H & R Block Inc (HRB) 2005 Q2 法說會逐字稿

Good afternoon.

My name is Derrick, and I will be your conference facilitator.

At this time, I would like to welcome everyone to the H&R Block 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 press star followed by the number 1 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, President, and CEO.

Please go ahead, sir.

Great, thank you.

Good afternoon, and thanks for joining us to discuss our fiscal 2005 second quarter results.

Before I begin this presentation, let me remind you that this presentation and the various comments made in connection with the conference call include certain estimates, projections and other forward-looking statements.

The words will, plan, estimate, approximate, project, intend, remain, expect, believe and variations thereof and similar expressions, are intended to identify forward-looking statements.

These statements speak only as of the date of which they were made, and are not guarantees of future performance.

Actual results may differ materially from those expressed, implied or forecast in the forward-looking statements.

Some factors that could cause actual results to differ include: The uncertainty that the company will achieve its revenue, earnings and earnings per share expectations for fiscal 2005 or any quarter thereof, and that actual financial results for fiscal year 2005 or any quarter thereof will fall within the guidance provided by the company; changes in economic, political, regulatory or competitive environments and effects of such changes; the inability of H&R Block subsidiaries to successfully expand their businesses; litigation involving H&R Block and its subsidiaries; other risks described from time to time in H&R Block's press releases and Forms 10-K, Forms 10-Q, Forms 8-K, and other filings with the Securities and Exchange Commission.

H&R Block undertakes no obligation to publicly release any revisions to forward-looking statements to reflect events or expectations after the date of these remarks.

H&R Block provides a detailed discussion of risk factors and periodic SEC filings, and you are encouraged to review those filings.

Whew.

Okay, with that, let me welcome and tell you that with me today are Jeff Yabuki, Executive Vice President and Chief Operating Officer;

Bill Trubeck, Executive Vice President and Chief Financial Officer, who joined the company on October 4th, and Bob Dubrish, President of our Mortgage Services Business.

In conjunction with today's call, supplemental financial information has been posted to the Investor Relations section of our website, at www.hrblock.com, to facilitate your analysis.

As mentioned in the first quarter call, we have included fiscal 2003 results by quarter under the new reporting format in the appendix to the supplemental financial information.

You will also find revised fiscal '04 results by quarter in the appendix.

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

And if you have it available, I encourage you to get the supplemental information off this website.

We will likely be referencing it today.

Before discussing our results, I'd like to remind you that we are holding our annual investment community conference on Wednesday, January 12th, 2005, at the Millennium Broadway Hotel in New York.

For those of you who are unable to attend the conference, we will also webcast the event.

If you want, please call our Investor Relations group if you need any additional information.

Since our last call, we've added two executives and an independent director to our organization.

As I mentioned earlier, our Chief Financial Officer, Bill Trubeck, joined us last month.

Also joining the HR Block management team is Mark West, Senior Vice President and Chief Information Officer.

Mark oversees the company's technology strategy and its implementation.

David Baker Lewis joined our board of directors last month.

David also serves as Chairman of the Board of Directors of Lewis & Munday, a Detroit-based legal firm, where he also chairs the firm's corporate services practices group.

I want to welcome all these individuals to H&R Block.

We welcome the contributions that you will make.

Let me turn to the discussion of our second quarter results, and then we'll follow with our outlook for the remainder of the fiscal year.

Overall, the company delivered disappointing financial results for the quarter, though we have a mix of positive and poor underlying performance across our business segments.

The fundamentals of our businesses and the outlook for long-term growth remain positive.

That being said, we are experiencing a tough competitive environment in the wholesale mortgage business, which has led to us reduce earnings expectations for the current fiscal year.

Our reported net loss for the quarter -- second quarter -- was $52 million, or 32 cents per share, compared to net income of $10 million or 6 cents per share last year.

Revenues decreased $30 million to $539 million, or 5%.

Our financial results for the quarter reflect a 42% year-over-year decline in our mortgage segment's earnings and continued weakness in investment services.

