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

F3Q08 Earnings Call

March 6, 2008, 8:00am ET

Executives

Scott Dudley - Vice President of Communications and Investor Relations

Richard Breeden - Chairman of the Board

Alan Bennett - Interim CEO

Tim Gokey - President of Retail Tax Services

Becky Shulman - Senior Vice President, Treasurer and Interim CFO

Tom Allanson – Group President Digital Tax Solutions

Joan Cohen – President Financial Advisors

Jeff Nachbor - Controller

Analysts

Scott Schneeberger – Oppenheimer

Andrew Fones – UBS Securities

Michael Millman – Soleil Securities

Larry [Shunamarche] – Oppenheimer

Kartik Mehta – FTN Midwest

Ed Shen – Ivory Capital

Operator

Welcome to the H&R Block Third Quarter Earnings Conference Call. [Operator Instructions] I would now like to turn the presentation over to your host for today’s call Mr. Scott Dudley, Vice President of Communications and Investor Relations.

Scott Dudley

Good morning and thank you for joining us to discuss our fiscal 2008 third quarter results. Presenting on the call today are Richard Breeden, Chairman of the Board, Alan Bennett, Interim CEO, Tim Gokey, President of Retail Tax Services and Becky Shulman, Senior Vice President, Treasurer and Interim CFO. They will comment on our results and then we will open the call to questions. Several members of our senior management team are also on the call and will be available during the Q&A session. Our call today is planned for about one 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 21E of the Securities Exchange Act of 1934. Such statements are based upon current information and managements expectations regarding the company, speak only as of the date of which they are made and are not guarantees of future performance and involve certain risks, uncertainties and assumptions that are difficult to predict. Therefore, actual outcomes and results could materially differ from what is expressed, implied or forecast in such forward looking statements.

Such differences could be caused by a number of factors including risks described from time to time and H&R Block’s Press Releases and Forms 10-K, 10-Q, 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.

In conjunction with today’s call there is an accompanying slide presentation which is posted to the Investor Relations section of our website at www.HRBlock.com. In addition, last evening we filed our third quarter 10-Q and issued a press release announcing our results including interim tax season information through the end of February. These documents are also available on our website.

To give as many participants as possible an opportunity to ask a question 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 will now turn the call over to Richard Breeden.

Richard Breeden

Good morning everyone. I’d like to give a general overview of developments during the quarter and a brief summary of certain longer term issues as well. The third quarter at H&R Block is less significant for performance in the quarter itself but rather for the insight it gives into the fourth fiscal quarter that drives Block’s annual financial performance. In that respect our tax performance during the quarter and in the month of February has certainly been gratifying, though the tax season for Block is far from over. I also believe that this quarter is important in a somewhat broader perspective as it marks the first full quarter of our new team and renewed focus on our basic tax business.

From an earnings perspective as Alan will go into in greater depth, the quarter showed a slight improvement to the third quarter of 2007. We had revenues of $973 million a 4.4% growth from $931 a year ago. Adjusted net earnings from continuing operations were $25 million or $0.08 per diluted share prior to severance charges. This compares with $22 million or $0.07 per share in the year earlier period. The net loss from discontinued operations was $57 million or $0.17 per share compared with $82 million or $0.25 per share in the year ago quarter. More importantly the net loss of $57 million in the third quarter is down from $366 million or $1.13 per share in the immediately preceding quarter.

As Becky will discuss and as you will see in the slides our total remaining exposure to Option One’s loan held for sale and real estate owned is now only $36 million net of reserves down from the billions not so long ago. As previously announced the company is in the process of attempting to sell our remaining Mortgage Loan Servicing business. Initial bids were due in mid January and since that time we have been refining the specifics of bids and focusing on the highest tier of bid prices. We are currently in advanced negotiations with more than one party. Although there can be no certainty in such matters we are optimistic we will have a signed contract in the near future.

At this time of year the most important question is expectations for the overall tax season. Alan Bennett and Tim Gokey will have more detailed comments on various metrics we are seeing as the tax season progresses. However, there are a few high level observations that may be useful to make at the outset. We believe and always have noted that the entire tax season got off to a slow start this year as the result of AMT and other issues. That slow start resulted in a decline of 3.5% in retail clients served through January 31. However, net tax preparation and rebate fees during the quarter grew 3.3% over the comparable quarter last year driven by a 7% increase in net average fee per US retail client.

Aggregate tax services revenues including digital and commercial markets were up 5.4% to $662 million while pre-tax income fell $14 million to $46 million. Operations in the month of February were appreciably stronger than January. The total number of clients grew 6.8% in February and aggregate tax preparation fees in the month of February grew 12.6% over February 2007. This brought year to date retail client growth to 2.6% and year to date growth in retail tax preparation fees to 8.7% although both numbers must take account of the fact that February this year had one additional day.

