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Executives

Russ Smyth – President & CEO

Becky Shulman – CFO

Sabrina Wiewel – Chief Tax Network Officer

Scott Dudley – VP IR

Analysts

Kartik Mehta - FTN Midwest Research

Andrew Fones - UBS Investment Research

Scott Schneeberger - Oppenheimer

Sloan Bohlen - Goldman Sachs

Vance Edelson - Morgan Stanley

Michael Millman - Millman Research

Unspecified Analyst

Todd Young - Morningstar

H&R Block, Inc. (HRB) Q4 2009 Earnings Call June 29, 2009 4:30 PM ET

Operator

Good afternoon. At this time I would like to welcome everyone to the H&R Block year-end earnings conference call. (Operator Instructions) I would now like to turn the call over to Mr. Scott Dudley, Vice President of Investor Relations.

Scott Dudley

Good afternoon everybody and thank you for joining us to discuss our fiscal 2009 results. Presenting on the call today are Russ Smyth, President and CEO, Sabrina Wiewel, Chief Tax Network Officer, and Becky Shulman, CFO. They will comment on our results and then we will open up the call for questions. Other members of our senior management team are with us this afternoon and they will be available during the Q&A session. Our call today is planned for about an hour.

To start, let me provide our Safe Harbor statement. Comments made on this call may contain forward-looking statements within the meaning of Section 21-E of the Securities Exchange Act of 1934. Such statements are based upon current information and management's expectations regarding the company, speak only as of the date on which they are made, and are not guarantees of future performance, and involve certain risks, uncertainties, and assumptions that are difficult to predict.

Therefore actual outcomes and results could materially differ from what is expressed, implied, or forecast in such forward-looking statements. Such differences could be caused by a number of factors including risks described from time to time in H&R Block's press releases and Forms 10-K, 10-Q, 8-K, and other filings with the SEC.

H&R Block undertakes no obligation to publicly release any revisions to forward-looking statements to reflected events or expectations after the date of these remarks. H&R Block provides a detailed discussion of risks factors in periodic SEC filings and you're encouraged to review these filings.

Today we filed our 10-K for fiscal 2009 and issued a press release announcing our results. Both of these documents are available on our website.

So with that, let me now turn the call over to Russ Smyth.

Russ Smyth

Thanks Scott, and hi everyone. As Scott just mentioned we released our earnings for fiscal 2009 and our guidance for fiscal 2010 earlier this afternoon, so I want to start with a brief recap of our strong earnings performance and some of the lessons that we are drawing from this last tax season, and then Sabrina and Becky will go into more detail on our results.

And then at the end I will outline some of the factors that are guiding our planning for fiscal year 2010.

We’ve got a number of initiatives that have been in the planning stages since I joined the company last August that we will be rolling out to drive our future growth. And despite some expected challenges in the marketplace in fiscal year 2010, we feel very good about our outlook and I’m happy to be able to share some of that thinking with you, although for competitive reasons we will have to leave many of the specifics until our Investor Conference which we plan to have later this year.

However let me first recap fiscal year 2009, first we improved our year over year financial results with income for continuing operations up 15% and earnings up 12.5% to $1.53 per share. We achieved this improvement despite a disappointing decline in retail tax returns prepared and our earnings growth is after the impact of an increase in shares outstanding which reduced EPS by $0.04 and then another $0.12 per share in loan loss provisions related to the bank’s mortgage portfolio this year.

Excluding the loss provisions in both years, EPS from continuing operations would have increased more than 15% to $1.65 in fiscal year 2009. In digital tax we grew our client base and increased our market share with great success in the online category which we believe is the key battleground within the digital space.

We significantly exceeded our targeted levels of cost reductions which helped us deliver our double-digit earnings growth and much higher operating margins in the tax services segment. We continue to narrow the focus of the company on our core tax business completing the sale of H&R Block Financial Advisors.

And we took advantage of an investment opportunity to strengthen our tax business acquiring our major Southwest franchise. The integration of this operation went smoothly and the acquisition added $45 million of incremental pretax income this year. Now to put this in context, that’s $12 million more than our largest branded retail tax competitor earned last year.

More importantly we believe we have a great opportunity to further develop this territory by increasing same office returns as well as expanding with some new offices. We also effectively managed the residual loan exposure after the sale of Option 1 in April, 2008.

Combined all of these efforts enabled us to end the year with a strong $1.4 billion GAAP equity position, unrestricted cash of more than $1.6 billion, and just $1.1 billion of total debt. And at the same time overall net debt improved by nearly $1 billion since last year.

Given that our fiscal 2009 was the worst economic year in decades, we’re proud to have achieved a combination of higher earnings, strong cash flow, and a solid balance sheet. However we also recognize that our results could have been significantly better had we avoided the reduction in clients and market share in our retail tax business and the addition of significant loan loss reserves at the bank.

The company has been consistent in emphasizing the importance of putting our financial house in order. The first phase was exiting both the subprime mortgage and financial advisory businesses which stopped the losses and enabled us to pay off a great deal of debt.

The second phase of our restructuring plan was to attack our cost structure and our financial results in fiscal year 2009 were favorably impacted by this emphasis. We are determined to drive efficiencies every year going forward and to maintain the cost conscious culture that we’ve begun to establish so that we do become the best value provider of tax services.