During the second quarter, our mortgage segment results were impacted by tougher than expected competitive pricing pressures, production volumes below our expectations, and a smaller increase in weighted average coupons than we expected.

The 50-basis-point improvement in margins that we discussed last quarter was not fully realized.

On the positive side, tax season preparations are going very well, and we now expect to open slightly more offices than we had originally anticipated.

Our year to year spending in the tax services segment is in line with our expectations.

Our business services segment continued to experience solid top-line growth this quarter from our risk management practice.

Business development activities, including our national sales organization, continue to gain momentum as we approach the upcoming heavy revenue season.

Reflecting our continued commitment to deploy excess capital in ways that drive value for our shareholders, we reacquired 3.8 million shares during the quarter, resulting in an 8% decline in shares outstanding compared to the same quarter last year.

Our results also include 7.9 million or 3 cents per share in stock-based compensation expense, compared to $3.1 million last year.

This increased expense reflects the second year of our three-year phase-in for expensing stock-based compensation.

I also want to briefly note the $10 million variance in the corporate segment versus the same quarter last year.

This variance is primarily related to new business development activities -- some of which we will discuss in January -- higher medical liability reserves, and some timing differences.

I'll now turn this discussion over to Jeff Yabuki to discuss our tax and investment services segments.

Thanks, Mark.

Our tax services segment, which now includes U.S. and international tax services, digital tax solutions, and payments related to refund anticipation loans, increased revenues $8 million or 12% over last year's second quarter.

The primary contributors to the increased revenues were an outstanding tax season in our Australian tax operations, growing revenue from our Peace of Mind program and the inclusion of results from former major franchise territories, some of which were only partially included in the prior year.

The pretax loss for the segment increased $4 million or 3%, and is within our plan expectations.

The increased loss over the year-ago quarter was primarily driven by cost increases related to our real estate expansion initiative, along with off-season expenses from the former major franchises.

To date, we have been pleased with our ability to manage the business cost structure while significantly expanding the delivery system.

As we have mentioned previously, we have been identifying process improvement opportunities within the existing business that will enhance earnings and build margins over time.

Our efforts are beginning to positively impact results, and we expect to get leverage out of these improvements over the next several years.

We are very pleased with our office network expansion results to date.

The effort is progressing well and better than planned.

As Mark mentioned, based on results to date, we are now projecting that we will open between 650 and 700 stand-alone offices this year.

In addition, we are still on track to add approximately 400 Wal-Mart locations for the upcoming tax season.

Roughly 60% will be company-owned locations, and the remainder in franchise territories, bringing our total to nearly 950 Wal-Mart locations.

On a combined basis, we expect to have about 11,000 points of presence, which will substantially increase our ability to serve clients this season.

Increased office density increases our convenience and accessibility.

We believe this enhanced availability will help us capture those tax filers who prefer H&R Block, but opt for a competitor when capacity constraints or convenience negatively impacts our availability.

In addition to new locations, we are also working on programs that will increase service capacity in existing offices.

At the same time, we continue to focus on our long-term strategy to consistently deliver high quality tax and financial services, differentiated on the basis of relevant and actionable advice, accessible to consumers in the channel of their choice.

While we will talk more about the upcoming tax season at our investor conference in January, we believe that our tax business will see increased results versus the prior year.

We are pleased with our progress to date.

We continue to advance our digital tax offerings, which include online tax preparation, online professional services, and our software products.

This year, we are excited to announce an innovative tax offer offering called H&R Block Signature, our first packaged -- packed software offering under the H&R Block brand.

We are the first and only company to offer this type of tax software product.

H&R Block Signature offers do it yourselfers the empowerment that they desire, combined with access to the expertise of an H&R Block tax professional who can review, complete, sign, and e-file their return.

The Signature product bundles control of the process for taxpayers, with the trust, security, and guarantees that come with a tax return signed by H&R Block.

This product will be available along with our award winning tax preparation software at retailers across the nation, or online at hrblock.com.

By offering consumers multiple tax preparation options, we believe we are best able to meet client needs and build overall tax market share.

