Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message|
( followers)  

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

F2Q08 Earnings Call

December 17, 2007 4:15 pm ET

Executives

Scott Dudley - VP, Investor Relations

Timothy C. Gokey - Group President, Retail Tax Services

Joan Cohen - President, H&R Block Financial Advisors

Alan Bennett - Interim Chief Executive Officer

Kathy Barney - President, H&R Block Bank

Becky Shulman - Acting Chief Financial Officer, Senior VP and Treasurer

Jeffrey Nachbor - Controller

Analysts

Scott Schneeberger - H&R Block

Mark Sproule - Thomas Weisel Partners

Michael Millman - Soleil Securities

Andrew Fones - UBS

Harry DeMoss - King Street Capital Management

Sy Lond - Morgan Stanley

Larry - Oppenheimer

Ed Shen - Ivory Capital

Sateesh Boulee - Merrill Lynch

Scott Dudley

Good afternoon. I appreciate you joining us to discuss our fiscal 2008 second quarter results. On the call today are Richard Breeden, Chairman of the Board; Alan Bennett, Interim Chief Executive Officer; and Becky Shulman, Senior Vice President, Treasurer, and Interim Chief Financial Officer. They will comment on our second quarter results and we will open up for questions. 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, are not guarantees of future performance, and involve certain risks, uncertainties, 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 risk described from time to time in H&R Block’s press releases and forms 10-K, form 10-Q, and forms 8-K and other filings with the Securities and Exchange Commission. H&R Block undertakes no obligation to publicly release any revisions to forward-looking statements to reflect events or expectations after the date of these remarks. H&R Block provides a detailed discussion of risk factors in periodic SEC filings and you are encouraged to review these filings.

You should note that in conjunction with today’s call there is an accompanying slide presentation which is posted to the Investor Relation section of our website at hrblock.com.

To give as many participants as possible an opportunity to ask a question during our Q&A Session, we ask that when you are called upon you limit your query to one initial question and then one related follow up question if needed. With that, I’ll turn the call over now to Richard Breeden.

Richard C. Breeden

Thank you very much Scott and good afternoon to everyone. Welcome to our review of second quarter fiscal year ’08 earnings and I’m happy to be here and be with our new management team. In recent weeks the company has appointed a new Interim CEO and CFO. We have separated the positions of Chairman and CEO in accordance with a Shareholder Resolution to that effect that passed at our last annual meeting in September. The Board elected me to serve as our initial non-executive chairman. We completed the transition to Deloitte & Touche, our new independent audit firm. We de-staggered our Board of Directors so that all directors will run for election each year beginning in 2008. We have appointed a search committee and selected a search firm to begin the process of selecting a permanent CEO. We reached an agreement announced December 4th with Cerberus Capital Management that permitted us to terminate our agreement relating to the sale of Option One Mortgage Corporation, the pendency of that agreement required the company to incur significant continuing operation costs relating to loan originations and the mutual agreement between H&R Block and Cerberus to bring that to a close was the key to enabling us to take the vigorous steps we announced on the fourth to begin eliminating the mortgage origination business of OOMC. We closed those activities, allowing with a cessation of new loan applications and we’re in the middle now of rapid wind down of origination activities at OOMC.

While we made changes, the Board has been working very well together and these decisions have for the most part reflected Board unanimity. Our former CEO had a long tenure and there are many natural changes that come with a new management team. The transition to Alan Bennett, our Interim CEO, has gone very smoothly and we are beginning to work our way through an evaluation of the company’s performance and strategy for the future.

The Board’s first priority in recent weeks has been to stop the bleeding at OOMC and to accelerate our exit from that business. As I mentioned on December 4th, we announced that we had ceased accepting new loan applications, that we would close our remaining loan origination activities, and that we were free to do this as a result of exiting from the ongoing agreement with Cerberus struck last April. We have been closing offices and separating personnel in accordance with this announcement. We continue to operate our loan servicing business but at the same time we’ve begun an effort to find one or more buyers for the activities of the servicing business.

We are taking steps to review our overall strategy and the hallmark of that strategic review is to return focus to our pre-eminent tax business. We have the good fortune to have the dominant market share in one of what is said to be only two inevitable things in life, death and taxes. We believe that is a paramount strategic advantage for us in the future and we intend to do everything in our power to strengthen market share and increase profitability in every segment of our existing tax preparation and tax services businesses. That will mean we renewed focus on our human capital and further enhancing our tax expertise. We hope to expand our presence in every segment of the market which will mean working to expand vertically up the income ladder and horizontally by further extending our digital professional and commercial activities. More than 110 million tax returns were filed in the United States last year without our assistance and we won’t be satisfied until we have begun to compete for every single one of those returns.

We have major opportunities in other business lines, both to reinforce our market position in tax and to generate complimentary fee income. We will review our strategy in operations in banking, financial advisors, business services, or RSM McGladrey. We do believe that these businesses must generate stronger returns on capital in the future and our initial effort will be to identify ways to improve the return characteristics of each of those businesses. While these are among our first priorities, we will be conducting the strategic review longer run to determine the best way to have each of these segments add value to H&R Block shareholders. Looking forward, we are fortunate to have attracted Alan Bennett to H&R Block to serve as our interim CEO while we search for a permanent chief executive. Alan comes with a great base of experience and he’s already made a wonderful contribution in the short time he’s been with the company.

In the near term, the primary focus for H&R Block will be on executing our plans in tax services to achieve an outstanding tax season. With the industry’s best tax professionals, continuation of our industry-leading Refund Anticipation Loan programs built on the Emerald card platform and what in the future we believe will be an interesting Emerald suite of products, and the launch of exciting new products relating to the Emerald advance line of credit, the ANEW RAL and other commercial market initiatives, we believe we are well-positioned for the coming tax season. We also have a strong lineup of digital tax products and a solid plan for continued growth. With these products and a strong marketing push to emphasize the expertise and knowledge of our tax professionals, we’re poised, we believe, to have a very solid tax season. Our future ambitions go well beyond having a solid tax season as we have traditionally defined it.

