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H&R Block (NYSE:HRB)

Q1 2012 Earnings Call

September 01, 2011 4:30 pm ET

Executives

Philip Mazzini - President of Retail Tax Services - HRB Tax Group Inc

Jason Houseworth -

James Ash - Interim General Counsel

William Cobb - Chief Executive Officer, President and Director

Derek Drysdale - Director of Investor Relations

Jeff Brown - Chief Financial Officer and Senior Vice President

Analysts

Vishnu Lekraj - Morningstar Inc.

Michael Millman - Millman Research Associates

Michael Turner - Compass Point Research & Trading, LLC

Michael Chapman - Enrossi Capital

Grant Keeney

Scott Schneeberger - Oppenheimer & Co. Inc.

Operator

Good afternoon. My name is Kristen, and I will be your conference operator today. At this time, I would like to welcome everyone to the H&R Block First Quarter Conference Call. [Operator Instructions] Thank you. At this time, I would like to turn the call over to our host, Mr. Derek Drysdale, Director of Investor Relations. Please go ahead.

Derek Drysdale

Thank you, Kristen. Good afternoon, everyone, and thank you for joining us. Today, Bill Cobb, our President and CEO; and Jeff Brown, our CFO, will review our first quarter results. Other members of our senior management team will participate during the Q&A.

In conjunction with today's call, you'll find the press release on our Investor Relations website at hrblock.com, and we plan to file our 10-Q later this afternoon.

I'd like to remind everyone that today's remarks may include forward-looking statements as defined under the Securities Exchange Act of 1934. Such statements are those relating to relating to matters that are not historical facts, and such facts, or 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 differ materially. Please see the risks factors included at our most recent periodic reports and other SEC filings. H&R Block undertakes no obligation to publicly update such risk factors or forward-looking statements.

After our prepared remarks, we'll take your questions. And with that, I'll now turn the call over to Bill.

William Cobb

Thank you, Derek, and thanks to all of you for joining us. I know many of you are anxious to begin the long weekend, so our prepared remarks before we take your questions will be rather brief. Earlier today, we reported first quarter results that were in line with our expectations. Our adjusted net loss from continuing operations of $111 million was essentially flat to the prior year. On a per-share basis, the adjusted loss of $0.37 was $0.02 below the prior year due to fewer shares outstanding.

Given the seasonality of our businesses and the fact that nearly all of our revenue and earnings come in the fourth quarter, our first quarter results generally don't provide a lot of color on our performance. That said, I am pleased with the initial progress we've shown in Q1. Following the sale of RSM, we will enter next tax season squarely focused on continuing to drive client and market share growth in each of our 4 key areas: Retail, digital, international and financial services. I'll have much more to say about our plans at our Investor Conference in New York City on December 8.

Now I'd like to provide a brief update on both TaxACT and RSM. First, the TaxACT preliminary injunction hearing is scheduled to begin next week on September 6. We anticipate the hearing will last several weeks, and we are hopeful that a decision will be made soon after. We continue to believe this merger is the right strategy, and that our legal position is strong. Combining H&R Block and TaxACT will do exactly what the Justice Department wants: Bring competition to a digital market that's currently dominated by one player, Intuit. Most importantly, we believe consumers will be the primary beneficiaries of the merger through innovation, enhanced functionality, and low prices.

Turning to RSM McGladrey, last week, we signed a non-binding letter of intent to sell substantially all of RSM's assets to the partners at McGladrey & Pullen. After a thorough review of the alternatives, we believe this sale is in the best interest of H&R Block and our shareholders. Most importantly, we see this transaction as an important step in refocusing the company on growing clients and market share in our core Tax business and improving our margins.

Total consideration is estimated at $610 million. Approximately 90% of that consideration will be in the form of cash at closing, with the remainder being financed by H&R Block over a term of 5 to 7 years. M&P will also assume substantially all liabilities. We anticipate this transaction will close by calendar year end.

I would like to wish our friends at McGladrey the very best. For 12 years, they have been our partners and shared in the journey with H&R Block. I'm confident that the outstanding professionals at McGladrey will prosper in the years ahead.