Alan and Tim will provide outlook for the results we anticipate for the full tax season despite the slow start and a very uncertain economy our experience as we head into the second half of the season where expertise clients have a larger impact suggests we are on track for a good year. Becky will provide further details on financial balance sheet and liquidity during the quarter. However, given the concerns about liquidity that many expressed at the time of our second quarter call we had several very positive developments.

We were successful in refinancing our $500 million in bridge loans during the quarter, the $600 million in medium term notes thereby eliminating this issue from our balance sheet. We have reduced our short term borrowings under our bank line of credit from $1.8 billion at January 31 to $950 million as of today and we expect to continue to pay down these borrowings through the end of the fiscal year.

Our search process for a new CEO is proceeding and we are in the process of interviewing candidates. We anticipate we will have a new CEO on board by early summer. The Board and Management expect to continue ongoing discussions of longer term strategy over the next few months and we will be considering opportunities to improve focus and profitability in every aspect of our tax services that were more than 110 million tax returns that we did not prepare in the United States last year and we believe improving our market penetration is our foremost challenge. This was an issue not only for our retail group but also for software and internet products through our digital channel

We also recognized the challenges inherent in changing views regarding traditional refund anticipation loans including the pending IRS rule making on this subject. Block has been a leader historically in reducing prices for these products and we are working on various ideas that may enable us to broaden our market share while providing clients with even better lower cost financial products. We are working to identify opportunities to strengthen both revenue growth and profit margins in our McGladrey unit and we recently began initial steps to reduce overhead costs.

We continue to review opportunities to refocus H&R Block Bank on providing low cost banking products to our tax customer base rather than its previous focus on purchasing mortgage loans. We are continuing our constructive discussions with the OTS concerning capital requirements related to the Bank once our disposition of Option One is complete. Overall we have many challenges but we believe we have even greater opportunities for increasing market share and profitability. The company has always benefited from our immensely talented tax professionals and we plan to put them to continued good use in the future.

H&R Block has a proud heritage but I firmly believe our best years lie ahead of us not behind. Now I’d like to turn the call over to Alan Bennett our Interim CEO.

Alan Bennett

I’d like to start by taking a moment to thank H&R Block associates throughout the organization and including more than 100,000 tax professionals in the midst of the busy season for your dedication, commitment to serving clients to an unmatched expertise and ultimately delivering value for our investors. Everyone has been working extremely hard and we sincerely appreciate your contribution to our results during this seasons first peak.

I will provide a quick summary of the performance of the non tax segments, following this Tim Gokey will provide significantly more detailed information on our Tax business including clients served, pricing, our Emerald products, client retention and other information. Becky Shulman will follow with an update on our financial position including a review of our balance sheet and detail on our remaining assets on Option One. Finally I’ll conclude with our financial outlook for the full year.

Starting with Consumer Financial Services which consists of our Bank and our Financial Advisory businesses, the segment delivered revenues from continuing operations of $117 million up 9% in the third quarter last year. Pre-tax income was up nearly 19% from the prior year to $13 million. Within the Consumer Financial Services segment the H&R Block Bank benefited from continued strong demand for the Emerald Card including demand for our Emerald Advanced Line of Credit generating revenues of $39 million for the third quarter up significantly from $22 million a year ago.

Pre-tax income rose a strong 91% to $12.3 million; the Bank realized an annualized pre-tax return on average assets of 3.47% and a significantly higher net interest margin of 7.28% reflecting the Emerald Advanced Line of Credit balances and Emerald Card account deposits. The Bank’s deposits continued to be largely comprised of assets from clients of Tax services and H&R Block financial advisors. We ended the quarter with $1.2 billion in Emerald account deposits which were invested primarily in overnight funds which drove total assets of the Bank to $2.4 billion at quarter end.

Due to the short term nature of these deposits we expect the asset base of the Bank to be lower during the fourth quarter. This increase in total assets required capital contributions totaling $107 million to be made during the quarter and we are pleased that the OTS has already approved our ability to dividend excess capital back to the holding company as the balance sheet shrinks in the fourth quarter. The Bank ended the quarter with $1 billion of mortgage loans held for investment.