Along with our existing tax businesses, we are evaluating several long-term retail strategies to increase tax market share and expand the reach of our services.

Although we won't discuss these at this time for competitive reasons, we will share insights at the upcoming investor conference, along with more detailed plans about the upcoming tax season.

Turning to investment services, second quarter results were again disappointing, as negative investor sentiment, particularly early in the quarter, impacted financial results.

We are once again cautiously optimistic that the October and November improvement in financial markets will provide us a much more realistic view of the earnings potential of this business in a more normal investment climate.

Revenues of $54 million for the quarter increased 2% compared to last year's quarter and were flat over -- were flat versus the first quarter revenues.

The pretax loss was $25 million in the second quarter, compared to a pretax loss of $15 million in last year's second quarter and a pretax loss of $18 million in the previous quarter.

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

The increased loss over the prior year is primarily due to an abnormal $6 million write-down of a branch office facility and operating cost increases.

Total production revenues decreased $1.3 million from the prior quarter, and were essentially flat compared to the previous year.

Second quarter trading volume decreased 17% from last year and 6% compared to the previous quarter, while revenue from annuity sales has increased 39% and revenue generated from investment advisory products has increased 44% over the prior year.

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

As of October 31st, we had over 1,000 tax professionals engaged in the process to become active members of the financial services team.

We know that establishing multiple relationships within the H&R Block brand builds client loyalty and retention.

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

However, second quarter recruiting efforts were mixed, with our total number of advisors remaining essentially flat, due to higher than expected advisor attrition.

We remain active in expanding the scale of our advisor distribution system.

I'll now turn the call back to Mark.

Thanks, Jeff.

For the mortgage discussion, what I'd like to do is first review the results that we are reporting, then discuss what we experienced during the quarter and how this was different than what we had anticipated.

Then I'll spend some time discussing what we expect the environment to be looking forward; and finally, I'll discuss actions that we're taking as a result.

Pretax income during the second quarter decreased 42% over the year-ago period and increased 14% over the previous quarter.

Second quarter loan production increased 3% over the year-ago quarter and decreased 5% from the sequential quarter.

Revenues for the second quarter were down 17% over last year, but up 5% from those of the first quarter.

Loan characteristics all remained consistent with those originated in the previous quarters, with average FICO scores of 609 and loan to value remaining in the 78% range.

During the quarter the average interest rate charged to borrowers, or WAC, on new originations was 7.46% .

This compares to 7.21% in the previous quarter, and 7.51% a year ago.

In both rising and declining rate environments, our market pricing lags the secondary market rates.

This reflects the operational norm within the nonprime mortgage industry.

Overall, our second quarter net gain on sales increased 11 basis points to 283 basis points compared to 272 basis points in the previous quarter.

The 25% -- or 25 basis point improvement in WACs quarter over quarter was consistent with the direction of our expectation, but we did not achieve as much of an improvement as we had anticipated.

In addition to the lower than expected WAC improvement, we did not achieve the level of loan production that we were staffed to support, causing our cost of origination to increase over our expectations, as these higher costs were leveraged over less than anticipated production.

We also saw somewhat poorer execution on our secondary market transactions.

The net result is that while we achieved an 11 basis point improvement in our net gain on sales, this was short of our original expectation for a 50-basis-point improvement this quarter.

The competitive environment that we faced this quarter was challenging, as overall industry loan originations slowed and some competitors used aggressive loan pricing as a response, despite rising interest rates in the secondary markets.

While we initially sought to raise rates consistent with the secondary market demand, we chose to remain price competitive in order to maintain the relationships that we've established with the mortgage broker community and in support of our expanding sales organization.

Looking into the next 12 to -- or 6 to 12 months, we expect that the competitive environment will remain challenging for a number of structural reasons.

We believe the move to a REIT structure by numerous competitors has resulted in a desire on their part to build their REIT portfolios through more aggressive pricing than the secondary market might warrant.

As a consequence, until those portfolios are filled, we expect continued price pressure.

Also, as overall industry originations levels fail to grow, we expect several competitors to aggressively pursue market share strategies.

