wasserstrom – UBS

Moshe Orenbuch – Credit Suisse

Scott Valentin – Friedman, Billings, Ramsey & Co.

Operator

Welcome to the American Express 2008 second quarter earnings conference call. (Operator Instructions) At this time I’d like to turn the conference over to your host, Senior Vice President of Investor Relations, Ron Stovall.

Ron Stovall

We appreciate all of you joining us for today’s discussion. As usual it’s my role to remind you 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, 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 included in the company’s financial and other goals are set forth within today’s earnings press release which was filed in an 8-K report and in the company’s 2007 10-K report already on file with the Securities & Exchange Commission.

In the second quarter 2008 earnings release, supplement and presentation slides which are now posted on our website at ir.AmericanExpress.com and on file with the SEC in an 8-K report, we have provided information that describes the company’s managed basis and other non-GAAP financial measures and the comparable GAAP financial information and we explain why these presentations are useful to management and to investors. We urge you to review that information in conjunction with today’s discussion.

Ken Chenault, Chairman and Chief Executive Officer of American Express will provide some brief opening comments addressing today’s announcement and the current environment. Then Dan Henry, Executive Vice President and Chief Financial Officer will the key points related to the quarter’s earnings through the series of slides provided and then conclude with summary remarks.

Once he completes his remarks we will turn to the moderator who will announce your opportunity to get in to the queue for the Q&A period where both Ken and Dan will be available to respond to your questions. 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 that you limit yourself to one question at a time during the Q&A.

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

Kenneth Chenault

My comments will be brief. Over the past month or so we have seen clear signs that the U.S. economy is weakening. Unemployment rates, as we know, took the largest jump in over 20 years. Home prices declined at the fastest rate in decades and consumer confidence is at one of the all time low points.

Now Card member spending particularly among consumers slowed sharply during the latter part of the quarter. Current indicators, as we signaled a few weeks ago, deteriorated beyond our expectations and by almost any measure the U.S. economy and business environment are much weaker than the assumptions we first spoke to you about back in January and the conditions that existed until June.

This fallout was evident across all of our consumer segments even our longer-term super prime card members. While we are obviously disappointed with the bottom line results, adding to our reserves this quarter translates into coverage levels that are substantially higher than at any point during the last two years.

Yet despite this challenging environment our revenue growth for the quarter was solid and our business metrics, that is billings and card growth, were strong. Now as you have seen from some of the earnings releases from financial services this quarter we have been able to generate substantial returns relative to other companies. But having said that, we do not expect to meet or exceed our long-term financial targets until we see improvements in the economy.

Now given the environment we will continue to scale back some card acquisition efforts and reduce credit line selectively in the U.S. At the same time, however, we also plan to take advantage of growth opportunities particularly in international and in the business-to-business markets. Our goal is to stay focused on profitable market share. I believe we have the strength and resources to do just that.

We obviously do not know the extent of the current downturn but the position of our company today is financially sound and competitively strong. We have lowered our risk profile by divesting a number of businesses in recent years and we are well positioned to execute against growth opportunities in a manner that balances our short, medium and long-term objectives.

Now as usual, Dan is going to review the major items and trends during the quarter. He will also offer some additional summary and help with comments. In light of the business and economic environment as Ron said I am going to join him for the follow-up discussion and we will be glad to take any of your questions.

With that let me turn it over to Dan.

Daniel Henry

As Ron indicated, we are using slides today to facilitate the review of the results. If you don’t have those you can find them at the company’s IR website. Let me start with Slide 2, a summary of financial performance.

You can see that revenues grew 8% and in a few slides I will talk about what that is on a managed basis. Income came in at $655 million and EPS at $0.56. This reflects strong performance in the international consumer, global commercial card and networking merchant services businesses offset in part by higher credit losses in U.S. card services. I’ll speak about that more as we proceed.

Despite the higher credit losses we earned in excess of $600 million and ROE remained strong. Looking at slide 3 we have identified the significant items. First is the addition to the lending credit reserves, $374 million after tax or $600 million pre-tax. This is a result of higher write offs and deterioration of loan rates that we saw in June and reflect the inherent risk in the portfolio and higher anticipated write offs in the balance of the year.

Second is an adjustment to the interest only strip. The interest only strip relates to our securitized loans. The $85 million after tax or $136 million pre-tax is a write down in value also related to the high credit losses we are experiencing. The tax benefit relates to the settlement of prior year items with both the IRS and certain states.

Looking now at Slide 4, capital generation, you can see we generated $756 million at the combination of income in the period as well as funds received related to either option or RSA activity. You can see that we had no share repurchases in the quarter. That is a decision we made early in the second quarter given the economic uncertainty. Going forward we will make decisions about share repurchases based on the economic conditions and company performance quarter by quarter? We are committed to maintaining a strong capital position.

Slide 5: Metric Performance. Metrics are a key measure of the health of the business. Second quarter metrics performed very well and are excellent compared to our competitors. Business-to-business grew 12% or 10% on an FX adjusted basis, down only 100 basis points from the first quarter. Cards in force increased by 10% reflecting investments in our proprietary business and growth in G&S cards. Global growth moderated to 12% down from 19% in the first quarter based on a slow down in consumer spending and travel sales remained very positive.

Slide 6: Revenue Performance. As I mentioned, revenues grew at 8% on a GAAP basis. As you can see, interest and securitization income actually decreased by 7% which reflects the higher credit losses. On a managed basis, revenues increased 12%. Card fee growth was very strong and reflects our customers’ recognition of the value proposition of our products. Other revenue reflects the corporate purchase of the GE Commercial Portfolio which helped that growth rate by about 600 basis points.

