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H&R Block, Inc. (NYSE:HRB)

F4Q10 (Qtr End 04/30/10) Earnings Call Transcript

June 24, 2010 4:30 pm ET

Executives

Derek Drysdale – Director, IR

Russ Smyth – President & CEO

Jeff Brown – Interim CFO

Kate Fulton – SVP, Government Relations & Public Policy

Analysts

Scott Schneeberger – Oppenheimer & Co.

Michael Millman – Millman Research Associates

Sloan Bohlen – Goldman Sachs

Vikram Malhotra – Morgan Stanley

Bill Carcache – Macquarie Research Equities

Vishnu Lekraj – Morningstar

Michael Chapman – Private Capital Management

Operator

Good day and welcome to today’s web conference. During today’s event for those dialed into the audio bridge, all lines have been muted to prevent background noise. This event is being recorded. There will be a question-and-answer session after the formal comment.

At this time, we would like to welcome everyone to today’s web event titled, “Fiscal 2010 Earnings Conference Call.” At this time, it is my pleasure to turn the floor over to Mr. Derek Drysdale. Mr. Drysdale, you have the floor.

Derek Drysdale

Thank you for joining us today. This is to discuss our fiscal 2010 results. Presenting on the call are Russ Smyth, President and CEO; and Jeff Brown, our Controller and Interim Chief Financial Officer. Other members of our senior management team will be available during the Q&A session.

I would like to remind everyone that today’s remarks will include forward-looking statements as defined under the Securities Exchange Act of 1934. Such statements are those relating to matters that are not historical facts and such statements are based on current information and management’s expectations as of this date and are not guarantees of future performance.

Forward-looking statements involve certain risks, uncertainties and assumptions that are difficult to predict and as a result, actual outcomes and results could materially differ.

Please see the risk factors included in our most recent periodic reports and other filings with the Securities and Exchange Commission. H&R Block undertakes no obligation to publicly update such Risk Factors or forward-looking statements.

Following our prepared remarks, we will open the call to Q&A. To give as many participants as possible an opportunity to ask a question, we ask that you limit your query to one initial question and then one related follow-up if needed.

With that, I’ll now turn the call over to Russ.

Russ Smyth

Thanks, Derek, and good afternoon everyone. Earlier today, we announced our fiscal 2010 results. We generated consolidated net income of $1.43 per share this year, which is a slight decline of 1.3% from last year, despite the IRS suffering its largest decline in total filings in nearly 40 years. And while these IRS results reflect the impact of an overall unemployment level of nearly 10%, for many in our core client base, unemployment was in the 15% to 30% range.

Given our overall performance this year, our financial position and liquidity base remained very strong which enables us to make the right strategic choices for growing our business and returning value to shareholders.

Here’s a quick recap of our fiscal 2010 results. We prepared 20.1 million U.S. tax returns this season, down about 4% from a year ago. We did a better job of retaining our existing clients.

In fact, our retention to the brand increased 130 basis points to 71.6%, but our marketing and pricing initiatives did not generate adequate new client growth to compensate for the loss in clients due to record levels of unemployment. We lost 65 basis points of share in the assisted market and 100 basis points in the digital online category.

At McGladrey, we successfully resolved the dispute with McGladrey & Pullen and created a new operating agreement that resolves the nagging issues of the past and positions the partnership for growth. However, there was a one-time drop in income as a result of this dispute and it adversely affected RSM’s ability to participate in proposals for new client engagements and we incurred more than $6 million of related legal expense.

Despite a difficult operating environment, we generated strong free cash flow of nearly $500 million. We returned substantially all of our earnings to shareholders in the form of share repurchase and dividends. In the past two quarters alone, we repurchased nearly 13 million shares, ending the year with $1.4 billion of equity and just $1.1 billion of total debt. These repurchases reflect our confidence in the future of our business.

So with that overview, our goal today is to talk about the areas in which we saw progress and then in those in which we need to improve. And I’ll also share some of our plans to address both the opportunities and the challenges that we expect to see in the tax industry next year.

But the headlines are this; we’ve got three key challenges for fiscal 2011. First, we’ve got to reduce the early season client loss in our retail business. Second, we need to significantly change our approach to be more competitive in digital. And third, we need to ensure that the McGladrey business is back on track, growing top line revenues, partner income and bottom line profits.

I’ll talk more specifically about the actions we plan to take for each of these later on the call. But, first, I’d like to start by sharing our analysis of the tax season 2010. We saw very clear and pronounced contrast between the first and second half of this tax season. Our results were directionally consistent with the trends in IRS filings, which were down significantly in the first half but recovered in the second half of tax season.

More than 90% of our client loss this year was among lower adjusted gross income first half filers, particularly those who file the 1040A Form and those who take settlement products. As you can see on the slide, unemployment rates within this client segment are up two to three times the national average.

Many were not required or chose not to file, while others went to an independent tax preparer. Some may have chosen a digital alternative, but based on our performance improvement in the second half, we believe many of these lost returns went unfiled.

We estimate that the total industry shift from assisted to DIY was about 75 basis points or approximately 1 million returns this year. The shift was significantly lower than our original projection of 100 to 125 basis points and it occurred predominantly in the first half of the season.

Frankly, we believe that the challenging economic conditions would lead to a larger shift. More recent data indicates that even during hard times and with changing demographic trends, the assisted tax prep category remains both resilient and relevant. In fact, the assisted category currently represents 61% of total IRS filings compared to 39% for do-it-yourself. These are the exact same percentages that they were back in 2002.

Another key factor for our early season performance was our inability to take advantage of the RAL disruption that occurred. We expected to see an increase in new clients, since we had RAL funding and many competitors did not. There was a lot of confusion in the settlement products space and our marketing or word-of-mouth were not able to dispel that confusion. So one of our top priorities for the 2011 tax season is to ensure that our overall value proposition and messaging to first few clients will be both clear and more effective.

Our second half results reflect improvement in both our performance and the overall industry. As indicated by our same-office returns being up 1% and our assisted market share holding essentially flat.

Second half client is said to have higher incomes and they’ve been less impacted by the economic conditions. We also believe our overall value proposition and our marketing messages resonated better with second half clients. So those were the quick headlines from this past year.

