H & R Block Inc (HRB) 2005 Q1 法說會逐字稿

Good afternoon, my name is Derrick and I will be your conference facilitator today.

At this time, I would like to welcome everyone to the H&R Block first-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 press star, followed by 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 and Chief Executive Officer.

Sir, you may begin.

Thank you.

Good afternoon and welcome.

Thanks for joining us to discuss our fiscal 2005 first-quarter results.

With me today are Jeff Yabuki, our Executive Vice-president and Chief Operating Officer;

Becky Shulman, our Vice-president and Treasurer;

Melanie Coleman, Vice-president and Controller and Mark Barnett, Director of Investor Relations.

I have also asked Bob Dubrish, who is President of our mortgage operations, to join us both this quarter and for the quarters going forward to provide another level of depth of discussion around that business to the extent that it's appropriate.

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 press releases and in H&R Block's report on Form 10-K, Form 10-Q, Form 8-K which are on file with the SEC.

In conjunction with today's call, there is some supplemental financial information that's been posted to the Investor Relations section of our Website at hrblock.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.

Before discussing our results, let me mention a couple of housekeeping items.

We will be holding our annual shareholders' meeting on September 8, at 9 a.m. central time here in Kansas City.

For those of you that are unable to attend a Webcast of the meeting will be available on our Web -- from our Website.

Also, we have tentatively scheduled our annual investment community conference for January 12, of 2005, which we will again host in New York.

The details concerning the conference will be provided in the early fall.

You may have already noted that we have made a couple of changes to the presentation of our financial statements.

First, in response to a request by the SEC in connection with their recent review of our periodic filings, we have modified our income statement to present aggregate costs related to our services revenue.

This differs from our previous practice of presenting operating expenses by their natural classifications on the face of our income statement.

Second, we have aggregated the U.S. tax service and international tax service segments into a single tax services segment.

These businesses have similar operating characteristics and presentations of results of a single reportable segment more closely reflects how we view the businesses.

We will continue to report foreign revenues and operating results in our SEC filings, but will no longer include a detailed discussion of our international business unless there's something noteworthy to report.

We've included fiscal '04 results by quarter under the new reporting format in the appendix to the supplemental financial information that's posted on our Website.

To assist you with the transition, the supplemental information continues to show U.S. tax services and international tax services separately, which we will continue for the remainder of this fiscal year.

We will also post FY 'O3 results by quarter on our Website within the next couple of weeks.

Finally, for some time now we've been providing a fair amount of statistical data, particularly related to our mortgage business, in the text of our prepared remarks.

We will continue to provide this data in the supplement to our -- on our Website but we will -- will comment on it only if there's something noteworthy to report.

Let me also take a moment to comment on several additions to our senior management team.

I'm very pleased to welcome Tim Gokey to H&R Block.

As we recently announced, Tim has joined us as President of our tax services businesses.

Tim brings with him a deep understanding of our tax business acquired through his work while a partner with MacKenzie & Company, including extensive work related to our tax office network expansion, pricing strategies, and differentiating H&R Block through advice-based services.

Tim's knowledge of our tax business combined with his broad business and financial services experience make him an excellent fit for our organization.

I expect that we will be in a position to be announcing the addition of two other key individuals to our executive team in the coming weeks.

In particular, we are in discussions with a CFO candidate and expect this position to be filled in the coming weeks.

Let me turn to our first-quarter results and then we'll provide our outlook for the remainder of the fiscal year.

First-quarter results, as I expect you have seen, declined $49 million to a loss of $44 million or 26 cents per share compared to net income of $5 million or 3 cents per share in the year-ago quarter.

Revenues declined 3%.

Results for the quarter were primarily driven by the expected decline in earnings for mortgage services and to a lesser extent off-season expenses in our tax business from the inclusion of the former major franchise territories not included last year.

It's important to note that our first-quarter results and in particular those from our mortgage segment, were generally consistent with our internal expectations for the quarter.

And we believe we are on track to meet our full-year performance expectations.

Our results include $5 million in stock-based compensation expense compared to $1 million last year.

The increased expense is due to the fact that we are in our second year of our three-year phase-in for expensing stock-based compensation.

Reflecting our commitment to remain focused on deploying excess capital in ways that drive value for our shareholders, we continue to devote a substantial majority of our free cash to share repurchase.

During the first quarter, we reacquired 7.5 million shares resulting in a 4% decline in shares outstanding compared to April 30.

Before discussing the specific financial results of our business segments, let me comment on a couple of points.

As I said earlier, the performance of our mortgage businesses this quarter was generally consistent with our expectations.

The primary driver of the significant decline in earnings from the previous quarter was significantly lower loan-sale gains caused by interest rate volatility, which offset strong loan origination volume growth and a tough comparable due to the inclusion of $24 million of gains from the sale of residual assets in the previous quarter, compared to no similar transactions in the first quarter.

There were also a couple of other negative comparisons impacting earnings, which I will discuss in my detailed review of the mortgage segment results.

While it's difficult to assess shareholder expectations, based on First Call estimates and results announced by other non-prime originators during our quarter I suspect that some of you may be surprised by the magnitude of the decline in first-quarter earnings from our mortgage operations.

While I hope I'm wrong, my concerns for our shareholders today is that some may attempt to assess the performance of our mortgage business and its outlook for the remainder of the fiscal year against what was an inaccurate expectation for the first quarter, rather than an assessment based on the fundamentals of the business.

Therefore, let me review our analysis of how rising interest rates are likely to impact our mortgage segment results.

As we have consistently said for some time, we believe revenue and earnings from our mortgage segment are not as cyclical compared to the prime mortgage business.

This statement is predicated on our view that we believe we can continue to grow non-prime origination volume even in a rising-rate environment.

At the same time, we also have consistently said that while the interest rate environment does not appear to have a dramatic affect on our levels of non-prime origination, it does affect our profit margin and we expect margins to compress in a rapidly rising rate environment.

On several of our previous conference calls, we have discussed the detail of the impact rising rates can have on our margins over the short term.

We've indicated that in our view, a normalized margin for the non-prime loan originations is in the 200 to 225 basis point range but over the last several years, we have earned abnormally high margins due to the prolonged period of low and declining interest rates.

We've also discussed that when rates begin to rise, we can see significant short-term margin compression below the normalized range.

This expected margin squeeze results from the fact that non-prime mortgage rates charge to borrowers tend to lag movements in market interest rates.

Therefore, in times of rapidly rising interest rates, loan sale pricing is reduced because non-prime mortgage rates do not rise as fast as market rates.

But it is our general expectation that as non-prime mortgage rates begin to catch up with mortgage rates, we would again experience more normalized gains.

When we announced our fiscal '05 guidance on June 9, we anticipated precash income in our mortgage segment to be flat to slightly down for fiscal '04 -- from fiscal '04, excluding the $41 million of gains from the sale of residual assets that we had last year.

In formulating that guidance, we anticipated and communicated to you that we expected higher volatility and interest rates to compress margins during the first and second quarters, but margins should normalize during the second half of the year.

What we actually saw during our first quarter is completely consistent with those expectations.

The significant increase in rates that occurred in April and early May resulted in lower loan-sale gains as we expected, which was partially offset by strong loan origination volume growth and, as we move into the second quarter, we are starting to see our loan-sale pricing catch up with the market-rate increase.

Based on what we are seeing -- we see going on in our mortgage business, full-year results for our mortgage segment remain on track with what we shared with you on June 9.

I'm going to discuss the factors affecting our outlook in more detail later.

It was clear back in June that there was a significant disparity between our internal expectations for first-quarter mortgage results versus First Call estimates.

On June 9, conference call, we pointed this out when we said, although we do not generally provide quarterly guidance, given the impact of rising interest rates on the mortgage business along with comparability issues in the tax business, due to the former major franchises, it's necessary to provide some insight into our first quarter given the current Street estimates for fiscal '05.