Our Mortgage Loan portfolio was reduced by $38.3 million during the quarter primarily due to scheduled principle payment received. The Mortgage portfolio balance at fiscal year end 2008, 2009 and 2010 is expected to total approximately $992 million, $792 million and $619 million respectively as Mortgage Loans runoff and are not replaced. We recorded our loans for loan losses representing our estimate of credit losses inherent in the Mortgage Loan portfolio. The majority of potential credit loss is evaluated on a pooled basis however we reviewed non-performing mortgage 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. Based upon our analysis conducted during the second quarter of this year a substantial increase in Mortgage Loan delinquencies was projected for the upcoming 12 months and accordingly we adjusted our loan loss reserve adding approximately $10 million in loan loss reserves at that time. As expected from that previous analysis our 30 day plus delinquent loans have risen during the quarter.

The Mortgage Loan portfolio 30 plus day delinquency rate at quarter end was 7.1% or $75 million worth of loans which is up from the previous quarter but in line with our second quarter projections and the loan loss reserve actions taken. Mortgage Loans delinquent by more than 90 days were $24 million at year end or 2.3% of the portfolio. At quarter end our loan loss reserve as a percent of all delinquent mortgage loans was 21.25%. The loan loss reserve is a percentage of all mortgage loans was 1.49% at quarter end.

The tendency for borrowers reaching 60 or more days past due to proceed towards foreclosure is showing a slightly increased trend over the past quarter. Consequently ongoing monitoring of collateral evaluations and the continued analysis of portfolios performance and trends may result in future increases in the loan loss reserve. H&R Block financial advisors reported results that were lower than a year ago quarter and what has clearly become a very challenging market and interest rate environment.

Third quarter year over year revenues fell 9% to $78 million, pre-tax income declined 85% to $670,000 compared to $4.5 million in the prior year. The current period benefited from a $6 million reduction in amortization of intangible assets as these assets were fully amortized in November 2007. Results for our financial advisors business were negatively impacted by the recent Fed rate cuts since in response we lowered the rates on margin and other asset balances which led to a decline in interest income.

Despite difficult market conditions average per activity per advisor increased 3% over the second quarter of fiscal 2008 and positive trends in recruiting and retention of higher level producers continued. Furthermore amortized revenues as a percentage of total production are ahead of plan as we continue to emphasize long term advisory relationships with our clients and focus on fee based annuity and insurance products. At quarter end we had $31.8 billion in assets under administration which is essentially flat with the prior year. Business Services revenues of $192 million were flat compared with the same quarter last year. Pre-tax income for the quarter was $7 million compared to income of $1 million last year reflecting efficiencies gained from integration of businesses.

Discontinued operations which are essentially all Option One recorded a pre-tax loss of $97 million during the quarter. This loss consisted of the following; $28 million of restructuring charges related to the shutdown of our Mortgage Originations Unit and this was $19 million lower than previously announced, $67 million of losses on the sale of Mortgage Loans including an impairment of residuals, $32 million of other operating losses offset somewhat by the reversal of the $30 million valuation allowance. Becky will discuss the discontinued operations balance sheet in detail in just a moment.

During the quarter we took a severance charge for corporate staff reductions and executive severance of $26 million pre-tax this charge was due to the elimination of 325 filled positions and we have also eliminated 180 open positions. These reductions represent about 23% of corporate support staffing and will reduce annual compensation expense by approximately $50 million. Our next phase of cost reduction is to approximately reduce our spending and overhead expenses such as consulting, travel, real estate and IT.

As Richard mentioned McGladrey has a program under way to reduce expenses by $15 million bringing our total cost reduction effort to $125 million. Our goal is to instill a better and sustained cost culture throughout the organization in order to improve the company’s competitive position, its operating margins and overall value to shareholders while maintaining or improving outstanding customer service. I will now turn the call over to Tim who will talk in more detail about tax season to date.

Tim Gokey

Before describing more deeply the results in different parts of the Tax segment let me comment on several market factors. The IRS is projecting total filer growth of about 1.1% after adjusting for telephone excise tax filers. It seems likely the impact of the economic stimulus package may move this growth upward, but how much remains to be seen.

The season saw an unusually slow start due primarily to publicity related to the AMT patch. Most of this delay corrected itself by mid to late February. Finally, the market saw an early season shift in share toward do it yourself methods through assisted preparation. This shift appears to be moderating as the season progresses. It is too early to say if the shift is time related due to the significant growth in marketing spend again so called free tax preparation by some competitors in the digital space.

Our in season market research suggests H&R Block retail has lost relatively few clients to free digital options today. This is an important metric that we will continue to monitor. After a slow start our Retail Tax business grew strongly in the month of February. Driven by gains in client retention our Retail Tax clients served excluding lending product only clients increased 6.8% and net tax preparation related fees grew 12.6% in February. Retail clients served gained 2.6% year to date through February 29, 2008, compared to February 28, 2007. Given the effect of the extra day due to leap year our best estimate that this is equivalent to an increase of 1.3% in the clients served on a comparable basis.