So now let’s turn to some of the initiatives that we outlined at December’s Investor Conference just prior to tax season. The first set of these initiatives were designed to improve the quality of our client experience and we saw meaningful improvement against these initiatives this year, which we believe will lead to better retention next year.

Clients in our tax offices were served much better. And when clients called us with a question or issue, they were quickly addressed or resolve. Here’s why we’re confident in these claims. First, we moved approximately 800,000 clients to our higher performing tax professionals, which helped improve perceptions of tax expertise and should leave the better retention rates.

Second, clients who said they will refer were up 2 points to 55% and those who said they were confident with their results were up 8 points to 87%. At our call center, our handle rates were up by more than 23 points to 98% and our first call resolution scores were up by more than 10 points. And finally, we reduced our walk-out rate by five percentage points or about 575,000 clients.

These improvements increased our client retention levels after years of steady declines and we’ll continue to improve the quality of our client experience, which will increase satisfaction, our value proposition and further increase retention. In our retail marketing initiatives, our top priority was growing new clients through increased brand consideration and trial.

Although improving consideration is a long-term goal, we did not change perceptions quickly enough to drive new clients in the first half. We made some key adjustments to our messaging in mid-season with more direct calls to action. As a result, we gained nearly two points of growth in new non-settlement product clients. We’ll build on this second half progress and our marketing focus in 2011 will be squarely focused on driving traffic into our retail offices.

Another key opportunity in retail is settlement product marketing. This was a big miss for us this last year, but it promises to be an even bigger opportunity for the upcoming season. With the benefit of 20/20 hindsight, we were too late to get our message out last year. Our message wasn’t clear enough to cut through the confusion in the marketplace. And we didn’t direct enough of our marketing resources to take advantage of this particular opportunity. With more time to prepare for this season, we expect significant improvement in our performance in this critical piece of our early season business in fiscal year ‘11.

Turning to our pricing initiatives, we said we would moderate increases to help improve our overall value proposition in conjunction with the service enhancements previously mentioned and we did exactly that. Our long-term objective remains to increase revenues through a healthy balance of client growth and targeted pricing actions.

Specifically, in fiscal year 2010, we held list prices flat throughout the year and let complexity flow through. We offset some of these increases with targeted pricing actions to accelerate trial and improve retention. And net of these actions our average, net average or our aggregate net average charge increased by about 1%.

Given the market conditions, we believe that showing restraint on pricing was the right thing to do for this past year. We’ve learned a lot about what pricing can and cannot do in terms of impacting our short and long-term business results.

Through the various price tests we ran this season, we’ve validated that retails clients remain relatively price inelastic and that price reductions will not result in immediate and significant client growth. We also know from some of our longer term testing that over time, pricing is an effective tool to prevent client attrition and is an important factor in client’s perception of our overall value proposition. We also learned that relative to the overall industry, our average pricing is near the median.

However, it’s important to keep in mind that one size does not fit all and averages can be very misleading. And we evaluate price relative to our product and service offerings, by specific client segments. That’s the reason we targeted 1040EZ clients this year with an attractive $39 federal return offer.

While our pricing actions did not help us grow our 1040EZ clients as we expected. It did help stabilize our market share after two consecutive years of share loss with this base form. This group of clients, who are typically younger in age, are a critical part of our long-term growth pipeline. So it’s important we capture them early, give them a great experience and retain them over the long run.

As we view pricing in light of our targeted client segments, there are opportunities to adjust pricing either up or down in conjunction with our service improvements to deliver both client and shareholder value. However, as I said earlier, each year’s pricing decisions will stand on their own and they’ll be evaluated relative to the competitive landscape and done in conjunction with our strategic business objectives.

By improving our service levels this year and showing restraints on pricing, we believe we’ve actually improved our pricing power for the long-term. So we view our price adjustments in fiscal 2010 as a multi-year investment, which will have a compounding impact over time.

Within the overall digital category, the online space continued to grow, while software and Free File Alliance categories continued to shrink. In the online category, which we believe is the key battleground in digital, our returns grew by 4%, but we lost 100 basis points of market share.

Meanwhile our software share declined by 170 basis points due to our decision to exit two unprofitable retail channels that accounted for about 250,000 returns. In the FFA category, our returns increased by nearly 3% and we estimate that we gained about 240 basis points of share.

At the investor conference, we said we commit to digital by making significant product improvements, to get to parity with the competition. Over the past year, we’ve redesigned and enhanced our product to improve the client experience and added the ability to import W-2 data and financial institution records.

As a result of these changes, independent reviews such as both from the New York Times, PC Magazine and Consumer Reports just to name a few, reported that our improvements approach parity with the competitors.

We also made solid progress in our digital marketing efforts, but did not convert as we should have. Awareness and consideration of our digital offerings were both up 4% each, in part due to our ‘click, call, or come over campaign. These efforts resulted in a 25% increase in Web site visits, but only a 4% increase in clients.

So clearly we have an opportunity to improve our conversion rate of visitors to clients. Next season in digital we’ll continue to build on the things that worked and improve on those that didn’t.

So the keys to our digital performance next year are

First, we will overhaul our Web site to improve our conversion rates. Second, we’ll use the free message much more aggressively to drive new clients as we know this is a critical entry point into the digital online category. Third, we’ll significantly reduce our digital operating costs, so we’ll become even more profitable as we achieve greater scale. And finally, we’ll invest in top leadership talent to drive these business results.

Looking beyond next year, we will leverage other strategic opportunities to help us grow our clients in new ways. For example, our recent partnership with Yodlee, gives us the chance to become the tax service provider for more than 25 million online banking clients currently being served by Yodlee’s platform.

Our last set of initiatives involve franchising and optimizing our office footprint and we delivered on our plan to franchise up to 300 company operated locations this last year. We still have an opportunity to improve our performance in some offices by putting them in the hands of local entrepreneurs.

But in addition, we believe there are substantial opportunities over time to attract independent tax preparers to H&R Block as franchisees, particularly those who maybe looking for access to settlement products, as well as strong training and infrastructure support.