We then went on to specifically comment that we expected lower mortgage segment earnings in our first and second quarters.

Unfortunately, following our remarks, there was only a modest change in First Call estimates for the quarter.

Before leaving this topic, I think it's appropriate to review our policy on guidance.

As I hope you know, we as a management team are very focused on creating superior returns on capital for the benefit of our shareholders by taking a long-term view and staying focused on achieving long-term objectives.

We are also committed to transparency and an open and candid dialogue with our shareholders within the legal constraints on disclosure, which we take very seriously.

Consistent with this view, our policy is to provide guidance on an annual rather than on a quarterly basis.

In our view, quarterly guidance places too much emphasis on achieving short-term results which can come at the expense of longer term objectives.

Moving on to an overview of results from our other businesses -- business segments, within our tax business, our off-season spending during the first quarter was within our planned levels.

Our office network expansion is progressing well and we continue to refine our strategic and tactical plans for the upcoming tax season.

I'm pleased with the progress that we're making in business services, top line growth benefited this quarter from some of our strategic growth initiatives, and I'm increasingly optimistic that our business development activities are gaining momentum as we progress through this fiscal year.

Investment services performance in the quarter was disappointing.

Results for the quarter fell below our internal expectations driven by weakness in retail investor sentiment, and we didn't reach our target for the number of advisors.

Let me ask Jeff to review results for several of our business segments.

Thanks, Mark.

Our cash services segment which now includes U.S. and international tax services, payments related to refund anticipation loans, and digital tax solutions, increased revenues 10% over last year.

The primary contributors to the higher revenues were our Peace of Mind service and inclusion of results from the former major franchise territories.

The pre-tax loss to the segment increased 14%.

The increased loss over the year-ago quarter was primarily driven by off-season losses related to the operations of the former major franchise territories of $9 million, along with the expected increase in occupancy costs for the year -- for the quarter.

As Mark said, our office network expansion efforts are progressing well.

We remain on track to add between 500 and 600 Company-owned regular offices this year, along with some expectation of limited office expansion within our franchise system.

Additionally, we expect to add about 400 Wal-Mart locations for the upcoming tax season.

Roughly half of which will be in Company locations, and the other half in franchise territories, bringing our total to approximately 900 Wal-Mart locations with H&R Block tax services.

We believe that alternative distribution partnerships like Wal-Mart along with our long-standing Sears relationship represent efficient client-growth opportunities which complement our regular office network.

We have a number of strategic initiatives underway to enhance our overall market-leading position and to deliver sustainable client growth.

For competitive reasons, I'm not going to provide details at this time.

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

In our digital tax businesses, we continue to be confident about the strength of our digital offerings.

In particular, we believe providing clients the flexibility to choose their preferred method of tax preparation each and every year while staying within the H&R Block family is an important advantage over our competitors.

While it is too early to discuss our plans for the upcoming year, we are continuing to look for ways to aggressively capture market share and to build long-term branded relationships with those consumers.

As we said, in addition to increasing the size of our office network, we must continue to differentiate our brand and services, increase loyalty, and enhance client acquisition.

As most of you know, one of our key long-term strategies is to consistently deliver high-quality tax and financial services to Middle America, differentiated on the basis of relevant and actionable advice, accessible to consumers in the channel of their choice.

Our confidence in this strategy is based in part on the improving customer satisfaction scores we have seen over the last two seasons, including our clients' view of price-value satisfaction, which we believe is in part linked to the actionable advice we are now providing clients.

We are also seeing significantly higher retention rates among tax clients who have multiple relationships within the brand.

Overall, we believe we are on the right path.

Turning to investment services, first-quarter results were somewhat disappointing as we saw a return to equity market weakness resulting in a decline in retail investor activity.

Revenues for the quarter declined 6% compared to last year's first quarter, and decreased 14% sequentially.

The pre-tax loss was $18 million in the first quarter, compared to a pre-tax loss of $14 million in last year's first quarter and a pre-tax loss of $23 million in the previous quarter.

All of these quarterly loss figures include $7 million of intangible amortization, the increased loss over the first quarter of last year was due primarily to lower revenues.

Total production revenue decreased 12% from the prior quarter and was essentially flat compared to the prior year.

The decline in production revenue over the prior quarter was driven primarily by lower trading volume.

First quarter trading volume declined 14% from last year and 21% compared to the previous quarter. 48% of production revenue came from mutual funds, annuities, and fee-based accounts compared with 34% in the first quarter last year and 43% in the prior quarter, which is consistent with our strategy of transitioning from a transactional to an advice-based business model.

We continue to look for ways to strengthen the financial services opportunities within our tax base.

As of July 31, we had over 1,000 tax professionals licensed or completing the licensing process to become active members of the financial planning team.

Our data shows that when tax professionals team up with financial advisors, we gain more tax clients, gather more financial assets, and increase overall client loyalty.

In terms of growing our revenue base, we continue to recruit experienced financial advisors as a way to leverage existing capacity and better serve our tax clients.

First quarter recruiting efforts were mixed.

We were ahead of internal expectations in terms of the number of recruits but below expectations in terms of the production level of those recruited advisors.

As anticipated, we did see considerable improvement from our fiscal '03 and fiscal '04 advisor productivity and continued to be very pleased with those recruiting classes.

However, the total number of advisors remained essentially flat this quarter, due to advisor attrition.

Our advisor retention for the higher producing advisors remains very strong.

We continue to expect to have a net increase of 150 to 200 advisors by the end of the fiscal year.

Now, I'll turn the call back to Mark for a review of our mortgage and business services operation.

Thank you, Jeff.

Results in mortgage services -- the mortgage services segment, which as you recall includes Option One and H&R Block Mortgage, reflect higher origination volumes and lower pricing on our loan sales as expected.

First-quarter loan production increased 28% over the year-ago quarter and 9% from the sequential quarter.

Revenues for the first quarter were down 8% over last year and 24% over the fourth quarter.

Excluding the $24 million gain from the sale of residual assets in the fourth quarter, first-quarter revenues declined 18% over the previous quarter.

Pre-tax income during the first quarter declined 43% over the year-ago period and 47% over the previous quarter.

There were four primary drivers of the sequential decline in pre-tax income.

First, gains on sale of mortgage loans decreased $40 million.

Our net gain on sales declined 82 basis points or about $56 million due to the significant upward move in interest rates that occurred in April and into May.

This was partially offset by $16 million of additional income associated with incremental volume growth compared to the previous quarter.

Overall, our net gain on sale, or if you want to think of it as gross margin, on originated loans, was 207 basis points compared to 289 basis points in the previous quarter and 364 basis points last year.

You should note that the net gain on sale is a new metric that will tie directly to the GAAP income statement.

This metric reflects the new gains on sales from loans originated during the quarter, including mortgage servicing rights and will less net origination expenses or the variable costs associated with originating loans and correspond to the revenues related to gains on mortgage loans on our income statement.

This new metric directly reflects the pricing on loan sales at the time of origination, and more directly allows assessment of revenues generated in the quarter, related to origination activity.

This new metric should be distinguished from the execution price, which sometimes previously had been referred to as net gain on sales.

The execution price is defined as total premium received divided by the total balance of loans delivered to third-party investors or to securitization vehicles.

The second driver of the variance this quarter from the previous quarter included a -- included the fact that in the fourth quarter there was a $24 million gain from the sale of residual assets compared to no similar transaction during the first quarter.

Third, accretion income from residual assets declined $24 million.

The decline in accretion income is primarily the result of the sales of residual assets during fiscal 2004 which has the effect of eliminating future accretion.

As we have reduced the number of securitizations that we have done in favor of whole-loan sales in the past 18 to 24 months, the net result is a less accretion income.

And fourth, initiatives -- we had a number of initiatives designed to enhance our market position and drive origination growth that resulted in about $6 million of incremental operating costs this quarter.

