H & R Block Inc (HRB) 2004 Q2 法說會逐字稿

Good afternoon, ladies and gentlemen, my name is Paul.

I will be your facilitator today.

At this time I would like to welcome everyone to H&R Block's second quarter earnings release conference call.

All lines have been placed on mute to prevent any background noise.

After the speakers' remarks, there will be a question-and-answer period.

If you would like to ask a question during this time, simply please press star then the number one on your telephone keypad.

If you would like to withdraw your question press the pound key.

Thank you.

I would now like to turn the conference over to Mr. Mark Ernst, Chairman & CEO.

Please go ahead, sir.

Thanks, Paul.

Good afternoon and welcome and thanks for joining us to discuss our fiscal 2004 second quarter results.

With me here today are Jeff Yabuki, our executive vice president and chief operating officer, Melanie Coleman, our vice president and controller, Becky Shulman, our vice president and treasurer, and Mark Barnett, who is our director of investor relations.

Before I begin my formal remarks I need to remind you that various comments we may make about future expectations, guidance, targets, estimates, assumptions, plans and prospects for the company constitute forward-looking statements within the meaning of the federal securities laws and are based on current information and expectations.

These statements speak only as of today.

Actual results may differ materially from those indicated by these forward-looking statements as a result of various important factors including those discussed in our second quarter press release and on H&R Block's reports on form 10K, form 10Q and form 8K, which are on file with the SEC.

In conjunction with today's call, supplemental financial information has been posted to the investor relations section of our website at handrblock.com to facilitate your analysis.

In addition, a copy of our prepared remarks will be posted to our website shortly after the conclusion of this call.

I would like to take this opportunity to invite you all to our annual investment community conference which we will host on January 14th in New York.

This year we will provide a comprehensive look at our growth strategies and how we are progressing with our plans to enhance the H&R Block brand and our business.

This conference will include an overview of our plans and outlook for the upcoming tax filing season.

The afternoon breakout sessions will include -- will provide a detailed look at the strategies of RSM McGladrey, our business services segment, H&R Block financial advisors, our investment services segment, and the Option 1 and H&R Block mortgage businesses.

Details concerning the conference will be posted on First Call or you can call Mark Barnett with any questions.

For those of you who are unable to join us in person, we will again be webcasting the conference.

During today's call we'll discuss results for the quarter and then provide our outlook for the remainder of the fiscal year.

Before I get into the details, I want to thank our thousands of associates throughout all of our businesses for their efforts that led to the results we are discussing today.

They all had a great quarter.

I'm pleased to be reporting very strong financial and operating performance in the second quarter.

Compared to the same period last year, revenues grew 23%, net income increased by $48 million, and we achieved a 27 cent improvement in earnings per diluted share.

This first ever profitable second quarter reflects the strength of our overall mix of businesses combined with very solid execution across all of our business segments.

While we are pleased to have achieved a profitable second quarter, I remind you that our strategy is not focused on balancing out profitability throughout the year.

We remain and expect to remain highly seasonal in our earnings.

We're focused on serving our clients better than our competitors across the annual cycle of our businesses.

Reported net income was $10 million or 6 cents per basic and diluted share compared to a loss of $37 million or 21 cents per share last year.

The prior year quarter included a $42 million charge or 14 cents related to the settlement of the Texas [INAUDIBLE] litigation and a $6 million or 3 cents per share goodwill impairment charge.

If you exclude these charges, we achieved a 10 cent improvement in earnings per share compared to the same quarter last year.

Revenues increased $108 million to $580 million compared to $471 million a year ago.

Our results this quarter were achieved through the continued strong performance in our mortgage businesses, solid management and cost controls within our tax businesses, improved results in both the business and investment services segments, and the results from a good tax season in Australia.

The strength of our results are further highlighted when you consider that this year's second quarter results included a couple of planned items that were not in last year's second quarter.

Most notably, the costs related to the commencement of operations in our former major franchise territories and $4 million in stock-based compensation expenses.

Let me turn to Jeff who's going to review with you financial results from several of our business segments.

Thanks, Mark.

Our U.S. stock operations, which includes U.S.-based tax services, refund anticipation loan participations, and E-solutions achieved very solid results this quarter.

I want to add my thanks and congratulations to our entire tax organization for their outstanding effort and focus in preparing for the upcoming tax season.

I am particularly pleased with our operational performance to date as our overall spending levels have been well managed even with the addition of over 200 new offices within our retail and tax network over the last year.

This solid performance was achieved through effective management of costs and continuing efforts to improve and streamline processes that should ultimately lead to continuing growth in operating margins.

Our U.S. tax segment reported second quarter revenues of $47 million, an increase of $14 million or 41% over last year.

The increase is driven primarily by the adoption of a new accounting standard related to the recognition of revenues for our peace of mind service in premium tax offices which I will cover in more detail in a moment.

In addition, revenues were favorably impacted by a $1 million bad debt true-up provision from last year's waiver agreement.

The pretax loss for the segment improved by $21 million to $131 million compared with $152 million last year.

However, excluding the $42 million charge in the prior year for the litigation settlement, pre-tax losses increased by $20 million.

Most of the cost increases resulted from a larger distribution system, including commencing company-owned operations in former franchise territories and having more offices in our system due to last year's expansion.

