HSBC FinCorp Restated10Q/1 04

HSBC Holdings PLC 31 March 2005 -------------------------------------------------------------------------------- UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 --------------------- FORM 10-Q/A --------------------- (Mark One) (X) QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2004 OR ( ) TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from ________ to________ COMMISSION FILE NUMBER 1-8198 --------------------- HSBC FINANCE CORPORATION (FORMERLY KNOWN AS HOUSEHOLD INTERNATIONAL, INC.) (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER) DELAWARE 86-1052062 (STATE OF INCORPORATION) (I.R.S. EMPLOYER IDENTIFICATION NO.) 2700 SANDERS ROAD, PROSPECT HEIGHTS, ILLINOIS 60070 (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE) (847) 564-5000 REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE --------------------- Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes (X) No ( ) Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes ( ) No (X) At April 30, 2004, there were 50 shares of the registrant's common stock outstanding, all of which were indirectly owned by HSBC Holdings plc. THE REGISTRANT MEETS THE CONDITIONS SET FORTH IN GENERAL INSTRUCTION H(1)(A) AND (B) OF FORM 10-Q AND IS THEREFORE FILING THIS FORM 10-Q WITH THE REDUCED DISCLOSURE FORMAT. -------------------------------------------------------------------------------- HOUSEHOLD INTERNATIONAL, INC. FORM 10-Q/A TABLE OF CONTENTS PART I. FINANCIAL INFORMATION ----------------------------------------------------------------------------------- Item 1. Consolidated Financial Statements Statement of Income......................................... 4 Balance Sheet............................................... 5 Statement of Changes in Shareholder's(s') Equity............ 6 Statement of Cash Flows..................................... 7 Notes to Consolidated Financial Statements.................. 8 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations Financial Highlights........................................ 18 Restatement................................................. 20 Executive Overview.......................................... 21 Basis of Reporting.......................................... 23 Operations Summary.......................................... 29 Receivables Review.......................................... 31 Results of Operations....................................... 32 Segment Results - Managed Basis............................. 37 Credit Quality.............................................. 40 Liquidity and Capital Resources............................. 45 Reconciliations to GAAP Financial Measures.................. 49 Item 4. Controls and Procedures..................................... 53 PART II. OTHER INFORMATION ----------------------------------------------------------------------------------- Item 1. Legal Proceedings........................................... 53 Item 6. Exhibits and Reports on Form 8-K............................ 56 Signature.................................................................... 57 2 EXPLANATORY NOTE HSBC Finance Corporation (formerly known as Household International, Inc.) is filing this amended Quarterly Report on Form 10-Q/A to reflect the restatement of its unaudited consolidated financial statements for the periods covered by this report. Please see Note 2 to the Consolidated Financial Statements and the "Restatement" section included in Item 2, Management's Discussion and Analysis of Financial Condition and Results of Operations below for a detailed discussion of the restatement. As more fully described therein, we have restated all reported periods since our acquisition by HSBC Holdings plc on March 28, 2003 to eliminate hedge accounting on all hedging relationships outstanding on that date and certain fair value swaps entered into after that date. This restatement is solely the result of the failure to satisfy certain technical requirements of Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities." This amended Quarterly Report on Form 10-Q/A restates the Quarterly Report on Form 10-Q for the quarter ended March 31, 2004. We have not modified or updated the disclosures in the original Quarterly Report on Form 10-Q except as required to give effect to the restatement. As a result, this amended Quarterly Report on Form 10-Q/A contains forward-looking information that has not been updated for events subsequent to the date of the original filing, and all information contained in this amended Quarterly Report on Form 10-Q/A and the original Quarterly Report on Form 10-Q is subject to updating and supplementing as provided in the periodic reports that we have filed and will file with the Securities and Exchange Commission after the original filing date of the Quarterly Report on Form 10-Q. 3 PART I. FINANCIAL INFORMATION -------------------------------------------------------------------------------- ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS Household International, Inc. -------------------------------------------------------------------------------- CONSOLIDATED STATEMENT OF INCOME THREE MONTHS MARCH 29 JANUARY 1 ENDED THROUGH THROUGH MARCH 31, MARCH 31, MARCH 28, 2004 2003 2003 ------------------------------------------------------------------------------------------------------ (SUCCESSOR) (SUCCESSOR) (PREDECESSOR) (RESTATED) (RESTATED) (IN MILLIONS) Finance and other interest income......................... $2,528 $ 75 $2,469 Interest expense.......................................... 708 19 897 ------ ---- ------ NET INTEREST INCOME....................................... 1,820 56 1,572 Provision for credit losses............................... 928 34 976 ------ ---- ------ NET INTEREST INCOME AFTER PROVISION FOR CREDIT LOSSES..... 892 22 596 ------ ---- ------ Other revenues: Securitization revenue.................................. 348 9 434 Insurance revenue....................................... 211 6 171 Investment income....................................... 41 1 80 Derivative income....................................... 52 215 2 Fee income.............................................. 265 9 280 Taxpayer financial services income...................... 206 - 181 Other income............................................ 100 5 64 ------ ---- ------ TOTAL OTHER REVENUES...................................... 1,223 245 1,212 ------ ---- ------ Costs and expenses: Salaries and employee benefits.......................... 485 18 491 Sales incentives........................................ 78 2 37 Occupancy and equipment expenses........................ 83 3 98 Other marketing expenses................................ 132 4 139 Other servicing and administrative expenses............. 226 9 314 Support services from HSBC affiliates................... 177 - - Amortization of intangibles............................. 116 2 12 Policyholders' benefits................................. 113 3 91 HSBC acquisition related costs incurred by Household.... - - 198 ------ ---- ------ TOTAL COSTS AND EXPENSES.................................. 1,410 41 1,380 ------ ---- ------ Income before income tax expense.......................... 705 226 428 Income tax expense........................................ 235 82 182 ------ ---- ------ NET INCOME................................................ $ 470 $144 $ 246 ====== ==== ====== The accompanying notes are an integral part of the consolidated financial statements. 4 Household International, Inc. -------------------------------------------------------------------------------- CONSOLIDATED BALANCE SHEET MARCH 31, DECEMBER 31, 2004 2003 ---------------------------------------------------------------------------------------------- (SUCCESSOR) (RESTATED) (SUCCESSOR) (IN MILLIONS, EXCEPT SHARE DATA) ASSETS Cash........................................................ $ 199 $ 463 Securities.................................................. 6,737 11,073 Receivables, net............................................ 92,034 91,027 Intangible assets, net...................................... 2,749 2,856 Goodwill.................................................... 6,853 6,697 Properties and equipment, net............................... 505 527 Real estate owned........................................... 656 631 Derivative financial assets................................. 3,152 3,016 Other assets................................................ 2,950 2,762 -------- -------- TOTAL ASSETS................................................ $115,835 $119,052 ======== ======== LIABILITIES Debt: Deposits.................................................. $ 91 $ 232 Commercial paper, bank and other borrowings............... 9,103 9,122 Due to affiliates......................................... 5,436 7,589 Long term debt (with original maturities over one year)... 77,754 79,632 -------- -------- Total debt.................................................. 92,384 96,575 Insurance policy and claim reserves......................... 1,264 1,258 Derivative related liabilities.............................. 500 597 Other liabilities........................................... 3,678 3,131 -------- -------- TOTAL LIABILITIES......................................... 97,826 101,561 SHAREHOLDER'S EQUITY Preferred stock held by HSBC................................ 1,100 1,100 Common shareholder's equity: Common stock, $0.01 par value, 100 shares authorized, 50 shares issued...................................... - - Additional paid-in capital............................. 14,640 14,645 Retained earnings...................................... 1,755 1,303 Accumulated other comprehensive income................. 514 443 -------- -------- TOTAL COMMON SHAREHOLDER'S EQUITY........................... 16,909 16,391 -------- -------- TOTAL LIABILITIES AND SHAREHOLDER'S EQUITY.................. $115,835 $119,052 ======== ======== The accompanying notes are an integral part of the consolidated financial statements. 5 Household International, Inc. -------------------------------------------------------------------------------- CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDER'S(S') EQUITY THREE MONTHS MARCH 29 JANUARY 1 ENDED THROUGH THROUGH MARCH 31, MARCH 31, MARCH 28, 2004 2003 2003 -------------------------------------------------------------------------------------------------------- (SUCCESSOR) (SUCCESSOR) (PREDECESSOR) (RESTATED) (RESTATED) (IN MILLIONS) PREFERRED STOCK Balance at beginning of period............................ $ 1,100 $ 1,100 $ 1,193 Reclassification of preferred stock issuance costs........ - - 21 Redemption of preferred stock............................. - - (114) ------- ------- ------- Balance at end of period.................................. $ 1,100 $ 1,100 $ 1,100 ======= ======= ======= COMMON SHAREHOLDER'S(S') EQUITY COMMON STOCK Balance at beginning of period.......................... $ - $ - $ 552 Effect of push-down accounting of HSBC's purchase price on net assets......................................... - - (552) ------- ------- ------- Balance at end of period................................ $ - $ - $ - ------- ------- ------- ADDITIONAL PAID-IN CAPITAL Balance at beginning of period.......................... $14,645 $14,661 $ 1,911 Return of capital to HSBC............................... (11) - - Employee benefit plans and other........................ 6 - 10 Reclassification of preferred stock issuance costs...... - - (21) Effect of push-down accounting of HSBC's purchase price on net assets......................................... - - 12,761 ------- ------- ------- Balance at end of period................................ $14,640 $14,661 $14,661 ------- ------- ------- RETAINED EARNINGS Balance at beginning of period.......................... $ 1,303 $ - $ 9,885 Net income.............................................. 470 144 246 Dividends: Preferred at stated rates............................. (18) - (22) Common, $.8694 per share.............................. - - (412) Effect of push-down accounting of HSBC's purchase price on net assets......................................... - - (9,697) ------- ------- ------- Balance at end of period................................ $ 1,755 $ 144 $ - ------- ------- ------- ACCUMULATED OTHER COMPREHENSIVE INCOME Balance at beginning of period.......................... $ 443 $ - $ (695) Net change in unrealized gains (losses) on: Derivatives classified as cash flow hedges.......... (17) 2 101 Securities available for sale and interest-only strip receivables................................. 49 7 (25) Minimum pension liability............................. - 4 - Foreign currency translation adjustments.............. 39 - (24) ------- ------- ------- Other comprehensive income, net of tax................ 71 13 52 Effect of push-down accounting of HSBC's purchase price on net assets......................................... - - 643 ------- ------- ------- Balance at end of period................................ $ 514 $ 13 $ - ------- ------- ------- COMMON STOCK IN TREASURY Balance at beginning of period.......................... $ - $ - $(2,431) Exercise of stock options............................... - - 12 Issuance of common stock for employee benefit plans..... - - 12 Purchase of treasury stock.............................. - - (164) Effect of push-down accounting of HSBC's purchase price on net assets......................................... - - 2,571 ------- ------- ------- Balance at end of period................................ - - - ------- ------- ------- TOTAL COMMON SHAREHOLDER'S(S') EQUITY....................... $16,909 $14,818 $14,661 ------- ------- ------- COMPREHENSIVE INCOME Net income................................................ $ 470 $ 144 $ 246 Other comprehensive income................................ 71 13 52 ------- ------- ------- COMPREHENSIVE INCOME........................................ $ 541 $ 157 $ 298 ======= ======= ======= The accompanying notes are an integral part of the consolidated financial statements. 6 Household International, Inc. -------------------------------------------------------------------------------- CONSOLIDATED STATEMENT OF CASH FLOWS THREE MONTHS MARCH 29 JANUARY 1 ENDED THROUGH THROUGH MARCH 31, MARCH 31, MARCH 28, 2004 2003 2003 -------------------------------------------------------------------------------------------------------- (SUCCESSOR) (SUCCESSOR) (PREDECESSOR) (RESTATED) (RESTATED) (IN MILLIONS) CASH FLOWS FROM OPERATING ACTIVITIES Net income.................................................. $ 470 $ 144 $ 246 Adjustments to reconcile net income to net cash provided by (used in) operating activities: Provision for credit losses............................... 928 34 976 Insurance policy and claim reserves....................... (36) 3 47 Depreciation and amortization............................. 145 4 53 Net change in interest-only strip receivables............. 112 5 30 Net change in other assets................................ (162) - (593) Net change in other liabilities........................... 350 26 616 Other, net................................................ 93 (257) 84 ---------- ------- --------- Net cash provided by (used in) operating activities......... 1,900 (41) 1,459 ---------- ------- --------- CASH FLOWS FROM INVESTING ACTIVITIES Securities: Purchased................................................. (608) - (1,047) Matured................................................... 572 8 584 Sold...................................................... 59 - 768 Net change in short-term securities available for sale...... 4,387 546 (375) Receivables: Originations, net of collections.......................... (10,927) (382) (8,255) Purchases and related premiums............................ (33) (117) (129) Initial and fill-up securitizations....................... 7,942 (154) 7,300 Sales to affiliates....................................... 856 - - Properties and equipment: Purchases................................................. (12) - (21) Sales..................................................... 1 - - ---------- ------- --------- Net cash provided by (used in) investing activities......... 2,237 (99) (1,175) ---------- ------- --------- CASH FLOWS FROM FINANCING ACTIVITIES Debt: Net change in short-term debt and deposits................ (54) 17 (514) Net change in time certificates........................... (133) - 150 Net change in due to affiliates........................... (2,247) - - Long term debt issued..................................... 929 - 4,361 Long term debt retired.................................... (2,861) (54) (4,030) Insurance: Policyholders' benefits paid.............................. (31) (1) (36) Cash received from policyholders.......................... 29 3 33 Shareholders' dividends..................................... - - (141) Redemption of preferred stock............................... - - (114) Purchase of treasury stock.................................. - - (164) Issuance of common stock for employee benefit plans......... - - 62 ---------- ------- --------- Net cash provided by (used in) financing activities......... (4,368) (35) (393) ---------- ------- --------- Effect of exchange rate changes on cash..................... (33) 4 (15) ---------- ------- --------- Net change in cash.......................................... (264) (171) (124) Cash at beginning of period................................. 463 674 798 ---------- ------- --------- CASH AT END OF PERIOD....................................... $ 199 $ 503 $ 674 ========== ======= ========= SUPPLEMENTAL CASH FLOW INFORMATION: Interest paid............................................... $ 780 $ 71 $ 897 Income taxes paid........................................... 120 - 40 ---------- ------- --------- SUPPLEMENTAL NONCASH FINANCING AND CAPITAL ACTIVITIES: Push-down of purchase price by HSBC......................... $ - $ - $ 14,661 Exchange of preferred stock for preferred stock issued to HSBC...................................................... - - 1,100 ========== ======= ========= The accompanying notes are an integral part of the consolidated financial statements. 