Sabrina and Becky will go into more detail on our successes in eliminating costs in fiscal 2009, but as we have gone through the process of reevaluating our business model, we have become convinced that there are still considerable cost and efficiency opportunities.

In addition to the margin improvement achieved this year, we remain confident that we can increase margins by another 100 basis points over fiscal year 2010 and 2011 while still reinvesting for growth as appropriate. I’ll have more to say about our cost reduction efforts when I discuss our future outlook.

Well its good that increasing and profits and that paying off our debt in last year’s difficult conditions and we’re happy with those results, the route we took to get there was not as good as if we had achieved client growth as a part of our mix.

We certainly slipped in our ability to attract new clients this year despite a significant increase in marketing spend. The number of tax filers that consider our brand has not improved in the past several years. We’ve taken a hard look at our marketing campaigns and later on the call, I’ll touch on some of the many changes that are underway.

Client services is another area where we believe we can improve. For example, we estimate that 1.8 million clients checked into our tax offices but left without ever starting a return this year. Converting more of the taxpayers already in our offices into paid returns, represents a significant opportunity to improve our performance in tax season 2010, and we believe that better operations can bring this number down substantially in the future and I’m convinced that we can solve this problem quite readily.

To discuss more specifically our performance in tax services, I will turn it over to Sabrina Wiewel. I’m excited to have Sabrina now oversee our tax network organization which brings together the franchise and company-owned field operations. As I believe many of you know Sabrina ran our digital business this past year with great success and she previously spent several years in the tax field including running one of our largest divisions in the retail tax business.

Sabrina Wiewel

Thank you Russ, good afternoon everyone. In evaluating our performance in tax services this year, we think it is important to look at it in the context of what happened overall in the category, what the impact was in the assisted and digital segments and then how we performed within each of those of segments.

The IRS reported a decline of more than 10 million returns or 72% this year. We realize that this decline was caused by the artificial growth created by the Economic Stimulus Act, or ESA in 2008 when IRS returns were up 11.4%.

We estimate that this year’s IRS volume declined by 0.50 million returns or about 40 basis points after adjusting for their estimated impact of ESA returns in 2008. Excluding ESA impact we believe that assisted tax preparation market share of total filings in tax season 2009 was approximately 62% which we estimate to be 40 to 60 basis points lower than prior year.

The slight shift to DIY this year was primarily due to heavy promotion of free offers within the digital category which resonated particularly well this year due to the tough economic circumstances. Within the assisted category our retail tax offices lost 900,000 clients this year excluding ESA or about 90 basis points of share.

A large number of our prior clients chose not to file this year primarily those clients with lower AGIs who cited a lack of employment or earnings as the reason. Of those that did file, and did not return to our retail channel about half chose to prepare their returns themselves and most of them used a digital solution.

The other half chose an alternative assisted solution with an independent accountant being their primarily choice. Even with a large percent of our lost retail client base chose a digital solution, we were able to retain a greater share of those clients within the H&R Block brand. Digital client migration within H&R Block brand improved significantly over last year by capturing more than double our general digital market share.

We believe this reflects the existing power and increasing opportunity of our balanced business model of offering our clients a choice in how they want to be served. Our client growth results varied considerably depending on AGI levels. At H&R Block we’ve historically been over indexed in filers with AGIs of less than $20,000.

We saw a decline of 7.8% among these low-income filers. Among middle income filers those with AGIs of $20,000 to $75,000, we experienced a 3.7% decline. However, consistent with our recent success in moving up the AGI ladder our higher income filers, those with AGIs over $75,000 increased 2.8%.

Overall however we clearly slipped in our ability to attract new clients and retain existing ones. Our client retention rate fell more than three percentage points this year to 69.5%. As we’ve mentioned previously a significant driver in this decline is the artificially high rate achieved last year due to the ESA halo impact as well as an increased price value perception by our lower income clients.

We also experienced some retention loss due to operational and client service break points. Some of these break points include operational and client service problems with our emerald advance program, low client call issue resolution outcomes, and long wait times on the phone. And reduced client facing labor in the tax offices primarily at our front desks.

As Russ mentioned this year we estimate that we had about 1.8 million clients who checked into our tax offices but left without ever starting a return. There are several reasons why this occurs but many represent either problems that can and will be solved or opportunities that we can take better advantage of in the future.

We also know that our best performing and most experienced tax professionals have significantly higher client retention rates but we don’t get enough of our clients served by them, often because we’re managing labor too tightly, we hired way too many new tax professionals, and we were not adequately taking into account client satisfaction rates.

We told you at our Investor Conference in January that our goal was to drive quality revenue growth over time by both moderating our price increases and growing clients. On the pricing front we made progress this year. While our net average fee was up almost 7% this year, only 1% of that was driven by list price increases on the company side.

This should help with retention rates for next year. The average fees increase was mainly due to higher return complexity which means our clients had more forms on average and due to our client mix shift to those with higher adjusted gross incomes.

Overall tax service pretax income for FY09 grew nearly 14% reflecting the combined benefit of higher revenues and lower field operating costs and corporate overhead expenses. A significant contributor to this growth was the Southwest franchise acquisition. The integration of this business went extremely well.