We also reduced our office footprint by more than 1,000 Wal-Marts and approximately 400 other office locations. We saved $35 million in operating cost. Our actual retention rates for these closures were slightly above our target; however, these closures did result in a loss of approximately 84,000 clients net of those retention efforts. We’ll continue to monitor office level performance to ensure we have right-sized our office footprint.

Now, I’ll turn the call over to Jeff to discuss our operating results and financial position.

Jeff Brown

Thanks, Russ. In our Tax Services segment, pretax income was $867 million, down more than 6% from the prior year and segment revenues fell 5% to $3 billion. These results were driven primarily by declines in tax returns prepared.

Total expenses dropped by nearly $100 million or 4.4%. Lower expenses were primarily the result of variable field compensation, reductions in our network footprint and incremental gains on the sale of tax offices. We expect to continue our efforts to sell certain tax offices that we believe are better operated by franchisees, but at reduced levels in the coming year.

Despite our top line challenges during the year, pretax margins were still solid at 29%. Current year margins exceeded 2008 levels by over 200 basis points due both the gains on tax office sales as well as focused cost control during that two-year period.

In Business Services, McGladrey’s revenues declined about 4% to $860 million. The current economic climate has continued to pressure billable rates and hours within the industry and companies had fewer discretionary dollars to spend on consulting.

Pretax income for the segment fell nearly 39% to $59 million. Profitability was negatively impacted by one-time expenses, associated with the previously resolved dispute with McGladrey & Pullen and other costs of litigation. Results also reflect a $15 million goodwill impairment charge at our capital markets business unit.

Excluding these charges, pretax income for the segment would have been $88 million and our pretax margin would have been 10.3%, essentially flat with prior year. Our revenue shortfall was partially mitigated by cost reduction efforts throughout the year. Those efforts included headcount reductions to reflect lower demand, as well as other actions to reduce costs without impacting client service levels.

In Corporate, our pretax loss of $142 million improved by nearly 23%. Lower losses were primarily due to reduced loss provisions on mortgage loans, reductions in insurance costs and gains on residual interest assets. These results include one-time favorable items of approximately $19 million which are not expected to repeat in 2011.

Our mortgage loan portfolio is static and continues to decline. Net mortgage loans held for investment declined by approximately $150 million during the year to $595 million at year end, substantially lower than the nearly $1.4 billion of loans held on our balance sheet just three years ago. Net loans at year end included only $350 million previously originated by Option One.

We saw delinquency and loss severity rates level off during the year and loan loss provisions declined from $64 million last year to $48 million in the current year. Our allowance for loan loss was $94 million or 13.7% of outstanding principal at year end.

Losses relating to loan repurchase obligations of our former mortgage business also remain low. It has been over two years since we completed the sale of this business and subsequently set up reserves totaling $243 million. During that period, we have incurred actual losses of $55 million and ended the current fiscal year with $188 million of remaining reserves.

We have not experienced any significant change in recent repurchase activity and although future claims cannot be predicted with certainty, we believe that time is our ally and trends over the last two years support the adequacy of our current reserves.

Our net loss in discontinued operations was less than $10 million compared to a loss of $27 million in 2009, declining primarily as a result of losses from the disposition of our financial advisory business last year.

Turning now to our financial position, we ended the year with a solid balance sheet and strong liquidity. In March, we successfully obtained a $1.7 billion committed line of credit through July 2013.

In addition, we ended the year with $1.8 billion of cash and total debt of $1.1 billion was flat to the prior year. Our equity was essentially flat at $1.4 billion, as substantially all of our current year earnings were returned to share holders through share repurchase and dividends.

The Company repurchased and retired nearly 13 million shares during the fiscal year at a cost of $250 million, including repurchases of 6 million shares in the fourth quarter at a cost of $100 million or about $17 per share.

Fiscal 2010 fully diluted shares outstanding were 333 million. Because share repurchases were mainly completed in the latter part of the year, they had a minimal impact on our average shares outstanding. We currently have more than $1.6 billion of share repurchase authorization remaining.

Receivables declined to $518 million from a seasonal high of $2.6 billion in our fiscal third quarter, reflecting the normal pattern of collections relating to our Emerald Advance line of credit product and our participation in RALs.

Our effective tax rate for continuing operations was 37.6%, compared to 38.9% in the prior year. This decline was due to tax planning strategies, which resulted in a $9 million reduction in deferred tax valuation allowances and non-taxable benefits on company-owned life insurance.

For the coming year, we expect our full year continuing operations tax rate to approximate 39%. Depreciation and amortization was $127 million for the year and our normal ongoing operating capital expenditures were $91 million. We expect no material change to these levels in fiscal 2011.

And with that I will turn the call back to Russ.

Russ Smyth

Thanks, Jeff. Before I close, I’d like to make just a few remarks about the external environment. No one really knows when the economy will recover or at what rate. However, we do know that for IRS filings to grow it will require either an increase in employment levels or some type of government stimulus program executed through the tax code, similar to what we saw with ESA in 2008.

There is also continued uncertainty in the RAL marketplace. Chase’s has exited the RAL business and there is a chance that others may follow. However, we think it’s likely that we’ll have some competition for this product. We are pleased that H&R Block is in the very enviable position of having a partner who is committed to funding RALs.

In addition an IRS and Treasury working group are reviewing settlement product usage within the tax preparation industry. We’ve been told to expect a report on its finding some time in July. This group has been reviewing a number of things including the IRS practice of providing the debt indicator used in the RAL approval process.

At Block, we are committed to offering best in class settlement products to meet the significant client demand in this tax season and we are well positioned to adjust as necessary in response to any changes brought about by this working group.

You saw in our release that today we are not providing detailed earnings guidance. We are committed to growing both revenues and earnings and we’re confident in our ability to execute our plan.

However, the uncertainties of employment levels, financial settlement products, tax code changes and the fact that substantially all of our revenues and earnings are generated in the fourth quarter, caused us not to predict results at this time.

As things play out in the coming months, we will continue to be transparent with all of our stakeholders, as we’ve been with our disclosures and reporting in the last few years. But for now, here’s a recap of directional insights for fiscal 2011.

First, we will continue to return substantially all of our earnings in shareholders via share repurchase and dividends. Second, we had a number of one-time charges and gains in fiscal 2010, which with the exception of gains on sale of tax offices largely offset each other. Please note that for your convenience, we’ve included an appendix slide, which recaps these one-time items.