The primary driver of the decline in our net gain on sales of mortgage loans was the rapid move up in interest rates we experienced in April and May.

We priced the interest-rate charge to the borrower, often discussed as the weighted average coupon or WAC, against the two-year swap.

The two-year swap rate began to rise in early April and rose about 100 basis points in a very short period of time.

Non-prime mortgage rates charged to borrowers tend to lag movements in market interest rates.

Therefore, in times of rapidly rising interest rates, our loan sale pricing tends to decline because our WAC tends to lag market rates.

At the same time, what we saw in origination volumes during the quarter was consistent with our view that the interest-rate environment does not have a dramatic affect on our level of originations.

As we said, the most critical management factor in this transitional period until rates stabilize is how effectively we price loans.

During the quarter, we realized on average, interest rates charged to borrowers or WAC on new originations of 7.21%.

This compares to a weighted average of 7.06% in the previous quarter and 7.54% a year ago.

In both rising and declining rate environments, our market pricing adjusts with a lag to the secondary market rates.

This reflects our relationship orientation with mortgage brokers and the impact this has on our sustainable service advantage with brokers.

But in times of rate transitions, which we are in, our pricing catches up with a lag that typically lasts one to two quarters.

We expect that we will recover approximately 50 basis points of margin through price adjustments coming through now in our second quarter and to be back to normalized margins by our third quarter.

This should be distinguished from our hedging strategies, which performed as expected during the first quarter.

As you know, we use forward sales of non-prime production as our primary hedging strategy, and there was no change in that strategy during the first quarter.

However, interest rate volatility did impact pricing of new forward loan-sale commitments reflecting that the market adjusted more quickly than we adjusted our WACs resulting in lower margins.

Within our retail mortgage operations, we have shifted our focus toward higher margin non-prime production due to the slowdown in prime refinance activity.

First-quarter retail non-prime origination volume grew 70% over last year, and 18% over the previous quarter.

Consistent with our expectations, retail prime origination volume declined 60% over last year's comparable quarter, and 31% on a sequential basis.

Of the total number of retail loans originated, more profitable non-prime volume represented 74% of the total.

In the quarter, 100% of our non-prime loan sales settled through the whole-loan sale market versus securitizations due to what we see to be comparatively superior execution in the whole-loan market.

The mix between whole-loan sales and securitizations is dependent upon a number of factors but is highly dependent upon how to best optimize the level of cash received for production in any given quarter balanced against the overall value received.

Credit quality, average loan to value and delinquency trends all remain positive. 12 months seasoned and beyond, delinquency rates have been decreasing steadily since January of 2002, which represents the period of highest delinquency rates in the current economic cycle.

At the end of July, 31 plus delinquency rates were 11% compared to 14.8% in January of 2002.

As both our whole-loan sales and securitizations are non-recourse transactions, it's important to note that our risk, as it relates to loan performance, is primarily limited to the value of residual assets in mortgage servicing rights on our balance sheet.

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

Our residual assets continue to perform better than expected, due primarily to lower than modeled losses.

Accordingly, during the quarter we realized a net write-up in residual balances of $54 million, which was recorded in other comprehensive income on the balance sheet net of deferred taxes.

Of note for those of you who will try to model the accretion that this write-up will create, the bulk of the write-up that we are now taking is against residuals that we originally booked at zero value.

As a consequence, accounting rules will result in a delay in the accretion in the income of this write-up generally until cash flows begin to -- to be received.

In this case, the bulk of the accretion related to the write-up will not start until fiscal 2006.

Turning to business services, first-quarter revenues increased 11% primarily due to strong off-season growth in tax, accounting, and consulting.

The pre-tax loss was $10 million compared to a loss of $7 million last year.

The increased operating loss was primarily the result of planned investments in marketing and business development initiatives and higher compensation and liability insurance costs.

In addition, last year's first-quarter results benefited from a backlog of business in our capital markets business at the end of fiscal '03, creating a difficult comparison.

We are making good progress on our strategic growth initiatives, including the development and implementation of a marketing and sales infrastructure to support our business development activities.

Overall, I think we are well positioned to capitalize in some of the dynamics taking place in the industry.

While we still face a cautious business climate, much of the revenue growth this quarter is attributable to growth initiatives, which is very encouraging.

The next six months will be an important time to capture new business, leading to the segment's full-year financial performance that is seasonally driven and biased towards the fourth quarter.

Now let me review some of the key balance-sheet items.

As compared to April 30th, 2004, some notable changes to the balance sheet, you'll note that cash and cash equivalents decreased from 1.1 billion to $317 million, primarily due to the normal things that we do in our first quarter.

Mortgage residual interest in securitizations increased $22 million during the quarter to $233 million.

Decreasing the balance were cash receipts of 39 million and impairments of $3 million.

Increasing the balance was accretion of 26 million and an increase in net unrealized holding gains of 39 million, which is -- consists of 54 million write-up net of $15 million in realized gains.

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

During the first quarter we reacquired 7.5 million shares, at a total cost of $347 million, or an average cost of $46.56 per share.

A total of 603,000 shares were issued for option exercises, Employee Stock Purchase Plan purchases and restricted shares.

As of July 31, there were 166 million shares outstanding.

Let me now turn to an update of our performance expectations for the remainder of this year.

Within our tax segment as we shared with you in June, we are investing in office network expansion and exploration of alternative business models that we believe will strengthen our market position and growth potential.

While these initiatives will not require substantial incremental capital, network expansion will impact the operating margin and profitability in the early years.

Our full-year expectation for the tax businesses remain unchanged from what we communicated in June.

For planning purposes we are assuming high single digit revenue and margins flat with fiscal '04, in effect absorbing the growth in offices into our current operating margins.

Within our mortgage businesses, the increase in rates charged to borrowers implemented during our first quarter will benefit our second-quarter results.

We currently expect an approximately 50 basis point improvement in our margin on loan sales compared to the first quarter.

Our planning assumption is that interest rates will continue to rise through the remainder of our fiscal year but in a slower less volatile manner.

And as our non-prime mortgage rates continue to catch up with market rates as our fiscal year progresses, we expect more normalized gains on sale occurring in the third and fourth quarters.

Based on this assumption, we continue to expect pre-tax income in our mortgage segment to be flat to slightly down from fiscal '04, excluding the $41 million gain from the sale of residual assets that we had during fiscal '04.

In our business services segment, we continue to expect moderate growth in our core accounting and tax services, and another strong year in our capital markets business.

Our investment in a number of start-up businesses will moderate our reported results again this year, but we believe overall performance for the segment will improve and be very solid.

In our financial advisor business, we revised our internal expectations to reflect at least what has so far been weaker retail investor sentiment than we expected going into the fiscal year.

We continue to believe that this business has been positioned in a way that allows us to compete effectively as the investment climate improves and we benefit from refinements in our business model.

While we expect some improvement in financial performance in fiscal '05, we will still operate at a loss for the year.

On a consolidated basis, we continue to expect fiscal '05 earnings per share in a range of $4 to $4.25 and revenue growth in the high single digits.

While this EPS growth is below the 29% compound growth we've achieved over the last five years, primarily due to the likely flattening out of mortgage gains and therefore earnings in '05, it's important to note that over the longer term, we continue to expect a target earnings per share growth of 13 to 18%.

As we have consistently stated with respect to our long-term guidance, in any given year we may exceed that range as we have over the last several years, and in some years, such as what we are -- we see is likely for '05, growth will fall below our target range.

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

Ladies and gentlemen.

At this time, I would like to re remind everyone, if you would like to ask a question, press star followed by the number one on your telephone keypad.

We'll pause for just a moment to compile the Q&A roster.

Your first question comes from Kartik Mehta with Midwest Research.

I wanted to ask you about what you are seeing in terms of pricing in the secondary market for mortgage loans?

Maybe what you've seen in the last few months?