I'd like to conclude with a few words on capital allocation. Clearly, capital allocation remains very important to us. First, I'd like to point out that we were restricted from buying shares in the most recent quarter due to the ongoing negotiations with M&P. Second, we have an authorization from the board to repurchase shares in fiscal 2012 that we fully intend to utilize.

Following last week's announcement, a recurring question was, "what will you do with the cash from the sale of RSM?" We must be mindful not to get ahead of ourselves by discussing the potential uses of cash until we have definitive resolution on both the pending acquisition of TaxACT and closing on the sale of RSM. We will have more to say about our capital allocation plans on December 8. With that, I'll now turn the call over to Jeff.

Jeff Brown

Thanks, Bill. I'd like to begin by breaking down the net after-tax charge of $0.20 per share included in our first quarter results. That net charge consisted of the following items: First, the goodwill impairment on the sale of RSM, which totaled $85 million or $0.17 per share. Second, we impaired all of the remaining goodwill at RSM EquiCo, a separate business of RSM's that is not included in the sale to M&P and which we will seek to dispose of separately. That impairment totaled $14 million or $0.02 per share. Third, we realized a pretax gain of $10 million or $0.02 per share on the first quarter sale of RSM's compensation and benefit consulting practice. And finally, we incurred a litigation charge of $15, or $0.03 per share in our Tax Services segment.

Now looking at segment results, Revenues and Tax Services were $91 million for the quarter, essentially flat to the prior year. The segment's quarterly pretax loss of $169 million improved from a pretax loss of $175 million a year ago. Each period included charges, the litigation charge of $15 million in the current quarter and a severance-related charge of nearly $17 million in the prior quarter.

In corporate, our pretax loss of $31 million was a slight improvement to the prior year. The improvement was due primarily to reduced loss provisions on mortgage loans held at H&R Block, which declined from $8 million a year ago to $5.6 million in the current quarter. The net principal balance of mortgage loans declined to $467 million at July 31, a decline of $18 million from the prior quarter.

Turning to discontinued operations, our first quarter loss of $2 million compared with a net loss of $3 million a year ago. Claims for alleged breaches of representations and warranties in the principal amount of $48 million were resolved during the quarter with incurred losses totaling $485,000. Sand Canyon received new and reasserted claims during the quarter of $35 million, and at July 31, claims totaling $66 million remained under review. Sand Canyon's reserve totaled $126 million at July 31, essentially unchanged from the prior quarter.

One other item of note relating to our discontinued mortgage operations. In August, H&R Block was dismissed as a defendant to a securities fraud action initiated in October 2010 by the Federal Home Loan Bank of Chicago. This claim involved 2 securitizations within an initial principal balance of approximately $50 million, of which $42 million remains outstanding. Sand Canyon remains as the sole defendant in this matter, and we have currently concluded that a loss on this claim is not probable for Sand Canyon.

With that, I'll turn the call back to the operator for questions.

Question-and-Answer Session

Operator

[Operator Instructions] And your first question is from the line of Scott Schneeberger with Oppenheimer.

Scott Schneeberger - Oppenheimer & Co. Inc.

I only have, about around, I think I have 3 questions. First one, guys a couple of week ago, we heard from Intuit in discussion of their tax season for TurboTax. They mentioned that they took some share. It looks like you took some share. Could you talk looking back now that the season has ended, on what you think the dynamic was? Where the puts and takes were effective?

William Cobb

I'll take that and then Jason if you want to add anything. They did mention that they gained share. We gained share. It's hard to speculate since the only information we have is IRS data and the public filings of our competitors. And essentially, I think we gained share clients and shares and we're optimistic that we'll -- that's the plan for next year. Jason, do you have anything to add to that?

Jason Houseworth

No. I mean, my team continues to be focused on the momentum that we created last year and providing a great experience to our customers in the upcoming tax season.

Scott Schneeberger - Oppenheimer & Co. Inc.

And the second question just following up on that, I think it's implied that if both you, and they took share, the smaller players including TaxACT probably lost a little. Any comments on that, and how you think that dynamic may play going forward?

William Cobb

None.

Scott Schneeberger - Oppenheimer & Co. Inc.