7 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. ORGANIZATION AND BASIS OF PRESENTATION -------------------------------------------------------------------------------- The accompanying unaudited interim consolidated financial statements of Household International, Inc. and its subsidiaries (collectively, "Household") have been prepared in accordance with accounting principles generally accepted in the United States of America ("U.S. GAAP") for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all normal and recurring adjustments considered necessary for a fair presentation of financial position, results of operations and cash flows for the interim periods have been made. Household may also be referred to in this Form 10-Q/A as "we," "us" or "our." These unaudited interim consolidated financial statements should be read in conjunction with the 2003 financial information included in our Annual Report on Form 10-K for the year ended December 31, 2004 (the "2004 Form 10-K"). Household International, Inc. is an indirect wholly owned subsidiary of HSBC Holdings plc ("HSBC"). Household was acquired by HSBC on March 28, 2003 in a purchase business combination recorded under the "push-down" method of accounting, which resulted in a new basis of accounting for the "successor" period beginning March 29, 2003. Information relating to all "predecessor" periods prior to the acquisition is presented using our historical basis of accounting, which impacts comparability to our successor period. The preparation of financial statements in conformity with U.S. GAAP requires the use of estimates and assumptions that affect reported amounts and disclosures. Actual results could differ from those estimates. Interim results should not be considered indicative of results in future periods. Interim financial statement disclosures required by U.S. GAAP regarding segments are included in the Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") section of this Form 10-Q/A. Certain reclassifications have been made to prior period amounts to conform to the current period presentation. Immaterial adjustments have been made to decrease finance income and increase securitization revenue as reported in prior periods. These adjustments reflect corrections after discovery of a system programming error in the posting of finance income between owned receivables and receivables serviced with limited recourse. Reported net income for all prior periods was not affected by these adjustments. 2. RESTATEMENT -------------------------------------------------------------------------------- We have restated our consolidated financial statements for the previously reported period March 29, 2003 through December 31, 2003, and the previously reported quarterly period ended March 31, 2004. This amended Quarterly Report on Form 10-Q/A and the exhibits included herewith include all adjustments relating to the restatement for the periods covered by this report. During the fourth quarter of 2004, as part of our preparation for the implementation of International Financial Reporting Standards ("IFRS") by HSBC from January 1, 2005, we undertook a review of our hedging activities to confirm conformity with the accounting requirements of IFRS, which differ in several respects from the hedge accounting requirements under U.S. GAAP as set out in Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities," ("SFAS 133"). As a result of this review, management determined that there were some deficiencies in the documentation required to support hedge accounting under U.S. GAAP. These documentation deficiencies arose following our acquisition by HSBC. As a consequence of the acquisition, pre-existing hedging relationships, including hedging relationships that had previously qualified under the "shortcut" method of accounting pursuant to SFAS 133, were required to be reestablished. At that time there was some debate in the accounting profession regarding the detailed technical requirements resulting from a business combination. We consulted with our independent accountants, KPMG LLP, in reaching a 8 determination of what was required in order to comply with SFAS 133. Following this, we took the actions we believed were necessary to maintain hedge accounting for all of our historical hedging relationships in our consolidated financial statements for the period ended December 31, 2003 and those consolidated financial statements received an unqualified audit opinion. Management, having determined during the fourth quarter of 2004 that there were certain documentation deficiencies, engaged independent expert consultants to advise on the continuing effectiveness of the identified hedging relationships. As a result of this assessment, we concluded that a substantial number of our hedges met the correlation effectiveness requirements of SFAS 133 throughout the period following our acquisition by HSBC. However, we also determined in conjunction with KPMG LLP that, although a substantial number of the impacted hedges satisfied the correlation effectiveness requirement of SFAS 133, there were technical deficiencies in the documentation that could not be corrected retroactively or disregarded notwithstanding the proven effectiveness of the hedging relationships in place and, consequently, that the requirements of SFAS 133 were not met and that hedge accounting was not appropriate during the period these documentation deficiencies existed. We have therefore determined that we should restate all the reported periods since our acquisition by HSBC to eliminate hedge accounting on all hedging relationships outstanding at March 29, 2003 and certain fair value swaps entered into after that date. This was accomplished primarily by reclassifying the mark to market of the changes in fair market value of the affected derivative financial instruments previously classified in either debt or other comprehensive income into current period earnings. The period to period changes in the fair value of these derivative financial instruments have been recognized as either an increase or decrease in our current period earnings through derivative income. As part of the restatement process, we have reclassified all previous hedging results reflected in interest expense associated with the affected derivative financial instruments to derivative income. Our independent registered public accounting firm has reviewed the March 31, 2004 financial results and has provided us a review report under Statement on Auditing Standards No. 100, which review report is attached to this amended Quarterly Report on Form 10-Q/A as Exhibit 99.2. The restatement effect on our pre-tax income and net income for the periods March 29, 2003 through March 31, 2003 and the quarter ended March 31, 2004 are summarized below: RESTATEMENTS TO REPORTED INCOME ---------------------------------------------- % CHANGE PRE-TAX TAX EFFECT AFTER-TAX TO REPORTED ------- ---------- --------- ----------- ----------------------------------------------------------------------------------------------------- (DOLLARS IN MILLIONS) March 29, 2003 through March 31, 2003................ $212 $(77) $135 100+% Quarter ended March 31, 2004......................... (17) 6 (11) (2.3) A detailed summary of the impact of the restatement on our consolidated statement of income and on our consolidated balance sheet is as follows: QUARTER ENDED MARCH 29, 2003 THROUGH MARCH 31, 2004 MARCH 31, 2003 --------------------------- --------------------------- AS PREVIOUSLY AS PREVIOUSLY AS REPORTED AS RESTATED REPORTED RESTATED ------------- ----------- ------------- ----------- --------------------------------------------------------------------------------------------------------- (IN MILLIONS) Consolidated Statement of Income: Net interest income......................... $1,891* $1,820 $60* $ 56 Other revenues.............................. 1,169* 1,223 29* 245 Income before income tax expense............ 722 705 14 226 Income tax expense.......................... 241 235 5 82 Net income.................................. 481 470 9 144 9 AT MARCH 31, 2004 AT DECEMBER 31, 2003 --------------------------- --------------------------- AS PREVIOUSLY AS PREVIOUSLY REPORTED AS RESTATED REPORTED AS RESTATED ------------- ----------- ------------- ----------- --------------------------------------------------------------------------------------------------------- (IN MILLIONS) Consolidated Balance Sheet: Derivative financial assets................. $ 3,190 $ 3,152 $ 3,118 $ 3,016 Long-term debt.............................. 77,564 77,754 79,464 79,632 Derivative related liabilities.............. 509 500 600 597 Other liabilities........................... 3,757 3,678 3,228 3,131 Common shareholder's equity................. 17,049 16,909 16,561 16,391 --------------- * Certain reclassifications have been made to prior period amounts to conform to the current year presentation. The resulting accounting does not reflect the economic reality of our hedging activity and has no impact on the timing or amount of operating cash flows or cash flows under any debt or derivative contract. It does not affect our ability to make required payments on our outstanding debt obligations. Furthermore, our economic risk management strategies have not required amendment. 3. SECURITIES -------------------------------------------------------------------------------- Securities consisted of the following available-for-sale investments: MARCH 31, 2004 DECEMBER 31, 2003 -------------------- --------------------- AMORTIZED FAIR AMORTIZED FAIR COST VALUE COST VALUE ------------------------------------------------------------------------------------------------- (IN MILLIONS) Corporate debt securities.......................... $ 2,362 $ 2,422 $ 5,641 $ 5,652 Money market funds................................. 924 924 794 794 Time deposits...................................... 326 326 952 952 U.S. government and federal agency debt securities....................................... 1,826 1,827 2,430 2,428 Marketable equity securities....................... - - 14 18 Non-government mortgage backed securities.......... 317 320 389 389 Other.............................................. 862 872 794 796 -------- -------- --------- --------- Subtotal........................................... 6,617 6,691 11,014 11,029 Accrued investment income.......................... 46 46 44 44 -------- -------- --------- --------- Total securities available for sale................ $ 6,663 $ 6,737 $ 11,058 $ 11,073 ======== ======== ========= ========= 10 4. RECEIVABLES -------------------------------------------------------------------------------- Receivables consisted of the following: MARCH 31, DECEMBER 31, 2004 2003 -------------------------------------------------------------------------------------- (IN MILLIONS) Real estate secured......................................... $ 52,440 $ 51,221 Auto finance................................................ 4,936 4,138 MasterCard(1)/Visa(1)....................................... 10,788 11,182 Private label............................................... 11,759 12,604 Personal non-credit card.................................... 13,343 12,832 Commercial and other........................................ 384 401 -------- -------- Total owned receivables..................................... 93,650 92,378 Purchase accounting fair value adjustments.................. 366 419 Accrued finance charges..................................... 1,363 1,432 Credit loss reserve for owned receivables................... (3,753) (3,793) Unearned credit insurance premiums and claims reserves...... (689) (703) Interest-only strip receivables............................. 944 1,036 Amounts due and deferred from receivable sales.............. 153 258 -------- -------- Total owned receivables, net................................ 92,034 91,027 Receivables serviced with limited recourse.................. 24,357 26,201 -------- -------- Total managed receivables, net.............................. $116,391 $117,228 ======== ======== --------------- (1) MasterCard is a registered trademark of MasterCard International, Incorporated and Visa is a registered trademark of VISA USA, Inc. Purchase accounting fair value adjustments represent adjustments which have been "pushed down" to record our receivables at fair value at the date of acquisition by HSBC. Interest-only strip receivables are reported net of our estimate of probable losses under the recourse provisions for receivables serviced with limited recourse. Our estimate of the recourse obligation totaled $2.2 billion at March 31, 2004 and $2.4 billion at December 31, 2003. Interest-only strip receivables also included fair value mark-to-market adjustments which increased the balance by $277 million at March 31, 2004 and $257 million at December 31, 2003. Receivables serviced with limited recourse consisted of the following: MARCH 31, DECEMBER 31, 2004 2003 -------------------------------------------------------------------------------------- (IN MILLIONS) Real estate secured......................................... $ 182 $ 194 Auto finance................................................ 4,093 4,675 MasterCard/Visa............................................. 9,536 9,967 Private label............................................... 5,261 5,261 Personal non-credit card.................................... 5,285 6,104 ------- ------- Total....................................................... $24,357 $26,201 ======= ======= 11 The combination of receivables owned and receivables serviced with limited recourse, which comprises our managed portfolio, is shown below: MARCH 31, DECEMBER 31, 2004 2003 -------------------------------------------------------------------------------------- (IN MILLIONS) Real estate secured......................................... $ 52,622 $ 51,415 Auto finance................................................ 9,029 8,813 MasterCard/Visa............................................. 20,324 21,149 Private label............................................... 17,020 17,865 Personal non-credit card.................................... 18,628 18,936 Commercial and other........................................ 384 401 -------- -------- Total....................................................... $118,007 $118,579 ======== ======== 5. CREDIT LOSS RESERVES -------------------------------------------------------------------------------- An analysis of credit loss reserves was as follows: THREE MONTHS ENDED MARCH 31, 2004 2003 ------------------------------------------------------------------------------ (IN MILLIONS) Owned receivables: Credit loss reserves at beginning of period............... $ 3,793 $3,333 Provision for credit losses............................... 928 1,010 Charge-offs............................................... (1,050) (934) Recoveries................................................ 80 60 Other, net................................................ 2 14 ------- ------ Credit loss reserves for owned receivables................ 3,753 3,483 ------- ------ Receivables serviced with limited recourse: Credit loss reserves at beginning of period............... 2,374 1,759 Provision for credit losses............................... 253 407 Charge-offs............................................... (499) (418) Recoveries................................................ 27 20 Other, net................................................ 4 8 ------- ------ Credit loss reserves for receivables serviced with limited recourse............................................... 2,159 1,776 ------- ------ Credit loss reserves for managed receivables................ $ 5,912 $5,259 ======= ====== We maintain credit loss reserves to cover probable losses of principal, interest and fees, including late, overlimit and annual fees. Credit loss reserves are based on a range of estimates and are intended to be adequate but not excessive. We estimate probable losses of owned consumer receivables using a roll rate migration analysis that estimates the likelihood that a loan will progress through the various stages of delinquency, or buckets, and ultimately charge off. This analysis considers delinquency status, loss experience and severity and takes into account whether loans are in bankruptcy, have been restructured or rewritten, or are subject to forbearance, an external debt management plan, hardship, modification, extension or deferment. Our credit loss reserves also take into consideration the loss severity expected based on the underlying collateral, if any, for the loan in the event of default. Delinquency status may be affected by customer account management policies and practices, such as the restructure of accounts, forbearance agreements, extended payment plans, modification arrangements, consumer credit counseling accommodations, loan rewrites and deferments. If customer account management policies, or changes thereto, shift loans from a "higher" delinquency bucket to a "lower" delinquency bucket, this will be 12 reflected in our roll rate statistics. To the extent that restructured accounts have a greater propensity to roll to higher delinquency buckets, this will be captured in the roll rates. Since the loss reserve is computed based on the composite of all of these calculations, this increase in roll rate will be applied to receivables in all respective delinquency buckets, which will increase the overall reserve level. In addition, loss reserves on consumer receivables are maintained to reflect our judgment of portfolio risk factors that may not be fully reflected in the statistical roll rate calculation. Risk factors considered in establishing loss reserves on consumer receivables include recent growth, product mix, bankruptcy trends, geographic concentrations, economic conditions, portfolio seasoning and current levels of charge-offs and delinquencies. While our credit loss reserves are available to absorb losses in the entire portfolio, we specifically consider the credit quality and other risk factors for each of our products. We recognize the different inherent loss characteristics in each of our products as well as customer account management policies and practices and risk management/collection practices. Charge-off policies are also considered when establishing loss reserve requirements to ensure the appropriate reserves exist for products with longer charge-off periods. We also consider key ratios such as reserves to nonperforming loans and reserves as a percentage of net charge-offs in developing our loss reserve estimates. Loss reserve estimates are reviewed periodically and adjustments are reported in earnings when they become known. As these estimates are influenced by factors outside of our control, such as consumer payment patterns and economic conditions, there is uncertainty inherent in these estimates, making it reasonably possible that they could change. 6. INTANGIBLE ASSETS -------------------------------------------------------------------------------- Intangible assets consisted of the following: ACCUMULATED CARRYING GROSS AMORTIZATION VALUE ---------------------------------------------------------------------------------------------- (IN MILLIONS) MARCH 31, 2004 Purchased credit card relationships and related programs.... $1,518 $196 $1,322 Retail services merchant relationships...................... 270 55 215 Other loan related relationships............................ 326 43 283 Trade names................................................. 717 - 717 Technology, customer lists and other contracts.............. 281 69 212 ------ ---- ------ Total....................................................... $3,112 $363 $2,749 ====== ==== ====== DECEMBER 31, 2003 Purchased credit card relationships and related programs.... $1,512 $149 $1,363 Retail services merchant relationships...................... 270 41 229 Other loan related relationships............................ 326 34 292 Trade names................................................. 717 - 717 Technology, customer lists and other contracts.............. 281 26 255 ------ ---- ------ Total....................................................... $3,106 $250 $2,856 ====== ==== ====== 13 Estimated amortization expense associated with our intangible assets for each of the following years is as follows: YEAR ENDING DECEMBER 31, --------------------------------------------------------------------------- (IN MILLIONS) 2004........................................................ $356 2005........................................................ 335 2006........................................................ 327 2007........................................................ 310 2008........................................................ 215 7. GOODWILL -------------------------------------------------------------------------------- In the process of finalizing our quarterly results and the purchase price allocation resulting from our merger with HSBC, we determined that certain adjustments to prior fair value estimates were necessary which resulted in a net increase to goodwill, excluding foreign exchange, in the approximate amount of $141 million. The adjustments related principally to writing off several aged items remaining on intercompany accounts and to correcting errors noted in respect of various marketing, rent and payroll accruals that arose over several prior periods. Since we have completed the one-year anniversary of our merger with HSBC, no further merger-related adjustments to our goodwill balance will occur, except for changes in estimates of the tax basis in our assets and liabilities or other tax estimates recorded at the date of our merger with HSBC, pursuant to Statement of Financial Accounting Standards Number 109, "Accounting for Income Taxes." 8. INCOME TAXES -------------------------------------------------------------------------------- Our effective tax rate was 33.3 percent (restated) for the quarter ended March 31, 2004 (successor), 36.3 percent (restated) for the period March 29 through March 31, 2003 (successor) and 42.5 percent for the period January 1 through March 28, 2003 (predecessor). The effective tax rate for the period ended March 28, 2003 was adversely impacted by the non-deductibility of certain HSBC acquisition related costs. Excluding HSBC acquisition related costs of $198 million, which resulted in a $27 million tax benefit, our effective tax rate was 33.3 percent for the period January 1 through March 28, 2003. The effective tax rate differs from the statutory federal income tax rate primarily because of the effects of state and local income taxes and tax credits. 9. ACCUMULATED OTHER COMPREHENSIVE INCOME -------------------------------------------------------------------------------- The components of accumulated other comprehensive income were as follows: MARCH 31, DECEMBER 31, 2004 2003 --------------------------------------------------------------------------------------- (RESTATED) (IN MILLIONS) Unrealized gains (losses) on cash flow hedging instruments............................................... $(27) $(11) Unrealized gains on investments and interest-only strip receivables............................................... 216 168 Foreign currency translation adjustments.................... 325 286 ---- ---- Accumulated other comprehensive income...................... $514 $443 ==== ==== 14 10. STOCK-BASED COMPENSATION -------------------------------------------------------------------------------- In 2002, we adopted the fair value method of accounting for our stock option and employee stock purchase plans. We elected to recognize stock compensation cost prospectively for all new awards granted under those plans beginning January 1, 2002 as provided under SFAS No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure (an amendment of FASB Statement No. 123)" ("SFAS No. 148"). Prior to 2002, we applied the recognition and measurement provisions of APB No. 25, "Accounting for Stock Issued to Employees" in accounting for those plans. Because options granted prior to November 2002 vested upon completion of the merger with HSBC on March 28, 2003, all of our stock options are now accounted for using the fair value method. Our employees currently participate in one or more stock compensation plans sponsored by HSBC. Compensation expense relating to stock awards is charged to earnings over the vesting period. During the first quarter of 2004, we began to consider forfeitures for all stock awards granted subsequent to March 28, 2003 as part of our estimate of compensation cost rather than adjust compensation cost for forfeitures as they occur. The cumulative impact of this change was not material. The following table illustrates the effect on net income if the fair value method had been applied to all outstanding and unvested awards in the period prior to our acquisition by HSBC. JANUARY 1 THROUGH MARCH 28, 2003 --------------------------------------------------------------------------- (PREDECESSOR) (IN MILLIONS) Net income, as reported..................................... $246 Add stock-based employee compensation expense included in reported net income, net of tax: Stock option and employee stock purchase plans............ 7 Restricted stock rights................................... 11 Deduct stock-based employee compensation expense determined under the fair value method, net of tax: Stock option and employee stock purchase plans............ (53) Restricted stock rights................................... (45) ---- Pro forma net income........................................ $166 ==== 11. RELATED PARTY TRANSACTIONS -------------------------------------------------------------------------------- In the normal course of business, we conduct transactions with HSBC and its subsidiaries. The following summarizes significant related party activity. Due to affiliates includes amounts owed to subsidiaries of HSBC (other than preferred stock) and totaled $5.4 billion at March 31, 2004 and $7.6 billion at December 31, 2003. Interest expense on this funding totaled $53 million for the quarter ended March 31, 2004. This funding was at interest rates (both the underlying benchmark rate and credit spreads) comparable to third-party rates for debt with similar maturities. The notional value of derivative contracts outstanding with HSBC subsidiaries totaled $47.8 billion at March 31, 2004 and $39.7 billion at December 31, 2003. Affiliate swap counterparties have provided collateral in the form of securities which are not recorded on our balance sheet and totaled $1.0 billion at March 31, 2004 and $.5 billion at December 31, 2003. On March 31, 2004, we sold approximately $.9 billion of real estate secured receivables from our mortgage services business to HSBC Bank USA. We recorded a pre-tax gain of $15.3 million on the sale. Under a separate servicing agreement, we have agreed to service all real estate secured receivables sold to HSBC 15 Bank USA including all future business they purchase from correspondents. As of March 31, 2004, we were servicing $3.8 billion of real estate secured receivables for HSBC Bank USA. Servicing fee revenue totaled $2 million for the quarter ended March 31, 2004. We received an additional $.6 million from HSBC Bank USA during the quarter ended March 31, 2004 pursuant to a service level agreement under which we sourced, underwrote and priced $.4 billion of real estate secured receivables purchased by HSBC Bank USA. These revenues have been recorded as other income. Under various service level agreements, we also provide various services to HSBC Bank USA. These services include credit card servicing and processing activities through our credit card services business, loan origination and servicing through our auto finance business and other operational and administrative support. Fees received for these services are reported as other income and totaled $3 million during the quarter ended March 31, 2004. As part of ongoing integration efforts, HSBC has instituted certain changes to its North American organization structure. Among these initiatives was the creation of a new technology services company, HSBC Technology and Services (USA) Inc. ("HTSU"). Effective January 1, 2004, our technology services employees, as well as technology services employees from other HSBC entities in North America, were transferred to HTSU. In addition, technology related assets and software purchased subsequent to January 1, 2004 are generally purchased and owned by HTSU. Technology related assets owned by Household prior to January 1, 2004 currently remain in place and were not transferred to HTSU. In addition to information technology services, HTSU also provides certain item processing and statement processing activities to us pursuant to a master service level agreement. As a result of these changes, operating expenses relating to services provided by HTSU, which have previously been reported as salaries and fringe benefits, occupancy and equipment expenses or other servicing and administrative expenses, are now reported as support services from affiliates. Support services from affiliates for the quarter ended March 31, 2004 includes $172 million related to services provided by HTSU and $5 million for banking services and other miscellaneous services provided by HSBC Bank USA and other subsidiaries of HSBC. HTSU also paid us $8 million during the current quarter for certain office space which we have rented to them, which has been recorded as a reduction of occupancy and equipment expenses. In addition, $4 million of revenue was received from HTSU for administrative costs and has been recorded as other income during the current quarter. During the fourth quarter of 2003, we reached an agreement with HSBC Bank USA whereby risk associated with HSBC Bank USA's credit life and disability insurance policies was transferred to us. This transaction did not have a significant impact on our results. 12. PENSION AND OTHER POSTRETIREMENT BENEFITS -------------------------------------------------------------------------------- Components of pension expense related to our defined benefit plans were as follows: THREE MONTHS MARCH 29 JANUARY 1 ENDED THROUGH THROUGH MARCH 31, MARCH 31, MARCH 28, 2004 2003 2003 ---------------------------------------------------------------------------------------------------- (SUCCESSOR) (SUCCESSOR) (PREDECESSOR) (IN MILLIONS) Service cost - benefits earned during the period........ $ 14 $ - $ 11 Interest cost on projected benefit obligation........... 13 - 5 Expected return on assets............................... (23) - (16) Amortization of prior service cost...................... - - - Recognized (gains) losses............................... (1) - 14 ---- ---- ---- Pension expense......................................... $ 3 $ - $ 14 ==== ==== ==== 16 Components of the net periodic benefit cost of our postretirement benefits other than pensions were as follows: THREE MONTHS MARCH 29 JANUARY 1 ENDED THROUGH THROUGH MARCH 31, MARCH 31, MARCH 28, 2004 2003 2003 ---------------------------------------------------------------------------------------------------- (SUCCESSOR) (SUCCESSOR) (PREDECESSOR) (IN MILLIONS) Service cost - benefits earned during the period........ $1 $ - $1 Interest cost on accumulated postretirement benefit obligation............................................ 3 - 1 Amortization of transition obligation................... - - 2 Amortization of prior service cost...................... - - - -- ---- -- Net periodic postretirement benefit cost................ $4 $ - $4 == ==== == 13. NEW ACCOUNTING PRONOUNCEMENTS -------------------------------------------------------------------------------- In December 2003, the American Institute of Certified Public Accountants (AICPA) released Statement of Position 03-3, "Accounting for Certain Loans or Debt Securities Acquired in a Transfer" ("SOP 03-3"). SOP 03-3 addresses accounting for differences between contractual cash flows and cash flows expected to be collected from an investor's initial investment in loans or debt securities acquired in a transfer if those differences are attributable to credit quality. SOP 03-3 is effective for loans acquired in fiscal years beginning after December 15, 2004. Adoption is not expected to have a material impact on our financial position or results of operations. In December 2003, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 132 (revised), "Employers' Disclosures about Pensions and Other Postretirement Benefits" ("SFAS 132 (revised)"). SFAS 132 (revised) revises employers' disclosures about pension plans and other postretirement benefit plans. It does not change the measurement or recognition of those plans. SFAS 132 (revised) revises certain disclosure requirements contained in the original SFAS 132. It also requires additional disclosures about the assets, obligations, cash flows, and net periodic benefit cost of defined benefit pension plans and other postretirement benefit plans. We adopted the annual disclosure requirements for SFAS 132 (revised) as of December 31, 2003, which are included in the 2003 financial information in our 2004 Form 10-K, and the interim period disclosure requirements in the previously filed March 31, 2004 Form 10-Q. In January 2004, the FASB issued FASB Staff Position 106-1, "Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003" ("FSP 106-1"). FSP 106-1 was issued in response to a new Medicare bill that provides prescription drug coverage to Medicare-eligible retirees and was signed into law in December 2003. FSP 106-1 allows plan sponsors the option of accounting for the effects of this new law in financial statements for periods that cover the date of enactment or making a one-time election to defer the accounting for the effects of the new law. As authoritative guidance to implement the new law has not been issued, we are unable to assess the impact, if any, the new law will have on our accumulated postretirement benefit obligation and our net periodic benefit cost. In March 2004, the FASB reached a consensus on EITF 03-1, "The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments" ("EITF 03-1"). EITF 03-1 provides guidance for determining when an investment is impaired and whether the impairment is other than temporary as well as guidance for quantifying the impairment. This new guidance is effective for reporting periods beginning after June 15, 2004. 17 Household International Inc., and Subsidiaries -------------------------------------------------------------------------------- ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS -------------------------------------------------------------------------------- FINANCIAL HIGHLIGHTS -------------------------------------------------------------------------------- On March 28, 2003, HSBC Holdings plc ("HSBC") acquired Household International, Inc. ("Household"). This has resulted in a new basis of accounting reflecting the fair market value of our assets and liabilities for the "successor" period beginning March 29, 2003. Information for all "predecessor" periods prior to the merger is presented using our historical basis of accounting, which impacts comparability to our "successor" period. To assist in the comparability of our financial results, the "predecessor period" (January 1 to March 28, 2003) has been combined with the "successor period" (March 29 to March 31, 2003) to present "combined" results for the quarter ended March 31, 2003. JANUARY 1 THREE MONTHS THREE MONTHS MARCH 29 THROUGH ENDED ENDED THROUGH MARCH 28, MARCH 31, 2004 MARCH 31, 2003 MARCH 31, 2003 2003 -------------------------------------------------------------------------------------------------------- (SUCCESSOR) (COMBINED) (SUCCESSOR) (PREDECESSOR) (RESTATED) (RESTATED) (RESTATED) (DOLLAR AMOUNTS ARE IN MILLIONS) Net income(1)......................... $ 470 $ 390 $ 144 $ 246 Net interest income................... 1,820 1,628 56 1,572 Provision for credit losses........... 928 1,010 34 976 OWNED BASIS RATIOS: Return on average owned assets(1)... 1.57% 1.55% Return on average common shareholder's equity(1).......... 10.9 15.4 Net interest margin................. 7.30 7.27 Consumer net charge-off ratio, annualized....................... 4.17 4.22 Reserves as a percentage of net charge-offs, annualized.......... 96.7 99.6 Efficiency ratio(1)(2).............. 44.3 44.4 MANAGED BASIS RATIOS:(3) Return on average managed assets(1)........................ 1.30% 1.25% Net interest margin................. 8.24 8.28 Risk adjusted revenue............... 7.06 7.92 Consumer net charge-off ratio, annualized....................... 4.88 4.75 Reserves as a percentage of net charge-offs, annualized.......... 102.5 103.3 Efficiency ratio(1)(2).............. 40.7 39.1 18 Household International Inc., and Subsidiaries -------------------------------------------------------------------------------- OWNED BASIS MANAGED BASIS(3) -------------------------- -------------------------- MARCH 31, DECEMBER 31, MARCH 31, DECEMBER 31, 2004 2003 2004 2003 ----------------------------------------------------------------------------------------------------- (SUCCESSOR) (SUCCESSOR) (SUCCESSOR) (SUCCESSOR) (RESTATED) (RESTATED) (DOLLAR AMOUNTS ARE IN MILLIONS) Total assets................................ $ 115,835 $ 119,052 $ 140,192 $ 145,253 Receivables................................. 93,650 92,378 118,007 118,579 Two-month-and-over contractual delinquency ratio..................................... 5.01% 5.36% 5.06% 5.39% Reserves as a percentage of receivables..... 4.01 4.11 5.01 5.20 Reserves as a percentage of nonperforming loans..................................... 96.7 93.7 119.8 118.0 Common and preferred equity to owned assets.................................... 15.55 14.69 N/A n/a Tangible shareholder's equity to tangible managed assets(4)......................... N/A n/a 7.67 7.03 Tangible shareholder's equity plus owned loss reserves to tangible managed assets(4)................................. N/A n/a 10.61 9.89 Tangible common equity to tangible managed assets(4)................................. N/A n/a 5.59 5.04 --------------- (1) The following non-GAAP financial information is provided for comparison of our operating trends only and should be read in conjunction with our owned basis GAAP financial information. See "Basis of Reporting" for additional discussion on the use of non-GAAP financial measures and "Reconciliations to GAAP Financial Measures" for quantitative reconciliations to the equivalent GAAP basis financial measure. COMBINED THREE MONTHS ENDED THREE MONTHS ENDED MARCH 31, 2004 MARCH 31, 2003 ------------------------------------------------------------------------------------------------------ (RESTATED) (RESTATED) (DOLLAR AMOUNTS ARE IN MILLIONS) Net income.................................................. $470 $390 HSBC acquisition related cots and other merger related items, after-tax.......................................... - 167 ---- ---- Operating net income........................................ $470 $557 ==== ==== Return on average owned assets.............................. 1.57% 2.22% Return on average common shareholder's equity............... 10.9 22.4 Owned basis efficiency ratio(2)............................. 44.3 37.7 Return on average managed assets............................ 1.30 1.79 Managed basis efficiency ratio(2)........................... 