As we mentioned earlier, our fiscal 2010 results included gains of $49 million on the sale of tax offices. Although we will continue to look for opportunities to transfer certain tax offices to qualified franchises, we expect future activity will be at lower levels than this past year.

Next, we expect to incur one-time pre-tax charge for severance related costs in connection with last month’s reorganization. We expect the amount of the charge to be less than previously announced, about $90 million, most of which will occur in the first quarter. We also expect no material change in our normal ongoing capital expenditures or depreciation and amortization amounts.

For next year, we expect our effective tax rate to approximate 39% and lastly, we have had no significant change in loan repurchase activity and we believe current reserves are adequate and our static mortgage loan portfolio that’s held for investment continues to wind down and appears to have stabilized.

Now it’s important to remember that we’re starting year two of a three-year growth plan. As I mentioned before, the tax market environment is in unchartered waters. The economy, unemployment, the regulatory environment are all in a state of transition and as a result so are customer needs.

Although we can’t predict the future, we are prepared to leverage our considerable strengths to create competitive advantages out of challenging market conditions. And as you’ve heard today, we believe we started on the right path by building on what we know works and quickly adjusting what doesn’t.

Our retail tax group is our biggest income contributor and continues to be our bread and butter and it’s not going away anytime soon. We’re taking the necessary steps to enhance our products and experiences to be best-in-class and we’ve taken a big step in reengineering our cost structure to allow us to become the best value provider in the industry.

We believe we can reduce the loss in early season clients by being more effective at targeting key client segments from both an operational and a marketing perspective, with a particular emphasis on settlement product clients.

As for our digital efforts, they continue to be an important element of our long-term growth strategy, even though today digitals profit contribution is significantly less than retail.

As I mentioned earlier, in order to improve, we’re making significant changes that include an overhaul of our Web site to improve our conversion rates, increased emphasis on using the free message to drive new client growth, significantly improving our operating cost structure within digital to further enhance profitability as we gain more scale and investing in top-class leadership talent to help drive our business results.

And McGladrey, our new operating agreement in partnership with McGladrey & Pullen has been significantly strengthened. C. E. Andrews and his new leadership team are in place. They’re focused on growing the business and are incentivized to grow quickly. They are exploring both organic and strategic opportunities to grow revenues, partner income and profitability and we expect McGladrey to get back to both top line and especially bottom line growth in fiscal year ‘11.

Within all of our businesses, attacking our cost structure will continue to be an important part of our ongoing objectives. We’ve already taken significant steps to be a much leaner and more cost effective organization and we’ll continue to ensure that cost discipline is engrained in every part of our business.

We’re getting more client-focused, we’re improving the client experience and we’re gaining better insights into what motivates our customers’ behavior and we will continue to get better and better at this every year. Finally, our people are one of our strongest assets. We’ve created a structure that gets us closer to the customer, while also creating a culture of responsibility and accountability for results.

Going forward, we’re excited about the opportunities and we remain focused on improving our business in spite of external market factors and doing it in a manner that achieves sustainable growth in fiscal year ‘11, fiscal year ‘12, fiscal year ‘13 and beyond.

So with that, we’re now ready to take your questions.

Question-and-Answer Session

Operator

(Operator instructions)

Russ Smith

Operator, looks like we’re going to some kind of technical difficulties there. We see that there are people in queue.

Operator

Yes, sir. And your first question comes from the line of Scott Schneeberger.

Scott Schneeberger – Oppenheimer & Co.

Hey, Russ. Good afternoon. First question, the $140 million to $150 million of cost savings, the question here is how much of that are you going to take and reinvest in the growth of the business and how much are you going to use that to help show us some margin expansion and let it fall to the bottom-line? And just the way you think about that and you’ve discussed that with the Board? Thanks, Russ.

Russ Smyth

Well Scott, it’s a combination of the two and we think it will be both. But essentially, I think a lot of that is going to help fund our profitability improvement over the next several years. And the $140 million to $150 million you mentioned, just to remind everyone, it was through fiscal year ‘12 and we haven’t said how much it’s going to be in fiscal year ‘11 or in ‘12. So it’s over a two-year period. But it’s a combination of two, investments for growth.

We made some good investments last year and we think we can continue at those kinds of cost rates and a lot of our action steps as we anticipate going into next year, we don’t believe are going to require as significant investment levels in ‘11 or ‘12 as what we invested in fiscal year ‘10.

Scott Schneeberger – Oppenheimer

Thanks. I mean you did mention earlier that you do expect to drive an outlook, revenue growth and EPS growth. And so thus I would assume some margin expansion. I guess from the follow-up, if I could ask, what is the thought process on return of cash to shareholders? You certainly have a lot sitting on the balance sheet now and I’m just curious how aggressive you maybe with that going forward, thanks?

Russ Smyth

Scott, on returning cash to shareholders, the limiting factor on what we can return has nothing to do with our cash balance. The biggest limiting factor for us, are the net equity covenants in our commercial line of credit agreements. As I think most of you know, we’ve just renegotiated that agreement in, I believe it was February of this year, under extremely favorable terms. But one of the covenants that remain from before was a minimum net equity covenant of $650 million.

And so essentially, that’s what prevents us from taking more of our cash on the balance sheet and returning it to shareholders either in the forms of more share buybacks or dividends. This year we returned substantially all of our earnings to shareholders and as we said kind of in our outlook going forward, we would expect to do the same in fiscal year ‘11 as well. But that’s the limiting factor, it’s not cash availability.

Scott Schneeberger – Oppenheimer

I’ll hop back in queue. Just a follow up to that though. With you guys continuing to strengthen your balance sheet I’d imagine just directionally you feel pretty comfortable that you can do a good bit of share repurchase because even in your down season you reflect well on that covenant?

Russ Smyth

As you saw, we were pretty active in repurchasing shares in the last quarter. And so if we like the stock price at 17, it’s not a leap of faith to assume that we like it better where it’s at today. In terms of share repurchases, not in terms that we are happy with the overall stock price.

Scott Schneeberger – Oppenheimer

Understood. All right. Thanks. I’ll hop back in queue.