Net tax preparation and related fees grew 8.7% year to date over the same period. This strong performance which has continued into early March is the result of many factors and it reflects many initiatives we have been pursuing for some time.

Turning to pricing, our net average tax preparation and related fees for retail client rose 7% for combined company owned and franchise operations as of January 31 through February 29 the year to date increase was 6.1%. The lower rate of pricing increase in February reflects a higher mix of low complexity clients including those not normally required to file but who have done so due to the economic stimulus package rebate. Excluding this later group we expect pricing for the season to be in line with our expectations of an increase of 6% to 8%.

As Richard noted earlier we are working to increase our market share in every segment of the market. Last quarter we described an approach for growing in speed of refund building a stronger position among expertise filers and building a great organization. Let me briefly recap our progress in each of these areas. In the speed of refund we had a very solid early season based in large part on our Emerald Suite of products. We made nearly $900,000 Emerald Advances for total credit extended of over $400 million. We are monitoring these advances carefully and we are experiencing client return and repayment generally in line with our expectations.

Our 36% APR Emerald RAL backed by our lowest cost guarantee proved popular. This drove a nearly 5% increase in refund anticipation loan applications to date and what we believe is a measurable share a gain of share in the RAL market. Importantly this product continued H&R Block’s tradition of being a leader in delivering high quality, less expensive financial products to our clients. More than 2.3 million clients have chosen an Emerald Card to date putting us on track to serve more than 2.5 million clients with Emerald Cards for the year. This represents more than 25% growth over the prior year.

The Emerald Card enables an important segment of our clients to avoid expensive check cashing and gives clients that may not have a traditional bank account the safety and convenience of a MasterCard. This year we’ve seen important retention gains from clients that took the Emerald Card last year. Beyond the strength of our product innovation we’ve also seen increased client service levels, minimal client wait times and improved marketing effectiveness and significant growth in our newest tax franchise business.

Excluding parts of the business we have closed down after last tax season we are currently seeing a gain of nearly 50% in Express Tax year to date. While currently small we believe Express Tax can be an important contributor to speed of refund growth in the future. We anticipate expanding Express Tax considerably in coming years. We are now into the second half of the season when expertise filers become more important and when H&R Block had a competitive advantage. We have seen good growth in the second half the past two seasons a leading indicators are good for this year.

The typical Block client is served by tax professions with more than eight years experience and more than 450 hours of training. Building on this depth of tax knowledge more than 35,000 tax specialists chose to enroll this year in special training on building a client base which is more than triple the number that did the previous year. Part of the end result we’ve seen a significant increase in referrals year to date. We’ve also seen an increase in the matching of clients with your tax professional from the previous year which positively impacts retention both this year and next.

When existing clients and potential clients see the skills and tax knowledge of our tax professionals it is very compelling. Year to date our tax professionals have completed more than 10,000 public speaking engagements on topics ranging from rental property to the impact of the tax rebate. We believe these efforts along with our new second look product; strong local marketing and continued growth and referrals will set us up for a strong second half.

Across both these client segments we continue to make progress, strengthening our organization. This year we have rolled out new training and new tools designed to build on H&R Block’s lead as the best place to be a tax professional. Last year we increased our tax professional retention by over two percentage points and this year it is trending one percentage point above that. It’s a significant gain. Client retention is also up year to date and client satisfaction is up three percentage points. Notably what we see of price value is also up nearly four percentage point from last year.

These indicators give us confidence that the important changes we have undertaken are bearing fruit in more satisfied and committed clients, tax professionals and associates. While these are difficult and not glamorous they are the important work of building a truly high performing company that attracts the best in the profession.

The entire digital market has seen a shift from software to online and the composition of online is increasingly laid out of free services. Although growth in digital e-files is coming from both increases in the free file alliance and from competitors offering free online tax products backed by significant fee increased marketing spending. During the quarter our digital operations were negatively impacted by these factors and slower start to this year’s tax season.

Digital clients served were down 10.8% through January 31st. While our digital clients served which includes only tax returns to which we have been paid a fee were down for both the quarter and through February 29th. We have participated in the overall growth of the online market. At the end of February our digital e-file growth was 5.5% year to date. This growth was driven by gains in FFA as well as online paid returns offset by the declines in software.