Okay. Shifting gears a bit, then. The sale of RSM, you've outlined some of the contingencies of what your -- what needs to occur for this to all be finalized. I just want to gauge, is there a high certainty that this does close. Anything incremental beyond by calendar year end, and what, I guess specifically in the question, what are your hurdles to seeing this deal completely finalized?

William Cobb

So I'll take the first part and then Jeff if you want to add anything. I think, Scott, this is one of the issues that we worked very hard on with our partners at RSM. We're confident that we can close. We want to be right up front. We're working through the definitive agreement and the financing that the partners will come up with, and we believe that they've had very good advice on their side, and that they will be able to close that. I don't know, Jeff, if you have anything to add.

Jeff Brown

Yes. I think, Scott, I would echo that. Conditions to close are really customary for a transaction of this size and nature. I think we mentioned in the earlier release that the buyer is in the process of raising financing. We have no reason to believe that they won't be successful in that, and we're targeting to close within the calendar year.

Scott Schneeberger - Oppenheimer & Co. Inc.

Okay. Jeff, I have one final question on a different tangent. At this point in the year, what are your thoughts year-over-year fiscal '12 vis-à-vis fiscal '11 with regard to cash flow and specifically your CapEx spending over the coming year?

Jeff Brown

Yes. The CapEx, Scott, I think we've mentioned that our CapEx will be perhaps slightly higher than last year, but not dramatically higher, and I don't -- I wouldn't point to anything out of the ordinary in the way of other cash flows other than obviously to the extent we're successful in closing RSM.

Scott Schneeberger - Oppenheimer & Co. Inc.

Okay. So with that closure and the way you look out at this year, I guess not to put the words in your mouth, but should the free cash flow in 2012 look pretty similar to '11?

Jeff Brown

Yes. I don't think I'm going to give any specific guidance, Scott, but I wouldn't point to anything that we think is -- would expect to be unusual about this year.

Operator

Our next question is from Grant Keeney with Northcoast Research.

Grant Keeney

As you analyze your results from last tax season, how many clients do you think the company may have lost by not having a RAL product? Is that client base big enough to fight to win back and have you made any considerations for RAL replacement other than a RAC this coming season?

William Cobb

Phil, you want to go first, and then I'll comment?

Philip Mazzini

Grant, I think what I would say is important here, in terms of the first part of your question is, last year or the year before, we retained 65% of our RAL clients. Last year, we retained 64% of our prior RAL clients. So, I think we have proven last year that the RAL is not so important to us. It certainly is something that we can -- we have a full portfolio of initiatives, and we'll serve our clients very well. So we're retaining clients, retaining clients at higher rates. The whole area of RAL, the financial products is an area of a lot of uncertainty right now. I can tell you that we continue to explore all the options at this point, and we'll talk more about that in the future.

Grant Keeney

Okay. That's fair. And then if you could, could you just provide some thoughts on the pricing environment in the retail and digital next tax season?

William Cobb

Grant, what specifically do you want to talk about? I mean it'll be -- everybody has indicated they're going to be very competitive and we expect it to be a highly competitive market.

Grant Keeney

Okay. And then just last question here, just a housekeeping question. When NOC [ph] broke out from -- you broke out a provision for bad debt and loan losses, I think for the first time, is that an expense that's going to be recurring in the perpetuity or should we treat that as an add-back?

William Cobb

Yes. I guess, Grant I would answer that in 2 ways. So that -- the line item that you're looking at would include loan-loss provisions on the mortgage loans at the bank, which we have seen a declining trend on, and we would expect that to decline as -- continue to decline into the future. It also includes some level, and of course, not a lot in this first quarter of bad debt just from our other businesses and receivables that they have on their balance sheet and that'll fluctuate from quarter-to-quarter, but on an annual basis, I wouldn't expect any big changes in that bad debt portion.

Operator

Your next question is from Michael Millman with Millman Research.

Michael Millman - Millman Research Associates

I guess a couple of questions as well. Can you talk about where you expect, sort of following up on earlier question from Scott, where do you expect online growth to come from?

Jason Houseworth

Well, and this is Jason. Mike, I appreciate your question. We expect -- and I'll have to say, online growth for the coming season to be in the low teens and we do expect a lot of that growth to continue to come from pen and paper filers as we've seen historically with the majority of those going to digital.