Costs associated with the integration and operations of the former major franchise territories during the quarter were $13 million including $2 million of intangible amortization expense related to assets acquired.

Also, excluding those operations in former franchise territories, occupancy and equipment costs increased $6 million due primarily to a 5% increase in the number of offices and a 8% increase in average rents paid.

Stock based compensation is now being reported within our business segments and totalled $800,000 this quarter in a tax segment versus no such expense last year.

As a result of the new accounting standard for the peace of mind guarantee in our premium offices an additional $10 million in deferred revenues were recognized in the second quarter and pre-tax income from the change improved second quarter results by $1 million.

This new accounting rule requires us to recognize revenues for peace of mind in our premium offices over the life of the guarantee rather than just during tax season as we have done in previous years.

While this change had the effect of increasing revenues in the first and second quarters, the cumulative full year impact of this new accounting rule on revenue and earnings will be slightly negative this year, but immaterial to full year results.

Revenues and earnings will be lower in the fourth quarter offsetting the impact of the change during the first three quarters.

Next, I'll update you on our operations in former major franchise territories.

We have made substantial progress in the transition of effective major franchises to company-owned operations and are increasingly comfortable with our progress for preparing for the upcoming tax season.

The transition is going as well as can be expected.

Most of the former franchisees are cooperating in the process.

In those former franchise territories, there are 476 new company-owned locations and 238 locations now operated by direct franchisees of the company.

More than 1.2 million H&R Block clients were served in these territories last year.

Only one effective major franchise territory remains in place and that franchise agreement will expire in 2005.

As discussed on prior calls, under the terms of the franchise agreements, the company must pay the major franchisees fair and equitable prices in the event of contract nonrenewal and discussions continue regarding an appropriate resolution.

To date we have made or accrued payments of $119 million for the major franchise businesses.

The courts will determine if any additional payments are required for these major franchise businesses.

In October of this year, the first of these cases was tried to a conclusion before a jury and that outcome was within the range of what we feel is an appropriate value.

The next major franchisee trial date has been scheduled for May 2004.

Based on our preliminary analysis related to our operations in former major franchise territories, we anticipate financial results that approximate break-even in the third quarter of this fiscal year.

For the full year we plan to be cautious in forecasting results in these territories until we have more certain visibility.

Given actions that we now believe were taken last year by a number of the former major franchisees to boost short-term profitability, we are going into the upcoming tax season in these territories with a view toward ensuring client satisfaction relative to prices charged.

That said, we continue to expect these operations to have a positive impact on our financial performance this year, which Mark will cover in his discussion of the outlook for the full fiscal year.

For the upcoming tax season, we have a number of strategic initiatives under way geared toward delivering sustainable client growth and enhanced operating margin.

As mentioned in previous calls for competitive reasons, I'm not going to provide details at this time.

We will provide you, however, with an in-depth look at our plans and expectations for the upcoming tax season at our January 14 investment community meeting.

However, what I can say is that we are continuing to focus on delivering increasing levels of service differentiation across all channels and developing a deeper relationship with our clients so that over the long-term our target clients have a compelling reason to choose H&R Block as their preferred tax and financial provider.

Our international tax operations, which include Canada, Australia and the United Kingdom, generated revenues of $19 million, a 25% increase over last year, and net income of $555,000 compared to a small loss last year.

The improved performance is primarily due to a successful tax season in Australia, where we achieved a 3.2% increase in tax returns prepared compared to the second quarter last year, solid expense management and a favorable exchange rate.

Turning now to investment services we saw modest improvement in the key drivers of the business during the quarter.

Second quarter revenues of $53 million were up 5% compared to the second quarter of last year and down 8% sequentially.

Most of the sequential decrease in revenues was due to a reduction in fixed income underwriting activity.

Absent the underwriting activity all other revenues improved by $1 million.

Investment services recorded a pre-tax loss of $15 million in the second quarter which compares to a pre-tax loss of $28 million in the second quarter of last year and a pre-tax loss of $14 million in the previous quarter.

Each of these quarterly loss figures includes $7 million of intangible amortization.

Last year second quarter results also included a $6 million impairment of goodwill.

Within our revenues total production revenue increased by $6 million from last year and decreased $2 million from the prior quarter.

The increase in production revenue from the prior year was driven primarily by increased mutual fund and annuity sales.

Second quarter trading volume was up 19% from last year and down 4% compared to the previous quarter. 37% of production revenue came from mutual funds, annuities and fee-based accounts compared with 26% in the prior year and 32% compared to the prior quarter which is consistent with our strategy.

Net interest income was $8 million in the second quarter and was essentially unchanged when compared to both last year and the previous quarter.

Ending margin balances increased 7% compared to last year and 4% compared to the previous quarter.

In the near term our focus within this business remains on growing the revenue base while controlling costs.

Balanced against our long-term opportunity to build a broad-based planning and advice orientation that is consistent with our tax and financial partner strategy.

In terms of the growth of our revenue base we continue to recruit experienced financial advisors as a way to leverage existing capacity.

We are also enhancing our business model by broadening our distribution capabilities, by aligning tax professionals with financial advisors to deliver a value proposition unique to H&R Block.

We are now linking small groups of experienced tax professionals with a financial advisor in a local market to provide a team-based approach to meeting client needs.