40.7 33.2 (2) Ratio of total costs and expenses less policyholders' benefits to net interest income and other revenues less policyholders' benefits. (3) We monitor our operations and evaluate trends on both an owned basis as shown in our financial statements and on a managed basis. Managed basis reporting (a non-GAAP financial measure) assumes that securitized receivables have not been sold and are still on our balance sheet. Managed basis information is intended to supplement, and should not be considered a substitute for, owned basis reporting and should be read in conjunction with reported owned basis results. See "Basis of Reporting" for additional discussion on the use of non-GAAP financial measures and "Reconciliations to GAAP Financial Measures" for quantitative reconciliations to the equivalent GAAP basis financial measure. (4) Tangible shareholder's equity to tangible managed assets ("TETMA"), tangible shareholder's equity plus owned loss reserves to tangible managed assets ("TETMA + Owned Reserves") and tangible common equity to tangible managed assets are non-GAAP financial ratios that are used by Household management and certain rating agencies to evaluate capital adequacy and may differ from similarly named measures presented by other companies. Common and preferred equity to owned assets is the most directly comparable GAAP financial measure. Our equity ratios excluding the impact of "push-down" accounting on our assets and common shareholder's equity would have been as follows: 19 Household International Inc., and Subsidiaries -------------------------------------------------------------------------------- MARCH 31, 2004 DECEMBER 31, 2003 ------------------------------------------------------------------------------------------------ (RESTATED) (RESTATED) TETMA....................................................... 9.69% 8.94% TETMA + Owned Reserves...................................... 12.64 11.81 Tangible common equity to tangible managed assets........... 7.64 6.98 See "Basis of Reporting" for additional discussion on the use of non-GAAP financial measures and "Reconciliations to GAAP Financial Measures" for quantitative reconciliations to the equivalent GAAP basis financial measure. RESTATEMENT -------------------------------------------------------------------------------- We have restated our consolidated financial statements for the previously reported period March 29, 2003 through December 31, 2003, and the previously reported quarterly period ended March 31, 2004. This amended Quarterly Report on Form 10-Q/A and the exhibits included herewith include all adjustments relating to the restatement for the periods covered by this report. During the fourth quarter of 2004, as part of our preparation for the implementation of International Financial Reporting Standards ("IFRS") by HSBC from January 1, 2005, we undertook a review of our hedging activities to confirm conformity with the accounting requirements of IFRS, which differ in several respects from the hedge accounting requirements under U.S. GAAP as set out in Statement of Financial Accounting Standards No. 133, "Accounting for Derivatives and Hedging Activities ("SFAS 133"). As a result of this review, management determined that there were some deficiencies in the documentation required to support hedge accounting under U.S. GAAP. These documentation deficiencies arose following our acquisition by HSBC. As a consequence of the acquisition, pre-existing hedging relationships, including hedging relationships that had previously qualified under the "shortcut" method of accounting pursuant to SFAS 133, were required to be reestablished. At that time there was some debate in the accounting profession regarding the detailed technical requirements resulting from a business combination. We consulted with our independent accountants, KPMG LLP, in reaching a determination of what was required in order to comply with SFAS 133. Following this, we took the actions we believed were necessary to maintain hedge accounting for all of our historical hedging relationships in our consolidated financial statements for the period ended December 31, 2003 and those consolidated financial statements received an unqualified audit opinion. Management, having determined during the fourth quarter of 2004 that there were certain documentation deficiencies, engaged independent expert consultants to advise on the continuing effectiveness of the identified hedging relationships and again consulted with our independent accountants, KPMG LLP. As a result of this assessment, we concluded that a substantial number of our hedges met the correlation effectiveness requirement of SFAS 133 throughout the period following our acquisition by HSBC. However, we also determined in conjunction with KPMG LLP that, although a substantial number of the impacted hedges satisfied the correlation effectiveness requirement of SFAS 133, there were technical deficiencies in the documentation that could not be corrected retroactively or disregarded notwithstanding the proven effectiveness of the hedging relationships in place and, consequently, that the requirements of SFAS 133 were not met and that hedge accounting was not appropriate during the period these documentation deficiencies existed. We have therefore determined that we should restate all the reported periods since our acquisition by HSBC to eliminate hedge accounting on all hedging relationships outstanding at March 29, 2003 and certain fair value swaps entered into after that date. This was accomplished primarily by reclassifying the mark to market of the changes in fair market value of the affected derivative financial instruments previously classified in either debt or other comprehensive income into current period earnings. The period to period changes in the fair value of these derivative financial instruments have been recognized as either an increase or decrease in our current period earnings through derivative income. As part of the restatement process, we have reclassified all previous hedging results reflected in interest 20 Household International Inc., and Subsidiaries -------------------------------------------------------------------------------- expense associated with the affected derivative financial instruments to derivative income. Our independent registered public accounting firm has reviewed the March 31, 2004 financial results and has provided us a review report under Statement on Auditing Standards No. 100, which review report is attached to this amended Quarterly Report on Form 10-Q/A as Exhibit 99.2. The cumulative restatement is as follows for the periods presented below: RESTATEMENTS TO REPORTED INCOME ---------------------------------------------- % CHANGE PRE-TAX TAX EFFECT AFTER TAX TO REPORTED ----------------------------------------------------------------------------------------------------- (DOLLARS IN MILLIONS) March 29, 2003 through March 31, 2003................ $212 $(77) $135 100+% Quarter ended March 31, 2004......................... (17) 6 (11) (2.3) See Note 2, "Restatement," for a detailed summary of the impact of the restatement on our consolidated statement of income and our consolidated balance sheet for the periods presented. The resulting accounting does not reflect the economic reality of our hedging activity and has no impact on the timing or amount of operating cash flows or cash flows under any debt or derivative contract. It does not affect our ability to make required payments on our outstanding debt obligations. Furthermore, the restatement has no impact on our results on a U.K. GAAP basis, which are used in measuring and rewarding performance of employees. Finally, our economic risk management strategies have not required amendment. EXECUTIVE OVERVIEW -------------------------------------------------------------------------------- Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") should be read in conjunction with the consolidated financial statements, notes and tables included elsewhere in this report and with the 2003 financial information included in our Annual Report on Form 10-K for the year ended December 31, 2004 (the "2004 Form 10-K"). MD&A may contain certain statements that may be forward-looking in nature within the meaning of the Private Securities Litigation Reform Act of 1995. Our results may differ materially from those noted in the forward-looking statements. Words such as "believe", "expects", "estimates", "targeted", "anticipates", "goal" and similar expressions are intended to identify forward-looking statements but should not be considered as the only means through which these statements may be made. Statements that are not historical facts, including statements about management's beliefs and expectations, are forward-looking statements which involve inherent risks and uncertainties and are based on current views and assumptions. A number of factors could cause actual results to differ materially from those contained in any forward-looking statements. For a list of important factors that may affect our actual results, see Cautionary Statement on Forward Looking Statements in Part I, Item 1 of our 2004 Form 10-K. Household is principally a non-operating holding company and an indirect wholly owned subsidiary of HSBC Holdings plc ("HSBC"). Household may also be referred to in MD&A as "we", "us", or "our". Household's acquisition by HSBC on March 28, 2003 has resulted in a new basis of accounting reflecting the fair market value of our assets and liabilities for the "successor" period beginning March 29, 2003. Information for all "predecessor" periods prior to the merger is presented using our historical basis of accounting, which impacts comparability to our "successor" period beginning March 29, 2003. During the quarter ended March 31, 2003, the "predecessor" period contributed $246 million of net income and the "successor" period contributed $144 million of net income. To assist in the comparability of our financial results and to make it easier to discuss and understand our results of operations, MD&A combines the "predecessor period" (January 1 to March 28, 2003) with the "successor period" (March 29 to March 31, 2003) to present "combined" results for the quarter ended March 31, 2003. 21 Household International Inc., and Subsidiaries -------------------------------------------------------------------------------- In addition to owned basis reporting, we also monitor our operations and evaluate trends on a managed basis (a non-GAAP financial measure), which assumes that securitized receivables have not been sold and are still on our balance sheet. See "Basis of Reporting" for further discussion of the reasons we use this non-GAAP financial measure. In measuring our results, management's primary focus is on receivable growth and operating net income (a non-GAAP financial measure which excludes $167 million, after-tax, of HSBC acquisition related costs and other merger related items incurred by Household in the first quarter of 2003.) See "Basis of Reporting" for further discussion of operating net income. Net income was $470 million for the quarter ended March 31, 2004 compared to operating net income of $557 million for the first quarter of 2003. The decrease was primarily due to lower other revenues resulting from lower securitization activity and lower derivative income as well as higher operating expenses, partially offset by higher net interest income and lower provision for credit losses due to improving credit quality. The increase in net interest income was due to lower funding costs, including the impact of purchase accounting adjustments, and higher average receivables, partially offset by lower yields on our receivables, particularly in real estate secured receivables. The increase in operating expenses was due to receivable growth and amortization of intangibles established in conjunction with the HSBC merger. The lower derivative income in the first quarter of 2004 reflects a decreasing rate environment coupled with a significant reduction in both our receive fixed and pay fixed swap portfolios which do not qualify for hedge accounting under SFAS 133. Amortization of purchase accounting fair value adjustments increased net income by $11 million for the quarter ended March 31, 2004. Because HSBC reports results on a U.K. GAAP basis, our management also separately monitors net income and earnings excluding goodwill amortization under U.K. GAAP (non-GAAP financial measures). Net income on a U.K. GAAP basis was $678 million for the quarter ended March 31, 2004. Earnings excluding the amortization of goodwill on a U.K. GAAP basis were $814 million for the quarter ended March 31, 2004. Owned receivables were $93.7 billion at March 31, 2004, $92.4 billion at December 31, 2003 and $83.4 billion at March 31, 2003. Real estate secured receivables were the primary driver of the growth despite sales to HSBC Bank USA. Real estate secured receivables reflect sales to HSBC Bank USA of $.9 billion on March 31, 2004 and $2.8 billion on December 31, 2003 and purchases directly by HSBC Bank USA in the first quarter of 2004 of $.4 billion of correspondent receivables, a portion of which we otherwise would have purchased. Lower securitization levels also contributed to the increase in owned receivables over both periods. Compared with December 31, 2003, growth was partially offset by normal seasonal run-off in our credit card portfolios. Subject to receipt of regulatory and other approvals, we also intend to transfer substantially all of our domestic private label credit card portfolio and our General Motors and Union Privilege MasterCard and Visa portfolios to HSBC Bank USA. We will, however, maintain the customer account relationships. We currently expect that approximately $10 billion in private label receivables ($14 billion on a managed basis) and $6 billion in MasterCard and Visa receivables ($13 billion on a managed basis), subject to these approvals, will be transferred to HSBC Bank USA in 2004. Subsequent to the initial sale of receivables, additional volume will be sold to HSBC Bank USA on a daily basis. As a result of these contemplated sales, our net interest income and fee income will be substantially reduced, but our other income will substantially increase as we record gains from these sales. Contingent upon receiving regulatory approval for these asset transfers in 2004, we would also expect to adopt charge-off and account management guidelines in accordance with the Uniform Retail Credit Classification and Account Management Policy issued by the Federal Financial Institutions Examination Council ("FFIEC") for those MasterCard and Visa and private label credit card receivables which will remain on our balance sheet. We cannot predict with any degree of certainty the timing as to when or if regulatory approval will be received and, therefore, when the related asset transfers will be completed. As a result, it is not possible to quantify the financial impact to Household for 2004 at this time. Additional information on the financial impact of 22 Household International Inc., and Subsidiaries -------------------------------------------------------------------------------- these proposed asset transfers will be reported as the regulatory approval process progresses and the amount becomes quantifiable. Our owned basis two-months-and-over-contractual delinquency ratio decreased to 5.01 percent at March 31, 2004, compared to 5.36 percent at December 31, 2003 and 5.50 percent at March 31, 2003. The decrease is consistent with improvements in early delinquency roll rate trends experienced in the fourth quarter of 2003 as a result of improvements in the economy and better underwriting, including both improved modeling and improved credit quality of originations. The decrease during the current quarter also reflects seasonal improvement in collections as customers use their tax refunds to reduce their outstanding balances. Net charge-offs of 4.17 percent for the March 2004 quarter increased over net charge-offs of 3.75 percent for the December 2003 quarter as higher delinquencies in prior quarters as a result of adverse economic conditions continue to charge off. Net charge-offs for the current quarter decreased from March 2003 net charge-offs of 4.22 percent as a result of a decrease in the percentage of the portfolio comprised of personal non-credit card receivables, which have a higher net charge-off rate than other products in our portfolio. During the current quarter, we decreased affiliate and third-party debt and initial securitization levels as we used proceeds from the sale of real estate secured receivables to HSBC Bank USA to assist in the funding of our businesses. Because we are now a subsidiary of HSBC, our credit spreads relative to treasuries have tightened. We recognized cash funding expense savings, primarily as a result of tightened credit spreads, in excess of $70 million for the current quarter and less than $5 million for the prior-year quarter compared to the funding costs we would have incurred using average spreads from the first half of 2002. BASIS OF REPORTING -------------------------------------------------------------------------------- Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States ("U.S. GAAP"). The discussion of our financial condition and results of operations included in MD&A is presented on an owned basis of reporting. Household's acquisition by HSBC on March 28, 2003 has resulted in a new basis of accounting reflecting the fair value of our assets and liabilities for the "successor" period beginning March 29, 2003. Information for all "predecessor" periods prior to the merger are presented using our historical basis of accounting, which impacts comparability with the "successor" period beginning March 29, 2003. To assist in the comparability of our financial results and to make it easier to discuss and understand our results of operations, MD&A combines the "predecessor" period (January 1 through March 28, 2003) with the "successor" period (March 29 through March 31, 2003) to present "combined" results for the quarter ended March 31, 2003. In addition to the U.S. GAAP financial results reported in our consolidated financial statements, MD&A includes reference to the following information which is presented on a non-GAAP basis: OPERATING RESULTS, PERCENTAGES AND RATIOS Certain percentages and ratios have been presented on an operating basis and have been calculated using "operating net income", a non-GAAP financial measure. "Operating net income" is net income excluding certain nonrecurring items. These nonrecurring items are also excluded in calculating our operating basis efficiency ratios. We believe that excluding nonrecurring items helps readers of our financial statements to better understand the results and trends of our underlying business. 23 Household International Inc., and Subsidiaries -------------------------------------------------------------------------------- A reconciliation of net income to operating net income follows: THREE MONTHS ENDED MARCH 31, ------------------- 2004 2003 --------------------------------------------------------------------------------- (RESTATED) (IN MILLIONS) Net income.................................................. $ 470 $ 390 HSBC acquisition related costs and other merger related items incurred by Household, after-tax.................... - 167 ------ ------ Operating net income........................................ $ 470 $ 557 ====== ====== For the three months ended March 31, 2004, amortization of purchase accounting fair value adjustments did not have a significant impact on net income. See "Operations Summary" for further discussion of first quarter 2004 results and related trends. MANAGED BASIS REPORTING We monitor our operations and evaluate trends on a managed basis (a non-GAAP financial measure), which assumes that securitized receivables have not been sold and are still on our balance sheet. We manage and evaluate our operations on a managed basis because the receivables that we securitize are subjected to underwriting standards comparable to our owned portfolio, are serviced by operating personnel without regard to ownership and result in a similar credit loss exposure for us. In addition, we fund our operations, review our operating results, and make decisions about allocating resources such as employees and capital on a managed basis. When reporting on a managed basis, net interest income, provision for credit losses and fee income related to receivables securitized are reclassified from securitization revenue in our owned statements of income into the appropriate caption. Additionally, charge-off and delinquency associated with these receivables are included in our managed basis credit quality statistics. Debt analysts, rating agencies and others also evaluate our operations on a managed basis for the reasons discussed above and have historically requested managed basis information from us. We believe that managed basis information enables investors and other interested parties to better understand the performance and quality of our entire managed loan portfolio and is important to understanding the quality of originations and the related credit risk inherent in our owned and securitized portfolios. EQUITY RATIOS Tangible shareholder's equity to tangible managed assets ("TETMA"), tangible shareholder's equity plus owned loss reserves to tangible managed assets ("TETMA + Owned Reserves") and tangible common equity to tangible managed assets are non-GAAP financial measures that are used by Household management or certain rating agencies to evaluate capital adequacy. These ratios may differ from similarly named measures presented by other companies. The most directly comparable GAAP financial measure is common and preferred equity to owned assets. We also monitor our equity ratios excluding the impact of purchase accounting adjustments. We do so because we believe that the purchase accounting adjustments represent non-cash transactions which do not affect our business operations, cash flows or ability to meet our debt obligations. Preferred securities issued by certain non-consolidated trusts are considered equity in the TETMA and TETMA + Owned Reserves calculations because of their long-term subordinated nature and the ability to defer dividends. Our Adjustable Conversion-Rate Equity Security Units, adjusted for purchase accounting adjustments, are also considered equity in these calculations because they include investor obligations to purchase HSBC ordinary shares in 2006. U.K. GAAP Because HSBC reports results on a U.K. GAAP basis, our management also separately monitors net income and earnings excluding goodwill amortization under U.K. GAAP (non-GAAP financial measures). The following table reconciles our net income on a U.S. GAAP basis for the quarter 24 Household International Inc., and Subsidiaries -------------------------------------------------------------------------------- ended March 31, 2004 to earnings excluding goodwill amortization and net income on a U.K. GAAP basis. --------------------------------------------------------------------------- (RESTATED) (IN MILLIONS) Net income - U.S. GAAP basis................................ $ 470 Adjustments, net-of-tax: Deferred origination expenses............................. (40) Derivative financial instruments.......................... 12 Securitizations........................................... 138 Intangibles............................................... 70 Purchase accounting adjustments........................... 135 Other..................................................... 29 ------- Earnings excluding goodwill amortization - U.K. GAAP basis..................................................... 814 Goodwill amortization....................................... (136) ------- Net income - U.K. GAAP basis................................ $ 678 ======= Differences between U.S. and U.K. GAAP are as follows: DEFERRED ORIGINATION EXPENSES U.K. GAAP - Fee and commission income is accounted for in the period when receivable, except when it is charged to cover the costs of a continuing service to, or risk borne for, the customer, or is interest in nature. In these cases, it is recognized on an appropriate basis over the relevant period. - Loan origination costs are generally expensed as incurred. As permitted by U.K. GAAP, HSBC applies a restricted definition of the incremental, directly attributable origination expenses that are deferred and subsequently amortized over the life of the loans. U.S. GAAP - Certain loan fee income and direct loan origination costs are amortized to the profit and loss account over the life of the loan as an adjustment to interest income (SFAS 91, "Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases".) DERIVATIVE FINANCIAL INSTRUMENTS U.K. GAAP - Non-trading derivatives are those which are held for hedging purposes as part of our risk management strategy against cash flows, assets, liabilities, or positions measured on an accruals basis. Non-trading transactions include qualifying hedges and positions that synthetically alter the characteristics of specified financial instruments. - Non-trading derivatives are accounted for on an equivalent basis to the underlying assets, liabilities or net positions. Any profit or loss arising is recognized on the same basis as that arising from the related assets, liabilities or positions. - To qualify as a hedge, a derivative must effectively reduce the price, foreign exchange or interest rate risk of the asset, liability or anticipated transaction to which it is linked and be designated as a hedge at inception of the derivative contract. Accordingly, changes in the market value of the derivative must be highly correlated with changes in the market value of the underlying hedged item at inception of the hedge and over the life of the hedge contract. If these criteria are met, the 25 Household International Inc., and Subsidiaries -------------------------------------------------------------------------------- derivative is accounted for on the same basis as the underlying hedged item. Derivatives used for hedging purposes include swaps, forwards and futures. - Interest rate swaps are also used to alter synthetically the interest rate characteristics of financial instruments. In order to qualify for synthetic alteration, a derivative instrument must be linked to specific individual, or pools of similar, assets or liabilities by the notional principal and interest rate risk of the associated instruments, and must achieve a result that is consistent with defined risk management objectives. If these criteria are met, accrual based accounting is applied, i.e. income or expense is recognized and accrued to the next settlement date in accordance with the contractual terms of the agreement. - Any gain or loss arising on the termination of a qualifying derivative is deferred and amortized to earnings over the original life of the terminated contract. Where the underlying asset, liability or position is sold or terminated, the qualifying derivative is immediately marked-to-market through the profit and loss account. - Derivatives that do not qualify as hedges or synthetic alterations at inception are marked-to-market through the profit and loss account, with gains and losses included within "other income". U.S. GAAP - All derivatives must be recognized as either assets or liabilities in the balance sheet and be measured at fair value (SFAS 133, "Accounting for Derivative Instruments and Hedging Activities"). - The accounting for changes in the fair value of a derivative (that is, gains and losses) depends on the intended use of the derivative and the resulting designation as described below: - For a derivative designated as hedging exposure to changes in the fair value of a recognized asset or liability or a firm commitment, the gain or loss is recognized in earnings in the period of change together with the associated loss or gain on the hedged item attributable to the risk being hedged. Any resulting net gain or loss represents the ineffective portion of the hedge. - For a derivative designated as hedging exposure to variable cash flows of a recognized asset or liability, or of a forecast transaction, the derivative's gain or loss associated with the effective portion of the hedge is initially reported as a component of other comprehensive income and subsequently reclassified into earnings when the forecast transaction affects earnings. The ineffective portion is reported in earnings immediately. - For net investment hedges in which derivatives hedge the foreign currency exposure of a net investment in a foreign operation, the change in fair value of the derivative associated with the effective portion of the hedge is included as a component of other comprehensive income, together with the associated loss or gain on the hedged item. The ineffective portion is reported in earnings immediately. - In order to apply hedge accounting it is necessary to comply with documentation requirements and to demonstrate the effectiveness of the hedge on an ongoing basis. - For a derivative not designated as a hedging instrument, the gain or loss is recognized in earnings in the period of change in fair value. SECURITIZATIONS U.K. GAAP - FRS 5, "Reporting the Substance of Transactions," requires that the accounting for securitized receivables is governed by whether the originator has access to the benefits of the securitized assets and exposure to the risks inherent in those benefits and whether the originator has a liability to repay the proceeds of the note issue: - The securitized assets should be derecognized in their entirety and a gain or loss on sale recorded where the originator retains no significant benefits and no significant risks relating to those securitized assets. 26 Household International Inc., and Subsidiaries -------------------------------------------------------------------------------- - The securitized assets and the related finance should be consolidated under a linked presentation where the originator retains significant benefits and significant risks relating to those securitized assets but where the downside exposure is limited to a fixed monetary amount and certain other conditions are met. - The securitized assets and the related finance should be consolidated on a gross basis where the originator retains significant benefits and significant risks relating to those securitized assets and does not meet the conditions required for linked presentation. - The run-off of prior period transactions and a lower volume of transactions in the current period have resulted in lower income under U.S. GAAP in the first quarter of 2004 and, therefore, higher reported income under U.K. GAAP. U.S. GAAP - SFAS 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities," requires that receivables that are sold to a special purpose entity and securitized can only be derecognized and a gain or loss on sale recognized if the originator has surrendered control over those securitized assets. - Control has been surrendered over transferred assets if and only if all of the following conditions are met: - The transferred assets have been put presumptively beyond the reach of the transferor and its creditors, even in bankruptcy or other receivership. - Each holder of interests in the transferee (i.e. holder of issued notes) has the right to pledge or exchange their beneficial interests, and no condition constrains this right and provides more than a trivial benefit to the transferor. - The transferor does not maintain effective control over the assets through either an agreement that obligates the transferor to repurchase or to redeem them before their maturity or through the ability to unilaterally cause the holder to return specific assets, other than through a clean-up call. - If these conditions are not met the securitized assets should continue to be consolidated. - Where we retain an interest in the securitized assets, such as a servicing right or the right to residual cash flows from the special purpose entity, we recognize this interest at fair value on sale of the assets. - There are no provisions for linked presentation of securitized assets and the related finance. INTANGIBLE ASSETS U.K. GAAP - An intangible asset is recognized separately from goodwill where it is identifiable and controlled. It is identifiable only if it can be disposed of or settled separately without disposing of the whole business. Control requires legal rights or custody over the item. - An intangible asset purchased as part of a business combination is capitalized at fair value based on its replacement cost, which is normally its estimated market value. U.S. GAAP - An intangible asset is recognized separately from goodwill when it arises from contractual or other legal rights or if it is separable, i.e. it is capable of being separated or divided from the acquired entity and sold, transferred, licensed, rented, or exchanged in combination with a related contract, asset or liability. The effect of this is that certain intangible assets such as trademarks and customer relationships are recognized under U.S. GAAP, although such assets will not be recognized under U.K. GAAP. - Intangible assets are initially recognized at fair value. An intangible asset with a finite useful life is amortized on a straight-line basis over the period for which it contributes to the future cash flows of the entity. An intangible asset with an indefinite useful life is not amortized but is tested for 27 Household International Inc., and Subsidiaries -------------------------------------------------------------------------------- impairment annually or more frequently if events or changes in circumstances indicate that the asset might be impaired. PURCHASE ACCOUNTING ADJUSTMENTS - The reconciling "purchase accounting adjustments" predominantly reflect: - the measurement of equity consideration at the date the terms of acquisition are agreed and announced under U.S. GAAP; under U.K. GAAP equity consideration is measured at the date of acquisition; - the recognition of a greater number of intangibles under U.S. GAAP on acquisitions, and, consequently, higher amortization charge; - recognition of deferred tax on all fair value adjustment under U.S. GAAP, and corresponding amortization post-acquisition; - non-recognition of residual interests in securitization vehicles existing at acquisition under U.K. GAAP. Instead, the assets and liabilities of the securitization vehicles are recognized on the U.K. GAAP balance sheet, and credit provisions are established against the loans and advances. This GAAP adjustment existing at acquisition unwinds over the life of the securitization vehicles; and - certain costs which under U.K. GAAP, relate to either post-acquisition management decisions or certain decisions made prior to the acquisition are required to be expensed to the post-acquisition profit and loss account and cannot be capitalized as goodwill, or included within the fair value of the liabilities of the acquired entity. OTHER - Includes adjustments related to suspension of interest accruals on nonperforming loans, capitalized software costs and other items. - Capitalized software costs - U.K. GAAP HSBC generally expenses costs of software developed for internal use. If it can be shown that conditions for capitalization are met under FRS 10, "Goodwill and intangible assets," or FRS 15, "Tangible fixed assets", the software is capitalized and amortized over its useful life. Website design and content development costs are capitalized only to the extent that they lead to the creation of an enduring asset delivering benefits at least as great as the amount capitalized. - U.S. GAAP The American Institute of Certified Public Accountants' ("AICPA") Statement of Position 98- 1, "Accounting for the costs of computer software developed or obtained for internal use," requires that all costs incurred in the preliminary project and post implementation stages of internal software development be expensed. Costs incurred in the application development stage must be capitalized and amortized over their estimated useful life. Website design costs are capitalized and website content development costs are expensed as they are incurred. GOODWILL AMORTIZATION U.K. GAAP - Goodwill arising on acquisitions of subsidiary undertakings, associates or joint ventures prior to 1998 was charged against reserves in the year of acquisition. - For acquisitions made on or after January 1, 1998, goodwill is included in the balance sheet and amortized over its estimated useful life on a straight-line basis. U.K. GAAP allows goodwill previously eliminated against reserves to be reinstated, but does not require it. - Goodwill included in the balance sheet is tested for impairment when necessary by comparing the recoverable amount of an entity with the carrying value of its net assets, including attributable goodwill. The recoverable amount of an entity is the higher of its value in use, generally the present value of the expected future cash flows from the entity, and its net realizable value. 