Before I turn over to Alan, let me first directly speak to our tax professionals and full time associates who are listening. In the short time since I joined the Board, I’ve been impressed by the quality and dedication of both our tax professionals and associates. On the eve of tax season, we couldn’t be more pleased with our readiness and focus and on behalf of the entire board of directors, I’d like to thank you for your efforts in getting us prepared to serve more than 20 million clients with distinction this season.

Secondly, I’d like to say a word on the alternate minimum tax situation which I know is an issue of concern to many people. As you all know, Congress has yet to enact an AMT patch to limit the effect of the alternate minimum tax on approximately 21 million taxpayers or roughly 15% of the filing universe who will otherwise be swept into paying AMT for the first time. The fact that more and more Americans are exposed to the complexities of AMT is, if anything, a factor that we believe will drive long-term growth in our tax business as people who may have prepared their own taxes seek professional assistance with this increasingly complex issue. In the short term, we won’t know the likely impact on Block until legislative action is complete and the IRS announces how it will handle the delay. In some scenarios we may benefit and in others we may see a short-run negative impact. We are pretty sure that whatever Congress does, it won’t abolish taxes in 2008 and we will be there for the public with the solutions expressly tailored to the provisions of the new law once it is enacted.

Now let me turn the balance of the call over to Alan.

Alan Bennett

Great, thank you, Richard. It’s a pleasure to be with you today to discuss our results and our outlook. By now you’ve all had a chance to review our press release and leaf through our 10-Q which was filed on December 13th. Let me begin by noting that several members of our senior management team are with me here this afternoon and will be actively participating in the Q & A session. This includes Tim Gokey, our Group President of Retail Tax Services, Joan Cohen, our President of H&R Block Financial Advisors, Kathy Barney, President, H&R Block Bank, Becky Shulman, our Treasurer and interim CFO, and Jeff Nachbor, our Controller.

Since my arrival here three weeks ago, I have observed some key attributes of H&R Block. First, as Richard has observed as well, we have strong businesses and strong brands. We also have a talented, committed, and engaged workforce that is focused on providing our clients with the best products, services, and experience possible. The leadership team is focused on repositioning H&R Block for long-term profitable growth. The first step in this repositioning effort was the announced shutdown of Option One’s Mortgage Origination activities. The next step will be the orderly sale of the remaining loan servicing operation. This will result in H&R Block going forward as a smaller, less volatile company and one that is more aligned with its core strengths and heritage.

Let me start by discussing our discontinued operation results which are essentially all related to Option One and where we recorded a pre-tax loss of $551 million inthe quarter. This loss is comprised of restructuring costs of approximately $61 million, losses on sale of mortgage loans including the impairment of residuals of $314 million, other operating losses of $53 million, and an additional impairment charge of $123 million to bring remaining assets of Option One to an estimated market value. We have been very active reducing our mortgage loan exposure during the second quarter by reducing loan originations and to aggressive sales of loans.

Let me start with loans on the balance sheet. We began the quarter with a gross loan amount of $248 million. We originated $128 million, repurchased $188 million, and sold $429 million of loans, resulting ina gross loan balance of $135 million at October 31. After netting a $65 million valuation allowance, we ended the second quarter with $70 million of loans held on the balance sheet.

With respect to exposure in our off balance sheet warehouse, we entered the quarter with $2.1 billion of sub-prime loans. We originated nearly $600 million during the second quarter, including $544 million inthe month of August alone, of which about 25% were prime loans. We sold $2.6 billion and ended the quarter with only $57 million principal amount of loans remaining inthe warehouse. The estimated losses on the future disposition of these remaining warehouse loans, which is $14 million, have been reflected in our second quarter operating results. So after the significant sale activity, here’s what remains of mortgage loans on our balance sheet and in our warehouse at October 31: loans inthe warehouse of $33 million at October 31, loans held for sale on the balance sheet totaled $70 million, which is reported net of a 48% allowance. We have established repurchase reserves of $86 million for potential losses on the purchases of loans previously sold. About 55% of the reserve is for potential repurchases due to reps and warranty defects and the rest relates to potential early payment defaults. This rate is consistent with a lower origination volume inthe quarter and the higher quality of loans originated since August. The repurchase reserve in total assumes an average loss severity rate of 42% which is up from 48% inthe first quarter.

At quarter end we also have loan applications inthe pipeline of $69 million, of which we believe $20 to $30 million will be funded, and then our loan originations will cease. Our total residual interest in securitizations are valued at $38 million at October 31, down from more than $90 million atthe end of the first quarter.

The discontinued operations balance sheet hasa $427 million deferred tax asset. As required by GAAP, we have reduced our gross tax asset by valuation allowances for any portion of the growth-deferred tax that is less than 50% likely to be realized in the future. Accordingly, the $427 million asset is net of a $56 million valuation allowance. We expect a significant portion of the deferred tax asset will be monetized as we close our originations business and dispose of remaining assets.

Option One held mortgage servicing rights or MSRs covering approximately $58 billion principal amount of mortgage loans owned by third parties as of October 31. These MSRs were carried on Option One’s books atcost which is the lower of cost of market or $200 million at October 31. At October 31, Option One had servicing advances and related assets of $821 million. These servicing advances primarily represent advances of principal and interest made to borrowers of loan pools when payment is not remitted by the borrower. These advances are generally considered to have top-of-the-waterfall priority in that we as the servicer are entitled to be the first party to collect any monies paid by the borrower or recover in foreclosure.