Through the end of the second quarter we have registered 231 tax professionals in the program and have another 460 in the registration process.

We are encouraged by the early results from this initiative.

Now let me turn the call back to Mark for a review of our mortgage and business services operations.

Thank you, Joe.

Our mortgage operations which primarily include Option One and H&R Block Mortgage Corporation, which is the retail mortgage operation of H&R Block, again delivered strong results this quarter.

Consistent with our view that the interest rate environment should not have a dramatic effect on our levels of originations, we continued very strong nonprime origination activity in the quarter.

Pre-tax income during the second quarter rose to $184 million, an increase of 12% over the previous quarter and 20% over the year ago period.

Growth was driven by our anticipated solid increase in nonprime origination volume partially offset by expected declining pricing in the capital markets.

Second quarter loan production totalled $6.3 billion, an increase of 19% over the previous quarter and 64% over the second quarter last year.

Revenues for the second quarter were $351 million, up 16% over the previous quarter and 28% over last year.

Within our retail mortgage operations, we have shifted our focus toward higher margin nonprime production in anticipation of the expected slow down in refinance activity due to rising interest rates.

Second quarter retail nonprime origination volume grew 35% over the previous quarter and 40% over last year.

Consistent with our expectations, retail prime origination volume declined 54% sequentially and was down 44% over last year's comparable quarter.

Of the total number of the retail loans originated, nonprime represented 68% of the total compared to 43% in the previous quarter and 47% last year.

Overall our net gain on sale on originated loans was 387 basis points compared to 442 basis points in the previous quarter and 478 basis points last year.

This anticipated decline in our net gain on sale is within planned levels and is primarily the result of lower loan sale execution in the secondary markets.

We are focusing on managing our cost of originations to allow us to sustain our margin advantage within the overall non-prime market.

The weighted average interest rate charged to nonprime borrowers on new originations during the quarter was 7.5%, unchanged from the previous quarter and down from 8.2% a year ago.

At quarter-end, Option One servicing portfolio was $40 billion, an increase of $13 billion over last year and $6 billion over the previous quarter.

In the quarter the majority of our nonprime loan sales settled through the home loan sale market versus securitization due to comparatively superior execution in the loan market.

Of nonprime loan sales completed during the quarter, 79% were sold in the whole loan market with the remaining 21% securitized.

This compares to 41% whole loan sales and 59% securitizations over the course of our previous fiscal year.

The mix between whole loan sales and securitizations is dependent upon a number of factors, but it's highly dependent on how to best optimize the level of cash received from production in any given quarter balanced against the overall value that we receive.

By our usual methodology, cash proceeds from the disposition of second quarter loan productions were 51% of the recorded gain on sale.

The percentage of gains -- of cash gains was lower than usual in the second quarter due to the timing of loan sale transactions relative to quarter end.

Compared to previous quarters, more loans were in the warehouse at quarter end as we were selling a higher percentage of loans than the whole loan market.

The whole loan sales represented complete cash transactions.

They also typically require a longer lag-time between origination date and the ultimate settlement of the loans to the whole loan buyer.

The increased origination activity this quarter also contributed to a slightly longer loan disposition cycle time relative to quarter end.

We don't expect this lengthening of the loan disposition cycle to repeat in the coming quarter.

Price quality remains strong on our nonprime originations.

Our average FICO scores for nonprime originations average 611 for current quarter originations compared to 607 last quarter and 604 for the year ago quarter.

Average loan to value remains steady at 78%.

Delinquency trends continue to be positive.

Using data reflecting only loans that are 12-month seasoned and beyond, delinquency rates have been decreasing slightly since January of 2002, which represents the period of highest delinquency rates in the current economic cycle.

At the end of October, 31 plus delinquency rates were 12.9% compared to 14.8% in January of 2002.

We are using data reflecting only loans that are 12-month seasoned to factor out the positive effect that increased loan origination volumes would have on the overall delinquency rates.

As both our whole loan sales and securitization are nonrecourse transactions, it's important to note that our risk as it relates to loan performance is primarily limited to the valuation of residual assets and mortgage servicing rights on our balance sheet.

As we've discussed on prior calls, we model our origination -- our residual interest against historical prepayment experience, cumulative losses and forward interest rates.

We then discount the expected cash flows.

As the value of these residual assets is based on future performance we are continually monitoring the reasonableness of our assumptions relative to actual loan performance and performance in the market.

Our residual interest continued to perform better than expected primarily due to lower than modeled losses, slower pre payments and lower interest rates.

Accordingly, during the quarter we realized a net write-up in residual balances of $10 million which was recorded in other comprehensive income on the balance sheet net of deferred taxes.

It is significant to note that Standard and Poors recently upgraded several [INAUDIBLE] of our securitizations from calendar years 2000 and 2001 due to the better than expected performance of the underlying loans.

As I mentioned in our last call the continuing outperformance of our residual assets gives us an opportunity to sell residual assets to accelerate the realization of cash this year and that while we had no plans to do so, we were evaluating this as an option.

We have concluded that we are not likely to enter into a reneg transaction this fiscal year.

