UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

Commission file number:                                             001-12351

METRIS COMPANIES INC.

10900 Wayzata Boulevard, Minnetonka, Minnesota 55305-1534
(Address of principal executive offices)

(952) 525-5020
(Registrant’s telephone number)

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 o

Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

Yes  x                              No o

As of October 31, 2004, 57,970,527 shares of the registrant’s common stock, par value $.01 per share, were outstanding.

METRIS COMPANIES INC.

FORM 10-Q

TABLE OF CONTENTS

September 30, 2004

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Part I. Financial Information

ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS

METRIS COMPANIES INC. AND SUBSIDIARIES

See accompanying Notes to Consolidated Financial Statements.

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METRIS COMPANIES INC. AND SUBSIDIARIES

See accompanying Notes to Consolidated Financial Statements.

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METRIS COMPANIES INC. AND SUBSIDIARIES

See accompanying Notes to Consolidated Financial Statements.

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METRIS COMPANIES INC. AND SUBSIDIARIES

See accompanying Notes to Consolidated Financial Statements.

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METRIS COMPANIES INC. AND SUBSIDIARIES

NOTE 1 — ORGANIZATION AND BASIS OF PRESENTATION

     The consolidated financial statements include the accounts of Metris Companies Inc. (“MCI”) and its subsidiaries. MCI’s principal subsidiaries are Direct Merchants Credit Card Bank, National Association (“Direct Merchants Bank” or the “Bank”), Metris Direct, Inc. and Metris Receivables, Inc. (“MRI”). MCI and its subsidiaries, as applicable, may be referred to as “we,” “us,” “our” or the “Company.” We are an information-based direct marketer of consumer lending products.

     All dollar amounts are presented as pre-tax amounts unless otherwise noted. We have eliminated all significant intercompany balances and transactions in consolidation.

     During the first quarter of 2004 we reclassified financial statement line items to more accurately reflect the continuing operations of our business. In prior periods we classified interest income from credit card loans, federal funds sold, and other as total interest income. For all periods presented, total interest income is classified as “Credit card loan and other interest income.” In prior periods we classified interest expense from deposits and other as total interest expense. For all periods presented total interest expense has been reclassified as “Interest expense.”

Interim Financial Statements

     We have prepared the unaudited interim consolidated financial statements and related unaudited financial information in the footnotes in accordance with accounting principles generally accepted in the United States of America (“GAAP”) and the rules and regulations of the Securities and Exchange Commission (“SEC”) for interim financial statements. These interim financial statements reflect all adjustments consisting of normal recurring accruals, which, in the opinion of management, are necessary to present fairly our consolidated financial position and the results of our operations and our cash flows for the interim periods. You should read these consolidated financial statements in conjunction with the financial statements and the notes thereto contained in our Annual Report on Form 10-K/A for the fiscal year ended December 31, 2003. The nature of our business is such that the results of any interim period may not be indicative of the results to be expected for the entire year.

Pervasiveness of Estimates

     We have prepared the consolidated financial statements in accordance with GAAP, which requires us to make estimates and assumptions that affect the reported amounts in the consolidated financial statements and accompanying notes. The most significant and subjective of these estimates are our determination of the valuation of our “Retained interests in loans securitized” and our determination of the “Allowance for loan losses.” The significant factors susceptible to future change that have an impact on these estimates include default rates, net interest spreads, payment rates, liquidity and the ability to finance future receivables activity and overall economic conditions. As a result, the fair value of our “Retained interests in loans securitized” and the actual losses in our “Credit card loan” portfolio as of September 30, 2004 and December 31, 2003, could materially differ from these estimates.

Comprehensive Income

     SFAS No. 130 “Reporting Comprehensive Income,” does not apply to our current financial results and therefore, net income equals comprehensive income.

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NOTE 2 – ACCOUNTING CHANGES

     In October, 2004, the Financial Accounting Standards Board (“FASB”) concluded that Statement 123R, Share-Based Payment, which will require all companies to measure and record in the income statement compensation cost for all share-based payments (including employee stock options) at fair value, would be effective for public companies for interim or annual periods beginning after June 15, 2005. The FASB plans to issue the final statement on or around December 15, 2004. We do not expect the adoption of Statement 123R will have a material impact on our financial statements.