As I mentioned earlier, at October 31 we booked an additional impairment of $123 million related to the discontinued operations balance sheet of Option One. This brings our total valuation allowance to $338 million and a net book value to $873 million.

I would note that for presentation purposes on this chart, we have removed the asset and offsetting liability of $927 million at 10/31 and $300 million at 7/31 related to loans held for sale with optional repurchase triggers. These triggers give us the right but not the requirement to exercise this option, and since we have no intention to repurchase, we have zero exposure on these loans. The FAS 140 requires that they be included in our 10-Q financial statement, which we have done.

Before I discuss the operating results from our continuing operations, I would like to review the mortgage loans held by H&R Block Bank. At October 31 we had approximately $1.1 billion of mortgage loans held from vestment. Our second quarter loan portfolio characteristics look very similar to those from the previous quarter. On average, the loan size is $219,000 with a 717 FICO score with combined loan-to-value ration of about 77%. The average debt-to-income ratio for the borrowers is 34% and the average weighted average coupon is 7.2%. The current delinquency rate defined as 30 plus days past due is 1.96%.

Approximately 68% of the mortgage loans were purchased from OOMC. The average FICO on the OOMC purchased loans is slightly lower at 711 and the combined loan-to-value is slightly higher at 81%. The average delinquency rate is approximately 2.4%. Atthe end of each quarter we record an allowance for loan losses representing our estimate of credit losses inherent inthe mortgage loan portfolio. The allowance represents estimated loan losses that we expect to incur over the next twelve months. The majority of the credit loss is evaluated on a pooled basis; however, we review non-performing loans individually and record loss estimates typically based on the value of the underlying collateral.

Loss rates are based on historical experience. Our assessment of economic and market conditions and loss rates of comparable financial institutions. As a result of declining collateral values due to declining residential home prices and increasing delinquencies occurring in October and November, we increased our loan loss provision inthe quarter by about $9.5 million.

Turning to continuing operations results for the second quarter, revenue was $435 million, up 10% from last year. Our net loss from continuing operations was $136 million or $0.42 per share compared with a loss of $121 million or $0.38 per share in the prior year. Tax services operating revenues from continuing operations increased 11% over the prior year to $91 million. Primarily due to strong growth in our Australian operations which achieved revenue growth of 23% over last year. Half of Australia’s revenue growth is attributable to currency exchange rate gains.

The tax segment’s pre-tax loss from continuing operations during this off-season quarter was 19% higher than a year ago. The higher loss resulted from an incremental $12 million write-off of Refund Anticipation Loan receivables and related collected expenses, and $7 million in off-season losses from a recently acquired commercial markets businesses, as well as normal increases in other operating expenses.

The $12 million charge is a result of increased withholding of taxpayer refunds by the IRS due to their enhanced fraud prevention efforts to screen returns aimed primarily at the individual taxpayer. This is not related to any fraud by tax preparers. Industry-wide, the IRS withheld refunds at more than 5 times the rate of the 2006 tax year.

In tax season 2007, our Retail Tax Group grew clients by nearly 90 basis points, grew earnings by 9%, improved client retention by 80 basis points, improved clients likelihood to recommend Block by 370 basis points, and increased retention of tax professionals by more than 200 basis points. As we re-energize our efforts on every aspect of tax services in tax season 2008, we plan to build on 2007’s success by continuing to drive our focus on building expertise, winning a speed of refund, and building a great organization.

H&R Block’s retail business is equally attractive to customers seeking expertise or a speed of refund. While Block’s current client base is split nearly evenly between these two groups, the market for clients whose main need is expertise is significantly larger. Growing our penetration in this important segment is our biggest long-term opportunity. While this opportunity stands for retail, digital, and commercial businesses, I will focus on the retail opportunity here.

Block has considerable assets to address this market, standing with our outstanding base of experienced and highly trained tax professionals. The average Block client is served by a tax professional with over eight years of experience and the equivalent of six university courses of training. Since consideration of Block among expertise-oriented non-clients is currently relatively low, giving small increases in consideration can translate into good growth for Block. Our strategy for winning the expertise client over thelong term includes both strengthening the value proposition of our core retail channel for expertise filers and developing new channels over time.

In tax season 2008, we are moving in this direction by focusing on our tax professionals and helping them to build their individual client bases. The expertise market is largely based on referrals and word of mouth. Inthe off-season, we have been giving our tax professionals the training, tools, and products they need to generate referrals, improve loyalty to them personally, and build their client base among expertise filers.

Our expertise-oriented marketing in tax season 2008 will directly support these efforts with a particular emphasis on directly exposing potential clients to the expertise of our tax professionals.

The market for speed-of-refund-oriented filers is nearly 40 million taxpayers, or about 30% of the total. Block is particularly strong in this segment and it makes up about half our client base. In recent years, intense competition in this segment fueled by the ready availability of RAL facilities to our competitors has led to rapid growth inthe number of both branded and independent tax preparation firms focused on this market. Since we charge fees on credit products that are markedly lower than most firms inthe tax preparation industry as a whole, we believe we will benefit if consumers begin to differentiate competitors based on their prices for credit products.

While expertise may bethe bigger long-term growth opportunity, we fully intend to increase our market share inthe speed-of-refund segment. Our long-term strategy for winning in the speed-of-refund segment is to combine industry-leading tax preparation and client service with renewed product superiority based on consumer-friendly products that simultaneously drive industry reform. Last year we offered the first 36% APR Refund Anticipation Loan. We introduced the Emerald card, an FDIC-insured bank account on a next-generation prepaid platform, and the card gained over 2 million clients for our bank. As we mentioned in August, we are expanding the 36% APR RAL program and are adding to it in ways that will over time create lower RAL prices and greater transparency throughout the industry. We’ve also enhanced the Emerald card platform by adding bill pay and money transfer capabilities by linking it to a savings account that pays industry leading rates and importantly by adding a simple line of credit, the Emerald Advance.