28 Household International Inc., and Subsidiaries -------------------------------------------------------------------------------- - At the date of disposal of subsidiaries, associates or joint ventures, any unamortized goodwill or goodwill charged directly against reserves is included in our share of the undertakings' total net assets in the calculation of the gain or loss on disposal. - Where quoted securities are issued as part of the purchase consideration in an acquisition, the fair value of those securities for the purpose of determining the cost of acquisition is the market price at the date of completion. U.S. GAAP - Goodwill acquired up to June 30, 2001 was capitalized and amortized over its useful life but not more than 25 years. The amortization of previously acquired goodwill ceased from December 31, 2001. - SFAS 142, "Goodwill and Other Intangible Assets" requires that goodwill should not be amortized but should be tested for impairment annually at the reporting unit level by applying a fair-value-based test. - The goodwill of a reporting unit should be tested for impairment between annual tests in response to events or changes in circumstance which could result in an impairment. - Where quoted securities are issued as part of the purchase consideration in an acquisition, the fair value of those securities for the purpose of determining the cost of acquisition is the average market price of the securities for a reasonable period before and after the date that the terms of the acquisition are agreed and announced. QUANTITATIVE RECONCILIATIONS OF NON-GAAP FINANCIAL MEASURES TO GAAP FINANCIAL MEASURES For a reconciliation of managed basis net interest income, fee income and provision for credit losses to the comparable owned basis amounts, see "Segment Results -- Managed Basis" in this MD&A. For a reconciliation of our owned loan portfolio by product to our managed loan portfolio, see Note 4, "Receivables," to the accompanying consolidated financial statements. For additional quantitative reconciliations of non-GAAP financial measures presented herein to the equivalent GAAP basis financial measures, see "Reconciliations to GAAP Financial Measures." OPERATIONS SUMMARY -------------------------------------------------------------------------------- Household's acquisition by HSBC on March 28, 2003 has resulted in a new basis of accounting reflecting the fair value of our assets and liabilities for the "successor" period beginning March 29, 2003. Information for all "predecessor" periods prior to the merger are presented using our historical basis of accounting, which impacts comparability with the "successor" period beginning March 29, 2003. During the quarter ended March 31, 2003, the "predecessor" period contributed $246 million of net income and the "successor" period contributed $144 million of net income. To assist in the comparability of our financial results and to make it easier to discuss and understand our results of operations, MD&A combines the "predecessor" period (January 1 through March 28, 2003) with the "successor" period (March 29 through March 31, 2003) to present "combined" results for the quarter ended March 31, 2003. Our net income was $470 million in the first quarter of 2004 and $390 million in the first quarter of 2003. Operating net income (a non-GAAP financial measure which excludes $167 million, after-tax, of HSBC acquisition related costs and other merger related items incurred by Household in March 2003) was $557 million in the first quarter of 2003. Net income for the quarter ended March 31, 2004 decreased compared with the first quarter of 2003 operating net income due to lower other revenues resulting from lower securitization activity and lower derivative income as well as higher operating expenses, partially offset by higher net interest income and lower provision for credit losses due to improving credit quality. The increase in net interest income was due to lower funding costs, including the impact of purchase accounting adjustments, and higher average receivables, partially offset by lower yields on our receivables, particularly in real estate secured receivables. The increase in operating expenses was due to receivable growth and amortization of 29 Household International Inc., and Subsidiaries -------------------------------------------------------------------------------- intangibles established in conjunction with the HSBC merger. The lower derivative income in the first quarter of 2004 reflects a decreasing rate environment coupled with a significant reduction in both our receive fixed and pay fixed swap portfolios which do not qualify for hedge accounting under SFAS 133. Amortization of purchase accounting fair value adjustments increased net income by $11 million for the quarter ended March 31, 2004. In March 2004, we sold $.9 billion of our higher quality non-conforming domestic real estate secured receivables to HSBC Bank USA and a pre-tax gain of $15 million was recorded. A similar sale of $2.8 billion with a pre-tax gain of $16 million was completed in December 2003. Similar real estate secured loan originations from correspondents totaling $.4 billion were purchased directly by HSBC Bank USA in the current quarter, a portion of which we otherwise would have purchased. We are paid a fee for each such loan purchased by HSBC Bank USA. Under a separate servicing agreement, we service all real estate secured loans sold to HSBC Bank USA including all business they purchase from correspondents. Subject to receipt of regulatory and other approvals, we also intend to transfer substantially all of our domestic private label credit card portfolio and our General Motors and Union Privilege MasterCard and Visa portfolios to HSBC Bank USA. We will, however, maintain the customer account relationships. We currently expect that approximately $10 billion in private label receivables ($14 billion on a managed basis) and $6 billion in MasterCard and Visa receivables ($13 billion on a managed basis), subject to these approvals, will be transferred to HSBC Bank USA in 2004. Subsequent to the initial sale of receivables, additional volume will be sold to HSBC Bank USA on a daily basis. As a result of these contemplated sales, our net interest income and fee income will be substantially reduced, but our other income will substantially increase as we record gains from these sales. Contingent upon receiving regulatory approval for these asset transfers in 2004, we would also expect to adopt charge-off and account management guidelines in accordance with the Uniform Retail Credit Classification and Account Management Policy issued by the FFIEC for those MasterCard and Visa and private label credit card receivables which will remain on our balance sheet. We cannot predict with any degree of certainty the timing as to when or if regulatory approval will be received and, therefore, when the related asset transfers will be completed. As a result, it is not possible to quantify the financial impact to Household for 2004 at this time. Additional information on the financial impact of these proposed asset transfers will be reported as the regulatory approval process progresses and the amount becomes quantifiable. 30 Household International Inc., and Subsidiaries -------------------------------------------------------------------------------- RECEIVABLES REVIEW -------------------------------------------------------------------------------- Owned receivables at March 31, 2004 and increases (decreases) from prior periods are shown in the following table: INCREASE (DECREASE) INCREASE FROM (DECREASE) FROM DECEMBER 31, MARCH 31, 2003 2003 MARCH 31, ------------ --------------- 2004 $ % $ % -------------------------------------------------------------------------------------------------- (DOLLAR AMOUNTS ARE IN MILLIONS) Real estate secured................................... $52,440 $1,219 2% $ 5,183 11% Auto finance.......................................... 4,936 798 19 2,780 129 MasterCard(1)/Visa(1)................................. 10,788 (394) (4) 2,335 28 Private label......................................... 11,759 (845) (7) 570 5 Personal non-credit card(2)........................... 13,343 511 4 (584) (4) Commercial and other.................................. 384 (17) (4) (72) (16) ------- ------ -- ------- --- Total owned receivables............................... $93,650 $1,272 1% $10,212 12% ======= ====== == ======= === --------------- (1) MasterCard is a registered trademark of MasterCard International, Incorporated and Visa is a registered trademark of VISA USA, Inc. (2) Personal non-credit card receivables are comprised of the following: MARCH 31, DECEMBER 31, MARCH 31, 2004 2003 2003 -------------------------------------------------------------------------------------------------- (IN MILLIONS) Domestic personal non-credit card........................... $ 5,907 $ 5,608 $ 6,503 Union Plus personal non-credit card......................... 640 714 978 Personal homeowner loans.................................... 3,384 3,302 3,974 Foreign personal non-credit card............................ 3,412 3,208 2,472 ------- ------- ------- Total personal non-credit card.............................. $13,343 $12,832 $13,927 ======= ======= ======= Owned receivables of $93.7 billion at March 31, 2004 increased $10.2 billion from a year ago. Driven by growth in our correspondent business, real estate secured receivables increased $5.2 billion over the year-ago period despite sales to HSBC Bank USA. Real estate secured receivables reflect sales to HSBC Bank USA of $.9 billion on March 31, 2004 and $2.8 billion on December 31, 2003 and $.4 billion of correspondent receivables purchased directly by HSBC Bank USA, a portion of which we otherwise would have purchased. Real estate secured receivable levels in our branch-based consumer lending business continue to improve, as sales volumes remain higher than the first half of 2003 following our intentional fourth quarter 2002 slowdown and we continue to emphasize real estate secured loans in our branches. Auto finance receivables increased $2.8 billion year-over-year to $4.9 billion at March 31, 2004 due to newly originated loans acquired from our dealer network and strategic alliances established during 2003 and lower securitization levels. MasterCard and Visa receivables increased $2.3 billion to $10.8 billion at March 31, 2004 and reflect a $.9 billion portfolio acquisition during 2003, organic growth especially in our GM and subprime portfolios and reduced securitization levels. Private label receivables increased $.6 billion to $11.8 billion. This growth reflects owned portfolio acquisitions of $1.2 billion during the second quarter of 2003 as well as organic growth through existing merchants which were partially offset by securitization activity. Personal non-credit card receivables declined $.6 billion to $13.3 billion as we decreased the size of this portfolio through tightened underwriting in our branches and decreased marketing in our branches and Union Plus portfolio. Compared to December 31, 2003, both our correspondent and branch businesses reported growth in their real estate secured portfolios. Our MasterCard and Visa and private label portfolios reflect seasonal run-off. 31 Household International Inc., and Subsidiaries -------------------------------------------------------------------------------- Growth in our auto finance and personal non-credit card portfolios reflects lower levels of securitizations. Our auto finance business also generated organic growth through its dealer network. RESULTS OF OPERATIONS -------------------------------------------------------------------------------- Unless noted otherwise, the following discusses amounts reported in our owned basis statements of income. NET INTEREST INCOME Net interest income on an owned basis was $1.8 billion for the first quarter of 2004, compared to $1.6 billion in the prior-year quarter. The increase was due to lower funding costs, including the impact of purchase accounting adjustments, and higher average receivables, partially offset by lower yields on our receivables, particularly in real estate secured receivables. The lower yields reflect reduced pricing as well as the run-off of higher yielding real estate secured receivables, including second lien loans. The HSBC merger-related purchase accounting adjustments include both amortization of fair value adjustments to our external debt obligations (which reduced interest expense) and to our receivables (which reduced finance income). Excluding amortization of purchase accounting adjustments, which totaled $189 million in 2004 and $8 million in 2003, net interest income on an owned basis was $1.6 billion in the current quarter and $1.6 billion in the prior-year quarter. Net interest income as a percent of average owned interest-earning assets, annualized, was 7.30 percent in the quarter compared to 7.27 percent in the year-ago period. As discussed above, the increase was primarily attributable to lower funding costs, including the impact of purchase accounting fair value adjustments, partially offset by the full quarter impact of the loss of hedge accounting following our acquisition by HSBC. Excluding the purchase accounting impact, the net interest margin ratio would have declined as a result of lower yields on our receivables as discussed above, partially offset by lower cost of funds. Our net interest margin on an owned basis was impacted by the loss of hedge accounting on the hedging relationships at the time of the merger. The loss of hedge accounting on the impacted hedging relationships reduced net interest income during the quarter by $71 million in 2004 and $4 million in 2003. The following table compares our reported net interest margin to what it otherwise would have been had hedge accounting not been lost: THREE MONTHS ENDED THREE MONTHS ENDED MARCH 31, 2004 MARCH 31, 2003 ----------------------- ----------------------- WITHOUT LOSS WITHOUT LOSS AS OF HEDGE AS OF HEDGE REPORTED ACCOUNTING* REPORTED ACCOUNTING* -------- ------------ -------- ------------ Net interest margin.............................. 7.30% 7.65% 7.27% 7.29% --------------- * Represents a non-GAAP financial measure which is being provided for comparison of our trends and should be read in conjunction with our reported results. Our net interest income on a managed basis includes finance income earned on our owned receivables as well as on our securitized receivables. This finance income is offset by interest expense on the debt recorded on our balance sheet as well as the contractual rate of return on the instruments issued to investors when the receivables were securitized. Managed basis net interest income was $2.6 billion in the first quarter of 2004 and $2.4 billion in the year-ago quarter. Net interest income as a percent of average managed interest-earning assets, annualized, was 8.24 percent in the current quarter, compared to 8.28 percent in the year-ago period. As discussed above, the decrease was due to lower yields on our receivables, particularly in real estate secured receivables, partially offset by lower funding costs, including the impact of purchase accounting fair value adjustments, and higher average receivables. Net interest income as a percent of receivables on a managed basis is greater than on an owned basis because the managed basis portfolio includes relatively more unsecured loans, which have higher yields. 32 Household International Inc., and Subsidiaries -------------------------------------------------------------------------------- Our net interest margin on a managed basis was impacted by the loss of hedge accounting as discussed above. The following table compares our reported net interest margin to what it otherwise would have been had hedge accounting not been lost: THREE MONTHS ENDED THREE MONTHS ENDED MARCH 31, 2004 MARCH 31, 2003 ----------------------- ----------------------- WITHOUT LOSS WITHOUT LOSS AS OF HEDGE AS OF HEDGE REPORTED ACCOUNTING* REPORTED ACCOUNTING* -------- ------------ -------- ------------ Net interest margin.............................. 8.24% 8.47% 8.28% 8.30% --------------- * Represents a non-GAAP financial measure which is being provided for comparison of our trends and should be read in conjunction with our reported results. PROVISION FOR CREDIT LOSSES The provision for credit losses was $.9 billion for the first quarter of 2004 and $1.0 billion in the prior-year quarter. Improving credit quality, partially offset by receivable growth, contributed to the decrease in the provision for credit losses. The provision as a percent of average owned receivables, annualized, was 3.98 percent in the first quarter of 2004 and 4.85 percent in the first quarter of 2003. During the quarter ended March 31, 2004, credit loss reserves decreased as the provision for owned credit losses was $43 million less than net charge-offs. In the first quarter of 2003, provision for owned credit losses was $136 million greater than net charge-offs. The provision for credit losses may vary from quarter to quarter, depending on the product mix and credit quality of loans in our portfolio. See Note 5, "Credit Loss Reserves" to the accompanying consolidated financial statements for further discussion of factors affecting the provision for credit losses. OTHER REVENUES Total other revenues included the following: THREE MONTHS ENDED MARCH 31, 2004 2003 ------------------------------------------------------------------------------------- (RESTATED) (RESTATED) (COMBINED) (IN MILLIONS) Securitization revenue...................................... $ 348 $ 443 Insurance revenue........................................... 211 177 Investment income........................................... 41 81 Derivative income........................................... 52 217 Fee income.................................................. 265 289 Taxpayer financial services income.......................... 206 181 Other income................................................ 100 69 ------ ------ Total other revenues........................................ $1,223 $1,457 ====== ====== Securitization revenue is the result of the securitization of our receivables and included the following: THREE MONTHS ENDED MARCH 31, 2004 2003 ------------------------------------------------------------------------------- (COMBINED) (IN MILLIONS) Net initial gains(1)........................................ $ 3 $ 35 Net replenishment gains(1).................................. 120 137 Servicing revenue and excess spread......................... 225 271 ---- ---- Total....................................................... $348 $443 ==== ==== --------------- (1) Net of our estimate of probable credit losses under the recourse provisions The decrease in securitization revenue was due to decreases in the level of receivables securitized during the first quarter of 2004 as a result of the use of alternative funding sources and lower excess spread which included amortization of purchase accounting fair value adjustments to our interest-only strip receivables. 33 Household International Inc., and Subsidiaries -------------------------------------------------------------------------------- Under U.K. GAAP as reported by HSBC, our securitizations are treated as financing transactions. Securitization revenue will vary each period based on the level and mix of receivables securitized in that particular period (which will impact the gross initial gains and related estimated probable credit losses under the recourse provisions). It is also affected by the overall level and mix of previously securitized receivables (which will impact servicing revenue and excess spread). The estimate for probable credit losses for securitized receivables is also impacted by the level and mix of current period securitizations because, depending upon loss estimates and severities, securitized receivables with longer lives may result in higher over-the-life losses than receivables securitized with shorter lives. Our interest-only strip receivables, net of the related loss reserve and excluding the mark-to-market adjustment recorded in accumulated other comprehensive income, decreased $112 million in the first quarter of 2004 and $35 million in the first quarter of 2003 as securitized receivables decreased. Insurance revenue was $211 million in the first quarter of 2004 compared to $177 million in the year-ago period. The increase reflects increased sales in our U.K. business. Investment income, which includes income on investment securities in our insurance business as well as realized gains and losses from the sale of investment securities, was $41 million in the first quarter of 2004 compared to $81 million in the year-ago period. The decrease was attributable to lower gains from security sales, lower interest income and the amortization of purchase accounting adjustments. Derivative income, which includes realized and unrealized gains and losses on derivatives which do not qualify as effective hedges under SFAS 133 as well as the ineffectiveness on derivatives associated with our qualifying hedges is summarized in the table below: THREE MONTHS ENDED MARCH 31, 2004 2003 --------------------------------------------------------------------------- (IN MILLIONS) Net realized gains (losses)................................. $ 7 $ 2 Net unrealized gains (losses)............................... 