Sure.

Well, we have obviously seen a big shift.

The biggest shift occurred, in -- in mid-May, when the sort of full -- full impact of the rate change happened in April and into May.

That's when the pricing really started to see the biggest impact.

We saw or at least the pools that we're out there selling, we saw beginning in May.

Those -- those gains dropped to the 103, you know, low 103 levels and you really can't explain that without -- without taking into consideration what the promised WAC is.

But we have seen that sort of market range expectations have kind of moved in conjunction with what the -- the two-year swap rate is.

So are the -- what's -- what would be the current pricing you're seeing?

Is it still staying at 103, or has that deteriorated in any way?

No.

We're seeing it pretty consistent in the 103 range for the pools that we're pricing.

Actually, you know, we're probably down in the high two twos for a while and the most-recent bit that we've had out there or that we sold forward is about in the 103 range.

And in terms of your hedging, I know you said you're not changing your hedging strategy.

Are you changing at all the number of days you're going out in terms of forwards you're purchasing because of the interest-rate environment right now we're in?

No.

Not particularly.

We are typically hedged so that we can -- we can in effect originate into a commitment that will cover us for the next -- anywhere from half a month to 30 days, generally.

So we're -- we are sold forward beyond our current pipeline, and we're sort of selling into a forward over the course of the -- the -- you know, the next 30 days, typically.

And I think -- you know, we looked at going out farther and at some point it's really cost prohibitive, that if you factor in a drop charge that makes it really economic.

Thank you very much.

Your next question comes from Michael Hodes with Goldman Sachs.

Hi, good afternoon, guys.

Two questions on mortgage and then a few balance-sheet questions.

First on mortgage.

I was hoping you could give us an update on the competitive landscape.

It looks like, if we take the three months ended July, your volumes were up around 9%, if I look at competitors and sub-prime mortgage like County-wide or New Century, I think their volumes were up 38% over the same period.

And, I was wondering if you could just comment on share -- your thoughts on -- on kind of how you're positioning yourself going forward.

And then, secondly -- and I apologize if this is an obvious question or something that you addressed, you know, in the June conference call.

But the execution price that you got in Q1 was 412 basis points and the execution price that you got in Q4 of '04 was 396 basis points.

And the differential between that and the new metric that you're now talking to was 205 basis points in terms of net sales on sales gross margin and in the fourth quarter it was 107.

I realize these are different denominators but maybe you could just elucidate for everyone's benefit what on the cost side of the equation--

Sure.

--increased so much and why, you guys may have seen more pressure than some of your peers on that front?

Yeah.

Let me clarify that because we're not seeing anything unusual.

This is purely a change in the metric that's being described, in the past we were talking about execution price, which was the gross price at which loans were being sold.

In this case, what we're describing is the -- in effect gross margin that -- that takes out any loan sales costs that we pay to brokers and it excludes the variable costs of loan origination.

And it matches up with the reported GAAP revenue item, which is the way you -- you --

That's the way we've been modeling it for years.

But I guess my question is why is the differential so much bigger?

I realize there was a lot of interest rate volatility in the period, but is this -- is this more a function of the timing, when you actually record what you're selling to the warehouse facilities and what you actually got out the other end?

Yeah.

That's precisely it.

When we are recording -- we are recording the -- the gain on sale when it goes into the warehouse as opposed to when the loan is ultimately sold into the secondary market from the warehouse.

And -- and as a result, you know, we are recording the earnings or the gains that are currently available in the market as the loans are being originated rather than when they are later being sold into -- into one of our forward commitments.

So I think that's one of the key differentials.

I mean, one of the -- one of the consequences of us -- you know, which we've said consistently but I -- you know, this is a -- this is the time you can see it.

We have always said we manage our business to generate free cash flow.

And we don't manage the -- the sort of earnings to kind of -- or the business to generate a particular level of -- of sort of consistency of earnings.

And that means that in a time like this when rates are rising in the non-prime business you really can't go out and recapture the dramatic -- in this case 100 basis point rise in rates that we saw in April and May.

You can't immediately get that by repricing in the market, you get that with a lag.

And we are getting -- we are seeing the effect of that lag coming through in our current quarter.

We think that there's -- more of that lag will be recovered now or we'll get back to about 50 basis points of that coming up in our second quarter and that we'll be back to more normalized margins in the third, so in effect our pricing to consumers will have fully caught up by the end of the second quarter in terms of -- of reflecting market rates, but the nature of our business is such that you don't get the opportunity to reprice loans on a daily basis or even a weekly basis, you do it with a lag.

As far as competitively speaking, I think I'm going to let Bob kind of take that.

You know, the one thing I would say about that is, you know, we have always managed our business a little bit different than a number of our competitors where we have a strong bias toward building long-term relationships with brokers and really managing the business in a more, you know, sort of -- in a way that allows us to grow at a very controlled pace.

And I think in general we would say that's what's happening to us.

And that, you know, some of our competitors are doing things that are, you know, more aggressive in the market to capture share through things like pricing that will grab share if you can while the -- you know, while it's out there.

We've always believed that we should be building our business on a more sustainable basis.

But Bob, you know --

I think that's about right, Mark, I think the controlled growth and focus and quality of service as well as quality of loan performance is pretty important.

We've been growing, I think we've talked about it at the share -- at the meeting -- investor meeting about 40% a year, and that's -- you know, been kind of the way we've been running the business.

One thing we do see right now that I think Mark mentioned, we have some expansion -- we spent some money in the first quarter.

We're sort of accelerating our expansion on the wholesale and retail side from a number of loan officers because we sort of see an opportunity in a lot of markets where, you know, we -- as you know, we have about 27,000 brokers approved, we do business typically with about 10,000 of those brokers.

A lot of our territories are just too big for our salespeople so we're going into those territories where we have a larger number of brokers and adding salespeople.

But again, we have to find the right people, make sure they're trained properly and for every salesperson we hire, we have to hire about 1.75 support people to make sure that the service levels and things are the way that we want them.

From a competitive standpoint, you know, it's kind of the usual guys out there.

And I think that, you know, if we're seeing -- if we're seeing competition in any place it's probably as Mark said in the price area.

Got you.

And then, I guess just on the balance sheet, the commercial paper issuance, was that done to fund the stock buy back?

I was a little surprised to see it in the quarter.

And then if you could just comment on the large year-over-year decline in operating cash flows?

Yeah.

You know, the -- in general, you know, we had a number of different working capital items that were kind of moving during the quarter so I wouldn't say -- I mean certainly we did more share repurchase in this first quarter than we did a year ago so that would explain some portion of it, but it's not all that.

We also had -- you know, sort of the normal things, the working capital decline or the working capital needs that we had in the first quarter that are sort of more unique in the first quarter.

The second half of the question, it was related to?

I just -- what was -- what was behind the commercial paper issuance?

Well, I mean, you know, we're just simply balancing our -- our pay downs on our -- our current liabilities.

So, you know, I wouldn't say that's all that unusual.

But -- okay.

But I --

The biggest -- the biggest thing was we paid -- you know, we have a large income tax payment that occurs in our first quarter, so that was happening -- you know, we had accruals of -- of our year-end bonuses that happened during our first quarter.

And then we had 345 million of share repurchase that occurred during the quarter.

So those are the -- the big drivers.

Got you.

Thanks a lot.

Your next question comes from Michael Neuman with (INAUDIBLE) Securities.

Thanks.

That was supposed to be Salay, but I wanted to ask actually some tax questions but I just wanted to ask a mortgage question.

According to the 10K, you had forward commitments I think it was at 438 points.

I was kind of curious as to how come that seemed to not show up in the numbers?

Well, yeah, let me clarify what the 438 basis points of commitment was that was reported in the K. At the end of the quarter, and this really gets back to this, you know -- are you looking at the impact of loans as they're being priced in the quarter and they're being written in the quarter, or are you looking at the pipeline, or are you looking at what's in the warehouse?