Results this year exceeded our expectations and this acquisition contributed to more than 40% of our pretax income growth in tax services. Due to the timing of this deal and the resulting lack of off season expenses in fiscal year 2009 we will have a margin impact of 50 basis points in FY10 which will be absorbed by other cost reductions within the tax segment.

As you recall our goal was to grow our operating margin in tax services by at least 200 basis points in FY09. I am proud to note that we exceeded that goal by 120 basis points and we did it despite lower than expected revenue.

More than half of the margin improvement comes from our cost reduction efforts. Expenses declined by nearly three percentage points or $63 million despite a significant additional investment of $40 million in marketing and nearly $55 million of expenses from the franchise operation.

The primarily source of the expense savings came from a reduction in total salaries and benefits due to the annualized impact of the headcount reductions that we made in February, 2008. In addition they reflect adjustments made to the size of our field management to an appropriate office span of control.

As our network size and mix changes we have and will continue to ensure our infrastructure adjusts accordingly. The remainder of FY09’s margin improvement is attributable to incremental earnings from our Emerald products, specifically we had a lower bad debt rate on our Emerald Advance and we had more Emerald cards issued this past tax season.

We funded more than one million Emerald Advances in the aggregate amount of $720 million and we issued nearly three million Emerald cards. Compared to last year, this reflects an increase of more than 160,000 Emerald Advances, $295 million outstanding as well as a nearly 100,000 more Emerald cards.

As we mentioned last quarter another factor which negatively impacted margin and profit this year was the large number of clients that switched from RAL to RACs, which reduced earnings by nearly $18 million. We believe this shift occurred due to consumers’ interest in spending less money and from uncertainty about RAL with respect to a clients’ rebate recovery credit.

With the absence of this credit we expect some of this trend to reverse itself in FY10. We will continue to monitor policy developments in Washington with respect to RAL. This year was a successful year of seasoning for our Emerald Advance program which is part of the suite of financial products we could offer clients in place of the traditional RAL if the rules change.

Now turning to our digital results, total returns prepared grew by 4.2% this year. Returns prepared with H&R Block online and Tax Cut grew by 21%. Our FFA filings were down 46% reflecting that many filers migrated to our digital solutions including our free federal filing offer. Overall we estimate FFA filings were down by nearly 30% across the industry.

We continue to believe that within the digital tax arena, online is the key battleground for the future. H&R Block online clients grew 45% with our new free federal online product driving growth. In this segment we believe our online market share increased nearly 100 basis points over the prior year.

Our free federal model worked well this year in acquiring clients and monetizing many of them to some form of a paid product. In fact, more than 30% of the clients that started out in free upgraded to a paid federal product and nearly 40% of all free online filers attached a state return for $29.95.

We have a number of other monetization opportunities that include form pre population, RACs, and tax assistance that were successful. Overall monetization of our free online clients exceeded our expectations in year one. However we have a lot of learning that we will use to continue to improve our ability to monetize free clients going forward.

Within the overall digital market the online space continued to grow. And the software category continued to shrink. However, units sold of our Tax Cut software were actually up 1.7% and we estimate that we gained nearly 300 basis points of market share in software.

Of the nearly six million returns handled by our digital channel, about 3.6 million were completed online including FFA. We estimated that we gained nearly 60 basis points of share in the overall DIY market.

The launch of our free online product and our industry-leading decision to offer free software e-filing helped us drive nearly a four point improvement in digital customer retention. However unlike in retail tax, the consumer awareness of our digital product is very low at 35% and our consumer consideration is even lower.

Our opportunity to grow this segment is significant as we build awareness, consideration, and trial of these products and better leverage the strength of our brand in the digital space. As clients’ needs change as we saw last tax season our ultimate focus is to serve our clients how they want to be served.

We believe we are uniquely positioned to fulfill those needs as we’re the only provider that can serve clients across retail, online, and software markets. With that I’ll turn the call over to Becky to discuss the remainder of our financial results.

Becky Shulman

Thank you Sabrina, I’d like to start with the review of RSM McGladrey, H&R Block bank and its mortgage portfolio, then wrap up with the balance sheet and liquidity.

In the business services segment, RSM McGladrey grew its fiscal 2009 pretax income by more than 8%. Total revenues were down $44 million while total expenses were down more than $50 million compared to fiscal 2008.

As a result the business achieved and improved pretax margin of 10.7%, up from 9.4% in fiscal 2008. While this is short of our original 12% target, we nonetheless made good progress against our objectives in a difficult economy.

Results for RSM McGladrey’s core services included good performances in tax and consulting which achieved revenue growth of 4% and 5% respectively and achieved combined profit growth of $22 million or 27%. Actions taken in FY08 and FY09 to reduce costs and streamline operations have positioned this business to continue to grow profitably.

In FY10 we will continue our ongoing strategic initiative to focus on improving brand awareness and client loyalty in order to drive new client growth and expand services to existing clients. New client growth will also be driven by continued investment in our business development organization and programs around building skills to support growth in our workforce.

We will maintain our focus on margin improvement through established cost and productivity improvement programs, including employee engagement and career development, strategic sourcing opportunities and real estate strategies.

Now let’s turn to the bank, the bank incurred a pretax loss of $14.5 million in fiscal 2009 compared to pretax income of $11.5 million last year. The decline in earnings was primarily driven by $22 million of incremental loan loss provisions. Total reserves recorded in FY09 were $64 million of which $12 million were taken in the fourth quarter.