Now turning to the segments, if you look at Slide 7, U.S. consumer services. U.S. Consumer Services billed business grew 6% down from 8% in the first quarter. Small business or opened held up very well at 11%. However, consumer continues to decline as we proceeded through the quarter. Cards in force growth are down slightly as we shifted some investment to the international consumer segment. Average spend was flat reflecting the economy and its impact on spending. Loan growth again slowed in this segment linked to the slowdown in spending.

Moving to Slide 8, here is a little bit more detail on the U.S. Consumer Services Billed business. It shows you the monthly trends. You will recall we saw a drop in spending in December. March’s results are depressed and April’s numbers are inflated based on where Easter fell in each respective year. Easter in 2007 was in April and in 2008 it was in March. You can clearly see the drop in May and again in June driven by the slowdown in the U.S. economy.

Moving now to Slide 9, International Consumer Services. On the other hand, International Consumer Services billed business held up very well increasing 20% or 10% on an FX adjusted basis, the same growth as we saw in the first quarter. Card acquisition focused on the premier sector as you can see that average spend grew by 17%. Card member loans grew volume and travel sales were strong.

Moving to Slide 10, Global Commercial Services had a very strong quarter. Billed business grew at 14% or 10% on an FX adjusted basis, again the same growth rate we saw in the first quarter. Cards in force and average spend growth was also very solid in this segment.

Moving to Slide 11, Global Network and Merchant Services, we see strong billed business growth outside the U.S. and I’ll also note that the U.S. retail and everyday spending grew at 9% and that category represents 69% of our U.S. billings. The discount rate held up very well only down 1% year-over-year and G&S, billed business and cards in force growth continues to be very impressive.

Moving to Slide 12, Expense and Provision performance, total expense increased 6% and was very well controlled. Marketing and promotion spending was comparable with the second quarter of 2007. Rewards expense grew with volume. HR and other included increased investment in our merchant sales force. Charge card provision grew modestly which reflects the lower U.S. consumer spending as well as credit actions. The lending provision increased significantly and I will address that over the next few slides. The tax rate of 14% includes the $101 million significant item I mentioned earlier. Without that the tax rate would have been approximately 28%.

Moving to Slide 13, focusing first on charge card net loss ratios, you can see that international consumer and the global commercial services remain very stable and I assure you we are monitoring this very closely. The U.S. consumer services group in the first quarter reflects a seasonal event largely and also to a larger extent the impact of 2008 slowing billings. So this calculation is the write-offs in the quarter which relate to accounts that went past due in the third quarter of 2007 when billings were very strong and at that time we set up appropriate reserves for those past-due’s.

Therefore their write-offs are not having a significant impact in the second quarter of 2008. That is divided by average billings for the past three months, April, May and June, where we had weaker billings. So the 44 basis points you see there in part has to do with the seasonal effect but more than that with the time that we actually set up reserves related to accounts that were past due in the third quarter.

Moving to Slide 14, charge card name to days past due, again you can see that international consumer and global commercial services are very stable and U.S. consumer services are actually improving which is common on a seasonal basis and is also based on the credit actions we are taking.

Moving to Slide 15, lending managed net write off rate, this is where we are seeing the significant negative impact in the P&L. Let me start by reminding you the way we report write-offs is different than the rest of the industry. The rest of the industry includes in write-offs principal only. We include principal, interest and fees. So for the U.S. consumer services we have reflected on the dotted line what our reported write off rate is and we have also noted what it is excluding interest and fees.

It is our intent in either the third or fourth quarter to move to the industry schedule. If you need comparison between our write off rates and the industry the 3.5% is the correct number to use. Let me just mention for a moment as you can see international consumer continues to be very stable and down from 2007. In June write-offs increased beyond our expectations and you can see that on the next slide.

Slide 16, here what we have done is provided low fee write off rates. We provided both the reported numbers and the numbers comparable to our competitors. As we indicated in the first quarter March was high in the average for the quarter and at the end of the first quarter we also indicated second quarter write-offs were going to be higher than first quarter. April and May were in line or slightly above our forecast but June increased well above our expectations.

Turning to Slide 17 we see lending managed 30-day past due’s. You can see that international is stable. The U.S. number is also consistent with the first quarter however roll rates deteriorated significantly in the second quarter in particular in June. Roll rates are the amount that move from current to 30, 30 to 60 and when roll rates increase it is an indicator of what is going to take place in the future and why we are anticipating higher write-offs in the balance of the year.

If you move to Slide 18 here we have included monthly innovation on our roll rates. The top chart is roll rates current to 30 days past due. The bottom chart is 30 days past due to write off. The first quarter if you look at the bottom chart, the 30 days to write off, you can see that while the first quarter is higher than the fourth quarter February and March were below January levels. If you look at the current to 30 you can see that it was improving in February and March. If we move to the second quarter the 30 day to write off number while it increased in April it improved in May.

Again if you go to the top chart and look at current to 30 you can see that April and May were improving. For these reasons we felt we were on track through May. However that changed in June. You can see in the top chart that the current to 30 increased and the 30 day to write off increased sharply. As a result in the second quarter the 30 to write off percentage increased by over 200 basis points compared to the first quarter. These higher roll rates will lead to higher write-offs in the third and fourth quarter.

If you move to Slide 19, this is U.S. consumer services managed 30 day past due by tenure. Now as you can see from this chart the 24-36 and the 36-48 buckets are growing at a faster rate than the overall portfolio. However, all tenures are increasing including the 48+ group. Here we believe the economy is affecting all tenures not just the recent accounts that we have put on the books.