We had -- we had approximately $5 billion of forward sale commitments that were priced at 438 basis points at year-end or at April 30.

However, 3.2 billion of that was already committed in the warehouse and had already been priced into our revenues and earnings for the fourth quarter.

So the balance of that, the 1.8 billion, was the portion that was for forward sales or for those -- those loans that were in the pipeline.

And, in fact, we would tell you that much of that was already in the pipeline and being priced in the pipeline and was -- is now coming through -- came through in the first quarter.

You know, but we did 6.6 billion of -- versus 1.8 of that was already forward committed, the balance was priced during the quarter.

So that's the way to think about that.

So anything that we were able to report -- you know, I think the key thing, which I realize that -- you know, several people sort of looked at that number and took it to be, you know, a -- an indication or a stronger indication of pricing that we would get in the first quarter.

The reality is that that was what was -- that was a forward commitment that was primarily there for what was already in the warehouse and had already been priced.

Okay.

I see.

Well, I'm not sure I see, but --

Well, let me make sure that I -- I clarified it then because if you don't understand it, I suspect other people wouldn't also.

We have -- we have loans and at year-end we had $3.2 billion of loans that were already priced and they were in our warehouse facility.

Those loans have a forward sale commitment that is -- that is matched or hedged against those forward sales -- or those sales that are sitting in the warehouse.

That 438 basis points was the rate that -- the execution price that was primarily there as a hedge for the loans already made and sitting in a warehouse.

And that revenue and that the earnings in effect the gain on those loans that were in the warehouse were reflected in the fourth quarter when the loan was funded.

So there was some excess of hedge in effect that was coming through in our first quarter, the difference in the -- the forward commitment was about 5 billion, the amount that had already been funded was 3.2 billion, so 1.8 billion of the first-quarter production was -- was in effect forward committed at 438.

The -- but that also reflects the pipeline in the loans that we were already in process of making commitments to our clients for that we could see coming through the pipeline but had not yet been funded.

And those fundings came through in the -- in the -- in the first quarter this year, but of the 6.6 billion of loan originations we did this quarter, only 1.8 billion were forward committed or forward funded -- not forward committed, at this rate, coming into the quarter.

And so the remainder was more at what the market was at the current time?

That's correct.

And those -- those commitments -- and this is why the timing of the rate increase that you saw in the market in really, you know, the last three weeks of April and the first week or two of May, you saw a dramatic spike in rates during that brief window of time.

These forward sale commitments that we had in the pipeline that went along with them that we could see coming, you know, were really priced before in many ways priced before the big spike up in rates.

And then as we went into the current fiscal year, we started, you know, getting more bids for -- for forward commitments that, you know, reflected or required a substantially higher market rate or else the margin was going to come down, and we knew that, you know, we could not reprice as quickly as the market rates had moved, but that it was going to take time, it was going to happen with a lag and we saw that's coming through a little bit now in the first quarter and we expect you'll see it play out fully now -- you see it play out more in the second quarter and will be fully back to sort of market pricing, or rates that -- WACs that reflect market rates by our third quarter.

And, well, I said was one, I guess there's more than one question on the mortgage before the tax.

Under the way you're reporting it now on a -- excluding the -- the cost of acquiring the mortgage, what -- is that normal rate, the 2 to 225, or is it something else?

Yeah.

I want to make sure.

We have this on the -- on the Website.

You'll find a -- some stats, called mortgage service operating statistics.

The 2.07 compares to 2.89, last quarter and 3.64 a year ago.

The -- included in there is about -- exclude -- maybe it's a better way to say this is excluded from that is about 90 to 100 basis points of fixed cost that -- that is -- will get you to the -- the net margin.

Okay.

So -- so that's 838, for example, would have been the equivalent of maybe something on -- on the order of -- not the -- the 438 would have been equivalent under this method to something like a 340 or so?

Yeah.

There's about 100.

That's about right, yes.

Okay.

And the -- and, again, the 225, just to clarify, just to confirm, I guess, is equivalent to a normalized execution rate less costs?

That -- yes.

Less direct costs and -- which is -- was how we -- the GAAP requires us to report it, not necessarily the way we exactly look at it but GAAP requires us to report the -- the growth gain minus the variable or direct -- what we -- you know, what are known as direct costs and those costs are not all the costs but they are the ones that -- sort of the variable with the origination of each loan.

This 207 in this quarter reflects the gross minus those variable costs.

There's about another 90 to 100 basis points of costs that is not included in, you know, this number to get you to the sort of operating margin that we have or the -- the net margin that we report is bottom line.

And --

And when we've talked about the 200 to 225 basis points, it really is after that additional cost.

So a normalized -- if you think about it this way, the 207 that's now being reported here, normalized, we would expect that to be in the 325 range.

That's a more normal level.

So a year ago we were getting a little bit more premium than we should have gotten, last quarter it was a little bit lighter than normal, and this quarter it's substantially lighter than normal.

We think that that number will improve by about 50 basis points in the coming quarter and that we'll be back to more of a more normalized 300 to 325 by -- by our third quarter.

And, Bob mentioned -- on -- I think to Michael Hodes' question, that there does seem to be some increased competition.

And I guess surprising to maybe all of us on our side, if not your side, is the kind of numbers that were put up, for example, by New Century, not only in volume, but also in margin.

And I suppose -- not to speak for Michael, but speaking for me, kind of surprised why there's such difference, if it's how it's hedged or something else that's not exactly apparent.

Sure.

Well, you know, well it's clearly, you know, probably not fully appropriate for us to comment on their results.

I realize that they are often used as a proxy for -- for our mortgage business.

And I tell you, I think there are a couple notable differences between the two that this situation is highlighting.

One is -- and we know this from, you know, both what they've announced and what we see in our own business.

Their numbers were through June.

July was a -- you know, was an interesting quarter -- interesting month that, you know, they have yet to report.

You know, the timing of loan sales, how they approach that versus how we approach it is a significant difference.

You know, we, as I said, manage our business to -- as sort of a pure mortgage broker to generate cash from our originations.

We don't have anything that is being carried on the balance sheet.

They have, as you know, have begun to build a portfolio and that gives them I guess both flexibility, maybe I'll use that term, flexibility about the timing of recognition of loan sales and gains that we, because of our peer mortgage banking approach and managing for free cash flow we don't do that.

So anything that's going on in the market flows right through our income statement and through our cash flows on a quarterly basis, versus anything you might do to sort of smooth that out.

Okay.

If I may, some tax questions.

You didn't discuss, but maybe you would.

You've talked about how -- I think it was 39% of your -- 39% of your market, so MSAs, you have high penetration and kind of similar, moderate.

What are some of those metrics that you use to determine your penetration?

And does it relate to also the number of EROs that are in those MSRs? -- MSAs?

The primary thing and I'll let Jeff kind of supplement this if appropriate or if I don't get it right.

The primary thing we look at.

It's a fairly sophisticated model.

We have over the last several years built a predictive model looking at the sort of demographic characteristics of the people who live in various different parts of the market or trade areas, and then we look at our market share of those people who fall into those target demographic groups.

And we look at and we're able to compare our market share of the target demographics that have historically been -- found the block business model appealing.

And looked at variations in our penetration of those types of demographic look-alikes across the United States.

And then -- and it's based on that analysis that we have determined, you know, sort of what our level of both optimal or at least -- we can see wide variations, the variations throughout for the penetration of those target demographics range anywhere from, you know, low teens all the way up to nearly 40%, in some markets.

And so as we looked at the markets and segregated them and said where do we have high penetration again of those target demographics and where do we have low, it's that analysis that led us to those statistics.

I see.

And so presumably, these new stores are going to go to places where you have low penetration?

Low -- low penetration of the target demographics.

And when you -- when you look at that, you can obviously check what everyone else is doing.

Are those areas where someone else has maybe high penetration?