H&R Block bank had a successful year supporting our tax business with the Emerald suite of products. Including amounts reported in our tax services segment, the products generated more than $60 million of incremental earnings.

Consistent with our goal of winding down the H&R Block bank mortgage portfolio, net mortgage loans held for investment declined more than $220 million during the year to $745 million. Loans purchased from retail originators continued to perform very well with 60 plus day delinquencies of less than 4% at year end while the [San Canyon] originated loans were at 22%.

We realize that investors and analysts evaluate the risk associated with the loan portfolio. Its important to note that this is a static loan pool and our potential losses are therefore [kept]. Not all of the loans will go bad nor will property values go to zero.

At some point we’ll no longer need to add to reserves and they will not be part of our long-term earnings trajectory. To provide more transparency, we’re making a change to our segment reporting in fiscal 2010, by redirecting the bank’s mortgage portfolio to the corporate segment. The remainder of the bank’s operations including the Emerald suite of products will be reported as part of the tax services segment going forward.

Turing to our overall financial position, we have continued to make significant strides over the past year. Full year enterprise wide expenses in continuing operations were down more than $107 million or 3.2% compared to the prior year despite $55 million of additional expenses due to our Southwest acquisition and $22 million of incremental loan loss reserves.

Overall or cost reduction efforts drove approximately 250 basis points of consolidated pretax margin improvement. Our cost conscious culture has resulted in radical change from our historical compounded annual expense growth of nearly 15% from fiscal 2005 through fiscal 2008. Driving our non value added cost from the business will continue to be a priority as we work to become the best value provider.

In addition we have made significant progress over the last year in strengthening our balance sheet and reducing risk. We increased our unrestricted cash position nearly $1 billion and increased our equity position by more than $400 million. Our total debt was essentially flat to the prior year at $1.1 billion.

However quarter end peak borrowings during the year also declined dramatically to just $2.8 billion compared to $5.4 billion last year and almost $10 billion at the peak of fiscal 2007. Receivables declined to $513 million from a season high of $2.6 billion in our fiscal third quarter reflecting the normal pattern of collections related to our Emerald Advance line of credit product and our participation in RAL.

For FY09 we had $334.5 million in fully diluted shares. During the fourth quarter we took advantage of a brief window when the company could engage in share repurchases. We bought 5.6 million shares of our common stock in an aggregate purchase price of approximately $100 million.

We now have $1.9 billion of share repurchase authorization remaining through June of 2012. We will continue to run our businesses to minimize the capital requirements while keeping with our historical view that any excess capital after investing in our business should be returned to our shareholders.

We intend to be both thoughtful and opportunistic in repurchasing shares going forward. Also the dividend rate in FY10 will remain at $0.60 per share as our current dividend represents a strong yield of approximately 4%.

We expect between $1.6 billion and $1.8 billion of our liquidity to be used to fund our off season expenses for this year given the seasonal nature of our business. Our $2 billion committed lines of credit remain in place through August of 2010 in addition to our unrestricted cash on hand of over $1.6 billion.

As you can see the changes we have made over the past two years have been dramatic and have put us in a strong financial position with more then adequate liquidity access to meet our needs. Here are just a few more items of note.

We expect our full year continuing operations tax rate to be approximately 40% in fiscal 2010. We estimate depreciation and amortization of $135 million compared to $124 million this year. Capital expenditures were $98 million in fiscal 2009 and we estimate approximately $120 million in fiscal 2010.

The increase is largely due to more office upgrades, testing of new office concepts, and the opening of a flagship office in New York at the start of this tax season. So with that I’ll turn the call back over to Russ to discuss our 2010 outlook.

Russ Smyth

Thanks Becky, in 2010 we will use our strong financial position as well as our increased focus on improving our marketing and operations to improve client attraction and retention. For fiscal year 2010 earnings from continuing operations are expected to be in the $1.60 to $1.80 per share range.

Due to the uncertainties in the economic environment for the coming year, this guidance range is wider then it has been historically. But an important point for us in thinking about our future is that our business model is actually very flexible and we have a number of different ways that we can achieve profitable growth.

Yet historically we’ve planned for one tactical plan. Clearly in today’s operating environment being able to adapt quickly is even more critical. So our plan for next year provides the flexibility we need to achieve our stated goals for fiscal year 2010 and also to do it in a way that builds a strong foundation for even better results in fiscal year 2011 and beyond.

Our guidance is based on a low single-digit revenue growth assumption. That’s driven by a couple of factors, first, the estimated overall IRS return declines due to sustained levels of unemployment. Second, the loss of 270,000 clients served in Wal-Mart locations or almost 2% of our client base prior to our retention efforts.

Third, a continued increase in return complexity due to growth in the higher AGI segments, existing clients having more complex filings, and tax law changes which will generally add to complexity. And last, a continued moderation of list price increases with targeted value offers in select client segments most effected by the economy.

While we are likely to continue to see an increase in our net average charge next year as a result of the increased complexity for most tax payers, we will not need to rely on pricing increases nearly as much as we have in the past to continue generating strong earnings growth.

Other significant factors effecting our guidance range are continued progress on margin improvement for tax services and RSM McGladrey, net of the investments required in each of those businesses to grow their businesses in the future, sensitivities to loan provisions at the bank based on various market conditions, and various share buybacks under our previously authorized $2 billion repurchase program.