If you move to Slide 20 now and let me take a little time to explain this chart, on the right you see the origination year which means the year a card member joined the American Express franchise. The time period are months across the bottom rank card member history with us in a 12 month time period. The respective plots are the write off rates for each year of origination as the group’s season through the normal curve. If you follow 2001, which is the red line, write-offs increased in the 13-24 months and 25-36 month buckets but then improved.

Now for all years 2003 and newer, the last two plot points are impacted by 2008 credit deterioration. For card members who joined us in 2003 in January through June they would be in the 61 month and greater bucket. Card members that joined July through December would be in the 48-60 month buckets. So as you can see for all years, 2003 through 2007 have been impacted by the 2008 economy.

So if you follow the chart across first you have blue which was 2003. You can see the last two plot points increased. Orange is 2004 and the last two plot points increased. That is true for 2005 and 2006 as well. So the higher than normal last two plot points for 2006 and 2007 are due to the economy. All tenures are being impacted.

The recent vintages, even if we experience higher write-offs for two years, these investments still have very strong economic returns.

Now let’s go to Slide 21. We have shown this chart to you before and it shows that FICO scores have not deteriorated. We don’t use FICO scores to do our acquisitions, we use our proprietary models. But this is an indicator we have not dropped our credit quality over the past several years.

Let me now make a few summary comments. Despite the significant impact that the weakening U.S. economic environment has had on our credit performance and bottom line this quarter most of the key business metrics that serve as a long-term indicator of our competitive strength has performed well. We see that the overall billed business and cards in force growth rate where the gap between our performance and that of most major competitors demonstrate the effectiveness and ongoing benefit of our marketing and rewards investment over the past several years.

Once again we benefit from the strong performance within our international consumer, global commercial services and global network and merchant services segments. The performance of these parts of the franchise reflect the benefits of the diversity of our business activities and the balance they provide within our results.

Unfortunately the revenue growth from these relatively strong results was more than offset from credit deterioration within the U.S. The severe decline in home prices and the marked rise in oil prices have had a fundamental impact on consumer budgets and behavior not just as it relates to mortgages and home related spending but also across the full spectrum of the consumer economy.

We saw the first signs of weakness in our credit indicators at the end of last year and communicated this to you in January when we reported our fourth quarter results. At that time we took a credit related charge in order to recognize the deterioration by strengthening our lending and charge card reserve curve ratios and levels.

In the first quarter U.S. lending write off rates rose further and at that time we indicated the second quarter loan loss rate would be higher than the first quarter which has proven to be the case. In April and May U.S. lending write off rates were generally consistent with the 4-6% EPS growth plan that we discussed with you in early June. However, as I showed you on the slide passage we saw credit deteriorate in June beyond our expectations as the write off rates rose and roll rates within the portfolio deteriorated versus prior months.

In other words, more and more consumers who are falling behind on their payments are remaining delinquent. This causes us to assume that a greater percentage of past due loans will not be repaid. In light of the magnitude of the negative economic trends and our experience now we believe the economic weakness in the U.S. will likely worsen throughout the remainder of the year and negatively impact credit and business strategies.

Therefore it was appropriate for us to further strengthen our lending reserves and reduce the fair value of our IO strip. This quarter reserve addition results in a coverage ratio of 135% of past due owned loans which is substantially above the coverage levels over the last three years. We believe this elevated coverage is appropriate in light of the continuing economic uncertainty before us, the inherent risk in our portfolio and the higher write off levels we expect.

As we discussed at the beginning of June, our 4-6% EPS growth forecast assumed an economic environment consistent with what we experienced throughout the first five months of the year. We indicated then that if the economic environment weakened further achieving these results would be difficult. The environment has clearly weakened significantly since then.

Given the credit deterioration we experienced in June and the continued moderation in U.S. volume growth as well as our outlook for continued weakness in the economy we are no longer tracking to this forecast. In addition we now expect that our lending write off rate in the third and fourth quarter will be higher than June levels.

As we move forward we will continue to be guided by our long-term, on average, over time financial objectives. Since we set our target in 1993 we have generally performed consistent with those goals and in fact have outperformed them in recent years. The ultimate goal is to ensure that American Express navigates through these challenging conditions in the best position possible relative to our payment competitors and relative to the overall industry.

Growth opportunities continue to exist in the marketplace but over the coming quarters we will be even more selective with our investment dollars moving them to areas of current opportunity as we work to prudently balance near-term performance against long-term profitability and growth. Throughout this decade re-engineering has resulted in a well controlled operating expense base but in light of our desire to maximize our ability to invest in the business we are further intensifying our re-engineering efforts with an eye towards reducing cost structure and staffing levels.

While we have not yet quantified the impact of these activities they will likely result in restructuring charges during the second half of the year. The anti trust settlement we reached with Visa and MasterCard also provides us with multi-year source of funds that can help to lessen the impact of the environment and when conditions improve give us the ability to step up investments in the business.

Collectively we believe these factors will position us to maximize our ability to invest for the long-term. However, these investments coupled with the economic environment will challenge our ability to meet our financial targets until we see improvements in the economy. While we are obviously disappointed with the impact that the current economic turmoil is having on our results the position of the company today is financially sound and competitively strong.

We divested certain businesses such as our international bank and have grown others such as B2B in order to lower our overall risk profile. Our business model has generated particularly attractive returns that provide capital, flexibility and strength. Even with the substantial credit related charges during the quarter we generated in excess of $600 million of earnings.

We have shown our ability to adjust to the environment positions whether it be to implement defensive measures or take advantage of competitive opportunities. Our balance sheet is appropriately positioned. We have access to diversified sources of funding and our cash position and liquidity profile provide us additional protection in these volatile times.