Well, clearly the consumers are going someplace.

You know, so we can in virtually every one of those markets tell you who the clients are going to in lieu of us.

So we know, I think within each trade area, where we are targeting, we know exactly who we're competing with and sort of, you know, what -- therefore what the value proposition differences need to be and how aggressive or -- you know, we have to be.

But to clarify that demographic point, you know, just to put it into context, we have virtually no offices in the upper East side of Manhattan and we're completely under penetrated there but we would not expect to go there because that's not our target demographic.

That's -- we understand the Hamptons and Beverly Hills probably don't have any of your offices either.

Easterners and Westerners.

So do you -- would you secondarily sit -- go to a market where you may be under penetrated but where for example, you see Liberty or Jackson Hewitt with high penetrations making it -- suggesting that that market may be better than a non-penetrated market where no one has high penetration?

Well, again, the consumers are doing something.

You know, if they're filing taxes, they're filing taxes, so somebody has it.

Now, we can see different degrees of penetration of paid preparation that also, you know -- so those target demographics, the proportion of those targets -- those demographics who are going to a paid preparer versus doing self-prep varies somewhat across different trade areas.

But I -- you know, I would tell you, we -- we -- you know, probably for competitive reasons aren't going to get into how exactly we're targeting where we're going to go.

Okay.

Well, I thank you very much and I appreciate the audience, I guess couldn't do very much about it, allowing me all this time.

No problem.

Your next question comes from Sharette Sharoff with Morgan Stanley.

Hi, good afternoon.

Mark or Bob, question on the mortgage business.

Can you guys provide the breakup of loan originations by the different channels; i.e., correspondence versus brokers versus retail?

And perhaps talk about various cost pressures that you are seeing in each of those channels?

Yeah.

I am trying to think.

You know, we have some of this in the supplemental -- the supplemental information that we put on the Website will give you the sort of channel breakdown and sort of the key drivers that we use.

So, you know, maybe rather than take you through those I'll, you know, refer you to that but I think it'll give you the information.

And the second half of your question?

Just trying to understand, the dynamics in each of those channels, is one more worth or better compared to the price competition that you see out there?

You know, there's not a big difference.

I think wholesale had the highest overall margin in the normal wholesale business.

National accounts we do business with large prime lenders so we get a lot of the just-missed prime customers so our margins were a little bit lower because the coupons were a little bit lower.

Bulk is sort of a different business we don't do very much of it so it really doesn't have much of an impact on the overall results and in the retail side I think we really successfully shifted our mix to about 70% non-prime so we've actually seen an increase in WACs there in coupons.

So an aside, you know, in general within the traditional wholesale business, both wholesale and national accounts, you're seeing very little real meaningful change in that and on the retail side we think we're doing the right thing to move that business toward a higher-value business.

Okay.

And then just really quickly on the cost of originations.

Where do you guys stand on your target of loading that to 250 basis points, when do you think we might get there?

Sorry, can you -- I didn't catch the question.

I apologize.

The cost of originations I guess your target is to lower that down to something like 250 or maybe lower than 250 basis points, just wondering where you were and when we might see that to happen?

Yeah.

The -- well, on the cost -- on the cost side we're -- you know, we're getting -- we're doing all right, I'd say.

You know, we probably think there's -- you know, 10, 15 basis points of improvement that we will get over the course of the next year or so, but I think we've made the kind of, you know, we're making the progress on the cost -- pure cost origination side.

You know, to us, the bigger, you know, point at the moment is, you know, how fast will we see the -- the margins in effect on the loans be recovered and on that side we think that's going to happen at about 50 basis points in the upcoming quarter and then we'll be back, you know, probably fully -- fully in -- in the third quarter.

Okay.

Fair enough.

And then my final question on the tax segment.

Mark or Jeff, either of you guys -- it looks like the seasonal preparers -- the number of seasonal preparers declined in fiscal '04 in spite of an increase in the number of company-owned offices.

Just curious if that was voluntary or involuntary attrition or any color that you guys can provide on that?

Well, yeah, that was a -- that was a 10K disclosure I think that you're referring to.

You know, what we did is -- this past year is we really worked on how to get greater efficiency out of the -- the tax professionals within the organization and to provide sort of more business to our long tenure tax professionals rather than bringing in a larger number of -- of new tax professionals in the first year.

So this is not a retention issue.

In fact, I would say it's just the opposite.

It's because we had good retention of our long tenured tax professionals we didn't find ourselves in a position of needing to -- or of hiring as many new people.

Okay.

So it's not a question of a loss to competition or anything like that.

No, no, not at all.

In fact it's the opposite.

We're seeing very good retention of our tax professionals.

Okay.

Thanks.

Your next question comes from Thomas Russo with Gardner, Russo, and Gardner.

Hi Mark and Jeff sorry for the background noise, I apologize.

Jeff, I was wondering if you could describe any kind of insight that you've imparted on the 500 new stores that your -- your tax prep centers that you're opening up this year.

What lessons have you learned from other designs that may have worked or not worked and (INAUDIBLE) store second figure.

Hi, Tom.

Hi.

We have not made large -- we -- large changes in how we're configuring the internal -- internal offices.

We have spent substantial amounts of time on our real estate selection formula.

You know, how we're going to decide where to put offices and at what pace.

And Mark talked a little bit about that earlier, so I won't -- I won't, bog down the call with that except to say that -- that our model also does kind of comparisons across all of the different opportunities to help us prioritize.

We'll take that and then we'll adjust that on a year-in and year out basis.

Again the real emphasis has been where to site the locations as opposed to how to configure the offices inside.

We continue to look at how can we create as the highest -- the highest-quality client experience and at the same time allowing those offices to serve as many -- as many clients as they can to create some better leverage.

Okay.

And so the experience of two years ago, the offices that didn't pan out or didn't deliver to your whole expectations, those weren't so much an interior or staffing restructures, they were just siting.

Yeah.

In fact, it was completely a siting issue.

And -- in terms of the speed of the ramp up.

Those offices that we placed a couple of years ago will actually ramp up to their -- where we would say their maturity level is, it will just take a little bit longer than we originally anticipated.

I think also, to be fair, there's a little bit of learning that we have about the staffing pattern and exactly whether we should open an office if we don't have the appropriate sort of mix of experienced and new tax professionals and that's another refinement that we're going to be implementing this year.

So it was siting plus staffing able to drive the process efficiently?

Yes.

Yes.

Okay.

Thank you very much.

Thanks.

Your next question comes from Andy Wagstaff with Touchstone Investments.

Hello?

Yes, hello?

Yes.

Sorry about that, I had you on mute there.

Sorry about that.

No problem.

Regarding the gentlemen's question on the, -- the 438 basis points which represented I guess the spreads on loans you guys had secured that was reflected in the 10K.

Yes.

Wanted to find out, if you could, just to summarize what the spreads were for the loans not included in those based upon the numbers you gave us, which was -- I think you said the average for the quarter was 270 -- or 207 basis points but that did not include roughly 100 basis points I guess of fixed costs.

So could you -- if you could, just kind of help me back in to what the number would be -- the spread on those loans which was not reflected in the -- in what was disclosed in the 10K.

You know, I -- I'm not sure.

I -- I can get you awful close.

Okay.

Basically, the equivalent for the 438, the balance for the quarter.

Right.

Would have been in the high -- or the low 300, so 310 kind of range.

Okay.

That's sort of the equivalent for the portion that was priced after the quarter ended -- or after the quarter started.

Okay.

But --

And again, as I -- you know, we would have normally expected that number -- you know, the 438 wasn't far off of what was -- what is more normal, but you saw this very big run up in -- in market rates, basically two-year swaps, that was -- that immediately came out of the -- out of this pricing.

And -- you know, we -- we saw that market reaction or that market adjustment to that higher rate environment happen immediately and we began the process in June of raising market rates to our borrowers to catch up, but it's really with a lag.