Let me conclude by reinforcing that we continue to manage the mortgage businesses to optimize cash, our originations remain very healthy, we are seeing the benefits of building a business serving the H&R Block tax client base and a small amount of residual assets that we have retained on our balance sheet is fairly valued.

Turning to business services, second quarter revenues increased 11% over last year to $109 million.

The increase was primarily driven by strong revenue growth in our capital markets business and improving performance in core accounting business.

The pretax loss was $3 million compared with a loss of $4 million last year.

The year-over-year improvement was due to increased earnings from capital markets and tax and accounting services offset by planned losses related to our payroll and benefits processing business.

While uncertainties remain in the business climate we are cautiously optimistic as we look to participate in a recovering economy.

This business which has strong seasonality also earns the bulk of its net profit during our fourth quarter and preparations for that point in our business cycle are progressing well.

Now you want to review some of the key balance sheet items.

Compared to July 31, 2003, there are several notable changes to the balance sheet.

Cash and cash equivalents decrease from $675 million at July 31 to $261 million at quarter end.

The decrease is largely attributable to payments made for the major franchise businesses, share repurchases, dividends and net changes in working capital at quarter end.

Cash requirements for the quarter were supplemented by short-term borrowings of $125 million.

Restricted cash increased by $43 million to $571 million.

This increase is primarily the result of higher segregated cash balances being held at our financial advisors business for the benefit of clients and at Option One for outstanding commitments to fund mortgage loans.

Prepaid expenses and other current assets increased $638 million from $472 million at July 31st.

The increase is primarily attributable to an increase in the receivable from warehouse trusts and Option One and servicing advances.

The increase in the receivable from the warehouse trusts is due to the timing of the loan sale transactions relative to quarter end and the increased pipeline activity that I mentioned earlier.

It's this increase that primarily drove the higher than normal percentage of noncash gains during the quarter.

Mortgage residual interest in securitizations increased $27 million during the quarter to $318 million.

The increase was entirely due to a NIM sale from late October that is being carried on our balance sheet at quarter end.

The structure of this transaction resulted in the accounting treatment requiring its inclusion on the balance sheet.

The offsetting NIM bond obligation is similarly being carried as other noncurrent liabilities.

The overall effect was to increase residuals by $40 million from the inclusion of this on balance sheet securitization.

Also increasing the balance was the addition of $2 million from our normal off balance sheet securitization and interest accretion of $37 million.

Offsetting these increases were cash receipts of $41 million and a decrease in net unrealized holding gains of $10 million which consists of $10 million write-up which I mentioned earlier, net of $21 million in gains that we realized this quarter.

We continue to focus on cash and minimizing balance sheet risk.

In that regard, it's noteworthy that our current residual balance of $318 million is $69 million or 18% less than the residuals at quarter end last year when they were at $387 million.

During the second quarter, we reacquired 2 million shares at a total cost of $95 million or an average cost of $42.30 per share.

Two million shares were issued for option exercises, employee stock purchase plan purchases and restricted shares.

You'll recall that this is our seasonably high option exercise period for our seasonal tax professionals.

For the fiscal year-to-date we reacquired 4 million shares at a total cost of $178 million or an average cost of $42.99 per share.

This is below the level of repurchase activity that we would like to have accomplished thus far.

As of October 31, there were 178 million shares outstanding which represents a decline of 2 million shares outstanding from the end of the last fiscal year.

Let me turn now to the -- our fiscal year outlook where we are cautiously optimistic on our tax season outlook.

We expect the environmental influences this year will be neutral as the slightly positive benefits of tax law changes will likely be offset by the continuation of the level of economic uncertainty that we saw last tax season.

Accordingly, growth in our tax businesses this year will be driven by internal factors including marketing effectiveness, growth in our distribution system, our multi-channel capabilities and enhanced programs targeted at retention.

As Jeff mentioned, we will provide you a more detailed look at our plans and expectations for the tax season at our January investment community meeting.

Our mortgage businesses continue to perform as we expected.

We are not seeing anything in the current environment that is causing us to alter this view.

As I've said for some time now while we have certainly benefited from the low interest rate environment much of our mortgage business growth has been achieved by our focus on controllable drivers within the business including systematic growth of our distribution channels and significant improvements in our closing ratio and average loan size.

The benefit of the low interest rate environment to our financial performance over the last couple of years has been on loan profitability rather than at the primary driver of originations.

We continue to focus on the controllable drivers within our mortgage businesses and our forecasting origination volume growth for the remainder of the fiscal year against moderated profit margins.

The progress within H&R Block financial advisors is good but we remain cautious when looking at the financial implications for this year.

Business services is performing very close to the expectations that we've had thus far.

We have growing confidence in the performance levels of all of our business units this year.

We are approaching forecasts for the former major franchise territories with caution given some of the short-term decisions that were made in those areas last year.

When we have made certain -- when we have made more certain visibility to the results from these operations we will provide more updates to you.

On that basis, we are now -- we now expect fiscal 2004 GAAP earnings per share in the range of $3.65 to $3.85 which would again be above our long-term growth target range of 13 to 18%.

Revenue growth is likely to be at the high end of our target range of 10 to 15%.

Included in these expectations is about $23 million or 8 cents per share of noncash stock based compensation expenses that are flowing through our income statement during this fiscal year at the segment level.

In conclusion I want to thank you all for joining us today.