Across all our businesses we will fill a strong focus on the customer, some where we need to stay close to regardless of the environment. Lastly our competitive position is stronger than it has been for decades. We will be impacted by the environment but given the products, customers, geographic breadth of our franchise we believe we are well positioned to execute against growth opportunities in a manner that continues to appropriately balance our short, medium and long-term business and financial goals.

Thanks for listening. We are now ready to take your questions.

Question-And-Answer Session

Operator

(Operator Instructions)Your first question comes from Meredith Whitney – Oppenheimer & Co.

Meredith Whitney – Oppenheimer & Co.

You talked about how all segments of the market were impacted from an economic standpoint. You talked about the investor day in January about how certain regions at the time were more impacted than others. Today could you talk about the derivative impact of line reductions? I know you had reduced lines in the high problem real estate areas, the high problem house price depreciation areas. I assume others did as well. What type of impact did that have on consumers? Was there any one catalyst aside from spending that you can attribute the real material increase in charge offs? I’m just looking for anything behavior related that can help us understand what the sudden change was.

Kenneth Chenault

I think clearly the reduction in line size impacts spending and that has a negative impact on spending. I think what we are certainly trying to do on a geographic basis is to be very, very targeted. What you don’t want to do in this situation is to apply a blunt instrument across the board because we have a number of relationships across tenures and across products that we want to preserve and grow. What we have been able to do is be very, very surgical against those customers that we believe based on our modeling have a higher risk. That is important both not only in setting up the models but making sure we have the right operational controls in place as far as our credit management is concerned.

Meredith Whitney – Oppenheimer & Co.

Is it too soon to tell when your competitors will cut lines to the same customers that you have? I’m really interested in those derivative impacts and the strain that multiple line reductions cause. What are your results in terms of higher defaults? Is it too soon to draw those conclusions yet?

Daniel Henry

I think we are continuing to learn as we go through this slow down. Every slow down is different and this has certainly been different than what we have seen in the past and we look to incorporate our learning as we make credit decisions. We continue to see the big significance in geographies where housing prices have fallen the greatest but recently we have actually started to see greater impact in customers who were in that middle cycle band, generally it is customers with low FICO’s where you see the greatest impact and we are certainly seeing it there. We are now seeing it creep into FICO scores of people between 650 and 750.

The other new thing we are seeing is historically if someone had multiple mortgages that was actually a positive factor but in recent months we are starting to see people with multiple mortgages are actually having greater difficulty.

Now to your point about what competitors are doing, we are keeping a close eye and if we identify customers that we have a significantly higher open to buy than our competitors that is another spot where we are seeing added risk and we are reacting to that. So we continue to integrate new lines into our decision but at the same time I want to emphasize we are also being very focused on our care programs. Some customers who are having temporary difficulties would be terrific long-term customers for the franchise and we want to make sure we acknowledge the credit actions we are taking to reduce near-term credit losses with the overall economics of the customer and a customer who could be of great value to us in the future.

Kenneth Chenault

This is one where we have got to be very, very comprehensive but we’ve got to be surgical and that is where we are really using our modeling and different techniques just to make sure we are focused on targeting those people we think are highest risk and those customers that we can project out and can manage better over the life cycle. We obviously want to continue to retain their business and loyalty.

Operator

Your next question comes from Christopher Brendler – Stifel Nicolaus & Co.

Christopher Brendler – Stifel Nicolaus & Co.

Can you talk at all about the raise in the charge card business? I was a little bit surprised you didn’t bill provisions there. Are you not seeing the same trends in the charge card business? Also if you could comment on roll rates, particularly late stage roll rates, in the month of July. Do you have any early read on July? Is it as bad as June?

Daniel Henry

In the charge card business a lot of the provisioning takes place when the account goes past due. So the people who actually wrote off in the second quarter went past due in the third quarter of last year and that is when the bulk of the provision was set up. We are actually seeing the percentage of customers going past due in the second quarter seasonally is always low but we also in the second quarter of 2008 are seeing the impact of lower spending as well as the impact of our credit adding. So because we don’t see the customers going past due in the second quarter we are not seeing a big pick up in the provision. Therefore provision for the charge cards increased only modestly only 3%. We are very comfortable with how we are handling charge card and where that provision is at this time.

In terms of roll rates you can see what we showed you on the charts and what took place in June. Before that when you combined what we were seeing in the current to 30 roll rates with what we were seeing in the 30 day to write off we were comfortable. But when both of them moved up in June which we hadn’t expected that caused us to be much more cautious about our outlook for the future in terms of evaluating the current risk in our portfolio to set up the reserves.

Christopher Brendler – Stifel Nicolaus & Co.

Any early read on July for those kinds of roll rates and also for spending?

Daniel Henry

Not at this time.

Christopher Brendler – Stifel Nicolaus & Co.

One final question on the lending provision or lending growth. You mentioned the lending put on and balance growth was due to lower volumes. Anything on the marketing side you have done to slow down the lending growth as well?

Daniel Henry

I think on the marketing side, marketing spend is obviously for acquisitions which wouldn’t have a quick near term impact on AR growth. It takes a little bit of time for customers to get their card and to spend and move into revolve. We still are marketing at a healthy level across the company. You can see that we spent about the same that we did last year although I will say we have shifted dollars to international and that is helping our spending levels there which are very good. To the extent we spend less on marketing in the U.S. that will have some impact in terms of growth in the U.S. in addition to what is taking place in the economy but we want to shift our investment dollars to the place that has the best current opportunity. We still have very good opportunities in the U.S. as well except we are doing those on a more surgical basis.