Michael Millman - Millman Research Associates

So you don't think the pen and paper, is, if not dried up, drying up?

Jason Houseworth

We think for the upcoming tax season, we continue to see that fueling the growth of online growth.

Michael Millman - Millman Research Associates

Okay. With -- regarding RSM, you're going to be -- keep the loss -- pretty much the losses, and give up by selling the profits. Do you expect to somehow report differently? Or you expect some offset to help the second half of the season?

William Cobb

Mike, your line was breaking up a little bit. I think the question you're asking and if I don't get it right, is -- obviously there was an impairment, and with the close of the sale, the Business Services segment will go away. I don't think we've settled in on reporting other than to assume that Tax Services will be our only business segment. But frankly we haven't made that, that decision yet. But Jeff, I don't know if there's, maybe we haven't talked about it so, I don't know if there's any -- we should assume its the Tax Services segment, right?

Jeff Brown

Yes. No current changes to plan that would change that.

Michael Millman - Millman Research Associates

My question is really, this year's year-over-year comparisons will be -- totally you'll be hurt because you have only losses and not the profits from IRS on an operating basis.

William Cobb

Yes. I think -- here's what I would say, Mike, is as we work through -- obviously the first item of business is to close the sale and as we work through that and as we get toward our conference in December 8, we'll have more clarity around what I think is your question, and how we move forward from there.

Michael Millman - Millman Research Associates

And on the international, which you didn't talk about, but have -- when I see it, it looks like the Canada and Australia are relatively small businesses for tax. They don't have any large preparers that are easy to buy that bring simple tax returns. Therefore, revenue maybe a third, a quarter of U.S. Your history in the U.K. was a failure. Can you kind of talk to us about what you see that suggests otherwise?

William Cobb

Well, I think as I said early on, and if anybody else wants to comment, as the new CEO, I'm going to look at all areas of the business. I'm not unmindful, and I think you and I have talked -- I'm unmindful of the past. But we're in review right now, and as I've said a couple of times, I think I'm going to beg indulgence here and let us go through our strategy review, we're right in the middle of it, and we're going to have more to say on all that, in December 8. And I would assume from my answer anything other than, we will talk about all aspects of the business as we get to our Investor Conference.

Operator

[Audio Gap] From Mike Turner with Compass Point.

Michael Turner - Compass Point Research & Trading, LLC

Just a couple of follow up questions.

[Technical Difficulty]

Operator

[Operator Instructions]

William Cobb

I'm not showing anyone else in the queue, if that is what you're seeing as well, I think we're...

Operator

And we do have Mike Turner back in the queue.

Michael Turner - Compass Point Research & Trading, LLC

Just a couple of questions on the RSM spinoff, would there be any additional savings in corporate overhead as part of that? Or should we just kind of assume that whatever we're modeling for RSM goes away?

William Cobb

And I'll let Jeff -- Jeff and his team are just really diving in. This was a long negotiation, a delicate negotiation. Jeff and his team are looking into that. But having said that, and I'll let Jeff weigh-in. RSM ran pretty independently as a Business Services segment, so I wouldn't anticipate a large number here, but I don't know, Jeff do you have anything to add?

Jeff Brown

I think that's the right answer, Mike. They ran largely independently.

Michael Turner - Compass Point Research & Trading, LLC

Okay. And then on the -- just looking into this coming fiscal year in the Retail Tax business. What's kind of a targeted retention rate? I know you're retention rate was up about 3% last year. Kind of what a target is or an expectation?

Jeff Brown

So, Mike, our retention rates run right now I think we're very close to 72%. It's actually the highest retention rates we've had in about 10 years. I will say this, new clients tend to retain at lower rates. So as we look forward, we expect, given all the initiatives we put in place and given the trends we've seen from those initiatives, that we will increase both our prior client retention and our new client retention. Overall retention, I think, I wouldn't expect much movement there because of the mix between new clients and prior clients. Does that -- I don't mean to get complicated on you, I just want to make sure I don't set an unrealistic expectation.

Michael Turner - Compass Point Research & Trading, LLC

No, that's helpful. I mean, I'm just trying to see is it -- I know you had a big jump. Next year it sounds like you're at least hoping to maintain basically what you're retention rate was last year.