We believe that our position in the market as a high service provider is a very strong place from which to compete.

Yet, this industry situation will likely make price increases challenging; and accordingly, we remain -- we will remain competitive, though never the market price leader.

In this environment, there are two critical actions that we can and are taking.

The first is to further extend our high service position in the broker community to ensure that we retain a preferred provider status with the brokers with whom we do business.

The second is to aggressively control origination costs.

Traditionally, we have enjoyed a pricing and production advantage coming from our delivery of industry leading service.

However, in the past several years, our competitors have outpaced us in technology enhancements and changed the way many mortgage brokers do business.

To maintain our competitive position, we have carefully developed our own broker support approach that incorporates technology into our broker relationships.

We are completing the development of two critical technologies that we will begin introducing in the third and fourth quarters.

The first of these is an Internet-delivered prequalification process that allows brokers to gain access to our products and pricing more quickly.

While in many ways, this positions us evenly to competitors with similar capabilities, we have the additional leverage of our reputation and strong broker relationships built on high customer service levels that we expect to net meaningful levels of production growth.

We plan to roll this technology out late in our third quarter.

In anticipation of its success, we have added significant additional staffing to support both the rollout and expected volume growth.

This will have a negative effect on our third quarter profitability, which in part gives rise to the reduction in earnings guidance that we've announced today.

At the same time, the pricing advantage that we have enjoyed in the past will only translate to an advantage for shareholders, if it is coupled with competitive cost of origination.

We've developed and will be implementing in the fourth quarter an automated underwriting technology that will streamline and accelerate our ability to serve the needs of mortgage brokers.

This technology is expected to further enhance our ability to drive production from the broker channel, and at the same time ultimately streamline our processes and allow us to aggressively lower our cost of origination.

Beginning in our -- late in our fourth quarter, and then more meaningfully in fiscal year 2006, we expect to realize a 50 to 75-basis-point improvement in our overall cost of origination, including the effect of potentially higher volumes.

These benefits will be realized as these new technologies impact staffing, process flows, and broker service.

These actions have a number of implications for our outlook over the next 12 to 18 months.

During the coming third quarter, we expect that pricing will remain under pressure and that we will respond to that pressure to maintain the position we have built with brokers.

At the same time, we will be finalizing our support staffing strategy in preparation for the introduction of these new technologies.

In combination, this will result in quarterly results at best similar, if not down, from our first quarter performance.

In the fourth quarter, we anticipate growth of production levels and lowered origination costs.

This combination, along with some improvement in WAC, would lead us to expect improved gains on sale and margins at higher level production levels, but still with operating margins below what we believe this business should ultimately achieve.

Within our retail mortgage operations, we continue our shift toward higher margin nonprime production, due to the slowdown in prime refinance activity.

Second quarter retail nonprime origination volumes increased 63% over last year and 29% over the previous quarter.

Consistent with our expectations, retail prime origination volume declined 26% over last year's comparable quarter and 15% on a sequential basis.

Overall, we don't believe that the expected rising rate environment will have quite as much impact on the retail business as the wholesale business.

Our direct retail client advisory relationships tend to give us slightly pricing -- a slight pricing premium over our broker relationships, which while also relationship-focused, face greater competitive pricing pressure.

In the quarter, 86% of our nonprime loan sales settled through the whole loan sale market versus 14% securitization.

Continued comparatively superior execution in the whole loan market impacted that decision.

The mix between whole loan sales and securitizations is dependant on a variety of factors, but is highly dependant on how to best optimize the level of cash received to production in any given quarter, balanced against the overall value received.

The percentage of cash proceeds received from nonprime capital market transactions was 85% for the current quarter compared to 90% for the first quarter.

In addition, rating agency standards are requiring the retention of higher than historical levels of reserves with securitizations.

As a result of this change, there is increased value in the residual, and less cash proceeds are received at settlement.

We anticipate that the mix of whole loans to securitizations may begin to shift in the coming quarters, as we are seeing superior securitization values in today's secondary markets.

This trade-off from cash to residuals would only be done when we felt like we could realize meaningful and additional value over time.