Kenneth Chenault

I think we have got to be and are being more targeted in the U.S. but I would just emphasize the overall opportunities we have in international and B2B, G&S provide very strong growth opportunities and I think it demonstrates the broadness and attractiveness of our business portfolio that we have areas in our business mix that in fact have a more conducive profile to some of the economic issues we are facing and we clearly are re-allocating some investments there. To Dan’s point we are being very targeted and surgical about the investments we are making in the U.S.

Operator

Your next question comes from Robert Napoli – Piper Jaffray.

Robert Napoli – Piper Jaffray

Ken a question on market position and strategy of American Express saying you are in a better position than you have been in the history of the company. One area that is clearly going to continue to gain market share not only in the U.S. but globally is the debit card product and I wondered if your thinking is, I know you have done 30-40 projects on debit cards over the years, you are just in a position where you are going to be relegated to a slower growth rate than the peers, the MasterCard and Visa that are large in those products globally.

Kenneth Chenault

Bob the way I’m going to answer that is I think one way you have to look at what the overall strategic objective is for us in payment. That is obviously to get a greater share of plastic spent against cash and checks. We have a variety of products to do that. As I said a number of times without direct access to a demand deposit account it makes it difficult for us to offer a debit card. However, when one looks at the economics of our charge card products and in fact some of our lending products, we believe that we can meet the functional pay in full spending needs of those customers and prospects through our variety of card products at frankly more attractive economics than we could get with debit.

The other key point where I think we are driving increased penetration is through our B2B products, corporate cards, our middle market products but also G&S. G&S allows us obviously with a very different risk profile and without having credit risk to go after that spending. So I think what you have got to look at is the range of products and what I would emphasize is that despite a very challenging economic environment from a market share standpoint the trends are encouraging relative to our growth overall in the U.S. and certainly when you then add international to that I think we have some very attractive growth prospects.

The point is the credit situation in the U.S. is disappointing but what I would emphasize is if you look at our top line metrics and I think what we have to understand is we are managing this company on average and over time to achieve some financial objectives that we think are ambitious. We have been able to do that historically. This is obviously a tough period right now in the U.S. but I am confident because of our market leading position and the way we have performed even this quarter from a metrics standpoint that the prospects for our card business in the future are in fact strong.

Obviously we need to see some improvements in the economic cycle in the U.S. but when I look at international, B2B and the opportunities in history of our business in the U.S. going through different cycles I do think we are at the strongest competitive position that we have been in a number of years. However, we are dealing in a very challenging economic environment in the U.S.

Robert Napoli – Piper Jaffray

On G&S, you have spending growth of 42% but revenue growth of 12% and higher provisions may be in that segment than we would expect over the last couple of quarters. I’m just wondering if the revenue growth and spending growth converge over time and why the provisions are as high as they are in that business.

Daniel Henry

The G&S growth at 42% is just a piece of that segment, the global network emerging services segment. That includes both G&S as well as our proprietary business that flowing through this segment. So I think that certainly the growth rate we have seen in G&S which has been absolutely terrific, I think any business to continue at 42% would be difficult but they have done a very nice job of continuing to grow at a very high rate.

The 12% you refer to is all of billed business proprietary and G&S.

Robert Napoli – Piper Jaffray

And the provisions?

Daniel Henry

So the provisions in G&S I think any time you have a slow down while there are much less impacted by credit losses there is reserves set up within the segment either related to small merchants who could potentially go out of business or large merchant reserves we set up that is required by FIN 45 and so in this quarter we actually saw an impact and we increased that reserve during the quarter primarily to reflect some of the difficulties we see in the airline industry.

Operator

Your next question comes from David Hochstim – Bear Stearns.

David Hochstim – Bear Stearns

Could you provide more color on the contrast between spend behavior and discretionary spending between U.S. charge card customers and how about on slide 20 how do the last few years of charge card customers compare in what you see in the U.S. lending and how does small business compare to that in terms of loss development?

Daniel Henry

We don’t provide a break out between charge card and lending products. What we provided you with was what is taking place on spending within the U.S. consumer segment which includes small business as well as consumer charge and lending products. I think as you can see from the charge small business growth in the quarter was 11% compared to 3% on the consumer side so small business is holding up better but on the consumer side we are seeing a greater impact and we are seeing it both on the charge card side and spending on our lending products. So we are seeing that across both those spectrums.

David Hochstim – Bear Stearns

So you are saying the consumer charge card spending has fallen off greater than consumer lending?

Daniel Henry

Consumer lending and charge card are being impacted by the economy and are both seeing the impact of the economy and some overspending by card members. Both card members who have lower FICO scores and card members who have high FICO scores both in card members who carry Blue Card and people who carry a Centurion card.

Kenneth Chenault

The reality David is that affluent people in fact in some cases are cutting back on discretionary spending. So they are not in the same situation as other segments but the reality is we are seeing very affluent people who have had historically very, very strong spending history with us cutting back on non-discretionary items. They are still very loyal to our product. They are still putting a good percentage of their spending on our products so we don’t believe we are losing share to other products based on our relative billings growth rate but we are seeing affluent customers change some of their spending behavior.

David Hochstim – Bear Stearns

Is the 2% year-over-year growth rate in billed business for USCF a run rate going into the third quarter do you think or do you think there is something funny going on in June and July like there was in March and April with Easter?

Daniel Henry

I don’t think there is an impact like Easter in the numbers. I think, as I mentioned there was a downward slope in the quarter and the average was 3% in the quarter but 2% in June so we’ll have to see whether that continues or not. We’ll have to see going forward before we know that.