     In March 2004, the Emerging Issues Task Force (“EITF”) reached a consensus on EITF Issue No. 03-6 “Participating Securities and the two-class method under FASB Statement 128,” (the “Consensus” or “EITF 03-6”). The Consensus requires net income to be reduced by the amount of dividends declared in the current period for each class of stock and by the contractual amount of dividends or other participation payments that are paid or accumulated for the current period. Undistributed earnings for the period are allocated to participating securities based on the contractual participation rights of the security to share in those current earnings assuming all earnings for the period are distributed. Our preferred shareholders have contractual participation rights on a converted basis that are equivalent to those of common shareholders. Therefore, we allocate undistributed earnings to preferred and common shareholders based on their respective ownership percentage, on a converted basis, as of the end of the period. The guidance in EITF 03-6 is effective for fiscal periods (interim or annual) beginning after March 31, 2004. Companies are required to restate prior period earnings per share amounts to conform to the guidance in EITF 03-6 upon adoption.

     The following table presents basic and diluted earnings (loss) per share using the two-class method for the first quarter of 2004 and the previous five annual periods:

⁽¹⁾ 1999 results include a one-time, non-cash, accounting adjustment of $101.6 million related to the conversion of Series B Preferred Stock, which is included in distributed earnings to preferred shareholders.

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NOTE 3 – EARNINGS (LOSS) PER SHARE

     The following table presents the computation of earnings (loss) per share.

(1) Preferred shareholders do not participate in any undistributed losses with common shareholders.

(2) For the three- and nine-month periods ended September 30, 2003 conversion of common share equivalents is not assumed because such conversion would be anti-dilutive.

NOTE 4 – STOCK-BASED COMPENSATION PLANS

     We recognize compensation cost for stock-based employee compensation plans based on the difference, if any, between the quoted market price of the stock on the date of grant and the amount an employee must pay to acquire the stock. No expense was reflected in net loss related to stock options as all options granted had an exercise price equal to the market value of the underlying common stock on the date of grant. For the three- and nine-month periods ended September 30, 2004 we recorded $0 and $15 thousand, respectively, in amortization of deferred compensation obligation, net of related tax benefit, in “Net income (loss)” related to restricted stock. This compares to $50 thousand and $195 thousand for the comparable periods in 2003. During the nine months ended 2004 we issued approximately 955,000 restricted stock units to employees. The units vest over a four-year period with possible acceleration of vesting if certain earning targets are met. Upon vesting each restricted stock unit converts to one share of common stock that is distributable to the employee. The fair value of the restricted stock units is expensed over the expected vesting period and included in “Employee compensation” on the consolidated statements of income and “Accrued expenses and other liabilities” on the consolidated balance sheets. For the three- and nine-month periods ended September 30, 2004, we recognized $551 thousand and $821 thousand, respectively in expense related to restricted stock units, net of related tax benefit.

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     The following table provides pro forma net income (loss) and earnings (loss) per share as if we accounted for our employee stock options under the fair value method. The fair value of the options was estimated at the grant date using a Black-Scholes option pricing model. The fair value of the options is amortized to expense over the options’ vesting periods. Under the fair value method, our “Net income (loss)” and “Earnings (loss) per share” would have been recorded at the pro forma amounts indicated below:

     The above pro forma amounts may not be representative of the effects on reported net income for future periods.

NOTE 5 – LIQUIDITY RESERVE DEPOSIT

     Direct Merchants Bank has established restricted deposits with third-party depository banks for the purpose of supporting Direct Merchants Bank’s funding needs and to satisfy banking regulators’ requirements under the Modified Operating Agreement, dated December 11, 2003, among Direct Merchants Bank, MCI, and the Office of the Comptroller of the Currency (“OCC”). These deposits are invested in short-term liquid investments. As of September 30, 2004, the balance of these deposits was $79.7 million and is classified on the balance sheets as “Liquidity reserve deposit.”

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NOTE 6 — ALLOWANCE FOR LOAN LOSSES

     The activity in the “Allowance for loan losses” is as follows:

     Credit card loans greater than 30 days contractually past due for the periods ended September 30, 2004, and December 31, 2003 were $8.8 million and $20.3 million, respectively.

NOTE 7 – RETAINED INTERESTS IN LOANS SECURITIZED

     The following table shows the fair value of the components of the “Retained interests in loans securitized” as of September 30, 2004 and December 31, 2003.