Right.

So is it safe to say that the balance of the loans, then, that were not reflected in the -- in the 10K were priced at something less than the 207 basis point average that you talked about, or no?

No, no, no.

It probably would have been priced -- it would have probably been priced at about -- you know, in the 300 basis point range.

Okay.

207, I apologize.

I realize we're putting out a new data point.

Yeah.

You guys are putting out a new data point, that 270 really includes another 100 basis points call it a fixed cost.

Actually call it variable cost.

Okay.

It's a variable cost that the accountants net out of gain on sale when we report revenues.

Okay.

And it's purely a direct cost, so it's -- the costs we have paying brokers, it's the price we -- or the variable costs we have for our own sales staff.

It's the variable costs associated with the origination of a loan.

All right.

And that's on the another 100 basis points.

Got you.

What -- what per cent of loans in the quarter were interest only?

Can you give me a ballpark there, if you can't give me an exact figure?

Yeah.

It's pretty small.

It's very small.

One of the things that we have not done is we have not rolled out an IO product.

We've been testing one and making sure that we get the right kind of loan performance data on that.

So it's -- it would be a very small part of the pool.

So you're not doing any IO products?

We have a couple of tests going right now, but it's less than -- I want to say less than 3% of our business.

Got you.

Could you just talk a little bit about your competition and some of the products they're offering in order to position themselves relative to where you guys are and how they're -- how they're being able to, you know, manage market share with those products?

Well, I mean I think -- you know, you named one of them, the interest-only product, seems to be -- for some of the competitors it's the majority of their business right now, that seems to be especially big in the larger loan balance states on the West Coast and the East Coast where you can get lower payments for the borrower.

There's 40-year loans out there.

I think more than anything, the difference is -- the subtle difference is -- between the companies is really in, say -- our biggest product is our 228 product that's really been the underwriting guidelines and what kind of LTDs you'll lend at and what kind of documentation is required for those loans and that's where we see more differences between the competitors than probably the actual type of product.

Because we're -- because our people are pretty much originating everything the prime people are today.

Right.

Okay.

So when you're losing -- when you're losing business by what kind of margin typically are you losing business?

You talked --

From a pricing perspective.

Yeah, from a pricing perspective, yes.

Well, I think that's one of the -- one of the issues is we're -- you know, because it's a relationship business, we have to -- you know, pretty much -- we think we -- we think that we can get a 25 basis point premium for our service.

But anywhere -- anywhere north of that, you know, -- the broker has sort of fiduciary responsibility to get the customer the best deal that they can.

And -- you know, I guess what we think is -- is that -- you know, I mean our managers have the authority to -- to get close to -- to make price exceptions to protect relationships, and -- so I'm not sure -- I think -- I mean it's sort of a case-by-case.

It's a territory by territory, market-by-market kind of decision that's made.

Got it.

If you had to look at a region of the country, or is there one region in particular that the lenders are being more aggressive than others.

I think California is always one of the most aggressive parts of the -- of the country from a -- from a lending standpoint.

Yeah, from a pure pricing perspective.

And you'll note, you know, we probably, you know, it's one of our lowest market share geographies.

Yeah.

About 21% of our business right now, maybe 22%.

I think most of our competitors are in the 40s.

Yeah.

Got it.

Okay.

All right.

Thanks for taking my questions.

Your next question comes from Dan Kurs with DK Equity.

Yes.

Good evening.

I wonder if you could revisit something a previous caller asked.

Specifically, concerning the statement of cash flows for the first three months of fiscal year '05, there's a negative variance of 406 million in terms of net cash from operations or in this case used.

I wonder, if you could -- how -- do you see cash from operations progressing for the balance of fiscal year '05?

And will that number be in line with where you expect income to go and if so, how will you make up the Q1 shortfall?

Yeah.

The -- we would think it would be in line with what income progresses to be for the balance of the -- of the year, you know, plus or minus a few things that are put to tank.

The primary thing that happens in this first quarter that comes out of working capital is we make our annual income tax payments and we make our annual variable compensation payments.

Both of which are accruals throughout the year and then the cash comes out in our first quarter.

Those two factors are really the -- the -- almost exclusive drivers of -- of that number in Q1.

And they don't recur for the balance of the year.

So the -- the divergence based upon those two factors is -- is that (INAUDIBLE) are very results driven.

Yeah and the divergence that the offset to that, if you will, will happen in the fourth quarter primarily.

Because the --

Okay.

We'll pick up -- you know, the bulk of our earnings virtually, you know, all the Company's earnings happen in the fourth quarter and as a result we do a big tax accrual in the fourth quarter so, you know, this really reflects almost all the income taxes we'll pay on our earnings for the full year, all gets accrued in our fourth quarter.

And there's a potential offset in Q4?

That's correct.

Okay.

Thank you very much.

Your next question comes from Amy Macanarny with H&R Block.

No, I'm sorry, I pushed the wrong button.

Excuse me.

Your next question comes from Peter Monaco with Tudor Investments.

Good evening, thanks for your time.

Two questions.

One on capital management and then I'm going to beat the dead horse, if you don't mind.

If I did my math correctly, the net reduction in shares out was roughly 8 million in the year-ended April.

The net reduction in shares this fiscal year to date is 6 million, roughly, or 6.5.

The average share price in the fiscal year '04 was roughly in line with the average share price in the quarter just ended.

So just talk to me a little bit about what you're thinking there and the big differential in the kind of pacing that share reduction?

Sure.

Well, the biggest thing is -- is that -- in fiscal '04, we were working toward a capital level that was consistent with our targets -- I guess the capital model that we've shared with the rating agencies and where we believe an appropriate prudent capital level for the company and at fiscal year-end '04, we reached the level that we felt was appropriate.

And that puts us in a position now this year where the expected free cash flow that we're generating from the business and the capital that we create is sort of all available for redeployment.

One of the things that we sort of comparisons year-over-year is last year we used about 250 million, roughly, for the acquisition of some of our major franchises and so we reserved or set aside that much that eventually was paid out in September.

This year we don't have a comparable program, so we would expect that the vast bulk of our free cash flow will go to share repurchase.

And while clearly we've sort of, you know -- it varies depending on a lot of different factors, I would tell you that we think there's probably a substantial amount to go yet this year.

Do you actually share with us a projected free cash flow for the year, assuming for the sake of argument that the positive working capital phenomenon of the fourth quarter offsets the negative phenomenon of the first quarter?

Yeah.

You know, again, assuming that's -- those two things balance one another, which we -- you know, this is just a -- sort of an accounting -- or the way in which the --

Right.

The accrual -- taxes.

And that you do have the normalization as you say of the -- of the gross margin equivalent in the loan-sale gain?

Yes, yes.

Again, we're -- we base our sort of capital deployment plan off of our projections that we are continually updating, but, you know, I tell you they are no different really today than they were, you know, two months ago, three months ago, the last time we shared results.

We are basing our capital deployment plans off of those full-year free cash flow targets.

And, you know, the key thing that -- that we have shared and I would share again are, you know, we don't have substantial CapEx expectations to spend this year.

We'll have some relative to the office openings in tax but not -- not dramatic.

We do not have major acquisitions of any substantial amount that we would expect our capital to go to.

We have reached the capital targets that we had for retention of capital in the business -- in the businesses going into this year.

So for the most part, our sort of earnings plus adding back non-cash amortization of -- that's running through our income statement is essentially all free cash flow.

Okay.

Thank you on that.

Now, if I just might beat the dead horse for one quick sec here.

Do -- do I understand correctly that, reported earnings and operating cash flow for a period are driven by the timing with which loans are sold to the warehouse rather than the timing with which they are securitized or whole loans sold to Wall Street or whatever?

No.

That -- that is not affecting the timing of -- well, I think -- yes, it is.

It does, because there's a balance-sheet item that you'll -- that I'll just point you to.