The Emerald Advance is designed to conform to the FDIC’s proposed approach for consumer-friendly small dollar lending. These product enhancements are complimented with our investments in improved client service, peak capacity, and targeted growth initiatives. These plans rest on building a great organization. We believe we already have the best people in the industry. Recruiting, developing, and retaining our tax professionals is akey priority. Last season we began a significant effort to refocus on our tax preparers and we intend to increase this in the future. We have introduced new training for both new and experienced tax professionals, improved our core tax preparation program, and provided new tools. We are consciously focused on moderating the number of new preparers we hire while increasing retention of experienced tax professionals. Last year’s two point gain in retention was a significant gain compared to prior years. We expect this to lead to improved productivity, client service, and client retention over time. Overall the retail business is poised to continue its growth by building on last year’s success, seizing the client retention opportunity created by the Emerald card, utilizing the increased number of experienced tax professionals, taking advantage of our product superiority, and leveraging the early season product exclusivity provided by the Emerald suite of products.

The market for digital filers is over 25 million taxpayers. We continue to view this market as a significant growth opportunity for H&R Block. Our long-term strategy is to grow our shares to an improved online experience, better distribution on the software side, and increased awareness of both by leveraging the Block brand. For 2008 we are focused on improving the bottom line and building on the strong momentum digital achieved last year, which saw overall client gains of 19%. Our Tax Cut software, named Product of the Year at office products retailer Staples, is already on store shelves for the start of the holiday season. Our product lineup features the same consumer-friendly bundles we offered last year but with higher price points to reflect the value of our product offering. We are expanding distribution into places such as Sam’s Club and as a result we are clearly well-positioned to increase volume and gain market share once again. We will continue to invest in this growing segment to capture do-it-yourselfers who migrate to digital and to introduce them to the H&R Block brand. We also look forward to improved performance from our software and online products.

Turning to consumer financial services which is comprised of H&R Block Bank and H&R Block Financial Advisors, the segment delivered strong top-line growth. Revenues from continuing operations were up 24% over the prior year to $101 million while the pre-tax loss from continuing operations was $9 million compared to the loss of $2 million in the prior year. For the quarter the Bank generated revenues of $23 million, up from $11 million inthe second quarter a year ago and a pre-tax loss of $4.4 million compared with pre-tax profit of $2.4 million a year ago. The drop in profit is mainly due to a $9.5 million increase in loan loss reserves which I mentioned earlier. The Bank’s quarter-end assets were $1.2 billion consisting of $1.1 million of mortgage loans held for investment. At quarter end, the 30 day delinquency rate on the Bank’s loan portfolio was 1.96%, representing $21 million worth of loans, and of this amount, 0.25% of the loans worth $3 million were delinquent by more than 90 days and the Bank did not hold any repossessed real estate at quarter end.

As I mentioned previously, the Bank increased its loan loss reserve levels inthe second quarter to 140 basis points up from 97 basis points atthe end of the first quarter. We believe that we have established an adequate reserve based on current conditions. We do not anticipate that the Bank will purchase either whole loans or mortgage securities inthe foreseeable future. The Bank’s deposits continued to be largely comprised of assets from clients of H&R Block Financial Advisors and Tax Services. H&R Block Financial Advisors utilized the Bank to hold $589 million in FDIC-insured customer deposits and tax clients accounted for $125 million in deposits. H&R Block Financial Advisors continued to improve performance. Second quarter revenues grew nearly 11% to $78.2 million while the pre-tax loss of $4.7 million was comparable to the loss in the year ago period. Both periods include $9 million of intangible amortization which will be completed in the third quarter of this year. Therefore, our second half earnings will significantly improve. At quarter end we had just over $34 billion in assets under administration, up 6% from the first quarter.

Average productivity per advisor during the quarter increased 19% over last year, driven by organic growth in our successful recruitment and retention of higher-level producers. The number of advisors at quarter end increased to 956, up 20 from the end of the first quarter. We look forward to continuing these positive trends. Annuitized revenues as a percentage of total production continue to grow, in line with our emphasis on long-term advisor relationships with our clients and a focus on a fee-based annuity and other insurance products. Production from partnering with tax was up more than 8% year over year and now represents more than 18% of our total production.

Business services experienced top-line growth and improved operating results. Total revenues were $239 million, up 4.5% over the same quarter last year and pre-tax income was $12 million compared to income of $1 million for the second quarter last year reflecting efficiencies gained from integration of businesses acquired in Fiscal ’06.

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

Becky Shulman

Thank you, Alan. I’d like to comment on our liquidity position as we’ve had a number of questions on this issue. I’ll begin by saying we believe our liquidity sources to be sufficient for the normal scenarios we envision. With tax season right around the corner, we have $200 million remaining on our lines of credit, plus our cash on hand which is about $250 million. I would also like to note that this year’s liquidity needs are quite different from last year’s. In tax season ’07, the company used approximately $227 million to fund our early season loan product. For tax season ’08, the early season product is being funded by H&R Block Bank which has different funding sources and therefore will not be a use of corporate cash.

Although we’re in a larger borrowing position due to the losses in the mortgage operations, I would point out that many of the mortgage losses were non-cash and the potential for additional cash losses in the mortgage operations are smaller given the actions taken that were discussed earlier in the call.