As with the expertise market there is a great deal of filing season left for the digital business. In the meantime we are successfully executing a plan to meet higher earnings objectives through a combination of optimizing our costs making targeted price increases and improving client retention which is up nearly 10 points to date. Based on these actions our Digital Tax business is on track to nearly double its profitability despite significant competitive actions.

Results from our continuing international operations we are in line with our expectations. We recorded a third quarter pre-tax loss of $8 million which is essentially flat compared to the prior year. Now I’ll turn the call over to Becky Shulman to discuss our financial position and balance sheet items.

Becky Shulman

As we did last quarter I want to take a moment to summarize our remaining Option One exposure. The shut down of Option One’s origination platform is essentially complete. All of our on balance sheet and off balance sheet warehouse facilities have either matured or been terminated consistent with our exit from the origination business.

We entered the quarter with $135 million in gross amount of loans in real estate owned on the balance sheet. We originated $43 million of loans of which two thirds were prime loans. We repurchased $100 million, $18 million of which was R&W repurchases and $82 million of which were early payment default repurchases. We sold $189 million of loans resulting in a loan balance on a growth basis of $89 million at January 31.

After netting a $53 million valuation allowance we ended the third quarter with $36 million of loans and real estate owned held on the balance sheet. We began the quarter with $57 million of off balance sheet exposure and sub-prime loans. All of these loans were sold during the third quarter and you no longer have any off balance sheet exposure. Our remaining Option One exposure at January 31 is as follows; loans held for sale and real estate owned on the balance sheet totaled $36 million net of reserve. Residual interest in securitizations were valued at $26 million down from $38 million in the prior quarter.

We also have a reserve for potential R&W repurchases of $69 million reflecting a similar loan repurchases of $138 million at a 50% loss severity. At the end of the third quarter the net book value of discontinued operations which is essentially all Option One with approximately $500 million inclusive of a $305 million valuation allowance. As Richard noted since our last earnings call we completed a number of important financing actions. In particular we issued $600 million in medium term notes in a difficult market with a coupon rate of 7.78%.

We have fully repaid the $500 million bridge loan as of February 15th. We successfully increased our servicing advance facility capacity from $750 million to $1.2 million and we believe this will provide sufficient capacity. As a result of these actions and seasonal cash inflows from our tax business we have paid down our lines of credit from $1.8 billion to $950 million as of March 5th. By the end of the fiscal year we expect these lines to be substantially paid off.

Also, the HSBC line of credit for financing RAL participation has reduced from $1.7 billion at January 31 to $152 million through yesterday. This line is expected to paid to the zero by fiscal year end. Our consolidated cash position increased $332 million compared to last January primarily due to increased Emerald Card balances at H&R Block Bank. Receivables increased $340 million year over year largely due to tax season timing differences as it applies to RAL and the increased Emerald Advance Line of Credit relative to the decline in IMAL.

Compared to the second quarter the discontinued operations balance sheet reflects higher servicing advances up $336 million and an increased use of the servicing advance facility up $468 million. The balance sheet also shows an increase in the repurchase option loans and offsetting liability up $700 million to $1.63 billion. These are the loans in the securitizations that have reached optional repurchase triggers and are required to be reported in the asset and liability sections of the balance sheet per GAAP. We will not be exercising the option to repurchase these loans. Now I’ll turn the call back to Alan for our conclusion.

Alan Bennett

Let me briefly comment on our outlook for the remainder of the tax season and our fiscal year. For full year 2008 we remain confident about the operating performance of our continuing businesses. As a result we are affirming our previous guidance range of $1.30 to $1.45 per share. We continue to expect that we will finish the year toward the low end of that range after absorbing the current quarter’s severance charge.

Specifically to the tax business we are pleased with our year to date results, however the season is far from over and our work is not finished. We anticipate growth in a number of domestic retail clients of up to 2%. We believe we will achieve high single digit revenue and earnings growth in the Tax segment. Thank you, we are now ready to take your questions.

Question & Answer Session

Operator

[Operator Instructions] Our first question comes from Scott Schneeberger from Oppenheimer.

Scott Schneeberger – Oppenheimer

If I could ask really quick one little housekeeping question. Rich you said that EPS guidance of $1.30 to $1.45 does that include the severance charge or not? I wasn’t clear when you mentioned that?

Richard Breeden

That’s after the affect of the severance charge.

Scott Schneeberger – Oppenheimer

So net of it is in there?

Richard Breeden

Yes.

Scott Schneeberger – Oppenheimer

For Tax Services it looks like really good at Retail but a little weak in Digital. Could you take us a little deeper with regard to the competition offering a lot of free, perhaps seeing some down volume as a result of that and your discussion of doing a little bit of pricing this year where you will double profit but at the same time you are losing a little share there. Could you speak a little deeper on that?