45 210 Ineffectiveness............................................. -- 5 --- ---- Total....................................................... $52 $217 === ==== Derivative income decreased in the first quarter. Derivative income was higher in the prior year quarter due to a decline in rates during the three day period following our acquisition by HSBC which increased the value associated with our receive fixed swap portfolio. Derivative income in 2004 reflects a decreasing rate environment coupled with a significant reduction in both our receive fixed and pay fixed swap portfolios which do not qualify for hedge accounting under SFAS 133. These derivatives remain economic hedges of the underlying debt instruments. Fee income, which includes revenues from fee-based products such as credit cards, was $265 million in the first quarter of 2004 compared to $289 million in the year-ago period. The decrease was primarily due to higher payments to merchant partners as a result of portfolio acquisitions in our retail services business. See "Segment Results -- Managed Basis" in this MD&A for additional information on fee income on a managed basis. Taxpayer financial services income was $206 million in the first quarter of 2004 compared to $181 million in the year-ago period. The increase is primarily due to lower funding costs as a result of our acquisition by HSBC. Other income, was $100 million in the first quarter of 2004 compared to $69 million in the year-ago period. The increase reflects higher revenues from our mortgage operations, including the $15 million gain on the sale of real estate secured receivables to HSBC Bank USA. EXPENSES As discussed earlier, effective January 1, 2004, our technology services employees were transferred to HSBC Technology and Services (USA) Inc. ("HTSU"). As a result, operating expenses 34 Household International Inc., and Subsidiaries -------------------------------------------------------------------------------- relating to information technology as well as certain item processing and statement processing activities, which have previously been reported as salaries and employee benefits, occupancy and equipment expenses, or other servicing and administrative expenses are now billed to us by HTSU and reported as support services from HSBC affiliates. Support services from HSBC affiliates also includes banking services and other miscellaneous services provided by HSBC Bank USA and other subsidiaries of HSBC. Total costs and expenses, excluding HSBC acquisition related costs incurred by Household in the first quarter of 2003, increased $187 million, or 15 percent, to $1.4 billion for the first quarter of 2004. The increase was primarily due to amortization of acquired intangibles established in conjunction with the HSBC merger and higher salaries and fringe benefits and sales incentives, excluding the HTSU transfer. Total costs and expenses included the following: THREE MONTHS ENDED MARCH 31, 2004 2003 --------------------------------------------------------------------------------- (COMBINED) (IN MILLIONS) Salaries and employee benefits.............................. $ 485 $ 509 Sales incentives............................................ 78 39 Occupancy and equipment expenses............................ 83 101 Other marketing expenses.................................... 132 143 Other servicing and administrative expenses................. 226 323 Support services from HSBC affiliates....................... 177 - Amortization of intangibles................................. 116 14 Policyholders' benefits..................................... 113 94 HSBC acquisition related costs incurred by Household........ - 198 ------ ------ Total costs and expenses.................................... $1,410 $1,421 ====== ====== Our owned basis efficiency ratio was 44.3 percent for the first quarter of 2004 and 44.4 percent for the year-ago quarter. Excluding HSBC acquisition related costs in 2003, our owned basis efficiency ratio was 37.7 percent. The increase in the 2004 efficiency ratio over the 2003 operating basis ratio was primarily attributable to an increase in expenses, particularly intangible amortization. Lower securitization revenue and lower derivative income also contributed to the increase. See "Reconciliation to GAAP Financial Measures" for quantitative reconciliations of our operating efficiency ratio to our owned basis GAAP efficiency ratio. Salaries and employee benefits for the first quarter of 2004 were $485 million compared to $509 million in the first quarter of 2003. The decrease was primarily due to the transfer of our technology personnel to HTSU. Excluding this change, salaries and employee benefits increased $32 million as a result of increases in substantially all of our business units. These increases were largely offset by decreases in employee benefit expenses as a result of non-recurring expenses incurred in 2003 in conjunction with the merger. Sales incentives for the first quarter of 2004 were $78 million compared to $39 million in the comparable prior-year period. The increase was primarily due to higher volumes in our branches as well as a special incentive program in our branches during the current quarter. Occupancy and equipment expenses for the first quarter of 2004 were $83 million compared to $101 million in the comparable prior-year period. Substantially all of the decrease was due to the formation of HTSU as discussed above. Other marketing expenses for the first quarter of 2004 were $132 million compared to $143 million in the comparable prior-year period. The decrease is primarily due to decreased credit card marketing. 35 Household International Inc., and Subsidiaries -------------------------------------------------------------------------------- Other servicing and administrative expenses for the first quarter of 2004 were $226 million compared to $323 million in the comparable prior-year period. Substantially all of the decrease was due to the transfer of certain item processing and statement processing services to HTSU. Support services from HSBC affiliates of $177 million for the first quarter of 2004 includes $172 million of information technology as well as certain item processing and statement processing services which are now charged to us by HTSU and $5 million of banking services and other miscellaneous services provided by HSBC Bank USA and other subsidiaries of HSBC. Amortization of intangibles for the first quarter of 2004 were $116 million compared to $14 million in the comparable prior-year period. The increase was attributable to the amortization of intangibles established in conjunction with our acquisition by HSBC. Policyholders' benefits for the first quarter of 2004 were $113 million compared to $94 million in the comparable prior-year period. The increase reflects higher sales in our U.K. business which were partially offset by lower expenses in our domestic business. The first quarter of 2004 also includes amortization of fair value adjustments relating to our insurance business. HSBC acquisition related costs incurred by Household in the first quarter of 2003 were $198 million and include payments to executives under existing employment contracts and investment banking, legal and other costs relating to our acquisition by HSBC. 36 Household International Inc., and Subsidiaries -------------------------------------------------------------------------------- SEGMENT RESULTS - MANAGED BASIS -------------------------------------------------------------------------------- We have three reportable segments: Consumer, Credit Card Services and International. Our Consumer segment consists of our consumer lending, mortgage services, retail services and auto finance businesses. Our Credit Card Services segment consists of our domestic MasterCard and Visa credit card business. Our International segment consists of our foreign operations in the United Kingdom, Canada, Ireland and the remainder of Europe. Effective January 1, 2004, our direct lending business, which has previously been reported in our "All Other" caption, was consolidated into our consumer lending business and as a result is now included in our Consumer segment. Prior periods have not been restated as the impact was not material. There have been no other changes in the basis of our segmentation or any changes in the measurement of segment profit as compared with the presentation of our 2003 financial information included in our 2004 Form 10-K. We monitor our operations and evaluate trends on a managed basis (a non-GAAP financial measure), which assumes that securitized receivables have not been sold and are still on our balance sheet. We manage and evaluate our operations on a managed basis because the receivables that we securitize are subjected to underwriting standards comparable to our owned portfolio, are serviced by operating personnel without regard to ownership and result in a similar credit loss exposure for us. In addition, we fund our operations, review our operating results, and make decisions about allocating resources such as employees and capital on a managed basis. When reporting on a managed basis, net interest income, provision for credit losses and fee income related to receivables securitized are reclassified from securitization revenue in our owned statements of income into the appropriate caption. CONSUMER SEGMENT Our Consumer segment reported net income of $304 million for the first quarter of 2004 compared to $216 million in the year-ago quarter. Increases in net interest income and decreases in provision for credit losses were partially offset by higher operating expenses and substantially lower other revenues, excluding fee income. Net interest income increased $127 million, or 7 percent, to $1.9 billion for the quarter as a result of higher receivable levels. Net interest income as a percentage of average interest-earning assets, annualized, was 8.38 percent for the first quarter of 2004 compared to 8.60 percent for the first quarter of 2003. The decrease is primarily attributable to lower yields on real estate secured receivables as a result of reduced pricing as well as the run-off of higher yielding real estate secured receivables, including second lien loans. Our auto finance business also reported lower net interest margin as we have targeted lower yielding but higher credit quality customers. Other revenues, excluding fee income, decreased $199 million, or more than 100 percent, to ($182) million for the quarter as a result of a $213 million decline in securitization revenue. Initial securitization levels were much lower in 2004 as we used funding from HSBC, including proceeds from receivable sales, to assist in the funding of our operations. Operating expenses increased $61 million, or 11 percent, to $627 million for the quarter as the result of additional operating costs to support the increased receivable levels including higher salaries and sales incentives. During the quarter, we experienced improved credit quality. Our managed basis provision for credit losses, which includes both provision for owned basis receivables and over-the-life provision for receivables serviced with limited recourse, decreased $275 million, or 29 percent, to $665 million for the quarter. Although we experienced higher net charge-offs in our owned portfolio during the quarter as a result of higher delinquency levels in prior quarters, our overall owned provision for credit losses was lower than net charge-offs in the current quarter because charge-offs are a lagging indicator of changes in credit quality. Over-the-life provisions for credit losses for securitized receivables recorded in any given period reflect the level and mix of securitizations in that period. Subsequent charge-offs of such receivables result in a decrease in the over-the-life reserves without any corresponding increase to managed loss provision. The combination of these factors resulted in a decrease in managed loss reserves during the current quarter as net charge-offs were greater than the provision for credit losses by $319 million. For the 2003 quarter, we increased managed loss reserves by recording loss provision greater than net charge-offs of $70 million. 37 Household International Inc., and Subsidiaries -------------------------------------------------------------------------------- Managed receivables of $87.7 billion at March 31, 2004 increased 1 percent compared to $87.1 billion at December 31, 2003 and 9 percent compared to $80.5 billion at March 31, 2003. Compared to December 31, 2003, growth in real estate secured receivables in both our correspondent and branch-based consumer lending businesses and in our auto finance portfolio was substantially offset by $.9 billion of real estate secured receivables sold to HSBC Bank USA and $.4 billion of correspondent receivables purchased directly by HSBC Bank USA (a portion of which we otherwise would have purchased), seasonal run-off in our private label portfolio, and continued reduction of our personal non-credit card portfolio as we reduced the size of this portfolio through tightened underwriting and decreased marketing in our branches. Compared to March 31, 2003, receivable growth was strongest in our real estate secured portfolio despite sales to HSBC Bank USA. Real estate secured receivables reflect sales to HSBC Bank USA totaling $3.7 billion and $.4 billion of correspondent receivables purchased directly by HSBC Bank USA, a portion of which we otherwise would have purchased. Our auto finance portfolio also reported strong growth as a result of newly originated loans acquired from our dealer network and strategic alliances established during 2003. Increases in private label receivables were the result of portfolio acquisitions as well as organic growth. Personal non-credit card receivables declined as we reduced the size of this portfolio through tightened underwriting and decreased marketing in our branches. Return on average managed assets ("ROMA") was 1.34 percent in the first quarter of 2004 compared to 1.04 percent in the year-ago quarter. The increase in the ratio reflects higher net income as discussed above. CREDIT CARD SERVICES SEGMENT Our Credit Card Services segment reported net income of $137 million for the first quarter of 2004 compared to $128 million for the year-ago quarter. The increase was due primarily to higher net interest income and fee income, substantially offset by higher provision for credit losses and the impact of lower securitization levels. Net interest income increased $50 million, or 10 percent, to $529 million and fee income increased $24 million, or 7 percent, to $350 million for the quarter as a result of higher receivable levels. Net interest income as a percentage of average interest-earning assets, annualized, of 9.99 percent for the quarter was comparable to 9.91 percent for the prior year quarter. Partially offsetting the revenue growth was higher provision for credit losses which increased $31 million, or 8 percent, to $422 million during the quarter as a result of the higher receivable levels, including an increase in the percentage of nonprime receivables in our portfolio, as well as seasoning in our portfolios. We increased managed loss reserves by recording loss provision greater than net charge-offs of $47 million during the current quarter and $58 million during the prior year quarter. Other revenues, excluding fee income, decreased $22 million, or 38 percent, to $36 million for the quarter primarily as a result of a decline in receivables securitized. Initial securitization levels were lower in 2004 as we used funding from HSBC, including proceeds from receivable sales, to assist in the funding of our operations. Managed receivables of $18.7 billion at March 31, 2004 decreased 5 percent compared to $19.6 billion at December 31, 2003 and increased 9 percent compared to $17.2 billion at March 31, 2003. The decrease during the current quarter was due to normal seasonal run-off. Compared to March 31, 2003, growth is largely attributable to portfolio acquisitions totaling $.9 billion and organic growth in our GM and subprime portfolios. ROMA of 2.54 percent in the first quarter of 2004 was comparable to 2.50 percent in the year-ago quarter. INTERNATIONAL SEGMENT Our International segment reported net income of $28 million for the first quarter of 2004 compared to $31 million for the year-ago quarter. Applying constant currency rates, which uses the average rate of exchange for the 2003 quarter to translate current quarter net income, net income would have been lower by $4 million in the current quarter. The decrease in net income reflects higher provision for credit losses and operating expenses, partially offset by higher net interest income and other revenues, excluding fee income. Net interest income increased $24 million, or 13 percent, to $203 million for the quarter due to higher receivable levels. Net interest income as a percentage of average interest-earning assets, annualized, of 7.18 percent for the first quarter of 2004 declined from 7.60 percent for the first quarter of 2003 due to product mix and pricing. Provision for credit losses rose $10 million, or 12 percent, to $95 million for the quarter primarily as a result of increased levels of receivables. We 38 Household International Inc., and Subsidiaries -------------------------------------------------------------------------------- increased managed loss reserves by recording loss provision greater than net charge-offs of $13 million during the current quarter and $18 million during the prior year quarter. Other revenues, excluding fee income, increased $15 million, or 21 percent, to $88 million for the quarter as a result of higher insurance revenues, partially offset by a $15 million decrease in securitization revenue as a result of a decline in receivables securitized. Total costs and expenses increased $34 million, or 25 percent, to $172 million during the quarter primarily as a result of higher salary expenses to support receivable growth and higher policyholder benefits, which resulted from increased insurance sales volumes. Managed receivables of $11.3 billion at March 31, 2004 increased 3 percent compared to $11.0 billion at December 31, 2003 and 23 percent compared to $9.1 billion at March 31, 2003. Compared to the prior quarter, growth in our real estate secured and personal non-credit card portfolios was substantially offset by normal seasonal run-off in our MasterCard and Visa and private label portfolios. Growth over the prior year quarter was strongest in our private label portfolio as the result of a $.4 billion portfolio acquisition in the second quarter of 2003. Strong growth in our real estate secured and personal non-credit card portfolios since March 31, 2003 was partially offset by a decline in our MasterCard and Visa portfolio in the United Kingdom. Applying constant currency rates, managed receivables at March 31, 2004 would have been $.2 billion lower using December 31, 2003 exchange rates and $1.5 billion lower using March 31, 2003 exchange rates. ROMA was .93 percent in the first quarter of 2004 compared to 1.21 percent in the year-ago quarter. The decrease is the result of the decrease in net interest income as a percent of average interest-earning assets and higher expenses, including provision for credit losses. RECONCILIATION OF MANAGED BASIS SEGMENT RESULTS Income statement information included in the table for the three months ended March 31, 2003 combines January 1 through March 28, 2003 (the "predecessor period") and March 29 to March 31, 2003 (the "successor period") in order to present "combined" financial results for the three months ended March 31, 2003. Fair value adjustments related to purchase accounting and related amortization have been allocated to Corporate, which is included in the "All Other" caption within our segment disclosure. As a result, managed and owned basis consolidated totals for the period ended March 31, 2003 include combined information from both the "successor" and "predecessor" periods which impacts comparability to the current period. 