David Hochstim – Bear Stearns

Could you just clarify the impact of the GE portfolio? Were there cards converted in the quarter? Was there billed business that you recognized from the GE acquisition? I think the other income you refer to is about $60 million of that $150 increase but I’m not sure if there was something else?

Daniel Henry

We’re very pleased with the progress we have made in terms of GE customers and contacts with them. Until we actually sign them and move them over onto our platform the revenues that we generate from them are included in other revenues and I was just commenting that on the 15% growth on that line about 600 basis points related to the GE acquisition.

David Hochstim – Bear Stearns

So you haven’t even converted GE employees to your card yet? So no billed business effect this quarter?

Kenneth Chenault

No. That is obviously as we said is going to occur over the next several months but up until this point no.

Operator

Your next question comes from Sanjay Sakhrani – Keefe, Bruyette & Woods.

Sanjay Sakhrani – Keefe, Bruyette & Woods

I’m just trying to get my arms around the trajectory of the lending charge off rate and U.S. billed business on a go forward basis. On the lending side you mentioned the third and fourth quarter rates will be above the June levels. How should we think about it related to seasoning versus cyclical? Will there be some abatement from the seasoning pressure at the end of the year? I know billed business, could you just talk about what caused such a pronounced slow down in May and June? Is it partly related to line reductions or largely related to line reductions? Finally, on lending reserves should we assume that coverage to delinquencies will remain as long as credit remains under pressure?

Daniel Henry

I’m not sure if that was one question or five questions. I think there is the seasoning that takes place really takes place about 12-36 in launch measure. So I don’t think in the near term we’re going to see any radical change in the seasoning impact because we have been fortunate in that we have been able to add significant new customers to the franchise which is what our intent is as we strive to drive spend and take share in the market place. Even today based on the investments we are making in the business we will continue to bring on card members. So I don’t think we’ll see seasoning impact have any quick change in the next 6-12 months.

We are having more of an impact of that seasoning on our business than our competitors are because they haven’t grown at the same rate that we have. In terms of billed business and the impact that we saw in May and June we think it is the impact of the economy. We looked across all products. We looked across all tenures. We looked across all FICO scores. As Ken was saying is people with very good FICO scores who have been long tenured customers are just being more cautious in this environment. So we are seeing a strong down in spend really across the board.

That is really what causes us to think that it is the economy plus I think you have seen from all of our competitors they have been impacted in the same manner in the second quarter.

Moving to your last question in terms of what we put up for reserves, reserves is set up as a combination of what we are seeing in write off rates, what we are seeing in roll rates, what we are also sensing is happening in the economy and certainly in June we saw unemployment jump dramatically, consumer confidence is down. So setting the reserve really contemplates all those things in assessing the inherent risks in the portfolio. So I think we will continue to keep what we consider to be an appropriate level of reserves as long as we continue to see slow down in the economy. If the economy were to get worse from here we’d see additions to reserves and when the economy improves we’ll take those reserves down in a prudent fashion.

Operator

Your next question comes from Brad Ball – Citigroup.

Brad Ball – Citigroup

A point of clarification on the chart on Page 20. Is that using the old method of computing the write off rate including interest and fees or is that the new method you are talking about excluding those?

Daniel Henry

I would think that is the old method including interest and fees.

Brad Ball – Citigroup

In terms of thinking about the magnitude of the impact you are experiencing relative to your industry peers, I think you just acknowledged that you are seeing a faster acceleration in lost dollar amount and loss rates relative to your much higher growth versus peers over the last couple of years, is that correct?

Daniel Henry

I wouldn’t call it acceleration Brad. I think we are being impacted the same way everybody is being impacted. Certainly if we decided to bring on fewer customers historically then loss rates in those areas would be lower. The way we view it is the life of the customer. So as we said we can bring on customers that have good economics over their life with us. We want to bring those customers onto the books. To the extent there is a slow down and to the extent we have more customers we are going to have higher write offs to provision in the short-term but our focus isn’t the short-term. Our focus is the medium to long-term and we think that those investments to bring in those customers are a good decision.

Kenneth Chenault

I think Brad what is important is and it is obviously understandable given the economic environment and credit situation if we were managing the business just for 2008 there would be a different set of strategies and tactics you would put in place. But I think what we have been able to demonstrate is as I look at our overall book of business I think we have best in class customers on our books and I believe that positions us very well from a multi-year standpoint. We take the current economic environment very seriously but what I would emphasize is we are balancing those risks against what we see as very strong opportunity from a multi-year basis.

As we look through history and we look at the last two down turns and that is why I have made this point that competitively I think we are far stronger and I think the quality of our customer base is very strong and as I said best in class. I think we are positioning ourselves so that we have multiple year growth with attractive economics going forward. I think that is the point. We could in fact limit the credit exposure by not growing at all and what I would submit is the economic trade offs we have made have been good trade offs over a multiple year period and that is really the philosophy we have used to manage our business.

Brad Ball – Citigroup

Just as a follow-up, roughly speaking if you look at your 2006 and 2007 vintage loan receivables what proportion of those are MR customers?

Daniel Henry

I would say a very high percentage of customers are either MR customers or on a product with our rewards.

Brad Ball – Citigroup

Like Starward or…

Kenneth Chenault

A rewards based product.

Brad Ball – Citigroup

Are we talking 90%, 100%?

Daniel Henry

I would say it is over 90% in volume.

Kenneth Chenault

I think Brad what is important is that the quality of accounts we have added in recent years is as strong as our traditional card members. So that is an important point I would emphasize. Clearly we have grown but we haven’t grown as a result of lowering the quality of our accounts. In fact the quality of our accounts is as strong as our traditional card members.

Operator

Your next question comes from [Inaudible].