There are a few variables which we’re watching closely. First is the volatility in the servicing advance growth. We believe our expected scenario takes into account the recent stress levels caused by increased delinquencies and reduced payoffs. That being said, we’re working on upsizing our servicing advance facility to ensure we can handle unanticipated increases in servicing advances. To date we’ve been successful in increasing our financing as these advances are very high-quality collateral.

The second is the cash flow timing impact from a potential delay and the start of the tax season due to a change in the AMT. It is unclear at this time what the outcome will be, but we are preparing for various scenarios and are working on arranging additional sources of liquidity for the sake of flexibility, including financing our headquarters building. We expect our $500 million bridge financing to be extended. So again, we believe our liquidity is adequate and we’re working to make sure that we have what we need to cover any uncertainties.

Alan will conclude with our outlook for the remainder of the year.

Alan Bennett

Thanks, Becky. I’d like to comment on the full year 2008 outlook and also our planned efforts to right size H&R Block post-Option One. For full year 2008, we remain confident about the operating performance of our continuing businesses. As a result, we are affirming our previous range of $1.30 to $1.45 per share. However, we will have higher borrowing costs anticipated when we set our last guidance and as a result, we expect our earnings will be toward the lower end of our guidance range. No adjustment to this estimate has been made for the impact of AMT. Some IRS alternatives could be net positives and some negatives, but I don’t want to speculate on that point at this time.

I do want to comment on our expense base. Our corporate support activities provide services to all of our operating companies. When the closing of our mortgage originations activity and hopefully the sale in the near future of loan servicing, we are now undertaking a comprehensive review of all expenses to realign our cost structure with our new, smaller company. Cost discipline and a healthy cost culture are characteristics of high performance companies. All of our businesses must have appropriate cost structures to compete successfully in the marketplace and have a fair return on investment. We must be razor sharp in investing SG&A dollars into the right activities and make certain that we get the appropriate benefit from our spend. We will be taking action once our review is complete, likely in the mid-January time frame. At the same time we will continue to invest in the tax segment in advance of what we believe will be a very solid tax season.

I’d like to thank you all for listening and we’re now ready to take questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Scott Schneeberger with H&R Block. Please proceed.

Scott Schneeberger - H&R Block

Good afternoon. A question on the decision to raise debt or equity if you do find that you need additional capital. I guess what is the timing and the quantity I guess my question and then I guess we’re allowed one follow up and my follow up would be why cut to the dividend if you are concerned about the capital situation? Thanks.

Alan Bennett

I think the way I’ll answer that is that we have base cases and some stretch cases that say that we are fine with our bridge facility and an upgrade to our servicing advances. We are thinking and looking to raising additional funds to provide a little more breathing room potentially with the refinancing of our building. With respect I think to going to market with debtor stock, I think we’d like to keep those open. I think we certainly have short-term debt that at some point we need to term out. I think we look to market conditions and other events to determine the size of that and the timing of that in the future and I think with respect to the dividend our approach is that it’s a good sign of confidence to the marketplace that we really believe inthe long-term prospects of the company. Is that responsive to your question?

Scott Schneeberger - H&R Block

Yes, thank you.

Operator

Your next question comes from the line of Mark Sproule with Thomas Weisel Partners. Please proceed.

Mark Sproule - Thomas Weisel Partners

Thanks. I guess the question is with all the volatility around the delay in closing the Option One business, how does this change your perspective of longer term trying to return capital to shareholders in light of some of the restrictions that you’re under currently?

Alan Bennett

I think we are very mindful of the impact that Option One has had on the company and its finances and the Board will see. Repairing the damage that has been done as an important priority but for the future we are acutely conscious of the importance of once that repair is accomplished of right-sizing our balance sheet and making sure that we have tight discipline on returns for our invested capital and that growth and shareholder value is a prime focus of the Board of Directors.

Mark Sproule - Thomas Weisel Partners

And I guess as a follow up, if you would... Is there any impact from a funding capacity perspective on your ability to provide services and operations for the tax season this year? Thanks.

Alan Bennett

I couldn’t hear you, you’re breaking up. Are you still on the line? If you could repeat that, it’d be great.

Mark Sproule - Thomas Weisel Partners

Yeah. Are there any impacts to the coming tax season from some of the funding limitations that might be going on currently?

Alan Bennett

No, I think it’s a great question. I appreciate the question. No, actually, we’re investing heavily in the tax season. I think as you look at kind of a short-term strategy here, the first thing obviously was the announcement to close origination and you can seethe work we’ve done and some of the talking points with respect to reducing our exposure to our loan portfolio. We’ve worked hard at not only stopping the originations but really looking hard atthe balance sheet. The servicing platform that we’re running right now is actually running about break-even and it has cash flow positive characteristics assuming that you can continue to finance the service advances. Even with the interest cost it’s $9 to $10 million cash flow positive, which is helpful. I think as you look at the things that we need to get done, obviously we’ve got to wall that off and complete the sale of that servicing platform. We have to get our operating costs in line. We have to get operating margins improved inall of our businesses and then we, as Richard mentioned, we’re going to go to work and really solidify our balance sheet but during this timeframe we’ve not been constricted on the type of activities and investments and products and people and locations within our tax segment. We’re gearing up, we think, for a very good 2008.

Mark Sproule - Thomas Weisel Partners

Thank you.

Operator

Your next question comes from the line of Michael Millman with Soleil Securities. Please proceed.

Michael Millman - Soleil Securities

Some follow up questions. [inaudible] shareholders elected you to the Board, certain options that you talked about including the [inaudible] managed for several years [inaudible] talk about you’ve learned now that you’ve been there for a while any things you want to do beyond what sounds like of executing better give us timetable as major items that you think can be accomplished?