Operator

Your next question comes from the line of Michael Millman.

Russ Smyth

Hi, Michael.

Michael Millman – Millman Research Associates

Can you give us a little more insight and maybe quantification of your thinking regarding marketing expense? When you this year expect to be more aggressive and again quantify it compared to last year and maybe give us some idea what you expect total expenditures to be? And I guess also in the past you found marketing often resonates well on surveys but not on the bottom-line?

Russ Smyth

Mike, in terms of the overall marketing dollars, we’ve never disclosed our total spend in marketing. However, having said that, when we talk about our marketing being more aggressive, you should not assume that that means we’re necessarily going to spend more. My comments about it being more aggressive are really about the messaging within marketing.

And I believe what you saw us do in the second half of this tax season is be a lot more direct and bolder and prouder of all the great things that we have to brag about with the product and services at H&R Block and less what I would call brand generic and feel good stuff and had a stronger call to action. And those marketing messages seem to resonate better.

So a big part of when I say more aggressive is in the type of tone and call to action that you can expect us to have with all of our messaging for next year. In addition to that, as we look at our marketing spend; we plan to kind of reallocate our resources in different ways for fiscal year ‘11 and into different priorities than when we put them into this last tax season.

So clearly, we plan to invest more marketing resources, direct more marketing resources into supporting our growth of clients looking for great settlement products in fiscal year ‘11. It’s one of our absolute strengths. We have the best-in-class products. We have the best and fairest pricing in the industry. We have the best disclosures around it. And as we’ve pointed out several times, we have a great supply and availability of the RAL funding.

And so we just need to leverage all those assets much better and marketing will play an important part of more effectively communicating that. And I believe that that will then resonate better on the bottom line than some of our marketing has resonated in the recent past.

Michael Millman – Millman Research Associates

Historically, you always told us that you had a concern with doing that have an early season because of the fact on making it looked like a RAL shop to the late season. How do you get around that now?

Russ Smyth

Mike, we lost 900,000 clients this last tax season and as we said over 90% of them were first-peak low income AGI filers looking for settlement products. We cannot allow that to happen, period. We’re doing much better in the second half, so we’re strong there. We need to prop up where we are weak and get much more aggressive and much more competitive.

Michael Millman – Millman Research Associates

And maybe a quick, can you tell us actually what the revenue and profits for digital were this year compared with last year?

Russ Smyth

As you know we don’t separately disclose the digital revenue or product or results. Those are included within the tax services segment and always have been.

Michael Millman – Millman Research Associates

Can you give us an order of magnitude?

Russ Smyth

As I said, significantly smaller than retail revenues and profitability.

Michael Millman – Millman Research Associates

And can you tell us whether they were up or down?

Russ Smyth

It was up.

Michael Millman – Millman Research Associates

Thank you.

Operator

Your next question comes from the line of Sloan Bohlen.

Sloan Bohlen – Goldman Sachs

Thank you. Good afternoon. Russ, could you maybe talk a little bit, certainly, heard a little bit about the marketing, but what degree do you guys look at pricing as a tool that you have for client retention in 2011? Certainly, it seems like you believe that the value of your product relative to your competitors there, to may be send a shock on the top line or improve profitability, to what degree would you use pricing as a tool?

Russ Smyth

Sloan, as we said in the piece, we look at the pricing by key client segments. So I think with certain client segments, as we’ve evaluated our pricing relative to the competition, we think we’ve got room to adjust upwards and we will do that where we think it makes good business sense. We also learned this year that pricing reductions have proven to be just as inelastic with our clients even in these tougher economic times, as what the Company had seen historically in the many previous years when they were increasing prices.

So we know it’s not a short-term client mover, but we do know that it has an impact over a three, four and five year period. And so I think pricing is one action that we review by client segment in conjunction with a number of different actions from a service perspective, from a marketing perspective, from a product perspective and it’s one tool in the tool kit, but it’s not the only thing that moves our top line business and it’s not the only thing that moves our bottom-line business and we’re just going to approach it from that perspective. It’s a part of the toolkit and it’s got to be done in balance and in conjunction with a number of other things.

Sloan Bohlen – Goldman Sachs

I guess as a related question, do you have a sense for the price elasticity or sensitivity within the groupings of clients and whether it’d be by income or how do you think about them? So for (inaudible) that’s on the lower end of the income section.

Russ Smyth

We do know specifically by client segment price sensitivity. Okay? I don’t want to give away all that good competitive information on a public call, but generally I will say and this probably won’t come as too much of a shock that the lower income level folks tend to be more price sensitive around tax prep pricing than higher income levels.

Sloan Bohlen – Goldman Sachs

All right, thank you.

Operator

Your next question comes from the line of Vance Edelson.

Vikram Malhotra – Morgan Stanley

Vikram in for Vance. Russ, I had two questions. One, one of your goals I guess for this year and then it’s more for next year is new client growth. Can you just give us a sense of what your plans or maybe some more details of how you plan to grow in that area?

Russ Smyth

Well, the one specific area, Vance [ph] that we said we’ve got to focus on is the settlement product clientele. It was our biggest missed opportunity last year, but because of the continued disruption in the RAL marketplace, we believe that is an even greater opportunity for us in fiscal year ‘11 and because of the strength of our settlement products and the availability of our settlement products, it’s also one of our distinct competitive advantages. So, that is clearly an area that we have to leverage better and should contribute very significantly to our new client growth initiatives in fiscal year ‘11.

We also think in terms of client growth that learning from this last year was, I think I mentioned in the call script. In the second half of this tax season, we grew our non-settlement product clients and we grew our same office returns in the second half.

So clearly the message is about our tax expertise, moving more clients to our best educated and trained and highest performing tax pros. Those are messages that seem to be resonating in the marketplace and we think that will help us grow our new clients in the second half of next tax season as well.

And then adding on to that I think all the work we’ve done on improving service in call center and just client handling issues and we saw retention bump this year, we think that’s going to continue to build momentum. And so increasing retention every year for our business also forces us to have less new client growth in order to get back to or exceed our overall client levels from the previous year. So I think it’s really primarily a combination of those three on the retail front.