The success of our ongoing cost reduction initiatives gives us much more flexibility in planning for next year’s tax season. Our next phase of cost reductions will include savings in occupancy expense by closing underperforming company owned locations and aggressively renegotiating leases in areas where we want to continue to do business.

As we learn more about shifts in client needs and market circumstances, we’ll continue to evaluate our real estate footprint to optimize our tax network. We’ll also continue to flatten our organizational structure and refranchise offices where the geographic location make it difficult for the company to provide proper support.

The company’s financial strength also enables us to reinvest in the training of our people, improve our retail and digital products, and enhance the financial offerings we provide to existing and new clients. Despite the growth in profits this fiscal year in a difficult economy we’re not satisfied with our results and are particularly disappointed with our decline in retail tax clients.

We understand that to grow our business in a sustainable profitable manner over the long-term we need to grow our client base. And we’ve identified several key areas critical to growing that client base. First, we need to improve our marketing muscle. Brand consideration and trial must be improved and we’ve recently changed ad agencies and refocused our marketing team to drive improved results in these two critical areas.

Our messaging will be more creditable and serious in tone, and more consistent in addressing key client priorities. We’ll also enhance the awareness of our digital products and position H&R Block as the only tax preparation company capable of serving clients in the ways that best fit their personal needs.

In addition we need to use a more balanced media mix to do a better job of targeting our client segment messages and need to communicate a compelling value proposition to clients of every income level. While these have been a weakness in recent years, its also a major opportunity for the future.

Second we need to improve our operations to deliver a better client experience. Overall our tax professionals do a wonderful job taking care of our clients, however there is a wide variation in retention rates among our tax professionals. And we need to get more clients in front of our best people.

It will cost a little bit more in terms of labor dollars per return but we believe the payback will be significant in terms of client satisfaction and retention not to mention that our best tax pros will be making more money as a result.

We also know that historically franchisees are better at growing clients on average then company offices. Due to geographic differences its currently difficult to compare both operating and financial performance between the two. However we refranchised 43 offices prior to this tax season and expect to do up to 300 more this year so we will have a better understanding of the benefits of franchising from both a client and a shareholder perspective. And in the meantime we will build a pipeline of quality franchisees so we are better positioned to make decisions about the proper mix of company offices and franchise offices beyond tax season 2010.

We also need to do a better job of making a strong first impression with our clients. We will improve our staffing and front office protocols for greeting and scheduling clients, including those that come to us via the phone to significantly reduce walk-outs and enhance the experience for all of our clients.

We will test new office concepts to determine the impact that a new look and feel can have on growing our business and providing great returns to our shareholders. In addition we’ll improve the consistency of our office level execution by reducing the number of new initiatives and changes to existing systems and procedures.

Historically we’ve made numerous changes, tweaking our operating practices. Few if any of these have made a noticeable impact on client growth and satisfaction. In order to further improve on how we train and prepare a large seasonal workforce for the upcoming tax season, we’ve created a new role to serve as a gatekeeper to limit the number of changes that hit the tax offices particularly the tax desk, and ensure proper deployment and execution of our key initiatives.

Lastly we will innovate. Leading brands and those that sustain growth need to innovate to keep up with and anticipate the needs of an ever evolving client base. Frankly we haven’t kept up. But we will catch up and then we’ll move ahead of the competition. The digital area is just one example.

Despite our progress this year we are still far behind where we should be. We’ll improve our product for 2010 in terms of branding and features but we have a unique opportunity to seamlessly integrate our retail offices and digital products to serve our clients in way that no other competitor can match, whether they are independent tax preparers, branded competitors, or digital software providers.

There is a lot of work to do and we’ve recently organized ourselves to flatten the structure, get key decision makers closer to our clients, promote accountability, driver greater innovation, and flexibility in tax operations, and eliminate redundant positions that were a legacy of the old holding company structure.

In addition to Sabrina’s new role, we’ve consolidated all of our tax operations support under Phil [Mazzini] who now leads our tax service support organization. Additionally I’d like to note that [Ken Tree] who previously had primary responsibility for franchise operations in the field will now be exclusively focused on our refranchising efforts and building a pipeline of high caliber franchisees.

And finally two weeks ago we named C.E. Andrews, a 29 year veteran of Arthur Anderson, as the new President of RSM McGladrey. His extensive industry background in leadership experience make him a great choice for the company as we pursue the tremendous market opportunities that lie ahead.

C.E. will lead efforts to further build the McGladrey brand, increase our ability to attract and retain talent, and increase our share among firms in the middle market. Now as all of you I’m sure know, earlier this month the IRS announced an initiative to review alternatives for improving the accuracy of tax filings and the ethics and integrity of all who hold themselves out directly or indirectly in providing tax preparation services.

For many years we have strongly supported efforts to upgrade training, professionalism, and ethics among all tax payers and we stand ready to continue to actively work with the IRS to assist in this timely and important review.

Despite the challenges we face I am more confident then ever that we are well prepared to succeed. We have a great brand with tremendous untapped potential. We have outstanding people resources particularly at the tax desk where it really matters.