Alan Bennett

I think I’ve got the gist of that. You’re breaking up a little bit, but I think what I would say right now is that based on a four week, three and a half week review of our businesses that we have, I think, pretty significant opportunities to tighten up and run into tighter tolerances inall of our business segments. So to the extent that we can make their businesses more competitive through cutting operating costs or improve margins in other ways, I think there’s opportunities for all of our businesses short term to improve the results. I think intermediate term post tax season there’s an additional review just to make sure that we have a proper alignment of our segments that there are meaningful synergies that all of our businesses add value to our base of tax business so I think that strategic review that Richard talked about will be ongoing as we also look to improve the operating performances of each of the business segments.

Richard C. Breeden

I think after... It should be clear that after nearly ten years under the tenure of the prior CEO there will bea zero based review of everything we do. We’re going to focus on changing a history in which H&R Block for the last few years has significantly underperformed the market and the Board is going to be determined to review each and every corner of the company and find every possible step that will move us if we can accomplish this from an underperformer to an overperformer.

Michael Millman - Soleil Securities

In terms of the Bank, discuss how you dispose of the Bank, if you dispose of the Bank, if the mark to market of the assets, what would they be?

Richard C. Breeden

You’re breaking up pretty severely. I think your question, but correct us if I’m wrong, was in connection with any possible sale of the Bank, what the issue would be of mark to market of assets?

Michael Millman - Soleil Securities

And also what [inaudible] different ways that you can dispose of the Bank?

Richard C. Breeden

Well I think that’s entirely premature at this point and so I don’t think it would be useful to go into that. The Bank is something that creates some very interesting strategic potential in terms of what we refer to as the Emerald suite of products to support our tax business with credit products that competitors may not be able to replicate, particularly as some of the traditional large providers of RAL credit exit that marketplace. We may have some strategic advantages that others do not. Inthe course of the proxy campaign, we raised the issue that the regulatory costs from owning a bank and in particular the 3% holding company capital requirement might bein excess of the benefits that the Bank brings to the companies, and there are clear benefits. Our first objective will be to try and restructure and reconfigure our banking operations to avoid those regulatory costs or minimize them in order to then evaluate where we are. For example, the 3% holding company capital requirement is not inthe law but it was imposed as a regulatory condition by the Office of Thrift Supervision. It was done at a time when H&R Block owned Option One and I know that as a former regulator the regulators at OTS were properly sensitive to the immense risks that OOMC represented. Indeed, the OTS to its credit, and since I had a little something to do with its creation when I was in Washington, I would say this was a little bit of pride for what they did, they were more sensitive to the OOMC risks then the company was itself. But that regulatory provision, the 3% rule, was crafted to deal with risks that will no longer exist once we have exited OMC and are no longer in the subprime mortgage lending. I can’t speak for the OTS but we certainly believe that it would be appropriate for them to consider eliminating that 3% requirement. If so, that would substantially change the economics of continued ownership of the Bank in a very favorable way to H&R Block. We don’t know where that will come out but there are many facets to the ultimate strategic decision of what to do with the Bank. The one thing that is very clear is that whether we own a bank or do not own a bank, we will continue to find through our own bank or through partnerships ways to offer the Emerald suite of products because those are directly related to success in our tax business.

Michael Millman - Soleil Securities

Excellent. I appreciate it. Thank you.

Operator

Your next question comes from the line of Andrew Fones with UBS. Please proceed.

Andrew Fones - UBS

Yeah. If I could just follow up to that comment you made. How do you expect to respond, you know, I think you have to respond by January 15th to the OTS’ request regarding minimum bank equity?

Richard C. Breeden

Well the issue is not minimum bank equity. The bank is actually heavily capitalized. The issue relates to how we plan to meet the 3% overall holding company tangible capital requirement and that of course assumes that any such requirement is still in effect. We cannot speak for them. It is in effect today and we will prepare financial projections. The OTS has been working very cooperatively with us. I’ve met with them on several occasions as does management on a regular basis and they appreciate that H&R Block without Option One is a totally different company and doesn’t present many of the risks that H&R Block as the owner of Option One did present and I expect that the regulatory community, I can’t predict what they’ll do, but that they will ina thoughtful way review our lower risk profile inthe future and adjust the capital requirement. Sothe people who look atit simply as assuming that the 3% which is a discretionary requirement imposed by OTS inthe OOMC days, not something mandated by law, people assume that that requirement will always be there. I don’t think that’s a necessarily good assumption but we will certainly be responsive and continue a dialogue that is ongoing with OTS.

Andrew Fones - UBS

Okay, thanks, and for my follow up, you’ve mentioned that you’re going to have a strong focus on returns on invested capital. I was wondering what returns you’re targeting or what thresholds you may have for the various businesses? Thanks.

Alan Bennett

Yeah, this is Alan again. I... We’re not going to give specific guidance on returns. I think that the focus will clearly be on margin improvement and then introduce more capital discipline around that. We’re right inthe middle of our strategic plan right now which will bethe basis for next year’s operating plan, so we’ll have more to say I think about that as we go along in time.

It would be fair to say that the days in which people focus on revenue growth without focusing on bottom line and margin levels are over.

Andrew Fones - UBS

Okay, thanks.

Operator

Your next question comes from the line of Harry DeMoss with King Street Capital Management. Please proceed.

Harry DeMoss - King Street Capital Management

Hi. I had two questions I guess. You mentioned that you guys expect the bridge to be extended. Obviously you have four days to come up with half a billion dollars. Do you have any more details on that or is that an ongoing negotiation and if you do have details, I’d love to know either how long it’s going to be extended for and how is that going to relate to the lines of credit and the clean down provisions there and then I have a follow up.

Alan Bennett

We’re in discussions right now, we actually have written approval on one half and a verbal on the other and we’re just papering the second half, so we’re moving ahead on good pace on that and what was your follow up?