Tim Gokey

I will comment briefly and I’m going to ask Tom Allanson to comment also. We did take a variety of moves to better strengthen our Digital position from a profitability standpoint both on the cost side and on the pricing side. We think those moves are being very effective. We do not believe that the volume changes we’ve seen in the business are related to our pricing actions. We feel very good about those. We did, however, see a very significant increase in particularly market spending behind free offers. As you know our major competitor is offering free on your home page and on TV. We felt that was not the right strategy for us and we’ll see how that plays out going forward but that certainly has had an impact in our volume in this early part of the season. I’m going to ask Tom to expand on that.

Tom Allanson

I think Tim answered the question very well.

Scott Schneeberger – Oppenheimer

If I could ask one quick follow up in the Tax space. I was a little confused by the pre-tax income line, the clarification of that in the press release. If you could clear up a little bit about why that was done year over year?

Tim Gokey

The major factor that caused that to be down year on year was a one time increase in our bad debt reserves related to refund anticipation loans. We changed, along with our lending partner HSBC, our collections practices to eliminate cost collections and we basically made an estimate of what is the future impact of that on all future collections and resulted in a net one time charge of about $14 million.

Operator

Our next question comes from Andrew Fones with UBS Securities.

Andrew Fones – UBS Securities

I was wondering if you could walk us through the EPS impact of some of the one time items for the year including in your full year guidance. I think that the severance charges were by my estimate about $0.05 can you confirm that? Also, this impairment for bad debt and the tax impact in Q3 is that also included in the guidance?

Alan Bennett

Both of those items are included. What I would say though is some, even though there is severance cost in the third quarter, was around $0.05. We will have some benefits in the fourth quarter for those actions. The guidance we gave you includes the net impact of the severance charge as well as the one time item that Tim just spoke of.

Andrew Fones – UBS Securities

In terms of the expense in the corporate line, I would expect cost cuts a little decline in the third quarter should we expect the impact of these cost cuts to be fully recognized in the fourth quarter or would you say that it will be the first quarter before we see the full impact there?

Alan Bennett

Most of the benefit that you will find will not be at the corporate line because we allocate those costs primarily to our businesses. The benefit will go into the businesses. What I would say with respect to the compensation issues you’ll see those immediately since we’ve taken the severance charge in the third quarter. With respect to the savings on spend it really depends on the pace and success we have on engineering some of those costs away over time.

Andrew Fones – UBS Securities

One final one if I could, you mentioned that profitability that Digital Tax business year over year can you tell us what that profitability was?

Alan Bennett

Could you repeat the question?

Andrew Fones – UBS Securities

You mentioned the profitability of the Digital Tax business, it’s a year over year, I was wondering if you could tell us what the come from that business is approximately?

Alan Bennett

We do not disclose separately the financial results of Digital. We view those as proprietary.

Operator

Our next question comes from Michael Millman from Soleil Securities.

Michael Millman – Soleil Securities

[regarding shareholder value could you give us a very rough, road map how you are going to increase the shareholder value and segment closing some of those segments and timing and that’s assuming that in the very near future.]

Becky Shulman

Michael, for some reason you are cutting out, I don’t know if you are on a headset. Can you repeat the question?

Michael Millman – Soleil Securities

I was asking for a road map of increasing shareholder value in looking at some of the different businesses you are in?

Richard Breeden

We have, as I indicated we are approaching these issues in what we believe is a systematic fashion. Clearly the primary challenge facing the company in returning to a sustained culture of shareholder value increase was to deal with Option One. That remains our number one challenge and I indicated where we are on the status of that. Once that is accomplished the Board and management will continue our ongoing discussions of looking at other parts of our business and I think it would be a fair road map to say that each and every area of our business will be considered for its profitability and for opportunities to increase market share and drive profitability to the company.

We expect to do that, you’ve seen some actions already in our cost cutting initiatives both at Corporate Central and also in McGladrey this quarter. Those efforts will continue. Obviously individual segment realignments are among the subjects that we will consider. Those will come as we unfold the sequence I’ve described.

Michael Millman – Soleil Securities

Could you give us some sort of date when you expect?

Richard Breeden

Michael we are cutting in an out we can hardly hear you. I heard you say the date. We are not going to predict any dates. We’ll let you know when we’ve done it.

Michael Millman – Soleil Securities

Related, with the Digital business growing off better than retail does this suggest that you might think of opening new stores or closing stores or selling stores to franchisees?