And we have the financial strength to thrive in tough times. With that we’ll now open it up for your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Kartik Mehta - FTN Midwest Research

Kartik Mehta - FTN Midwest Research

I wanted to ask you a little bit about the guidance you gave at least on the tax side, you talked about industry being negative, Wal-Mart having if you don’t get anything back negative 2% impact on your overall filer growth and then you talked about pricing being [moded]. If you take all of that into consideration, would it be fair to assume that you’re expecting on the low end for tax revenues to be flat to slightly down next year.

Russ Smyth

As I said in kind of the explanation about the guidance inherent in that is an assumption of single-digit revenue growth. In terms of the various specific spec and into that, we really think about our EPS range as a range of outcomes and its got a lot of different variables as you know; client growth, what happens with net average charge, benefits of complexity, assumptions about margin improvements, loan loss provisions, share buybacks.

As a management team we are focused on managing this overall portfolio of variables. And we’re committed to managing that in a way that hits the earnings guidance that we’ve given you and so we need that flexibility in this kind of environment to be able to make the right decisions to number one, hit those EPS guideline we’ve given, as well as doing it in a way that builds our opportunity to have future success in 2011 and beyond.

So that’s how we’re looking at those variables. I know a lot of you would like to have specific assumptions about each one of them but frankly that’s not how we run the business or manage the business. We manage the portfolio to get to the right outcome and that’s my view of the job of our senior management team and myself.

Kartik Mehta - FTN Midwest Research

And then on the margin side, you talked about margins for the tax business growing 100 basis points I believe next fiscal year, is that just a result of cost containment that you’re going to do or do you need to see flow through from a revenue perspective to get to that 100 basis points.

Russ Smyth

First of all just to clarify, the 100 basis points was over two years, fiscal year 2010 and fiscal year 2011 and again in terms of where that’s coming from, it’s a combination of the cost reduction efforts that we will continue to have. It is a combination of some of the P&L reinvestment we will make back into our business to make sure that we can grow our business in 2010 and 2011 and beyond.

And it also has a component about the flow through that would materialize as we grow clients and top line revenue. So that margin point improvement is a combination of all those factors.

Operator

Your next question comes from the line of Andrew Fones - UBS Investment Research

Andrew Fones - UBS Investment Research

I was wondering if you could detail the negative impact in the first half of next year for the seasonality of the Southwest acquisition that you did. You mentioned obviously that will be a little bit of a drag during the first half. It wasn’t in during the off season last year.

Becky Shulman

We expect expenses will be about $20 million higher, we talked about a $55 million number this year. We expect it to be about $20 million higher for the full year.

Andrew Fones - UBS Investment Research

And then, and the reason I asked you was in order to better understand what the perhaps the minimum level of equity you’d be comfortable with given that, the buyback announcement. If there isn’t going to be any significant additional expense, what would you be comfortable in running as a minimum level of equity for this year.

Becky Shulman

Fortunately we are in a very, very different position then last year or the year before when I was answering this question. So we really from an equity constraint, the committed line of credit $650 million covenant, is not an issue. It really doesn’t come into play given where we are and from a liquidity standpoint it really doesn’t come into play either.

So we believe that its important to maintain an investment grade rating so there’s a lot of different things as you know that go into that. One of those things that some agencies look at is positive tangible capital at fiscal year end, not intra year where we dipped below that, but for the most part I think we are in a very fortunate position where equity and liquidity really aren’t constraints within the context of the Board authority that we currently have.

Operator

Your next question comes from the line of Scott Schneeberger - Oppenheimer

Scott Schneeberger - Oppenheimer

You mentioned a slight increase in CapEx, I think it was 90 something million to $120 million next year, is most of that increase going to be spent on improving existing tax stores and is some of that going to be spent on increasing tax stores, what do you think, will you have a net increase or decrease in tax stores next year.

Becky Shulman

The majority of the increase in CapEx is really about upgrading the look and feel of our offices. We’re going to be testing new office concepts and also opening a flagship store and that really is what you see there in terms of the increase in CapEx.

In terms of the number of our stores for next year, I would think about it more rather then increase and decrease, is we have a much greater focus on optimization of our retail footprint. So we are closing underperforming stores, I think there was 130 last year, another 260 at a minimum that we’re looking at this year but at the same time, there will be an optimization and there will be places where we potentially open them.

I think as we think about our cost cutting initiatives over the long-term though, I think the real estate expansion that we had, we may have gone a little too far, we’re reevaluating all of that and we think that there’s a considerable amount of savings to come by looking at the size of our overall network.

Scott Schneeberger - Oppenheimer

The commentary in the press release on dividends, does that mean that you are not opening the door to increase the dividend at any point in FY10 or just not for now.

Russ Smyth

I think what we’re saying is right now there is no change.

Operator

Your next question comes from the line of Sloan Bohlen - Goldman Sachs

Sloan Bohlen - Goldman Sachs

You spoke about investing in the business, do you have budgeted amounts for what you’d be willing to spend both on training new personnel or investing in digital and are those amounts included in that $1.6 to $1.8 billion off season expense number.

Becky Shulman

Yes, and yes.

Sloan Bohlen - Goldman Sachs

But do you have specifics—

Russ Smyth

You want to know how much we’re going to spend in training? I think we do over 10,000 hours of training each year for our tax professionals. To be honest with you, I don’t know the number that we spend on training off the top of my head. If you’d like us to give you a perspective on that, we can probably follow-up off line and do that.