     The following table illustrates the significant assumptions used for estimating the fair value of retained interests as of September 30, 2004 and December 31, 2003.

(1) Includes expected cash flows from finance charges, late and overlimit fees, debt waiver premiums and bad debt recoveries, net of finance charge and fee charge-offs. Gross yield for purposes of estimating fair value does not include interchange income or cash advance fees.

(2) Interest earned on spread accounts receivable is now calculated as a monthly cash flow in the valuation of the spread reserve deposits using the current London Inter Bank Offered Rate yield curve. As of December 31, 2003 the discount rate applied to the spread reserve deposits was reduced to account for the interest income earned.

(3) Includes contractual retained interest and required minimum spread reserve deposits.

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     At September 30, 2004, the sensitivity of the current fair value of the retained interests to immediate 10% and 20% adverse changes are as follows (in millions):

     As the sensitivity chart indicates, the value of the Company’s “Retained interests in loans securitized” on its consolidated balance sheets, as well as reported earnings related to those interests, could differ significantly if different assumptions or conditions prevail.

NOTE 8 — CONVERTIBLE PREFERRED STOCK

     Affiliates of Thomas H. Lee Partners, L.P. (“THL Partners”), a Boston-based investment firm, and THL Partners’ co-investors hold 100% of the outstanding shares of our preferred stock. The preferred shareholders are entitled to receive quarterly dividends payable in additional shares of preferred stock (“dividends in-kind”). The annual dividend rate is 9% through December 8, 2008 and 15% thereafter (except following a Change in Control Triggering Event, as described below). Preferred shareholders are also entitled to receive cash dividends paid on our common stock based on the number of shares of common stock into which the preferred stock would convert on the record date of the dividend. The preferred shareholders may also receive, in lieu of a dividend in-kind, dividends payable in cash, property or other securities which are economically equivalent to a dividend in-kind if the Board of Directors determines that paying dividends in-kind would be inadvisable and the payment of such other dividend is approved by 80% of the Board of Directors, which 80% must include a majority of the directors elected by the preferred stock (or, if there are no such directors, must be approved by holders of a majority of the preferred stock).

     So long as THL Partners or their affiliates own at least 25% of the originally issued preferred stock (or any shares of common stock issued upon conversion thereof), the holders of a majority of the shares of preferred stock are entitled to elect four of eleven directors of the Company’s Board of Directors. So long as THL Partners or their affiliates own at least 10% but less than 25% of the originally issued preferred stock (or any shares of common stock issued upon conversion thereof), the holders of a majority of the shares of preferred stock are entitled to elect one director. Preferred shareholders have the right to vote on general corporate matters with common shareholders on a converted basis.

     Each share of preferred stock is convertible into 30 shares of common stock and, if converted before December 9, 2005, a premium amount guaranteeing seven years of dividends at the 9% rate through December 9, 2005. The preferred shareholders are able to convert at anytime, and the preferred shares automatically convert into common shares after December 9, 2005 if the common stock trades at a share price of $21.33 or more for 20 consecutive days. As of September 30, 2004 the preferred stock is convertible into 45,053,541 common shares, or approximately 43.7%, of the outstanding common stock on a converted basis.

     Before December 9, 2008 all of the preferred stock may be redeemed by us by paying 103% of the redemption price of $372.50 and any accrued dividends at the time of redemption. Such redemption can only occur at a time when (i) the common stock has traded at a share price of $21.33 or more for the most recent 20 consecutive trading days and (ii) the Company has an unsecured corporate debt rating of at least Baa3 from Moody’s and BBB- from Standard and Poor’s. We also have the option to redeem the preferred stock after December 9, 2008, without restriction, by paying the redemption price of $372.50 and any accrued dividends at the time of redemption.

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     If a Change in Control were to occur, we are obligated to offer redemption of the preferred stock for cash at 101% of the greater of (i) the as converted value of the preferred stock or (ii) $372.50 per share of preferred stock plus accrued and unpaid dividends payable at the rate of 9% per annum through December 9, 2005 (such greater amount referred to as the “Liquidation Preference”). THL Partners has the right, but is not obligated, to accept redemption of the preferred stock. If an offer of redemption is not made, a Change in Control Trigger Event occurs and, as a result, (i) additional shares of preferred stock are issued to the holders of preferred stock such that the total number of outstanding shares of preferred stock equal the Liquidation Preference divided by $372.50, (ii) the preferred stock dividend rate increases to 11.5% before December 9, 2008 and 15% thereafter and dividends are due quarterly in cash, and (iii) the Company becomes subject to limitations on indebtedness and the issuance of capital stock and we cannot pay any dividends or make distributions on, redeem or purchase any classes of stock. If the Company fails to comply with any of the changes in terms, the dividend rate increases another 2% and THL Partners can require the Company to purchase the preferred stock at 101% of the Liquidation Preference.