Richard Breeden

While the profitability of Digital is up in percentage terms greater than the profitability in Retail we believe we are doing extremely well in the Retail sector, certainly in aggregate profitability. We will hopefully on a regular basis examine our operations in every sector including Retail packs for opportunities to groom our office network in other ways of improving profit margins. I’ve tried to indicate in the past and I think our team is fully engaged in the idea that we are not as a one time basis but on a sustained basis going to look at every opportunity to both increase share and increase profit margins in every nook and cranny of the Tax business.

Operator

[Operator Instructions] Our next question comes from Larry [Shunamarche] with Oppenheimer.

Larry [Shunamarche] – Oppenheimer

A couple of questions, does H&R Block have any exposure to the auction rate security stuff?

Joan Cohen

Our clients hold just north of $100 million of auction rate securities but the firm itself is not included, it does not hold any.

Larry [Shunamarche] – Oppenheimer

Back to the Option One, how long has that been carried as discontinued ops and how much longer can it be if there is no sale?

Becky Shulman

It can be carried in discontinued ops for one year.

Larry [Shunamarche] – Oppenheimer

How long has it been being carried as discontinued ops?

Jeff Nachbor

In theory it should be carried for one year but what happens as you know we went through a transaction where we were selling the entire business and that transaction actually fell through and so that one year basically started at that point in time. We have had on our books in discontinued operations, this is the fourth quarter. We fully expect to have that resolved within the next couple of quarters. We feel like we are within the accounting guidance.

Larry [Shunamarche] – Oppenheimer

Is there a contingency plan if that is unable to be sold?

Alan Bennett

If you look at the balance sheet the originations business is gone and as Becky pointed out we had very little exposure left. We have a servicing platform left and a servicing operation that continues to provide positive cash flow every month. We are in, as Richard described, very active negotiations with multiple bids on this business. We feel very optimistic that this will resolve itself in the very near term.

Operator

Our next question comes from Kartik Mehta with FTN Midwest.

Kartik Mehta – FTN Midwest

If you were able to quantify the improvements you had in the Tax business is it the Emerald Card and maybe going forward how much do you think that could help?

Tim Gokey

The Emerald Card did contribute materially to improved retention year to date for competitive reasons I don’t want to say exactly how much that is. Year to date for clients that we have seen by this time last year our overall client retention is up about a percentage point over last year. There are many factors contributing to this of which the Emerald Card is one.

Kartik Mehta – FTN Midwest

If you look at the Emerald Card and everything do you still believe that you may have to offer this are there banks that offer this [inaudible]?

Richard Breeden

We do not believe that ownership of a bank is mandatory and operating in partnership with independently owned banks is definitely an option for the future and is one that as we review strategies we will consider. At the same time we have a bank; we believe that ownership of the bank carries with it certain flexibilities and cost savings so long as the regulatory costs and the impact of any balance sheet and financial inflexibility caused by bank regulation are not in excess of the benefits. That is a cost benefit analysis that we are looking at and will continue to look at.

Our principle focus as we described on last quarters call and mentioned again this time is working with the OTS to see if we can reach agreement with them on changes in the 3% tangible holding company capital requirement which was designed quite specifically to deal with the risks of Option One. Once Option One is gone is a rule which we believe could be safely confined to the annals of history. That’s a discussion that goes on with our regulator and obviously they have the final say on that. It will affect our calculations of whether we move forward on a Bank or partnering with third party banks.

Kartik Mehta – FTN Midwest

[Inaudible] able to dividend back up to the holding company. Are we just talking a net zero or are you going to be able to dividend back into the bank or will you be able to take the bank out.

Becky Shulman

We’ll be able to dividend out to the banks capital requirement which is currently 12%.

Operator

Our next question comes from Scott Schneeberger with Oppenheimer.

Scott Schneeberger – Oppenheimer

Could you speak a little bit, you touched on liquidity but could we talk a little bit about capex and what the horizon looks like for that, if we will be adding more or less tax going forward? Broader, what other things might be included in that so we can get an idea operationally what might go through to free cash?

Becky Shulman

We expect capex to be somewhere in the neighborhood of $94 to $95 million for the year. I’ll let Tim speak to stores.

Tim Gokey

We would expect our plans for expansion of Tax offices to be roughly in line with what we have done this past year as you know we have significantly moderated the pace of office openings and we would expect to be in that range or slightly lower this coming year.

Scott Schneeberger – Oppenheimer

Could you remind me, are you net positive this year or a lot lower than in past years correct?

Alan Bennett

That’s correct; we opened on the company side about 120 new offices this year.

Scott Schneeberger – Oppenheimer

That question was broader, it was specific on the Tax business but also Richard maybe if you could add anything, are you looking to spend capex elsewhere in the business or are we more in a disposition mindset?