Sloan Bohlen - Goldman Sachs

I’m just trying to get an idea of the incremental amount and then a question on the digital, do you have a sense, you said single-digit revenue increases, do you have a different trend or pricing expectation for digital.

Russ Smyth

Before we go to the digital question I just want to make sure that we’re clear that any incremental spend we do to invest in training and the personnel is going to be more than offset by further cost reductions because we’re planning for margin improvement in both 2010 and 2011. So please don’t view that reinvestment back in the business as something you need to add on top of. We will figure out how to pay for that through other cost reductions.

Sloan Bohlen - Goldman Sachs

Fair enough, I think I wanted to get an idea of the mix but I’ll follow-up offline.

Sabrina Wiewel

Probably high single-digit revenue growth.

Operator

Your next question comes from the line of Vance Edelson - Morgan Stanley

Vance Edelson - Morgan Stanley

The franchisee partners that were running a Wal-Mart location and no longer will be, it would seem there’s an opportunity to keep them on board elsewhere franchising another perhaps larger location, is that much of a focus or do you figure most of them will be finding employment elsewhere.

Russ Smyth

Well a lot of our franchisees I believe that have Wal-Mart also have traditional, our franchisees have traditional retail tax offices so while they won’t be running those Wal-Mart locations any more, they are still franchisees of H&R Block.

Vance Edelson - Morgan Stanley

And on staffing overall, given the higher complexity that’s expected in the returns next year, is there a related staffing increase needed for that reason, or is it more you’ll be increasing the investment in training your current people that you mentioned.

Russ Smyth

We talked about the importance of getting more clients in front of our best tax professionals and so particularly given our expectations about increased complexity those are the type of clients that we need to get in front of our best tax professionals.

So its not a matter of increased staffing, its getting more hours and more clients in front of our best performing tax pros. So a better matching of client needs with tax pro capabilities.

Operator

Your next question comes from the line of Michael Millman - Millman Research

Michael Millman - Millman Research

Could you, on the digital to the extent that you push more digital do you run the risk of confusing retail customers, run the risk of cannibalizing some of the retail business and sort of related to that, compare the profit from the digital to the retail or order of magnitude.

Russ Smyth

On the cannibalization piece, we’re in the tax preparation business. And we are interested in preparing taxes for everybody who files a return. How they chose to want to do it, frankly is up to them. I want them to come to H&R Block regardless of the way they choose to get their taxes prepared.

So if they choose to do it digitally, I want them to come to H&R Block. If they come to do it in an office, I want them to come to Block. If they pick any way of doing taxes in between which is some combination version, I want them to come to H&R Block. So I think the key to our long-term success is not to think about cannibalizing our business, but think about how we grow our overall client base and build better loyalty overall to our brand.

And so that’s how we’re looking at it. If people are going to switch, they’re going to switch. I want them to stay within the brand and not go to another brand. And that’s where I think our digital business will actually help us in the long-term retain clients, make them more brand loyal and become essentially a feeder system longer-term to drive more clients into our retail tax offices, where Sabrina is about to tell you, they are a little bit more profitable today, but our digital team is working on narrowing that gap by improving how we monetize those existing digital tax clients.

Sabrina Wiewel

Yes, so as we have been introducing some integrated products into the retail segment, what we’ve been able to see is that the retail tax office client has definitely a higher average revenue but what we’ve seen is that we can actually do a blended where people can maintain their tax professional, start online at home, and then finish with a tax professional in an office.

And it tends to appeal to a higher end client and they’re willing to pay closer to the average cost of our retail tax segment. So identifying an integrated solution that let’s them not leave us for other tax preparation methods and remain with a tax professional especially as we match them with better tax professionals in the strategy that we just introduced to you, we can do a blended strategy or an integrated strategy for about the same average revenue per customer.

Michael Millman - Millman Research

I think last year you talked about pounding, pounding market share, is that still what the company is looking for and does that pounding of market share combining the retail and the digital or is that meant only for the retail.

Russ Smyth

Not its meant for both and focusing on market share is still a priority for us. We were not happy with what happened to us in market share this year. As you know overall, the growth in the tax paying category is over time probably going to be slightly positive. We have higher growth expectations for our business then that.

And so the only way to grow our business the way we think its capable of growing is by taking market share from people both on the retail side and on the digital side. And so we clearly achieved good market share growth this year in digital. We think that’s the start of a trend and we think we’ve got a lot of good opportunities and ideas on how to do a better job of taking market share in 2010 and beyond on the retail side.

So its still a priority for us. We didn’t like what happened to us on the retail side this year but we intend to change that in both of our segments going forward.

Operator

Your next question comes from the line of Unspecified Analyst

Unspecified Analyst

My first question is on capacity, can you just address whether you mentioned that most of your CapEx was going towards the improvement of the actual retail store locations, do you feel comfortable that your existing infrastructure gives you the capacity to support significant growth in online filing and how should we think about any incremental CapEx that might be needed to fund any potential future expansion of that capacity.

Russ Smyth

You were talking about CapEx requirements to fund for additional capacity in online?

Unspecified Analyst

Yes, is there any incremental cost to adding say X million new online filers or it kind of like the cost has already been incurred and you can grow the number of filers independent of, there’s no additional cost to growing filers or would there by.