In terms of our digital clients, as we mentioned, the different marketing initiatives drove a lot of traffic to our Web site, a 25% increase. Our problem was our Web site is just far too clunky and tough to get through and it takes too many clicks from a client to enter the Web site to get to actually becoming a user of the product.

And so we’ve really got to redesign the Web site, make it much easier for the clients to entry point on the product. And as we improve that conversion rate that should increase a significant number of clients on the digital side, as well our push to really more openly and aggressively use the free message in the digital space.

We’ve clearly seen within our own results, as well as across the industry, more and more clients are entering digital online in a free option and then are converting over to different pay choices, but they are entering through free and so we’ve just got to get more aggressive in pushing that free message in the digital online space. So those are the two big areas that I think will have an impact on client growth within the Digital segment.

Vikram Malhotra – Morgan Stanley

Great. Just as a follow-up on the Digital segment. I think you have a product in there called Best of Both, which basically somebody does it online and then gets help from a tax, I’m just wondering, could you give us a little color, what traction you saw on that specific product?

Russ Smyth

Yes, Best of Both is a product that was in pilot mode this last year. It got off to a slow start frankly because we had some technical difficulties with some of the changes that we had made to the programs and the software. Once those were resolved, I believe that it grew pretty significantly from February through the end of season and was up probably about 25% to 35%. I think more like 35% in the second half, but it’s still a small base of numbers.

So while we think offering clients choices around services within the digital realm was an interesting idea, at this point, we haven’t been able to find the right way to prove that there is great client demand for it. But we’ll continue to kind of tweak it and try to improve on it, but at this point, none of us should count on that being a significant driver of growth in our digital business for fiscal year ‘11.

Vikram Malhotra – Morgan Stanley

Great. And then just lastly, could you talk a little bit more about refranchising, just probably longer-term, what goals you have then, how do you see that playing out over the next year?

Russ Smyth

So as we mentioned, we did just under 300 sales of company offices to franchisees in fiscal year ‘10. We think we picked the lowest hanging fruit off of those lists. However, we still believe there are opportunities in geographic areas that are pretty remote from where we can easily support them with company personnel and/or in ethnic communities in urban cities where a franchisee of that ethnicity we believe would do a significantly better job of running the office than company employees would.

So we still have those types of opportunities and they are still pretty meaningful, but it won’t happen at the same rate that it did this last year. How many we’ll do will be based on getting the right quality franchise candidate in those geographies or in those ethnic communities, but somewhere between 25% to 50% of the same level as we did last year into fiscal year ‘11.

Vikram Malhotra – Morgan Stanley

Great. Thanks very much.

Operator

Your next question comes from the line of Bill Carcache.

Bill Carcache – Macquarie Research Equities

Good evening. Russ, a follow-up on your comments earlier about the minimum $650 million net worth covenant. So it looks like given where you are right now that kind of incorporates some cushion for the potential or for the unprofitable off-season. And so is this kind of like a level that we can look to as a base line year-after-year at least for the time being, so that to the extent that you drive earnings growth that kind of flows into retained earnings and you exceed this $1.4 billion mark, which we’ve now seen for the last couple of years that that would be available for return to shareholders, repurchases and dividends?

Russ Smyth

I’ll let Jeff Brown, our interim CFO take that one.

Jeff Brown

This is Jeff. There are probably two key things to think about in that regard. So we have the $650 million covenant that acts as a gatekeeper I guess, if you will, as to how much share repurchase we can do. And really we have to look to, as you alluded to our off-season losses and therefore typically the third quarter is kind of our low point of equity. So as we think about share repurchase early in the year, we always have to anticipate where we will land at the end of that third quarter.

And I think really the second key thought which Russ mentioned in the prepared remarks is that, as has been historically, our intent really is to return to shareholders earnings that we make during any given fiscal year and so whether it’s in the form of dividends or share repurchase, we’ll look to some mix of those two key components to return value to shareholders every year.

Russ Smyth

And Bill, beyond that, if we were to do something else that would have a positive impact on net equity. That’s not earnings-related that would change the dynamic going forward. And in addition, as we look at kind of that low point that Jeff described in Q3, obviously, we want to keep some buffer for unknowns and we don’t want to get too perilously close and run the risk of being in violation of those covenants, particularly given the very favorable terms that we got through that commercial line of credit.

Bill Carcache – Macquarie Research Equities

And can you give an example of what would be something that would positively impact that equity balance, like for example, would that be like a sale of some asset or I guess anything that would fit that description?

Russ Smyth

An increase in goodwill or in other intangible asset would be something that would I believe would increase our net equity.

Bill Carcache – Macquarie Research Equities

Okay. I’ll follow up with you guys on that one offline, but another question is along the lines of the digital growth that you guys have been talking about, just from a big picture perspective if we just kind of dissect that, where that’s going to be kind of coming from, do you foresee more of it kind of coming from stealing share from the likes of Intuit or is there still a fairly large number of customers out there that are using pencil and paper today that you could convert over to your digital solution?

Russ Smyth

The population of pencil and paper users is diminishing pretty quickly and so at current run rates, there is maybe another three or so years left before there will be very, very few pencil and paper users. And I suspect that there are some of those folks that are going to keep using pencil and paper until they are not filing returns anymore at all.

So I think more of the growth of the category is going to have to come from us stealing share from other competitors, Intuit and others, as well as, we mentioned that we have seen some migration from assisted to digital overall the last two years. This year, it was 75 basis points or about a million returns. And last year I think it was 50 basis points, so probably 700,000 returns last year that migrated into the digital category and actually put some tailwinds into their growth beyond just stealing from pencil and paper.

Bill Carcache – Macquarie Research Equities

And on the regulatory changes requiring tax preparer certification, can you just talk about, from the standpoint of the benefit that you stand to gain from that, is that something that just kind of comes or is there a way you could position yourself so that you can make sure that you’re one of the beneficiaries of that change, if you could just share some of your thoughts on that?

Russ Smyth

Yes, I think for any tax preparers to be able to benefit from the change I think we need to have a better sense of two things from the IRS that they haven’t yet clarified completely for us. The first is from an enforcement standpoint, what are they going to do and what resources will they have available to ensure that once people are certified and registered that they are strictly enforcing the tax regs for those individuals.