Our residual assets, given -- [INAUDIBLE] residual assets, delinquency and prepayment trends remain positive.

12-month 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 October, 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 tax-effective value of residual assets and 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 and a less yield -- or less steep yield curve.

Accordingly, during the quarter, we realized a net write-up in residual balances of $35 million, which was recorded in other comprehensive income on the balance sheet net of deferred taxes.

When we announced our fiscal 2005 guidance on June 9th, we anticipated pretax income in our mortgage segment to be flight to slightly down 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 in interest rates to compress margins during the first and second quarters, with margins normalizing during the second half of the year.

We are updating our overall corporate guidance to reflect the challenging market environment that I've been discussing.

We anticipate that, excluding last year's gains on sales of residual assets, we may see an approximate 30% reduction in pretax earnings for the full fiscal year.

Turning now to business services, there, the core businesses within the segment continue to perform well, due to strong, off season growth in accounting, consulting, and risk management services.

This was offset by underperformance of their capital markets business during the quarter.

As you will recall, we have several high potential, early phase businesses within this segment that require initial investment, and have pressed results in the short term, but are set to deliver solid earnings and margin over the long term.

This is reflected in our growing revenues from these businesses.

Second quarter revenues increased 18% to $129 million, and pretax loss was $5 million compared to a loss of $3 million last year.

The operating loss was primarily driven by weaker than expected capital markets results and continued investment in our strategic growth initiatives.

As we approach this segment's most productive quarters we are encouraged by the strong performance of our core businesses.

An important growth initiative for this segment has been to deliver sustainable sales and business development capacity.

We have been investing in the infrastructure to deliver growth for the last several quarters, and we are beginning to see solid results.

Although it's early, we are encouraged by the progress that has been made and believe that we are well positioned to expand our reach to middle market businesses.

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

Thank you, Mark.

As compared to July 31st, 2004, cash and cash equivalents, excluding 258 million being held for the repayment of the medium term notes that matured on November 1st, remained relatively flat at 317 million.

Funding is primarily for treasury share repurchases, dividends, income tax payments and off-season working capital requirements.

Cash requirements for the quarter were supplemented by short-term commercial paper borrowings of 316 million.

Near the end of the second quarter, we issued 400 million of 5-1/8% ten-year senior notes.

A significant portion of the offering was used to repay our $250 million of 6-3/4% notes that were due November 1st.

The remaining 150 million will be used for general corporate purchases.

Given the attractive interest rate environment, we felt it was appropriate to secure additional long-term financing.

The mortgage services segment is planning to implement a $3 billion commercial paper conduit program by fiscal year-end The program will be on balance sheet and will bring total available warehouse capacity to approximately $10 billion.

Mortgage residual interest and securitizations increased 28 million during the quarter to $262 million, decreasing the balance for cash receipts of 34 million.

The increase in the balance was $15 million in additions from new securitizations, accretion of 32 million, and an increase in net unrealized holding gains of 15 million, which consist of 35 million write up and net of 20 million in realized gains.

During the second quarter, we reacquired 3.8 million shares at a total cost of 182 million, or an average price of $47.81 per share.

A total of one million shares were issued for option exercises, employee stock purchase plan purchases, and restricted shares.

As of October 31st, there were 163.5 million shares outstanding.

Now I'll turn the call back to Mark for a wrap-up.

Thanks, Bill.

For our full fiscal year, we remain cautiously optimistic about the tax season outlook..

We expect to serve more clients from growth in our retail and digital distribution channels, capacity expansion, increased marketing effectiveness, and multichannel capabilities.

We'll provide more details around our tax season plans at our January investor conference.

Although our office network expansion costs will not require substantial incremental capital, as we've mentioned before, we expect the network expansion to negatively impact the operating margin and profitability in the early years, and provide margin and earnings lift as the office network matures.

Our full year expectations for the tax business remain unchanged from what we communicated in June.

We continue to believe we will experience high single-digit revenue growth and margins flat with fiscal '04, in effect absorbing the growth in offices into our current operating margins.