The results that we reported today are indicative in my opinion the strength in our mix of businesses and the quality of the associates and management that we have across the company.

We remain focused on managing our businesses to improve operating performance, to drive additional growth toward the execution of our longer-term strategies while managing our capital allocation to reward shareholders.

Let me again remind you that we will be holding our investor conference in New York on January 14th and we hope you all will be able to join us for part of that day.

With that, operator, we'd be happy to open up the line for questions.

Ladies and gentlemen, as a reminder, if you do have any questions or comments, press star then the number one on your telephone keypad.

Your first question is from Michael Hodes from Goldman Sachs.

Hi, good afternoon.

Congratulations on the strong showing.

A few questions.

First on mortgage.

Mark, last quarter you were kind enough to give us an indication of what the pipeline was at the end of August.

I was hoping you would give us a flavor of what it is looking like here towards the end of November.

And along similar lines, seeing as you sell forward a lot of your mortgage volume, I was wondering if you could give us a sense of what that execution looks like.

It seems like you should know, to a large extent, what the January quarter execution is going to look like.

And then this lastly on mortgage before I go to my tax questions.

If you could just give us, perhaps, another cut at the rationale behind the longer time line in the warehouse.

I see that's distorted some of the numbers in a couple different areas on both the balance sheet and the statement of cash flows.

Sure.

Let me take a shot at those.

Our mortgage pipeline is still pretty strong.

It's about at the level, maybe slightly higher than the level we were at in August.

So we -- as we have anticipated within the overall business mix we are continuing to see our origination levels be very solid.

And so, you know, not only are we in good position for this -- you know with the results we are reporting but I think looking certainly into the next quarter and we believe, even beyond that, we think that the origination levels continue to look strong.

As far as forward sales, you're right.

We are sold forward for the bulk if not all of the expected volume that we have in pipeline today.

That's our policy, which is to either be forward sold or forward hedged on anything that we would expect that's in the pipeline in any of the different levels of the pipeline.

We are actually seeing good execution levels or execution prices in the secondary markets into our forward sales.

You know, they are consistent with, if not just a touch better than where we were at this quarter.

So all in all, I think we are expecting that the January quarter is going to be, again, strong for this business.

The point about the longer -- you know the loans being in warehouse longer than usual is a good point and let me sort of reiterate kind of what we are trying to describe.

We have, you know, historically had 50, 60% plus going into securitization.

We had about 40% of our loans -- this is last year's numbers, being sold as whole loans.

When you do a whole loan sale, the due diligence timing is longer than it is when a loan is going into a securitization because we were no longer on our schedule where we can control the schedule but rather we are on the due diligence schedule of the whole loan buyer.

It's always been our experience and we saw that this quarter when we are on somebody else's schedule while the price is locked in their final acceptance of the loan is subject to when they finish their due diligence and that can only happen on their schedule.

Because we shifted so much of our production to whole loan sales this quarter, we had carry-over in the warehouse that was sort of abnormally high.

I wouldn't expect that that's going to continue to be the case, but it was something that, you know, sort of happened as a result of, again, two things, really.

The substantial amount that we're selling as whole loan sales that were the schedule is a little bit harder to control, as well as the heavy origination levels.

You know, we are again up quite a bit in origination levels and moving that stuff through and out of the warehouse just takes a big effort.

You know, we're working on how to make sure that that, you know, keeps flowing.

But that's one of the consequences of growth.

Gotcha.

On the tax side, am I right in assuming that your guidance currently reflects no accretion from the major franchise purchases?

You know, I would tell you that we are -- what do I want to say about guidance?

We are trying to be prudent and cautious with our guidance.

And not get ahead of ourselves.

Having said that, I think that we are now -- you know, we are in a position where we can see what is, you know, from the operating performance from the major franchises.

For litigation reasons we are hesitant to put a specific number on that for operating performance for the coming year.

But I would tell you I think that guidance does include the major franchises.

This is obviously a drag in the second quarter.

Just lastly.

I don't want to monopolize the call.

Can you update us on the CFO search?

Sure.

We have -- I've talked to a number of what I think of as consider high quality candidates.

We are in the sort of second and third rounds of talking to two or three -- I guess three individuals, and I'm expecting that we are going for have the search concluded and somebody announced and maybe even on board by the end of December.

Thanks.

Thank you.

Your next question is from Chris Gutek with Morgan Stanley.

Hi, thanks.

Mark, a couple questions.

Could you give us a quick status update with the emerging Wal-Mart relationship with respect to how many locations you expect to have up and running.

Sure.

Let me have Jeff do that.

Chris we are looking at about 560 locations this year, and just as a bit of a disclaimer, know that those offices won't -- they are much smaller.

They are two-desk kiosks so they won't perform as a normal new office will.

And are you still assuming essentially neutral in fact at the bottom line?

Yeah, pretty close.

Okay.

Then with the -- with the franchise repurchases it looks as if you have spent another $120 million or so on the locations taken over.

Could you explain the purchase price allocation in particular I think it was 1.7 million of intangibles amortization in the quarter.

How are those -- how was the purchase price being allocated and what are we expecting going forward in terms of intangibles and amortization.

I am going to actually have Melanie Coleman who is our controller take you through that.