Absent enforcement, frankly, these changes will not have the impact that I know the IRS wants and intents them to have. And so we believe that they will determine how to properly enforce this, but they haven’t shared with any of us exactly how they will do that. And until we know that it will be hard to determine how much benefit we can get.

The second potential benefit for us is really how the IRS will allow those preparers that are certified and registered to be able to essentially market this feature. So will they allow people to be able to say they are an IRS certified preparer or an IRS approved preparer. And to the extent they allow block or others who pass and are registered to have some kind of additional certification name that we can apply, I think that’s a feature that would help us all differentiate ourselves from others in the category and that would benefit from us. So I think enforcement and kind of ability to have some type of IRS certification tag are the two big things that would create benefit for Block or others who are certified and registered.

Bill Carcache – Macquarie Research Equities

But Russ, on the enforcement comment, wouldn’t they need to put their certification number on the return and therefore you would know whether the return was being prepared by somebody who is certified or not and if it’s not then you just don’t accept it and so you could enforcement it and as simple a way is that, I don’t know, can you just I guess help me understand that?

Russ Smyth

Well, I guess, so let’s use pay stub filing as an example. So right now there is a regulation that prohibits filing with an end of year pay stub as opposed to a W-2. There are still a number of returns that are filed with pay stubs and it’s very difficult to track that and enforce it when you’ve got 120,000 individual tax preparers, even if they’re registered. So while they will have the tracking mechanism, Bill, if they don’t use the tracking mechanism to identify those who are not complying with their regulations and then following up with them, just having them being registered doesn’t really accomplish very much.

Bill Carcache – Macquarie Research

Just final one, if I may. This is one I’ve been getting asked a lot and I didn’t hear it in the prepared remarks, but if I missed it, I apologize, but just the value of the loans that are being backed by your rep and warranty reserve, is that something that you might be able to disclose with us?

Russ Smyth

So Bill, it’s not a number we ordinarily disclose. Option One, originated loans that are still outstanding, we have several billions of dollars of principal balance that’s still outstanding that would correspond to that $188 million reserve we referenced in our prepared remarks.

Bill Carcache – Macquarie Research

Thank you very much.

Operator

Your next question comes from the line of Vishnu Lekraj.

Vishnu Lekraj – Morningstar

Hey, guys. Thanks for taking my call. Forgive me, but I’m still a little confused as to how the digital product is going to interface with your office product to your office service? Can you give me a little more color as to how that’s going to flow through 2011 and maybe beyond that?

Russ Smyth

I’m sorry. Vishnu, can you repeat the piece about how our digital product is going to?

Vishnu Lekraj – Morningstar

Yes. I mean, you guys are an office preparer. Your service is brick and mortar. However, it looks like some of the customers for that service are moving over to digital. I’m just trying to get a sense as to how you plan on dealing with that or what is your plan for digital moving along with the office?

Russ Smyth

The first thing I’ll say is we’ve got to run these like two separate businesses, okay? We’ve got the retail office business and we’ve got to grow that business and drive that business aggressively. On the other hand, there’s this interesting little emerging category called, “digital online software” that has been growing significantly in the past 10 years mostly at the expense of pencil and paper. But I think for us to be effective from a long-term standpoint, it’s important for us to also be very competitive in the digital online space.

And I’ll give you a specific reason why. Because when we see that clients are using our digital products, as their life gets more complicated and they own a house and they have kids, they then need more help preparing their taxes and want to see a tax specialist. When they are using our digital product and make that switch, they use our retail tax offices at two to three times the rates that people that don’t use our digital products come into our tax offices.

So essentially, digital looks like it could be a very attractive feeder channel for younger clientele with simpler returns to do their returns when they are young, but as their life gets more complicated, but they’ve learnt to like our product and trust our brand, when they go to switch to a tax specialist, they are far more likely to pick one at H&R Block.

And so I think for that reason, it’s very important to be in the digital business as well because it will be a feeder channel for retail. And I also think we can be very profitable in the digital business as a standalone entity. So I think those are two reasons why we think it’s important to play in the digital business. We think there’s a business to be had there. We think it can be very profitable. And two, we think ultimately, it’s a great way to expose young people to our brand and then give us a better chance to serve them in a retail office later on in their life.

Vishnu Lekraj – Morningstar

Moving on to my question then, looking at the RAL product itself, how do you see that moving forward? It looks like Washington is poised or may do something here within the next year or two in terms of either covering back the fees you can charge for those or regulating them to a greater degree. How do you view those moving forward along with your other services?

Russ Smyth

Yes, I know, we’ve got Kate Fulton, who is our Senior VP in-charge of Government Relations and Public Policy on the line. Kate, do you want to talk about what’s been happening in Washington on this front?

Kate Fulton

Sure. As you may know, when the IRS announced the return preparer proposals, they announced at the same time the creation of a working group that’s based at the IRS but includes representatives from the bank regulators and treasury. We understand…

Russ Smyth

Kate, I think we’ve lost you. So, let me try to pick up.

Kate Fulton

I’m sorry [ph].

Russ Smyth

Are you back?

Kate Fulton

Yes, I’m here.

Russ Smyth

Okay. Keep going.

Kate Fulton

And that, as they stated in the initial announcement in January, they intended to look at the debt indicator. We understand that the debt indicator, how it’s furnished, it’s on the table. We don’t know yet exactly what they might do in terms of withholding our conditioning in the debt indicator. They are also looking at a variety of fees that are charged in the industry. And we do expect that they’ll release just in time for changes we made in time for this tax season. So we do believe that their intention is to make a decision so that changes can be implemented for this tax season.

Russ Smyth

I know, here in Kansas City we had a hard time hearing, Kate, I’m not sure if everyone else on the line had the same.

Vishnu Lekraj – Morningstar

Yes so did I.

Kate Fulton

Is that better?

Russ Smyth

Yes, much. Can you retell –

Kate Fulton

So I’ll just reiterate just quickly that we do expect that this working group that’s housed at IRS and includes members of the financial regulatory community and Treasury will issue a report in July that will likely impact this tax season and that we understand they’re looking at the debt indicator.