Jeff Brown

Yes. I would say we expect to see improved retention on both prior and new clients. That's the way, I think, you should think about it.

Michael Turner - Compass Point Research & Trading, LLC

Okay. And then also if you can remind me, how much do you have remaining on your buyback approval?

Jeff Brown

It's like $1.3 billion, Mike.

Michael Turner - Compass Point Research & Trading, LLC

Okay. That's what I knew it was...

William Cobb

That was obviously a multi-year authorization.

Michael Turner - Compass Point Research & Trading, LLC

Okay. And then just -- the last question. The dismissal of the Sand Canyon case. Was that -- can you give me any color? Was that like a jurisdictional issue or was that where they actually tried to pierce the veil and they didn't find it appropriate?

James Ash

This is Jim Ash. That was an agreement with the plaintiffs to dismiss on personal jurisdiction grounds.

Operator

And your next question is from Michael Chapman with Private Capital Management.

Michael Chapman - Enrossi Capital

Quick question. What is the CapEx associated -- what was the CapEx associated with the McGladrey last year?

Jeff Brown

It's probably a question I'll have to take offline. I would tell you not significant, but the specific amount, I'd probably take offline.

Michael Chapman - Enrossi Capital

Okay. Just in the context of -- you guys had said that last year's $77 million operating income and in the K you had $19 million depreciation and additional $11.5 million in amortization of intangible assets. I was wondering if that depreciation is essentially free cash, that's not in an operating income if there's no real offsetting CapEx.

Jeff Brown

No. They would have a level of maintenance CapEx that they incur every year.

Michael Chapman - Enrossi Capital

Okay. So is the depreciation a relatively good assessment of that unless we can get a more accurate one offline?

Jeff Brown

Yes. And in fact -- so here is last year's I've got in front of me now, and it's in our 10-K as well if you wanted to grab it, but it's like $20 million last year.

Michael Chapman - Enrossi Capital

Okay. So it's in line with depreciation, then.

Jeff Brown

Yes.

Michael Chapman - Enrossi Capital

And then when you said other liabilities associated with it, any more granularity on that? If there was any debt, were there any liabilities buried, and other that will come off as a part of this sale, I guess?

Jeff Brown

Well, in addition to the on balance sheet liabilities, payables and accruals, they would step into all of the lease obligations as well going forward.

Operator

Vishnu Lekraj with Morningstar.

Vishnu Lekraj - Morningstar Inc.

Just looking here at -- just a little over a longer-term question. Looking at the change in product mix and some of your business mix, how should we view your operating margins, not necessarily 1 or 2 years out, but maybe 3 or 4 years out? Should they get back to your peak levels? Or how should we think about that moving forward?

William Cobb

I think at this point, Vishnu, we're looking at -- that's kind of what we're gearing up for December, is to take a longer-term view of where we're headed so stay tuned on that.

Vishnu Lekraj - Morningstar Inc.

One more follow-up, then, real quick on the DIY market. Do you think there's a huge amount of opportunity there for this year especially given where you guys are taking your focus, and how much growth you believe that's going to amount to over the next 2, 3 years?

William Cobb

Can you repeat the question? I'm not sure, you -- I'm sorry for all the technical difficulties we're having on this call, but could -- you're breaking up a little bit. Can you repeat the question?

Vishnu Lekraj - Morningstar Inc.

Yes. apologize if this has been asked previously, but how much of the opportunity do you see in regards to the DIY market for this upcoming tax season in relation to TaxACT and in relation to Intuit and your other competitors?

Jeff Brown

Well, I think that -- what I'm most focused on, Vishnu, is really thinking about coming off the tax season which my online retention was up 5 points. My net promoter score was up 5 points, I draw my contact rates about 5 points, and really looking at that, and thinking about how can we build on that momentum, and we feel really good about that. We're looking at the coming tax season, we see, like I said, low teens growth in the category and we feel like we're well positioned to take advantage of our position.

Operator

And Mr. Drysdale, do you have any closing remarks?

Derek Drysdale

Everyone, thank you for joining us today. Have a great holiday weekend and we'll chat soon. Thank you.

Operator

Thank you, sir. This does conclude today's conference call. You may now disconnect.

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