Russ Smyth

There’s some minor incremental cost of growing filers but not significant and it certainly wouldn’t require significant CapEx. If anything you’ll see something a little bit in terms of some variable costs on the operating costs side. But a lot of the cost structure in digital and online is fixed.

Unspecified Analyst

Can you talk about, just trying to get a sense for whether goodwill is tied at all to your bank covenants and just trying to get a sense of what the underlying acquisitions are that the goodwill balance is tied to and then the potential for an impairment charge, just trying to get a sense for whether you would potentially be at risk of violating any bank covenants that are tied to book value if you did take an impairment.

Becky Shulman

Our bank lines of credit are tied to true GAAP equity and we have more detail on the goodwill and intangibles in the 10-K that we just filed today so I encourage you to go back and read it. Our testing date is February 1, so we think everything is fairly valued as of that date.

Operator

Your next question comes from the line of Todd Young - Morningstar

Todd Young - Morningstar

I wanted to drill in a little bit to the 1.8 million filers that you said came into the office and left, you mentioned there was various reasons that that happened and some of them you could address and some you couldn’t. Could you maybe talk a little bit more about that please.

Russ Smyth

Sure, it’s so, the things that could be addressed are sometimes they leave because the service was rude. Sometimes they leave because they didn’t have all the documents that they needed so that they could work with a tax professional to get the return properly prepared. And unfortunately they didn’t come back after they went home to get those documents.

Sometimes they leave because the waiting room is full and it looks they’ll have to wait too long to be able to be properly serviced. Sometimes they check in and really just have a tax question and get that question answered and leave without getting a return done. Now that’s not a service problem, but it’s a sales opportunity and so I think we have to look at all those people.

Some are operational things that we can fix probably sooner rather than later but others are sales opportunities where once people are in our offices, I don’t want them to leave. I want them to complete a tax return. And so I think that’s why we’re looking at the 1.8 million as an overall opportunity even thought the cause of why they leave vary significantly from client to client.

Todd Young - Morningstar

And can you talk a little bit about what the percentages of the clients that are coming in have something scheduled and how many are just walk in, just trying to get a feel of how many you could touch to about making sure they have the right documents and things like that.

Phil Mazzini

So the question is what percentage of clients come in via appointment?

Todd Young - Morningstar

Correct.

Phil Mazzini

That’s a number that’s been increasing pretty rapidly last few years and I think we’re probably getting close to half of our clients coming in via appointment at this point.

Operator

Your next question is a follow-up from the line of Scott Schneeberger - Oppenheimer

Scott Schneeberger - Oppenheimer

You had mentioned I think refund anticipation loans lost about $18 million of earnings year over year, some uncertainty about rebate recovery credit and a potential to reverse in 2010, could you take us a little deeper there on the potential bounce back and what occurred in the 2009 season.

Russ Smyth

I think as many of you know the refund credit this year was part of the follow-up to the ESA program last year where it was kind of a true up. Initially at the start of the tax season if the IRS was seeing a credit come through as part of a RAL, they were initially kicking back all those returns, and assuming that there were errors made.

So even though the RAL process the client had been approved for a RAL, it was getting kicked back initially by the IRS which was causing us to then turn around and deny the RALs to those clients who would have otherwise been approved.

And so because, and this happened industry wide, this was not specific to H&R Block. So that caused a lot of confusion initially and the way frankly a lot of preparers including us dealt with it is try to separate those two things and file for the RRC separate from the RAL application. The IRS fixed it about a week to 10 days later, I believe, but still there was probably some lost clients in there during the initial part of first peak.

We think that caused some of that swing. So that’s why we think some of it will bounce back next year because of that nuance that occurred in tax season 2009.

Scott Schneeberger - Oppenheimer

And then within the tax business, you mentioned in prepared remarks that peer pricing increased really only 1%. The majority of the drive was complexity and that you hope that that will benefit next year as the fact that the peer pricing was small and then it was the increase in the complexity and you also alluded to the shift in higher AGI filers that you saw. Could you talk a little bit more about that. Do you think that folks will come back and was it more mix or is it more, hey you think people think the pricing is a reasonable level.

Russ Smyth

We actually, particularly in the second half of the season, we actually had price reductions for many of our clients. And we did some training of our tax professionals in the middle of the season so that they could better look at the computer screens and take the time to explain to the clients that if they’re return hadn’t changed in terms of complexity that they were actually getting a better price.

So we think that that’s part of the reason why we’ll see some benefit to that for next tax season because we didn’t increase prices like we historically had and in many cases in the second half of the year, clients actually saw price reductions.

So we know when we adjust price that it takes a little bit of time to see, not all the benefit will happen in year one just because of the way tax preparation pricing gets done but we do know that if you can moderate your price increases that over the course of a couple of years it is a big factor in helping us grow our client base.

So we think we’ll see some benefit of that in 2010 but as we do more of it we’ll see I think a compounding effect in 2011 and beyond.

Operator

There are no additional questions at this time; I would like to turn it back over to management for any additional or closing comments.

Scott Dudley

Just wanted to thank you all for joining us today for the call and if you have further follow-up questions, please give us a call. Thank you much.

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Source: H&R Block, Inc. F4Q09 (Qtr End 04/30/09) Earnings Call Transcript
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