We’re not exactly sure what they may recommend in terms of the way the debt indicator is provided or whether they will condition providing the debt indicator. They’re also looking at a variety of fees and that they intend to have the report released in time for the recommendations or the direction to be implemented in time for this tax season.

Russ Smyth

In terms of what impact that could possibly have on Block or the industry, from the debt indicator standpoint, Block is one of the few firms that offers RAL that doesn’t rely upon the debt indicator; it’s called an instant RAL. So we believe that if they were to make the decision to pull the debt indicator that we would be well-positioned, because we’ve already got an operational product available. Their product is at a higher price to the clients because it carries more credit risk, because we don’t have the debt indicator provided, so that would be an unfortunate consequence from a client standpoint. But we would have product availability, we believe, even if the IRS were to not make the debt indicator available to tax preparers.

Vishnu Lekraj – Morningstar

Got you. Appreciate it. Thank you.

Operator

Your next question comes from the line of Michael Chapman.

Michael Chapman – Private Capital Management

Hey, Russ. A couple of quick questions on the special items. I’m assuming just wanted to check that $38 million that’s pretax?

Russ Smyth

That’s pretax.

Michael Chapman – Private Capital Management

And the gain on sale; was that in Corporate or was that actually in Tax Services?

Russ Smyth

It’s in Tax Services.

Michael Chapman – Private Capital Management

Okay. Previously, you guys had said that you’d like to buyback $2 billion over four years, so about $500 million in share backs. Is the new discussion of returning all earnings to shareholders, is that now the description of that and we should disregard the $500 million or is that roughly $500 million a year still in your mind, the number you’re shooting for?

Russ Smyth

So I’m going to have to apologize, because I’m not a 100% certain about what you are referring to with regard to the $500 million. I think what I would say is –

Michael Chapman – Private Capital Management

Well, you guys had said $2 billion over four years.

Russ Smyth

So we still have $1.6 billion remaining on that authorization that is through 2013. It provides us more authorization than what we’ll actually achieve in share repurchase through that time period. But I think what I would say is much like our historical practice has been, our intent will be to return as much value to shareholders as we can. And the earnings that we make in any given year, we’ll return to shareholders through some combination of share repurchase or dividend.

Jeff Brown

Michael, I’m not sure if you were at our Investor Conference prior to last tax season. We did say that while we were still operating under that $2 billion share repurchase authorization, that it might take us an additional year or so beyond what we had originally thought at the time that that was announced. So I do want to reiterate that again here, because that’s part of the answer to your question I believe.

Michael Chapman – Private Capital Management

And then just two quick follow-ups. What was the ending share count and then when does your share buyback blackout period around earnings end?

Jeff Brown

Michael, can we, rather than have the financial folks, they are trying to search through a lot of data for that, can Derek call up with you?

Michael Chapman – Private Capital Management

Yes, that’d be great.

Operator

Your next question comes from the line of Scott Schneeberger.

Russ Smyth

Welcome back, Scott.

Scott Schneeberger – Oppenheimer & Co.

Hey, guys, thanks for taking the follow-up. I actually have a few. I’ll ask them all upfront if you want to jot them down. First one is your view of dividends versus repurchases and dividend increases perhaps versus repurchase here your thought process there? Number two is update on the CFO search. Number three, is there any way if the debt indicator is pulled that HSBC and you contractually can separate, just any thoughts on that?

And then finally, the way you are thinking about the upcoming season, but we saw new IRS forecast for every year going forward, next year to 2017, they are looking for growth in tax filers next year of about 0.5%. Just how you think about that and was that out in time for you to work in your equation about how you are thinking of next year?

Russ Smyth

Let’s go with the debt indicator one first, because we have just talked about that a little bit earlier. Our legal counsel has looked into this in many different ways and we feel very confident that there are no outs in the contract with HSBC, that would terminate or that would cause the agreement to terminate if the debt indicators were pulled.

And in fact in our recent discussions with them, they have reiterated that the partnership worked even better this last tax season than it ever has before and that they intend to on our contract through fiscal year ‘13, which includes the two-year option extensions. CFO search, we are making very good progress, we’ve seen a number of candidates. We like a couple in particular and our goal is to try to wrap that up over the next couple of weeks. Outlook for tax season, I just did see Scott, that information when it came up the other day and I think a lot of that is going to be driven off of people’s expectations about economic recovery and job recovery.

And so frankly, when we look at industry-wide things for next year, as we said in the conversation, without job growth or without some other type of ESA type stimulus or refundable credits that drive people in and force them to file taxes, I think it’s going to be tough for those numbers to grow, absent either one or both of those two events occurring.

And then on the dividend and repurchase piece, so we talk to our major investors on a regular basis, part of that conversation is typically, how they view dividends versus repurchase. And as we look at our dividend yield ratio, it’s relatively high. Now, part of that, frankly, is driven by the fact that the stock prices is lower than we think it ought to be. But even if the price were to go back up, our dividend yield ratio is already pretty high.

So, we think about how a change in the dividend versus share repurchase, signals externally our own views about our business opportunities and our growth potential. I think this is a balancing act. It’s not kind of all one or not the other. I think it’s a healthy thing to have dividend growth overtime. It puts pressure on management to continue to grow earnings. However, when you’ve got opportunities to purchase stock at what you think are great prices, in those situations, you would probably air more on the balance of share repurchases.

So I think these are things we regularly evaluate and discuss, both from a management team perspective and more importantly; this is a regular part of our Board discussions. And there is no absolute one method versus the other and we’ve chosen to say, here’s the dividend rate that we’ve declared in the past and we’ll be opportunistic on share purchases, but we’ll evaluate that again at our next Board meeting, which is when we’ll decide on the next quarterly dividend.

Scott Schneeberger – Oppenheimer & Co.

Thanks for your answer. (inaudible)

Operator

And at this time, I am showing there are no further questions.

Russ Smyth

Well, thank you very much for your time, everyone. We appreciate spending time on the call and if we don’t talk to you before hand, have a wonderful 4th of July holiday.

Jeff Brown

Thank you.

Operator

And this does conclude today’s conference call. You may now disconnect.

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Source: H&R Block, Inc. F4Q10 (Qtr End 04/30/10) Earnings Call Transcript

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