Harry DeMoss - King Street Capital Management

Well I guess just on that one in particular, how is that going to relate in terms of the extension to the clean down provisions you have on the HELOCs and the timing of those and then my follow up was simply you mentioned your building out there, your headquarters building, in general any sense as to what you think that’s worth or what it would cost and does it have a mortgage on it now?

Alan Bennett

The first position first is that the bridge would carry us through to tax season so that would... it would be clearly a bridge to our revenue and then the revenue would be the driver of taking the clock down. So that would be a neat package for our financing. With respect to the building, we do not have debt on it now. We’ve got lots of room because we think it’s worth up to $170 million or so, sothe question is how much do we really want to take? Should we borrow more than we need? So we’re going through that right now.

Harry DeMoss - King Street Capital Management

Okay, great. Thanks a lot.

Operator

Your next question comes from Larry with Oppenheimer. Please proceed.

Larry - Oppenheimer

Hi. One of my questions was answered. I think actually both of them have been answered. Thank you.

Alan Bennett

Great. Thanks, Larry.

Operator

Your next question comes from the line of Sy Lond with Morgan Stanley. Please proceed.

Sy Lond - Morgan Stanley

Hi, Sy Lond from Morgan Stanley. Question on working capital inthe context of your comments that you’re investing inthe company going into the tax season. Typically when I look atthe company historically we generally need over $1 billion of short-term debt going into tax season but when I look at your availability right now there’s only about $200 million available on the revolver and I appreciate the comments on cash flow timing and the corporate headquarters, but how do we reconcile this gap of your typical working capital need in tax season, what’s your availability is right now?

Becky Shulman

I tried to lay out, I think atthe beginning of my comments, because I’ve got tena lot of questions on what last year was versus what this year is and I think that there’s significant differences, not just in how we’re funding but also the fact that a year ago we were issuing commercial paper. This year we’re operating under working capital lines of credit so you don’t have overlap in raising funding and there’s just quite a few differences there, so keep in mind too that we are inthe middle of December now and tax season is just right around the corner, but our expectation is that in December there’s probably allin about $250 or so million dollars of need, about $204 is related to tax and our seasonal businesses, and then in January you’re offset with earnings. Sothe need declines quite a bit, sothe need from an all-end basis is about $41 million in January.

Sy Lond - Morgan Stanley

Can you try explaining ita little bit more in detail because it’s a big question in the market because if you look at your seasonal CP borrowings there’s a huge spike ahead of tax season and we just won’t see that this year?

Alan Bennett

You’re breaking up. Can you repeat that last?

Sy Lond - Morgan Stanley

If you look atthe company going back six or seven years even, there’s always a dramatic increase in commercial paper borrowing inthe January time frame and I’m just trying to reconcile what is so dramatically different this year versus prior years.

Becky Shulman

One of the primary differences is the company has historically funded its participation interests in Refund Anticipation Loans and beginning last year we were no longer responsible for that funding. But again last year we were still responsible for the early season funding and this year we will be responsible for none of that.

Richard C. Breeden

And one of the many questions about ownership of the Bank, it is a very important difference on the plus side of the ledger to remember that even with a roughly 12% capital level that you’re getting an 8:1 leverage on capital injection into the bank in terms of its ability to support lending products associated with RAL needs and things that used to be done with corporate cash are now done to a significant volume with supported by bank deposits and the funding requirement for Block is roughly one-eighth of those funding requirements.

Sy Lond - Morgan Stanley

Okay, thank you.

Operator

Your next question comes from the line of Larry with Oppenheimer. Please proceed.

Larry - Oppenheimer

Hi guys. Sorry. How much stock has been bought back in 2007 and one other question, has there been any, I don’t know if the right word is push back, from the H&R Block advisors about kind of the upheaval going on at the firm, stock price, things like that? Thanks a lot.

Alan Bennett

The first question on this stock buy back is virtually zero stock bought back this year. I think the second question was really about turmoil within financial advisors and frankly we’ve had great stability there over the last quarter. We brought a net twenty new advisors inthe quarter which is very successful, so we are retaining some, attracting others. We’re finding that there are other firms out there that have turmoil and we are successfully recruiting against them. So not only are we adding more advisors, we have more experience in total with our advisors and our productivity within our advisors is higher and we’re selling more annuitized products so I would say that right now the indicators, thekey indicators from that business, are very positive.

Operator

Your next question comes from the line of Ed Shen with Ivory Capital. Please proceed.

Ed Shen - Ivory Capital

Hi. I just wanted to go back and make sure I had the numbers correct on one of your previous responses. I believe you said that in December you have anall in cash need for the tax business of $260 million, expecting theall end amount to be $40 million in January? Did I get that down correctly?

Becky Shulman

Yes.

Ed Shen - Ivory Capital

Okay and that includes operating losses as well as working capital?

Becky Shulman

Yes.

Ed Shen - Ivory Capital

Okay and against that you have $250 million of cash on the balance sheet and $200 million in availability on your HELOC, is that correct?

Becky Shulman

Yes.

Ed Shen - Ivory Capital

Got it. Soit sounds like you have a cushion of about $150 million.

Becky Shulman

We also have the servicing advance facility and the servicing advance facility we have $750 million in capacity today and as I said we are working on an upsize there and servicing advances as those vary can change those numbers. So there can be additional capacity there but again at our peak in November, I think we were at about $705 million against that. So there’s other inflows and outflows. There’s other sources available but primarily that’s right.

Ed Shen - Ivory Capital

And when do you expect to complete the servicing advance facility?

Alan Bennett

I would sayit would probably be very early in January.

Ed Shen - Ivory Capital

Are you expecting to increase the size of that facility substantially or is it going to be an increase similar to the size that you had in November?