As mentioned earlier, the strong results that we've experienced over the past years in the mortgage business are moderating this fiscal year.

This remains of very good business for us, and with the changes we are making to address the near-term market challenges, we expect to find ourselves in a very strong position as we head into our fiscal 2006.

In business services segment, we continue to expect strong growth in our core accounting and tax services.

Additional start-up business investments will moderate our reported results again this year, but we believe overall performance for the segment will continue to improve.

In our investment services segment, we have revised our internal expectations last quarter to reflect this year's retail investor sentiment and our modest financial advisor growth.

We continue to believe that the business is positioned to compete effectively as the investment climate improves and we benefit from refinements in our business model.

We expect fiscal '05 financial performance to be slightly below fiscal '04.

On a consolidated basis, we expect fiscal '05 earnings per share in a range of $3.50 to $4.

In conclusion, let me thank you for joining us for this segment of the call.

The results reported today reflect investments that we've made in each of our business segments to improve operating performance and to drive additional growth.

We remain focused on prudent management of all of our businesses, as well as capitol allocation to create long-term value for our shareholders.

We look forward to meeting many of you at our annual investor conference on January 12th.

For those of you who are unable to attend the event, we hope you will join us on the webcast.

And with that, operator, we're now ready to open the lines for questions.

At this time, ladies and gentlemen, I would like to remind everyone if you would like to ask a question, please 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.

Good afternoon.

Hi.

Mark, I know you said you don't want to talk much about the tax season, and you'll tell us more in the January meeting.

But I was wondering if you could talk at all about any changes in marketing you plan in terms of product for the tax business?

Well, can you clarify, when you say, in terms of product?

Well, will you emphasize one product over another product?

You know, will there be more focus on RALs versus another product more focused on the digital part of the business versus just the core business.

Okay, great.

I understand.

Well, actually, we will -- we are looking at shifting around our communication mix and strategy a bit from where we've been last year, and I would tell you that's really in reflection of how markets are shifting and changing.

You know, we'll again, we'll discuss this in much more detail in January; but fundamentally, the market -- the campaign structure that we used last year is going to be carried forward and used again.

That's consistent with what we saw coming out of last year's campaign results, which was that while consumers really liked the campaign structure and the messaging generally, there were some things that we believed we could do with it to improve its effectiveness in driving clients, and we are making those changes.

One of those will be how we communicate the speed of refund advantage that you have available at H&R Block services.

And that -- you know, while we really like the -- and thought we had a strong message for that last year, what we found subsequently was that did it not drive the kind of awareness of that product in its availability and features that we need.

So we are making a meaningful change in the way that product is communicated.

Probably the other thing I would highlight is, we are looking at how to best communicate the range of digital products that we have veil afternoon.

There the problem is a little bit different, and we'll describe in much more detail in January how we're going about that.

If you could talk about the mortgage business a little bit, I know you've talked about reduction in pretax earnings and you expect continued growth pricing pressure, at least over the next six months.

What are your expectations in terms of volume?

Would you anticipate volume to remain somewhat flat for the second half compared to the first half, or would you expect a little bit of a rebound, especially since the new product is coming out?

Yeah, you know, I'd tell you that the -- there's a number of things that we're doing related to the production or productivity levels that we have within the business, and probably two things.

One that we've talked about previously, and then one that we're talking about today that is new, both of which we believe will have a longer term effect on our ability to drive higher levels of production.

The first of those is, we've been adding account executives throughout our system over the course of the last, roughly, six months, and they are really just now getting to the point where they're productivity levels are starting to accelerate, as they have been in the field doing -- you know, meeting with our client in the mortgage broker community on a pretty regular basis.

So we think that we're going to begin to see some pickup in productivity from that effort, now in the third quarter and into the fourth quarter, and then very meaningfully into '06.

The other thing that is new, which we are just talking about today for the first time, is some of this technology that we are bringing on board.

You know, we've been hesitant up to this point to discuss the technology or implications, simply because we wanted to make sure it was really going to do for us what we thought it could do before we set any expectations about it coming into the market.