The allocation we have recorded at this point in time we have allocated approximately $83 million to goodwill.

We have allocated about $21 million to customer relationships and about $10 million to noncompete and the rest going to hard assets or property, plant and equipment.

So the customer relationships and the noncompetes are both amortizable.

The customer relationship is being amortized over ten years.

Ten years.

And the noncompete I believe is a three-year amortization period.

That's correct.

Based on the one lawsuit that's now been settled what is the likely increase in addition -- or the additional spending you are going to have to make to finalize all of these acquisitions?

This is a -- you know, this is a -- it's a tough one.

Clearly the, you know, the first case that was -- I won't even say it's finally finished, but it was resolved by the jury, you know, if that were the pattern and that one were applied properly, there's probably another $60 million of overall goodwill, roughly --

That's right.

-- That would be paid.

It's not clear to us that that will become the pattern for a whole host of legal reasons which I guess I'm going to beg off and not try to get into.

But, again, we think that, you know, in the end the economic consequence of this will be fair.

And the long-run will give us better control over the development of our system.

Okay.

Fair enough.

Final question is the corporate expense was down quite a bit both sequentially and year-over-year.

I guess that's net of corporate interest expense.

Could you explain what's driving that?

Yeah.

There was actually no one thing.

There were a list of about five things that drove that.

If I can remember them off the top of my head.

I know that we had -- last year we had some unusual health insurance items that were of 2 or $3 million that we, you know, were hit with in corporate which were overruns and some specific claims.

There was more interest expense of about $1.5 million to $2 million last year compared to this year.

There was about $2 million of deferred compensation.

Impact that was greater last year than this year.

You know, so there was no one thing.

It was kind of a collection of a variety of things.

Probably the other one which is probably notable and important to understand is last year due to some of the [ INAUDIBLE ] changes, we had about -- in this quarter about $2 million of investments into our finance function either systems or other investments that were one-time that went through last year that aren't repeating themselves.

So it was no one thing, it was a variety of things.

Great.

Thank you.

Your next question is from Michael Hodes of Goldman Sachs.

Wow, that was fast.

Some follow-up questions just on the mortgage side.

First, I was wondering, given the regulatory back drop on sub prime mortgage, I know there's been some tough laws enacted in a number of states.

Maybe you could comment on what's going on in New Jersey.

Secondly, just focusing in on the statement of cash flows, I noticed the usually the additions to trading securities due to the residual interests in securitization, the proceeds from net interest margin transactions tend to roughly match, but there was, you know, a pretty wide variance this period, and I was just curious it doesn't seem like that would be related to greater whole loan sales.

I was wondering if you can elaborate on that.

I can touch on both those.

On the regulatory front there are probably two things we are obviously very actively involved with and paying attention to.

The one is the is the state by state regulation and all the things that swirl around that topic in general.

The law that becomes effective in New Jersey in December, we think will have the effect of having people like us shrinking or reducing our participation in that market and that is currently our likely course of action.

I think that, you know, over time this may end up being something similar to what happened in Georgia where I think, you know, the state will identify, people within the state may come to identify that well intentioned law has consequences that they didn't see coming, and will modify it.

But, you know, what that means is that we will -- you know, we will sort of pull back from that market until there's better position relative to the regulatory environment.

We originate about $150 million a month of our production comes from New Jersey, and we would expect that to shrink pretty substantially if not completely, you know, starting December.

So that will have an effect on us.

As far as the statement of cash flows is concerned, the key thing which I mentioned that there was a NIM transaction that was -- a NIM securitization that remained on balance sheet at the end of this quarter, and that -- and it's sitting in our residual balances.

That's the reason because of that one NIM transaction that remained on the balance sheet, that the proceeds from NIM transactions or net interest margin transactions is off.

The offset is down in the cash flow financing activities where you'll see a new line item called proceeds from issuance of securitization financing.

That is the proceeds from the NIM transaction, and that's where you put the proceeds from the NIM transaction when it is on the balance sheet.

So that's why the two are different.

Gotcha.

Thanks a lot.

Okay.

Thanks.

Next question is from David Deppeto with Ray Muse Capital.

Hello, gentlemen.

Hi, David.

I'm wondering if you can walk mow through the effect on the top line in the tax preparation business from these acquisitions, and just kind of give me a feel going forward, you know, what sort of incremental revenue that will give you versus the last fiscal year.

And I guess the second part of that is what we should expect in terms of margins in the tax preparation business considering that they went up this year versus last year in the second quarter.

Yeah.

You know, I'm going to -- I'm going to give you a sense of the revenues and I'm going to have Jeff talk a little bit about margins.

We will go in much more depth and talk about the margins and the various things we have going on when we meet in January.

The impact on a reported basis for the major franchises now being part of the reported company operations will be between 100 and $110 million of incremental revenue.

So that's the top line effect.

That's for the full fiscal year?

That's for the full fiscal year, yes.

Okay.

That's consistent.

One of the things we need to point out about this transition that is occurring is we started taking over the -- we took over the operations and started incurring the expenses as of various different times, September, October primarily, and now during the balance of our third and fourth quarters.

On the other hand, virtually all the revenues from this business come in through January through April.

We will have a disproportionately good year this year margin-wise and that will fall back to more normal margin levels next year when we have a full off-season of expenses.