Becky Shulman

We are looking for a substantial increase inthe size of the facility, I think. Keep inmind thought that the facility can only be used to the extent that you have the advances to draw down so if we had... If we got the facility upsized to $2 billion, it’s not $2 billion of incremental recruiting only to the extent that you have advances to put in there, so we are looking to grow the size of the facility as our servicing advances grow.

Ed Shen - Ivory Capital

Got it. Thank you.

Operator

Your next question comes from the line of Andrew Fones with UBS. Please proceed.

Andrew Fones - UBS

Yeah, thanks. First I was wondering if you could give us any color regarding the sale of the servicing business, how that’s going, if you see much interest there? Thanks.

Richard C. Breeden

We have had quite a few strong interest expressed from quite a number of sources in both the servicing platform and possible sale of MSRs. That process is moving along very smoothly with a lot of interest and so we expect to be able to make some decisions really inthe New Year.

Andrew Fones - UBS

Okay, thank you, and then secondly, regarding the earnings guidance, you say now that you think that the earnings might come in towards the low end of the prior range due to higher interest expense. Can you quantify the interest expense or the change in your projection there? Thanks.

Alan Bennett

I would saythe incremental continuing operations interest costin the range of $0.04 per share or so.

Andrew Fones - UBS

Okay. Thank you.

Operator

Your next question comes from the line of Scott Schneeberger with H&R Block. Please proceed.

Scott Schneeberger - H&R Block

Thank you. Could you give us an idea of how many incremental tax offices you’ll be rolling out this year, year over year, and what type of CapEx forecast you have?

Alan Bennett

The first half of that question is we have a modest increase in the offsets in the range of $150 or so for the upcoming tax season. On the CapEx, we’ll get back to you on the CapEx part of that.

Scott Schneeberger - H&R Block

Thanks and I just wanted to follow up on an unrelated matter. I recognize inthe 10-Q that you mention share repurchases should not be expected at the earliest until after FY09 year as opposed to, I believe it was FY08 year before. I assume that’s business as usual with how the company is structured right now. Would itbe possible to move that up with say achange inthe way you’re regulated with the bank or removal of the bank or any other scenario? Thank you.

Richard C. Breeden

I suppose the easy answer is anything’s possible. We are looking in the next year at, as I mentioned, possible change in the regulatory requirements and I want to emphasize those are decisions that are exclusively within the province of the OTS. We cannot speak for them but it is something that they acknowledge, that the 3% requirement was created for a set of risks that will be dramatically different inthe future and therefore we’re optimistic that we will have a good dialogue with OTS and that it will lead to a rational solution. So one possibility that will change the picture is elimination in its entirety of the 3% holding company tangible rule or modification to reduce it from where it is today. The other thing that will happen in calendar 2008 is to a, I would say, to a very high degree of likelihood is asset sales. We are inan active marketing process for both our servicing business platform and separately MSRs and so our current position is a function. Our projected position is going to be a function of both operating results and changes in rules and proceeds of asset sales.

Scott Schneeberger - H&R Block

Thank you. Real quick if I could sneak one more back in on tax. You mentioned that you are increasing pricing this year on Tax Cut software bundling. Could you speak a little bit more to that strategy, how you’re expanding that offering, any color there would be appreciated. Thanks so much.

Alan Bennett

What we said in guidance is essentially with respect to tax prices, the retail price increases arein the range of 6-8% and that’s really where the guidance we’re getting on top line price increases are.

Scott Schneeberger - H&R Block

Specifically on your bundling though, I think you had mentioned some commentary on increasing pricing there and perhaps a broadening of who you’re approaching as a customer base. Could you speak a little bit more on that?

Richard C. Breeden

On the Tax Cut bundling and the sort of thinking strategically around that and our pricing, we have historically been sort of positioned as just as good as Turbo Tax but for less and I think as we made very significant price improvements over the last two years we see a real ability to narrow that different, so particularly retail, on front end pricing we will beat parity to a few dollars less. We’ll still be below them on back end pricing but we dosee our products changes enabling us to be a much closer price to them going forward.

Scott Schneeberger - H&R Block

Thank you.

Operator

Your next question comes from the line of Sateesh Boulee with Merrill Lynch. Please proceed.

Sateesh Boulee - Merrill Lynch

My question was related to the servicing advances that you’re making against very [inaudible] Typically, is the payment profile that you expect in terms of the cash coming back to you against advances that you are making?

Alan Bennett

Can you repeat the question? It was very difficult to hear it here.

Sateesh Boulee - Merrill Lynch

All right. Maybe I’ll try again. I’m looking for a bit more detail on the servicing advances that you’re making against delinquent loans.

Richard C. Breeden

Oh, I see, okay, thank you. Yes, I understand. The servicing advances. Just for a little bit of background, the servicing advances are monies that we as servicer remit to the owners of the mortgage loans where people are delinquent. We have first priority, top-of-the-waterfall rights to those assets so that any proceeds on payoff or on foreclosure or on other settlement to that asset come to us first. We also have the right not to remit if we feel that we have impairment or could possibly have impairment on advances that we might make. So we have... this is considered to bea very good asset. We expect to getthe asset back.

Sateesh Boulee - Merrill Lynch

Thank you.

Operator

This concludes the Q&A Session and I’d now like to turn the call over for closing remarks.

Alan Bennett

Thank you very much everyone for joining us and if you have follow up questions, please feel free to call Investor Relations. Thanks again.

Operator

This concludes the call. You may all now disconnect.

Copyright policy: All transcripts on this site arethe copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES INTHE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: H&R Block F2Q08 (Qtr End 10/31/07) Earnings Call Transcript
This Transcript
All Transcripts