[Unidentified Analyst]

I have just a question on how you model future credit losses and the degree of confidence in your modeling given just the changes we are seeing in consumer behavior and the fact that we are seeing, for example, a nationwide decline in home values and we don’t know what that means for consumer behavior. How confident are you in your modeling? Can you talk about how often you review it and the feedback mechanism and how often you would incorporate that into new assumptions?

Daniel Henry

We are using historical data to form our view of the future and we look at both the absolute level of performance today as well as the trends over the last several months. We look at what we are seeing in roll rates once things are in delinquency to assess what percentage will ultimately go to write off which helps inform us in terms of where our reserves should be.

What we assume is that roll rates we see today will worsen somewhat over the balance of the year and so I have high confidence in our ability to model what will happen assuming that is exactly what happens; it is slightly worse. Now if next month or over the next few months things get significantly worse then we will build that into the model but it will cause write-offs to be higher in the balance of the year.

Quite frankly the inverse is true. If customer behavior improves then it will be better. So we use all the information at our disposal and we look at not only what is happening in write offs and roll rates but what is happening in spend to help form our view of what is going to happen in the balance of the year. So I feel good about our ability to forecast the next six months. Once you get beyond that it becomes a lot more difficult.

Kenneth Chenault

I would just really cover this one example which you used which is multiple mortgages. That is just an example of where we have been able to incorporate a change from what we saw historically and the reality is we are looking at a whole set of drivers where we have a constant feedback loop to understand what is the change in causing the credit performance. That is something we are very, very focused on and it really is a constant feedback loop that we have and we have demonstrated we can act on that I think very, very quickly and feed that into our overall system.

Operator

Your next question comes from Mike Taiano – Sandler O’Neill & Partners L.P.

Mike Taiano – Sandler O’Neill & Partners L.P.

Just looking at your slides, Page 18 on roll rates. The dip in May in both the top and bottom is it fair to assume maybe some of that was attributable to the tax rebate checks?

Daniel Henry

Hard to say definitively. That certainly could have an impact. I would say sometimes there is movement month to month and we try not to react too dramatically just to one week’s information or one month’s information because as you can see from these charts it can bounce back. May could have been impacted by the rebate checks. It is hard to assess. Our look was that it looked like at least for 30 day past due to write off May seems to be something of an aberration compared to the trend.

Kenneth Chenault

I would just say the tax rebates that is Dan’s point is we really don’t have any evidence in credit or spending that we are seeing an impact and if you look at the overall profile of our customer base my own personal view would be I don’t think there is much impact. I can’t say that for certain but when I look at the profile of our customer base I don’t think that would have much of an impact.

Mike Taiano – Sandler O’Neill & Partners L.P.

On your comments on the multiple mortgages attribute. Could you maybe clarify why would that have been a positive effect and how quickly have you made that change to the underwriting model?

Daniel Henry

The comment is just based on historical performance. Historically folks that had multiple mortgages appeared to be people who had the capacity to handle those mortgages, continue to be financially balanced and continue to spend and make payments on our product. That is just a historical fact. What we have started to see is that in this environment probably heavily impacted by the drop in housing prices that the inverse is starting to happen. As a group people who have multiple mortgages are starting to perform less well than folks who do not have multiple mortgages. As we started to see that and we started to build that into our credit decision so that our models are as up to date as possible to help us make the best decision.

Kenneth Chenault

I think on the multiple mortgage issue the reality is an example you had a historically highly credit worthy customer who had very good credit scores. The issue is for a multiple mortgage if they had a sharp valuation decline some of them are caught in the middle and so you wouldn’t see that up front in modeling that someone’s credit score was different. This was a group that I would say intuitively would stand to reason that in a range of environments, highly credit worthy, they have multiple mortgages and then they had a price decline on one or two of those properties and that is going to have an impact. By any modeling you have done they looked like and acted and performed and paid as very good customers. That is why I point to the example but I think the logic of it, which was born out by their performance over multi-year periods was that these were very highly creditworthy people who in fact performed well.

Mike Taiano – Sandler O’Neill & Partners L.P.

Have you seen a more pronounced area of change in the areas most affected by the home price depreciation? California? Florida?

Daniel Henry

Absolutely, that was true in the first quarter and continues to be true this quarter.

Operator

Your next question comes from Eric Wasserstrom – UBS.

Eric Wasserstrom – UBS

Just to get back to the roll rate analysis, the roll rate obviously is an important tool in determining the number of current people going bad that will ultimately go through default. Do you have a view about incremental incidents of loss which won’t be reflected there?

Daniel Henry

This is historical data so the question is how many people who are current today will ultimately go past due and we will ultimately write off. We use the historical data we have and as I said we increased above the current level to reflect our view of the economy but having that is going to worsen or improve I think would be very much driven by the economy we see in the U.S.

Eric Wasserstrom – UBS

I’m trying to determine whether there is an expectation I think it will or will not get worse and whether that is baked into this future loss expectation?

Daniel Henry

Our reserve anticipates higher write-offs in the third and fourth quarter and anticipates the roll rates will get somewhat worse.

Eric Wasserstrom – UBS

If I can just ask a follow-up on slide 20. Do you have any commentary on the slope of the recent vintages and how much that differential versus some older vintages relate to a seasoning issue versus changes in underwriting?

Daniel Henry

That is clearly a key question and I think the reason we included these multiple years is that from the very early origination years of 2001 and 2002 you can see the normal seasoning take place. But as you can see it is having an impact on the 2003, 2004, 2005 vintages which are very strong vintages so it causes us to conclude the impact we are seeing in 2007 and 2006 is being driven by the economy as opposed to that group was less credit worthy than the groups in the earlier years.