Jeff, do you want to talk about margins generally?

Yeah, I would say we would still expect to have to increase in our operating margins X the major franchise.

I mean we'll clearly have an increase in margins from that, but we'll be able to talk after tax season about those operational segments separately so that we can isolate the performance of the core business.

But even given the new offices in Wal-Mart, we would expect to see increases in margins coming from some of the efficiencies that we have been able to build into the system over the last several years.

And I think -- the thing I would add is we are starting to see the effect of that this quarter.

You know, this was within the tax business, even with a much larger network of offices, and a lot of other costs that were new this quarter, we, you know, really managed the entire business to be, you know, expense flat relative to where we were a year ago when you net out all the sort of new moving parts.

And I think that is, you know, just outstanding performance that we are seeing all across the management team and the people who are making that happen in the system.

That's part of the early, you know, things we had to do to continue to improve the margins in this business generally.

So I guess for modeling purposes I should look at it -- I should basically use the assumption on a dollar basis that the expenses are going to remain flat in the tax prep business in fiscal '04 despite the increase in revenues you get from the acquisitions?

I would say the expenses won't remain flat.

I would say you would see proportionate expenses relating to the incremental revenues as we see in our normal operations.

And then there would be a fairly big Delta between those two items.

Okay.

The one last question is in the guidance that you guys gave today, what sort of revenue growth are you looking for in the tax prep business?

Like what's kind of baked into those numbers?

Well, if you include -- if you include the majors in this, you know, you're -- I mean the tax business will have revenue growth probably better than any of the other segments of our business.

Better than mortgage?

Yes.

In revenue percent -- on a percentage basis?

On a year-over-year basis, I would expect that.

Thanks for your time.

Next question is from Adam Taylor with Cove Asset Management.

Hi, guys, congratulations on a strong quarter.

Thanks, Adam.

First question I have is the interest income in the mortgage segment.

I was looking and it's up dramatically from the July quarter $42 million versus $27 million I was wondering if you could give me some idea why the increase.

That was primarily driven by -- because of moving toward whole loan sales and the longer due diligence cycle for loans that are going to whole loan buyers we had them in warehouse longer and that's what drove higher interest income in that part of the business.

It's a little bit of an offset that occurs because, you know, we get probably -- at different times you get different execution in the whole loan versus the securitization market, you know, the slightly longer holding period time in there is providing a little bit more interest income.

Again, we would not expect that to be happening on a recurring or regular basis.

It's sort of a unique thing that's happening this quarter because we've shifted so much of our sales to whole loans.

Okay.

And secondly, how much of the revenue -- do the loans in the warehouse contribute to the mortgage results?

I'm sorry, can you say that again?

Sure.

How much of the revenue do the loan in the warehouse contribute to the mortgage sales results?

If there was any or if there was any gain on sales from the loans in the warehouse?

You know we have to book those at sort of the expected values that they are committed to go out and I don't know what that is exactly off the top of my head.

What I can tell you is about -- somebody is telling me about $154 million.

The thing you should know is that those loans, even at this point, are now already out of the warehouse and they have probably moved on.

So that balance has already been received by the company.

It doesn't sort of sit there and have risk associated with it for very long.

Okay, great.

Thanks.

Thanks.

Next question from David Abrams with Abrams Capital.

Hi, guys.

Hi, David.

I was wondering if you could give a little more color on shifting more loans into the whole loan sale market versus securitization, some of the pricing, just a little more color?

Sure.

You know, what we are seeing is that there is a -- you know, pretty active whole loan market right now, and that, you know, that the pricing that we're able to achieve there exceeds what our models would say we would likely get if we did a securitization.

We have chosen -- it used to be we would trade off and go wherever the best prices were.

We have shifted that strategy only slightly to sort of keep one foot in both markets.

Both securitization market and the whole loan market so that we kind of keep our secondary market activities active in both parts of the market and sort of keep very current on what's happening.

But right now, you know, without naming buyers on the whole loan side which I don't think would be appropriate, we are seeing a number of people who have, for various different reasons, either balance sheet reasons in some cases for, you know, the desire to, you know, control their own securitization on the other side, we're seeing a lot of very active buyers.

I think, you know, my personal sense of that is that some of it's due to the slow down in the refinance activity in the traditional mortgage business which has left a lot of excess capacity in the securitization staffs that are around, and they're looking for product to keep their pipeline, you know, active, and that means that whole loan pricing is pretty strong.

That would be, I think, you know, the primary speculation for why it's doing as well as it is right now.

Can you give any rough indication about how much the pricing was up on the whole loans quarter-over-quarter?

Well, I know it better sort of looking forward.

You know, we are seeing 20, 30 basis points even in improvement in the whole loan prices that we are expecting going forward.

So, you know, while we have expected that they would be shrinking, the fact is they are actually getting a little bit stronger.

Who knows how long that will last and we are kind of active in the forward sale market on a regular basis.

So, you know, we are keeping pretty close to that, but so far it's holding up very nicely.

Thanks.

Next question is from Michael Millman with Millman Research.

Thank you.

I have some actually tax questions.

One, I just wanted to make sure I understood that on the major franchise business, you're going to get a better margin than you were getting before when you were getting royalties without any costs attached to them.