It's called beneficial interest in trusts-trading.

That is the sort of accrued profit margin in the loans that are in the warehouse.

So changes in that number, I guess, would -- would -- you know, if it was very volatile, would affect sort of -- in the period cash flows, but as you can see for example, this quarter it's really flat quarter over quarter so it had -- that affect had little affect on cash flows during the quarter.

I'm sorry, maybe I -- maybe I, asked the question confusingly.

The 203, margin or metric as compared with the 280 the prior quarter and the 340 by 60 of a year ago is a function of the WAC, the -- and the, effective execution price on what happens with that loan, and then of course the costs -- certain costs associated with the origination of that loan?

Yes.

So, the majority of the sharp rise in interest rates that has occurred recently actually occurred in the fiscal fourth quarter, the -- you're saying that the WAC on most of the loans in the fiscal fourth quarter was established prior to the sharp run-up in rates and the loan-sale commitment based on that WAC, and now, in the second quarter -- in the first fiscal quarter, even though, -- even though there has been a general decline in rates, the -- the -- see, I'm confused.

Help -- give me a real-world example.

If you originated a loan in March and you originated a loan --

Sure.

-- in June, tell me -- tell me what the rough WACs were and what the associated commitment was?

Sure.

Let me see if I can do this -- I'll even try to map it back to the balance sheet and the cash flow statement.

If -- if you were originating a loan -- if we originated a loan and funded a loan in March.

Yeah.

Okay.

We might have been funding it at let 's say seven, seven flat.

Uh-huh.

And we had a forward commitment to sell that loan at -- you know, with seven WACs, we would get a 10430.

Okay.

10438.

So basically as we made that loan, we were putting it into the warehouse -- once the loan was funded in March, and we would book a -- the margin on that loan, the variable margin on that loan, which would have been about 290, let's call it 300 basis points.

Uh-huh.

Okay.

So that 300 basis points hasn't yet been received in cash and that's the balance-sheet item, the accrued profit margin, if you will, on that loan is what the balance-sheet item is called beneficial interest in trust trading.

Then when we actually deliver the loan out of warehouse to the former commitment and get the cash, the whole thing kind of reverses and we reverse this accrual and we book it as cash, but the profit itself was recorded in the fourth quarter when the loan was funded in March.

Got you.

So now let's fast forward to June.

Correct.

Market rates have risen by 100 basis points.

Correct.

We are now originating loans at about a 720 WAC, let's say for argument's sake, so it's up about 20 basis points, but the loan -- the secondary market requires that -- to be -- to get the same gain on sales that we were getting at -- back in March, that loan needed to be priced more like 800 basis points.

That variance, that -- that -- so in effect, that 80 basis point difference in WAC versus market expectation comes out of our margin.

Fair and understood.

I guess what is -- what remains unclear is if we're in mid-June and you are committing to a customer and you've had a hundred-odd basis point rise in rates over the previous -- over the April and May period, how come your WAC to him is only up 20 basis points at that point?

That is the -- that -- that is the key point in the market that -- in the non-prime market and the way in which we do business, our rates adjust with a lag.

We do not run sort of daily prices out to the market.

We are typically adjusting rates about once a month.

Uh-huh.

Most often and as a result, you know, we have price commitments for particular loan products that we will -- we will sort of live with and absorb through our margins and sort of -- you know, and absorb ourselves the volatility of movements in rates up and down during, you know, a window of time.

And that has been our practice, that's part of what -- you know, allows us to have the kind of relationships with mortgage brokers that we have -- have built over the years, and we think that -- and that also means that when rates decrease, we have a lag before our WACs come down, and when rates increase we have a lag before our WACs increase to fully reflect that.

And this quarter is the quarter where we kind of -- you know, the -- the increased side of that is running through the numbers.

Your point that you will recapture that margin, due to a subsequent decline in rates is well-taken.

So now, let me clarify.

When we say that we expect that we will recapture, what we really mean is that we -- our WACs will catch up to market rates in time and that over the -- over the next quarter we think that we're going to recapture about 50 basis points of -- of margin as -- as WACs come up and we think we will have fully recaptured through our WAC, the higher market rates that are out there by our third quarter.

So we are not assuming that there's a decline in rates that's somehow going to come and change the direction of our profit margins.

Oh, no.

Fair enough.

Fair enough.

I -- I understand that -- that you're talking more about the WAC gravitating toward the market.

I guess the final thing -- and then I'll drop it, is how does all that reconcile with the arguable need in -- in the non-conforming mortgage business to ensure that you manage to a level of profitability on, frankly, every loan, because at the end of the day that's what's really going to drive the cash flows of your business.

Sure.

And I think that -- that is a well-taken point.

You know, we -- we are very careful about the -- not wanting to be in a position of daily repricing of loans because of the way in which we have built relationships with mortgage brokers and one of the things they have come to value from us is that we -- we provide a degree of consistency.

And in fact, you know, you can argue that we may get negatively selected or, you know, at times where we have not yet adjusted rates as rapidly as we need to, but we have seen that in fact we get the opposite effect as well, that we do not have the kind of pressure to lower rates as rapidly in a declining-rate environment and again that really reflects the nature of the relationship orientation of our business.

Fair enough.

Your patience tonight is -- is really laudable.

Thank you.

Thanks.

Your next question comes from Rosa Wie with Sim Co.

Hi.

This is Josh Hansen from Sim Co. This is a follow-up to that last question.

How can you reconcile the 50 basis of increase in the higher WACs with being able to grow the portfolio and everybody else trying to maintain margins?

If you're at a seven -- you know, 60 WAC over the next quarter or so that's essentially where we spent most of 2003 in the nonperforming market and have -- my second question is that have broker fees come under pressure in a yet -- I'm not aware if they are or not.

And thirdly given how fast the 2000 to 2003 vintages are pre-paying, the 50-plus range, I'm surprised there's no pressure on residuals yet.

Do you expect, you know, that to cause people to maintain lower WACs because they have to replace the residuals that are rolling off so quickly?

Thank you.

Let me see if I can get those just right.

You know, on the -- your point about, you know, sort of competitive pressure and, you know, can you sustain those WACs, frankly we think that that is pretty doable.

You know, that the 760s, we're seeing that coming in now as we are pricing loans so it's, you know, as we look into the next quarter, none of this is -- seems to us to be hard to actually deliver on because we can see it coming through -- through our pipeline as we speak.

You know, the issue about competitively, you know, how fast and how far can this move up, frankly, everybody is living with the same economics and the same market environment, so I'm not sure that what we are doing is any different than everybody else.

Now, if you can find somebody who -- you know, for the long term wants to live with very, very, very thin margins and -- and as a consequence very low returns on capital, you know, I suppose they're out there.

But we don't -- we generally find that the market is pretty rational.

You know, and there are players who are doing different things strategically as we speak to try to sort of manage through the rate environment change that we're in the middle of, but for the most part it looks pretty rational.

On the print paid point, we have not seen a dramatic change in pre-paids.

So, you know, to the extent your point about the -- you know, the -- the -- I guess it was the '01s and '02s and '03s even are pre-paying faster, that's not our experience so to that extent we don't think there's pressure.

We're not seeing any pressure at all from that vantage point on our resids.

In fact we're seeing as you noted from our write ups this quarter we're seeing resid values rising and that's due to -- essentially stable prepays, but improving or -- credit -- credit experience.

Okay.

Thank you.

Thanks.

Your next question is a follow-up question from Michael Hodes with Goldman Sachs.

Asked and answered, thanks.

You have no further questions at this time.

Great.

Well, thank you.

I just want to thank people for sticking with us and kind of working through this.

We obviously are available and be happy to spend more time one on one as people get through their analysis.

So thanks for joining us and we look forward to talking with you again next quarter.

That concludes today's H&R Block first-quarter earnings release conference call.

You may now disconnect.