Eric Wasserstrom – UBS

I’m having difficulty reconciling that with the severity of the slope on the 2006 and 2007. It would seem to suggest that they are following the same pattern but seem to be more fully loaded curves.

Daniel Henry

I think the folks in the 12-36 months are probably the most vulnerable group because they are in the height of the curve and the height of the curve is where you are going to have the greatest impact. That is the most logical assumption to me. I think you are seeing some of the other curves here move up by 100 basis points on each plot point. I think you have to look at all the data you have available. If you look at slide 21 here clearly you can see that using FICO scores as an indicator we not only didn’t drop FICO scores but we actually increased in customers just looking at FICO scores.

I think the plot points you are seeing for 2006 is reflecting the fact they are at the height of the curve and therefore are being more impacted but we still think we have a large group of customers within that origination year who will be terrific customers long-term.

Kenneth Chenault

The other point again is we keep on emphasizing is we don’t use FICO scores from a modeling standpoint but to categorize where we have come out we have given this example and the blue card portfolio which is the largest 12% in 2001 were 750 and above FICO scores. At the end of 2006 46% were 750 or above. It just goes back to a quality of customer that we have been bringing in. Obviously there is an impact from a seasoning standpoint and an impact on the economic environment overall but I do not believe it is an issue that we have lowered the criteria to add more customers.

Daniel Henry

I must add that a point I’d make that when you look at the earlier terms for customers who came in 2001-2004, they were going through that difficult seasoning period when the economy was very strong and so naturally you would expect them to be lower than the curves.

Operator

Your next question comes from Moshe Orenbuch – Credit Suisse.

Moshe Orenbuch – Credit Suisse

Dan given your comment the reserves are anticipated, any deterioration in losses, I noticed you and you expressed them as a potential for delinquencies and your ratio of charge offs to delinquencies doubled over the last year. It went from 135-137% up to 175% and if you look at the global owned charge offs they are running in the second quarter 30% at an annual rate ahead of reserve and you are saying you expect it to go up so I wanted to understand how anticipatory that is and what we should expect for the reserve if charge off’s increase in the third and fourth quarters?

Daniel Henry

Usually we show old and managed statistics. Generally we look more often to the managed specifics where I think about the health of the overall franchise. Over the last three years when the economy was strong coverage ratio in delinquencies has been in the 95-100% range. We have taken them up to 135% on a loan basis and 144% on a managed basis which are, I think at the levels we had when we were back in the last slowdown. We actually feel very comfortable that we have an appropriate level of reserves based on what we’ve seen to date and anticipate it will be somewhat worse going forward.

Moshe Orenbuch – Credit Suisse

How many months in charge off’s do you expect to keep in reserve?

Daniel Henry

We don’t use loans coverage of write off. It is one of the statistics we obviously look at. So currently we would have over 12 months of write off coverage in our book and even assuming that write-offs increase the way that our models say even after that if you looked out to December we would have over [inaudible] coverage.

Moshe Orenbuch – Credit Suisse

I’m having trouble with that since the current annualized charge off rate is in excess of the reserve in both loans and a managed basis.

Daniel Henry

I’m not sure exactly what the rate you are referring to?

Moshe Orenbuch – Credit Suisse

There is $827 million in write-offs on the owned worldwide portfolio and $2.6 million in reserves. So $800 x 4 is $3.2 million or $3.3 million.

Daniel Henry

I think for the two months comped, right, first I recommend we do it on a managed basis and we have to go back and that number is for one month of the quarter so you actually have to track back over the last three quarters.

Moshe Orenbuch – Credit Suisse

So you are saying it is historical not a prospect?

Daniel Henry

Yes it is historical.

Operator

Your last question comes from Scott Valentin – Friedman, Billings, Ramsey & Co.

Scott Valentin – Friedman, Billings, Ramsey & Co.

Historically you had it get out that a few everyday spend categories is slow but modest pressure on the discount rate. I was wondering given the comments of moving away from discretionary and moving towards non-discretionary spend if you expect the discount pressure to accelerate?

Daniel Henry

I think without any pricing actions on our part based on the growth and every day spend we would expect the discount rate to drop by 2-3 basis points a year. However, we have been very successful with certain categories to go back to that and demonstrate the value that we bring to them and actually have been able to increase price. As a result of that, last year I think we stayed pretty flat. This year we have seen a very modest reduction in discount rate. So we will continue I think to see growth in every day spend pressure on the discount rate but I think we will also continue to look at whether it is appropriate based on the value we bring to increase certain categories.

Kenneth Chenault

I would also say that given some of the reward programs and marketing programs that we have created the reality is there are a number of merchants in a range of categories who want to build business up. The point is while we have seen decline since I have talked about at some of our more affluent customers, their loyalty to the product and their use of the product has continued. So I think that was is incumbent upon us and we have been successful at this the last several years is to continue to increase the value that we can provide merchants and to use what is clearly a very challenging economic time to reinforce our value and bring more business to merchants.

So while no one likes being in this situation I think it is an opportunity for us to continue to demonstrate the value we are providing merchants and to have that card member assistance and loyalty which I think is still continuing despite the fact that people are lowering their level of spending. When they are spending we want them obviously using our product and services.

We want to thank everyone for joining the call this afternoon. As usual we will be available for follow-up questions a portion of this evening and certainly tomorrow and over the coming days. Once again thanks very much for joining us and we look forward to talk with you.

The one point I would make is there is an analyst meeting coming up in early August and I think as we indicated in the invite there will be further discussion by Al Kelly and Ed Gilligan around our business and trends and the like and look forward to seeing many of you there as well.

Thanks very much.

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