NOTE 9 – INCOME TAXES

     The components of the expense (benefit) for income taxes consisted of the following:

     A reconciliation of our effective income tax rate compared to the statutory federal income tax rate is as follows:

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     Our deferred tax assets and liabilities are as follows:

     During the third quarter of 2004, the Company reduced the portion of its valuation allowance related to its net operating loss carry forwards by $7.7 million primarily as a result of current period earnings. The remaining valuation allowance primarily relates to alternative minimum tax credit carry forwards. We believe, based on our expected reversals of taxable temporary differences and, to a lesser degree, reliance on future earnings, the remaining deferred tax assets are fully realizable. The net deferred tax liability is included in “Accrued expenses and other liabilities” on the consolidated balance sheets.

NOTE 10 – ASSET IMPAIRMENTS, LEASE WRITE-OFFS AND SEVERANCE

     “Asset impairments, lease write-offs and severance” for the three months ended September 30, 2004 consists of charges related to severance and the write-down of various operating leases. During the comparable period in 2003, this amount included a $2.6 million charge related to workforce reductions, approximately $5.4 million in write-downs of excess property, equipment, and operating leases and a $22.0 million write-off of purchased portfolio premium on “Credit card loans” sold during 2003. During the nine-month period ended September 30, 2004 this amount also included other workforce reduction charges. The nine months ended September 30, 2003 included an $8.3 million charge for workforce reductions, $5.1 million for commitment fees, $17.4 million for write-downs of excess property and equipment and a $22.0 million write-off of purchased portfolio premium on “Credit card loans” sold during 2003.

NOTE 11 – SALE OF MEMBERSHIP CLUB AND WARRANTY BUSINESS

     On July 29, 2003, we sold our membership club and warranty business to CPP Group, a privately-owned provider of assistance products and services throughout Europe, for cash proceeds of $45 million. We recorded a gain on the sale of $80.4 million. Included in the gain was the recognition of $82.7 million of “Deferred income” and the write-off of $36.6 million of deferred costs.

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NOTE 12 – SALE OF CREDIT CARD LOANS

     On April 30, 2004 we sold approximately $38 million of “Credit Card Loans” from Direct Merchants Bank. Proceeds from the sale approximated the carrying value of those loans.

     On September 16, 2003, we sold approximately 160,000 credit card accounts amounting to $590.9 million of “Credit card loans” to a third party for cash proceeds of $488.3 million. The sale included $144.4 million of receivables from Direct Merchants Bank and $446.5 million of receivables from Metris Receivables, Inc. On November 13, 2003, we sold approximately 125,000 credit card accounts amounting to $494.3 million of “Credit card loans” to a third party for cash proceeds of $396.5 million. During the third quarter of 2003 we recorded a loss on these sales of $117.2 million related to these transactions.

NOTE 13 – SALE OF DEPOSITS

     On September 30, 2003, we sold all of the brokered and retail jumbo certificates of deposit issued by Direct Merchants Bank. The face value of the “Deposits” sold was $559.3 million. We recorded a loss on that sale of $33.0 million.

NOTE 14 – SUPPLEMENTAL CONSOLIDATING FINANCIAL STATEMENTS

     We have various subsidiaries that do not guarantee Company debt. We have prepared condensed consolidating financial statements of the Company, the guarantor subsidiaries and the non-guarantor subsidiaries for purposes of complying with SEC reporting requirements. Separate financial statements of the guaranteeing subsidiaries and non-guaranteeing subsidiaries are not presented because we have determined that separate presentation of the subsidiaries’ financial information would not be material to investors.

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METRIS COMPANIES INC.
Supplemental Consolidating Balance Sheets
September 30, 2004
(Dollars in thousands)
Unaudited

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METRIS COMPANIES INC.
Supplemental Consolidating Balance Sheets
December 31, 2003
(Dollars in thousands)
Unaudited