Richard Breeden

We say when we will not rule out the expenditure of capital in initiatives to increase our business. When we look at what we are doing now, lack of capital spending has not been the problem over the last couple of years. It has been lack of discipline on allocation and spending of capital and so our primary focus is to stop throwing away capital on loss making operations or on operations that generate unacceptably low levels of return. While I would never rule out the opportunities to make investments in any of our businesses I think you will see a consistent very strong focus from us on discipline in the expenditure of capital.

Operator

[Operator Instructions] Our next question comes from Andrew Fones from UBS Securities.

Andrew Fones – UBS Securities

I had a quick question on the Option One balance sheet. I see that the deferred capex feel from about $427 million in Q2 to about $200 million this quarter. Were you able to use that at apparent level and the $200 million that remains what are your thoughts on that?

Scott Austin

The reduction in the net DTA in discontinued operations from Q2 to Q3 included a reclassification of $286 million from the deferred tax asset at Q2 to a long term tax receivable in Q3. This reduction was partially offset by increases to the book to tax timing differences of about $59 million. Of the $200 million that is remaining we expect to receive approximately 75% or $150 million of monetization of those benefits in the next 12 months with the remaining standing out for roughly a five to seven year period.

Andrew Fones – UBS Securities

In terms of the potential timing of the sale of the Mortgage Servicing business can you explain what remains in terms of the process towards the sale? Perhaps if you are able to give us some approximately sense of timing?

Richard Breeden

I’ve said everything we are going to say on that subject. We’ll leave it where it is. Our bidders are listening to this call as well as you and we’ve said enough.

Operator

Our next question comes from Ed Shen from Ivory Capital.

Ed Shen – Ivory Capital

A quick question on the guidance the $1.30 to $1.45 that you are reaffirming. I wanted to understand what assumption you are making for some of the cost reduction activities you’ve already announced. It sounds like you achieved $50 of the $100 plus that you had already announced. I wanted to know how much of that is included? In addition, you had $15 million that you announced today from the RSN business, is any of that included in the industry’s guidance?

Richard Breeden

With regard to RSN I don’t think any of that will impact this effort at all, as a matter of fact we may have a small severance charge there which we’ll absorb as well. With regard the $50 million, that’s an annual savings rate so we will realize up to a quarter of that depending on the timing of the actions in the fourth quarter that somewhat offset the $26 million charge we took and is included in the guidance as well.

Ed Shen – Ivory Capital

The remaining half or so of the previously announced reductions are not included in the guidance?

Richard Breeden

We are making immediate gains; there is some low hanging fruit that we are taking advantage of right away. There is some very modest one rate savings that we will accrue in the fourth fiscal quarter. I would say most of that will benefit next year.

Ed Shen – Ivory Capital

To be clear the severance from this quarter is included in that guidance and also it sounds like some additional severance from the other actions or some other charges from the actions are going to be included in that in Q4?

Richard Breeden

Yes, we are, we are going to absorb that into the guidance we have given.

Operator

Our next question comes from Michael Millman with Soleil Securities.

Michael Millman – Soleil Securities

Can you talk about of where the competition has been very aggressive on free, what extent you would like to see in net profit to what extent do you think that your rates costs of digital?

Tom Allanson

I got the first part of the question which I think had to do with specifically what some of the competitors are doing. What we are seeing in national advertising is advertising for free. If you go a website for some of our competitors you’ll find they are offering online Federal products for free. Some of the shifts that we believe we’ve seen in online is the result of advertising for free and that product being available for free.

Michael Millman – Soleil Securities

My question was what you were doing?

Tom Allanson

We participated in the free file alliance which is a product which is free Federal, we are seeing nice growth there but our focus this year, going into the year was to focus on earnings growth and we feel like we’ve achieved that. That the path we’ve stayed on through the course of this year.

Michael Millman – Soleil Securities

Your competition claims that free is profitable and not centralize the full service products? It sounds like you disagree?

Tom Allanson

We went into this year with the philosophy of growing earnings and we’ve been testing a number of different free options that we are exploring for future years. We did not go into this year thinking that free was a good strategy for us based on our plans.

Operator

I’d like to turn the call over to Mr. Scott Dudley for closing remarks.

Scott Dudley

Thank you everyone for joining us today. If you have any follow up questions or issues please give us a call in Investor Relations. Thank you.

Operator

Thank you for participating in today’s conference, this concludes the presentation you may now disconnect. Have a great day.

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Source: H&R Block, Inc. F3Q08 (Qtr End 01/31/08) Earnings Call Transcript
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