39 Household International Inc., and Subsidiaries -------------------------------------------------------------------------------- Reconciliations of our managed basis segment results to managed basis and owned basis consolidated totals are as follows: MANAGED CREDIT ADJUSTMENTS/ BASIS CARD RECONCILING CONSOLIDATED CONSUMER SERVICES INTERNATIONAL ALL OTHER TOTALS ITEMS TOTALS ------------------------------------------------------------------------------------------------------------------ (IN MILLIONS) THREE MONTHS ENDED MARCH 31, 2004 (RESTATED) Net interest income..... $ 1,865 $ 529 $ 203 $ (23) $ 2,574 - $ 2,574 Fee income.............. 94 350 20 (2) 462 - 462 Other revenues, excluding fee income... (182) 36 88 350 292 (32)(2) 260 Intersegment revenues... 22 8 3 (1) 32 (32)(2) - Provision for credit losses................. 665 422 95 (1) 1,181 - 1,181 Net income.............. 304 137 28 22 491 (21) 470 Receivables............. 87,697 18,680 11,257 373 118,007 - 118,007 Assets.................. 90,154 20,645 12,272 25,801 148,872 (8,680)(4) 140,192 ------- ------- ------- ------- -------- ------ -------- THREE MONTHS ENDED MARCH 31, 2003 (RESTATED) Net interest income..... $ 1,738 $ 479 $ 179 $ (42) $ 2,354 - $ 2,354 Fee income.............. 97 326 19 1 443 - 443 Other revenues, excluding fee income... 17 58 73 583 731 (36)(2) 695 Intersegment revenues... 26 9 2 (1) 36 (36)(2) - Provision for credit losses................. 940 391 85 - 1,416 1(3) 1,417 HSBC acquisition related costs incurred by Household.............. - - - 198 198 - 198 Net income.............. 216 128 31 39 414 (24) 390 Operating net income(1).............. 216 128 31 206 581 (24) 557 Receivables............. 80,475 17,158 9,118 943 107,694 - 107,694 Assets.................. 83,406 19,754 10,485 26,902 140,547 (8,875)(4) 131,672 ------- ------- ------- ------- -------- ------ -------- OWNED BASIS SECURITIZATION CONSOLIDATED ADJUSTMENTS TOTALS ------------------------ ----------------------------- (IN MILLIONS) THREE MONTHS ENDED MARCH 31, 2004 (RESTATED) Net interest income..... $ (754)(5) $ 1,820 Fee income.............. (197)(5) 265 Other revenues, excluding fee income... 698(5) 958 Intersegment revenues... - - Provision for credit losses................. (253)(5) 928 Net income.............. - 470 Receivables............. (24,357)(6) 93,650 Assets.................. (24,357)(6) 115,835 -------- -------- THREE MONTHS ENDED MARCH 31, 2003 (RESTATED) Net interest income..... $ (726)(5) $ 1,628 Fee income.............. (154)(5) 289 Other revenues, excluding fee income... 473(5) 1,168 Intersegment revenues... - - Provision for credit losses................. (407)(5) 1,010 HSBC acquisition related costs incurred by Household.............. - 198 Net income.............. - 390 Operating net income(1).............. - 557 Receivables............. (24,256)(6) 83,438 Assets.................. (24,256)(6) 107,416 -------- -------- --------------- (1) This non-GAAP financial measure is provided for comparison of our operating trends only and should be read in conjunction with our owned basis GAAP financial information. Operating net income excludes $167 million (after-tax) of HSBC acquisition related costs and other merger related items incurred by Household in 2003. See "Basis of Reporting" in Management's Discussion and Analysis for additional discussion on the use of non-GAAP financial measures and quantitative reconciliations to GAAP basis net income. (2) Eliminates intersegment revenues. (3) Eliminates bad debt recovery sales between operating segments. (4) Eliminates investments in subsidiaries and intercompany borrowings. (5) Reclassifies net interest income, fee income and provision for credit losses relating to securitized receivables to other revenues. (6) Represents receivables serviced with limited recourse. CREDIT QUALITY -------------------------------------------------------------------------------- Subject to receipt of regulatory and other approvals, we intend to transfer substantially all of our domestic private label credit card portfolio and our General Motors and Union Privilege MasterCard and Visa portfolios to HSBC Bank USA. Contingent upon receiving regulatory approval for these asset transfers in 2004, we would also expect to adopt charge-off and account management guidelines in accordance with the Uniform Retail Credit Classification and Account Management Policy issued by the FFIEC for those MasterCard and Visa and private label credit card receivables which remain on our balance sheet. See "Operations Summary" for further discussion. 40 Household International Inc., and Subsidiaries -------------------------------------------------------------------------------- CREDIT LOSS RESERVES We maintain credit loss reserves to cover probable losses of principal, interest and fees, including late, overlimit and annual fees. Credit loss reserves are based on a range of estimates and intended to be adequate but not excessive. While our credit loss reserves are available to absorb losses in the entire portfolio, we specifically consider the credit quality and other risk factors for each of our products. We recognize the different inherent loss characteristics in each of our products as well as customer account management policies and practices and risk management/collection practices. Charge-off policies are also considered when establishing loss reserve requirements to ensure the appropriate reserves exist for products with longer charge-off periods. We also consider key ratios such as reserves to nonperforming loans and reserves as a percentage of net charge-offs in developing our loss reserve estimates. Loss reserve estimates are reviewed periodically and adjustments are reported in earnings when they become known. As these estimates are influenced by factors outside of our control, such as consumer payment patterns and economic conditions, there is uncertainty inherent in these estimates, making it reasonably possible that they could change. See Note 4, "Receivables," in the accompanying consolidated financial statements for receivables by product type and Note 5, "Credit Loss Reserves," for our credit loss reserve methodology and an analysis of changes in the credit loss reserves. The following table sets forth owned basis credit loss reserves for the periods indicated: MARCH 31, DECEMBER 31, MARCH 31, 2004 2003 2003 -------------------------------------------------------------------------------------------------- (DOLLAR AMOUNTS ARE IN MILLIONS) Owned credit loss reserves.................................. $ 3,753 $ 3,793 $ 3,483 Reserves as a percent of: Receivables............................................... 4.01% 4.11% 4.17% Net charge-offs(1)........................................ 96.7 107.3 99.6 Nonperforming loans....................................... 96.7 93.7 92.6 -------- -------- -------- --------------- (1) Quarter-to-date, annualized During the quarter ended March 31, 2004, credit loss reserves decreased as the provision for owned credit losses was $43 million less than net charge-offs. In the first quarter of 2003, provision for owned credit losses was $136 million greater than net charge-offs. Reserve levels at March 31, 2004 reflect improving credit quality. For securitized receivables, we also record a provision for estimated probable losses that we expect to incur under the recourse provisions. The following table sets forth managed credit loss reserves for the periods indicated: MARCH 31, DECEMBER 31, MARCH 31, 2004 2003 2003 ----------------------------------------------------------------------------------------------------- (DOLLAR AMOUNTS ARE STATED IN MILLIONS) Managed credit loss reserves................................ $ 5,912 $ 6,167 $ 5,259 Reserves as a percent of: Receivables............................................... 5.01% 5.20% 4.88% Net charge-offs(1)........................................ 102.5 118.2 103.3 Nonperforming loans....................................... 119.8 118.0 111.3 -------- -------- -------- --------------- (1) Quarter-to-date, annualized See "Basis of Reporting" for additional discussion on the use of non-GAAP financial measures and "Reconciliations to GAAP Financial Measures" for quantitative reconciliations of the non-GAAP financial measures to the comparable GAAP basis financial measure. 41 Household International Inc., and Subsidiaries -------------------------------------------------------------------------------- DELINQUENCY - OWNED BASIS Two-Months-and-Over Contractual Delinquency (as a percent of consumer receivables): MARCH 31, DECEMBER 31, MARCH 31, 2004 2003 2003 -------------------------------------------------------------------------------------------------- Real estate secured......................................... 3.87% 4.33% 4.15% Auto finance................................................ 1.68 2.51 2.75 MasterCard/Visa............................................. 5.90 5.76 6.87 Private label............................................... 5.38 5.42 6.06 Personal non-credit card.................................... 9.64 10.01 9.23 ---- ----- ---- Total....................................................... 5.01% 5.36% 5.50% ==== ===== ==== Total owned delinquency decreased $265 million and 35 basis points compared to the prior quarter. This decrease is consistent with improvements in early delinquency roll rate trends experienced in the fourth quarter of 2003 as a result of improvements in the economy and better underwriting, including both improved modeling and improved credit quality of originations. The decrease also reflects seasonal improvement in collections as customers use their tax refunds to reduce their outstanding balances. These improvements were partially offset in our real estate secured and total delinquency ratios by the negative impact of the sale of predominantly non-delinquent real estate secured receivables to HSBC Bank USA. The overall decrease in our real estate secured portfolio reflects receivable growth and improved collection efforts which were partially offset by the seasoning and maturation of the portfolio. The decrease in auto finance delinquency is consistent with historical seasonal trends and also reflects the positive impact of tightened underwriting and higher receivable levels as a result of acquisitions from strategic alliances and lower securitization levels. Lower levels of receivables due to normal seasonal run-off, partially offset by lower securitization levels, had a negative impact on both MasterCard and Visa and private label delinquency. In our private label portfolio, this negative impact was more than offset by improved underwriting, collections and credit models. The decrease in personal non-credit card delinquency reflects the positive impact of tightened underwriting and reduced marketing in our branches as well as improved collection efforts. Compared to a year ago, total delinquency decreased 49 basis points as all products, other than personal non-credit card, reported lower delinquency levels. The improvements are generally the result of improvements in the economy, receivable growth and better underwriting. The increase in our personal non-credit card portfolio reflects maturation of the portfolio as well as reduced originations. NET CHARGE-OFFS OF CONSUMER RECEIVABLES - OWNED BASIS Net Charge-offs of Consumer Receivables (as a percent, annualized, of average consumer receivables): MARCH 31, DECEMBER 31, MARCH 31, 2004 2003 2003 -------------------------------------------------------------------------------------------------- Real estate secured......................................... 1.15% .94% 1.12% Auto finance................................................ 4.65 3.36 7.71 MasterCard/Visa............................................. 8.66 8.55 9.26 Private label............................................... 5.29 5.05 6.27 Personal non-credit card.................................... 11.17 10.11 9.04 ----- ----- ---- Total....................................................... 4.17% 3.75% 4.22% ===== ===== ==== Real estate secured net charge-offs and REO expense as a percent of average real estate secured receivables........ 1.63% 1.37% 1.52% ----- ----- ---- 42 Household International Inc., and Subsidiaries -------------------------------------------------------------------------------- Net charge-offs increased 42 basis points compared to the quarter ended December 31, 2003 as higher delinquencies in prior quarters as a result of adverse economic conditions continue to charge off. The increase in auto finance net charge-offs reflects a normal seasonal pattern related to higher delinquencies in the fourth quarter. The increase in our MasterCard and Visa portfolio is primarily attributable to a reduction in promotional receivables in our U.K. portfolio. The increase in private label net charge-offs is primarily attributable to the seasonal timing of promotion expirations. Increases in our personal non-credit card portfolio reflect continued maturation of older loans. Total net charge-offs for the current quarter decreased slightly from from March 2003 net charge-offs levels as a result of a decrease in the percentage of the portfolio comprised of personal non-credit card receivables, which have a higher net charge-off rate than other products in our portfolio. Excluding the adoption of FSP 144-1, which resulted in the reclassification of sales commissions related to the sale of foreclosed assets from other servicing and administrative expenses to charge-offs, real estate secured net charge-offs would have declined compared to the March 2003 quarter. Auto finance, MasterCard and Visa and private label reported lower net charge-off levels generally as a result of receivable growth and better underwriting, including both improved modeling and improved credit quality of originations. Auto finance net charge-offs also reflect improved used auto prices which resulted in lower loss severities. The increase in our personal non-credit card portfolio reflects maturation of the portfolio as well as reduced originations. The increase in real estate secured net charge-offs and REO expense as a percent of average real estate secured receivables for the current quarter compared to the quarter ended December 31, 2003 reflects improved efficiencies in the foreclosure process which have resulted in an increase in the number of completed foreclosures. OWNED NONPERFORMING ASSETS MARCH 31, DECEMBER 31, MARCH 31, 2004 2003 2003 -------------------------------------------------------------------------------------------------- (DOLLAR AMOUNTS ARE IN MILLIONS) Nonaccrual receivables...................................... $ 3,003 $ 3,144 $ 2,880 Accruing consumer receivables 90 or more days delinquent.... 876 904 878 Renegotiated commercial loans............................... 2 2 2 -------- -------- -------- Total nonperforming receivables............................. 3,881 4,050 3,760 Real estate owned........................................... 656 631 445 -------- -------- -------- Total nonperforming assets.................................. $ 4,537 $ 4,681 $ 4,205 ======== ======== ======== Credit loss reserves as a percent of nonperforming receivables............................................... 96.7% 93.7% 92.6% -------- -------- -------- Compared to December 31, 2003, the decrease in nonaccrual receivables and total nonperforming assets is primarily attributable to a decrease in our real estate secured portfolio due to improved credit quality and collection efforts. Accruing consumer receivables 90 or more days delinquent includes domestic MasterCard and Visa and private label credit card receivables, consistent with industry practice. ACCOUNT MANAGEMENT POLICIES AND PRACTICES Our policies and practices for the collection of consumer receivables, including our account management policies and practices, permit us to reset the contractual delinquency status of an account to current, based on indicia or criteria which, in our judgment, evidence continued payment probability. Such policies and practices vary by product and are designed to manage customer relationships, maximize collection opportunities and avoid foreclosure or repossession if reasonably possible. The tables below summarize approximate restructuring statistics in our managed basis domestic portfolio. We report our restructuring statistics on a managed basis only because the receivables that we securitize 43 Household International Inc., and Subsidiaries -------------------------------------------------------------------------------- are subject to underwriting standards comparable to our owned portfolio, are serviced and collected without regard to ownership and result in a similar credit loss exposure for us. Our restructure statistics are compiled using certain assumptions and estimates and we continue to enhance our ability to capture restructure data across all business units. When comparing restructuring statistics from different periods, the fact that our restructure policies and practices will change over time, that exceptions are made to those policies and practices, and that our data capture methodologies will be enhanced over time, should be taken into account. Further, to the best of our knowledge, most of our competitors do not disclose account restructuring, reaging, loan rewriting, forbearance, modification, deferment or extended payment information comparable to the information we have disclosed, and the lack of such disclosure by other lenders may limit the ability to draw meaningful conclusions about us and our business based solely on data or information regarding account restructuring statistics or policies. MORE TO FOLLOW This information is provided by RNS The company news service from the London Stock Exchange

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