And secondly, I think you've indicated more recently that you believe that the attrition -- part of the churn going to digital was more than you thought.

Maybe you could talk about how much you think went from part of the churn to digital last year, how you expect to promote to get some of that back, where you expect to get it back mostly in box or in web.

Maybe you can also compare the profitability of office and box and web.

And then, compare your thinking on the growth with what Intuit is looking at which is about a 10 to 20% increase in digital.

Thank you.

Sure.

Now, some of that I think maybe Intuit has made those comments not us.

In a particular I'm sort of seeing more movement to digital from professional than what was anticipated.

I don't think -- certainly against our expectations the movement we see in the industry from professional to digital actually we think about it as moves between paid and self and within self you get different movements between paper and pencil and software and online.

So there's a bunch of shifting going on.

Our observation is not that you're seeing more shifting than we had anticipated.

But I'm getting ahead of myself.

I'm going to have Jeff talk about the margin point and we can come back and talk more about digital.

Sure.

Michael, on the margin point you're absolutely right.

The absolute margin on the royalties coming from the major franchises as a percentage is significant, you know, somewhere close to 95, 100 -- between 95 and 97% of that is profitability.

But in absolute scale, the absolute scale as Mark indicated the 100 to $110 million the absolute dollar scale on that is sufficient to give us a higher -- a higher margin when you add that into the core tax business.

So even though we're going to lose some dollars in royalties, the absolute profitability because we don't have the off-season expenses in the tax business will actually have the effect of moving up the tax margins in a way that is not sustainable.

We will fall back to a normalized level in FY '05.

The absolute profit will grow but the margin itself will not.

Okay.

Thank you.

Can you give us an idea of how much that margin is going to differ from the business X major or what the increment might be?

Yeah.

It -- it will be higher.

I mean one of the things that you heard Mark talking a little bit about is that, you know, we have some concern on what's going to happen with the major franchises in general.

I'm sorry, the major franchise territories in general.

Not that we don't think they will perform, we think they will perform fine.

We want to be careful and cautious about allowing expectations to get ahead of absolute performance.

We think the margins will be higher.

At the investor day we'll give more insight into what we think that will look like in January.

But for right now, it's just -- it wouldn't be prudent to give any more color on that topic.

In general, you know, we are looking at our expectations for the major franchises kind of at the low end at least are guiding with that view toward the low end of our major franchise expectations knowing that there's a lot that we will better understand as that -- as we get into tax seasons and we see the effects of some of the things that were done last year in those territories.

I want to come back to the digital point and just speak briefly about our overall digital strategy and I guess the positioning we have and I'm not sure we're in a position necessarily to talk about what that will translate into for the upcoming season per se and frankly, it's, you know, I wish this weren't the case, but the business is really immaterial to us so anything I tell you probably has more relevance to Intuit than it does to us.

You know overall we have had a strategy of moving toward a more blended channel where what we are trying to do is position that you can access H&R Block's professional tax services and tax professionals whether that's, you know, in our offices or across the web or by having one of our tax professionals work with you when you have been a software client and using that as a point of differentiation that we think we can -- we think we can win with.

Our research would say there's a segment of the population where that is an attractive element that isn't available generally and will play well for us.

We are looking at that and we think that's a good position for us to take.

But, you know, this market is still fairly fluid software market generally is probably more stable both in the product set that works as well as distribution strategies that work out there, you know, we could tell you there's no major changes coming in the distribution arrangements for software this year as much as we wish there was, there really isn't.

And, you know, online which is where the real growth is in the digital space these days, is a little bit more of an open market.

I think, you know, there depending on your brand name and how you promote the business, you can -- you can do more.

You know, our real overall strategy is to, you know, capture people who are going to go digital and who would otherwise go to one of our competitors whether that's out of the H&R Block base or somewhere else and get them to stay with H&R Block.

Are you going to increase your spending in order to get them to do exactly that, particularly pointing at those who want to go digital?

Yeah.

No.

You know our general strategy on maintaining our keeping people within our base wherever they are going to end up wanting to go.

We have been working hard to model and try to anticipate or identify whether we can anticipate where people -- who's likely to trend and where they are likely do go.

To the extent we can model that and we have increasing earnings now for the last couple of years, we will be more aggressive within our own base to move them to the channel they are most likely to want to get to on their own.

And what's your guess as to -- or what's -- of the roughly 5 million churn you had last year, how much of that went from professional to DYI?

To DYI?

About 50% and about that 50% about half, a little less than half went to a digital solution.

Okay, great.

Thanks, Mark.

Next response is from Adam Taylor with Cove Asset Management.

Hey guys just a quick follow-up.

I wanted to make sure the 150 million in gain on sale was from loans in the warehouse did I get the number right and everything?

I think that's -- yeah that's the revenue it's not the gain it's the revenue.

Was there any gain in sale from that?

Oh, sure.

It would probably be our typical margin so it's been maybe half of that, a little less than half of that.

Okay.

All right.

Great.

Thanks.

There are no further questions at this time.

Great.

Thanks for, you know, on a holiday week taking time with us.

So we want to thank you for joining us.

As always if you want more clarity on anything we've discussed, please feel free to call us.

Thank you very much.

Thank you, ladies and gentlemen, for participating in today's teleconference.

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