We have a high degree of confidence in the broker prequalification technology that will be implemented come January.

And the evidence that we have seen from others who have introduced that similar technology, is that it has a pretty good effect on broker submission, so we are looking that by the beginning of the fourth quarter, then again more into '06, that we're going to begin to see some productivity improvement across our system that will result in higher levels of production as a result of implementing that technology.

Just one follow up to that, Mark.

You said you're adding account executives.

Can you talk about maybe how many account executives you have now that -- if you could maybe segment them, how many would be considered seasoned -- you know, maybe a year's experience or more, versus how many are new -- to get an idea of how many account executives you have that will become more productive and the ability for them to add to the business as we move forward?

Sure.

I'll just give you a quick data point, and then I'll have Bob Dubrish join in on this.

If you'll -- on the slide that we've included in the website -- or on the website -- you'll find specific numbers of account execs -- or sales associates, I think they're called down there -- and it'll show you the trend line of where -- how many we had previously versus how many are there now.

And you'll see it was a pretty meaningful -- it's something in the order of over fiscal '04, about a 30% increase in the number of sales associates.

So clearly, we're making progress.

Bob, what else would you -- ?

Yeah, as far as on the whole sale AEs, you know, we sort of track the new people versus people who've already been in the field for sometime, and I think the number is about 250, or the -- it's roughly the number of existing AEs, The new ones we've got is about 91.

You know, actually, they're ramping up exactly kind of how we would expect them to do.

Typically, we think it takes about 18 months to get an average account exec up to -- probably at an average level of production, and they're -- we're kind of right on target.

But one thing that we've -- Mark didn't mention was, we've also increased our retail loan officer base from about 500 to about 700, so almost about a 40% increase in the number of retail loan officers, which we also are starting to see the impact of that in the retail business.

Thank you very much.

I appreciate the answers.

Thanks.

Your next question comes from Michael Hodes with Goldman Sachs.

Hi, good afternoon, guys.

I wanted to focus in on mortgage with just a couple of questions.

First, Mark, maybe you could give us a sense are of -- what if any kind of price erosion you've seen, you know, so far in November, just so we could kind of contrast it with it the run rate on average in the quarter, as well as any degradation in volumes.

And then if you could just kind of at a high level, talk about your visibility in this business, particularly in contrast to, you know, some of the very specific comments that you offered up in August.

Kind of just give us a sense of how the competitive environment, you know, changed substantially over the last couple of weeks, and some of the highlights from that changing backdrop.

Yeah, you know, the one thing I would point out, I'm not sure it's changed a lot in the last several weeks, at least that we can, you know, kind of discern.

So I can talk more about what we saw developing over the course of the quarter, and then a little bit of what we -- you know, at least are anticipating to see heading forward.

No, right now we're seeing that the WAPs that we're originating at are coming in about kind of flat with where we were at, but you know, we contrast that -- we're -- you know, we've been -- we're originating kind of flat WAPs against a rising rate environment, so that's one of the reasons we are concerned about -- the prospects for the upcoming quarter.

You know, the thing that is -- that is surprising -- that was not anticipated by us for the previous -- the last quarter -- was that we thought that, you know, some of the competitive pricing pressure that out there was going to moderate.

You know, we have seen rates, at least early in this fiscal year, starting in May and June, we saw rates spike up.

We thought that was beginning of the longer term trend and that we would be on a sort of steadily raising -- rising trend line.

Obviously, that didn't happen through the first quarter -- they actually came back down.

And now we're back into a rising rate environment again.

So this volatility or the movements up and down a little bit that we're seeing in the secondary markets, I think, is causing various different players in the market to take a more cautious view on how quickly they should or could or might have raise rates, and we have to remain competitive if we want to maintain the position that we have with our broker clients.

So -- so that's really what's going on.

You know, we also think that there's some specific industry participants who have specific sort of strategies that they are pursuing that is causing them to want to, you know, do what they can to gain market share at this point in time.

And there are, you know, those who are unlike us and don't really have a strong service position, have no alternative other than to use price as a way to do that.

We have typically and historically not used -- or you know, competed, as the lower price provider, and we will continue not to look to be the low price in the market.

But that means -- it doesn't mean we can get too far out away from the where the market leader is, whoever is setting the lowest price in the market.

So as a consequence, we think that the experience we've just had in the second quarter, where we didn't see the market -- our competitors in the market -- start to sort of move their rates in conjunction with secondary market rates, has led us to be very cautious about what's going to happen in the next three to six months, if not into '06.

And accordingly, we're taking the actions, both with guidance, but also with our own cost structure, to ensure that we remain competitive.

And just to confirm, my understanding is that if we look at the two-year kind of swap curve and look at the progression of rates over the last couple of weeks, it's up -- call it 40, maybe 50 basis points.

You're saying that, you know, your WACs are basically flat against that increase?

Yeah, that's right.

You know, and frankly, you know, there's a lag from the time that secondary markets move and pricing increases go into the market, and then ours have been realized in the market, so we know there's going to be a lag, and we're anticipating that to have a meaningful effect on us now in the third quarter.

And you know, frankly, we're -- many of us in the industry, I think, are all kind of waiting to see who's going to move first on rate increases, and we haven't seen that happen meaningfully yet, but you know, based on what's happening in secondary markets, we, you know, broadly view that it's got to happen sooner rather than later.

And this is a good backdrop to be kind of staffing up and kind of expanding?

Well, you know, we have -- we had made the commitment to the account executive staffing levels back in March and April already, so we are really beginning to see the benefits of that staffing decision from then on our productions.

They're really starting to pick up now in the third quarter, so -- you know, and we also believe that -- that -- we have been incurring the cost to ensure that we have the back office capacity, in terms of underwriters and account managers and that sort of thing, to support the new account executives as they became productive -- so we think that, you know, that will allow us to bring down our average cost of origination -- not with higher cost, but also with higher levels of production.

The other key thing is that, you know, we saw this new technology coming that we were about to implement, and we have been, you know, spending to support that technology in advance of its rollout.

So a lot of the costs that were -- are in place are consistent with our desire to have a bigger footprint in terms of the number of account executives and the reach we have, and they are now just reaching kind of the stage where we're seeing some good productivity lift coming out of their activities, and the cost structure that we have in place is really there to support both those new AEs and the technology.

All right.

And two just quick questions, and then I'll yield the floor here.

The on-balance sheet CP conduit that was mentioned, did that create any income recognition distortions, just given the way the revenues have been recognized previously with the off-balance sheet conduits in the past?

Yeah, it would.

Anything that is in the on-balance sheet CP conduit would not result in revenue recognition in the quarter that the loans were originated, if they remain funded by that CP conduit.

So anything that remains on balance sheet would just have a deferral in the revenue recognition.

And that's in the guidance or not in the guidance?

Well, our current plan is that we'll have that CP conduit in place by the fourth quarter.

My current -- our current guidance would not anticipate that we would carry anything over year end in that conduit.

Okay.

Then just lastly, if we were to have calculated the net gross gain on sale margin, or whatever the phrasing is that you used, for the month of November, how much down would it be from what it was in average -- on average in Q2?

You know, I don't know that number off the top of my head, but you know, we are generally -- we are generally looking for it to be, you know, kind of flat to down, you know, slightly.

Okay.

Thank you very much.

Thanks.

Thanks.

Your next question comes from Chris Gutek with Morgan Stanley.

Thanks.

Hi, good afternoon.

A couple of big picture questions.

First on the mortgage business, for Mark and Bob.

You guys, back at your analyst day in November -- excuse me -- January of '04, I think you guys talked in pretty positive terms about the long-term secular trends that were driving strong growth in the subprime market, as more low-income people were buying houses and the products were becoming less onerous, and therefore the market was expanding.

Have you guys moderated your fairly bullish long-term secular outlook for the subprime industry?

No, I don't think we have.

In fact, we're, you know, in the process of developing sort of an update to that view that we're going to share in January, so you know, we will get updates -- at least our point of view on that -- but I don't think anything that we're see would suggest that this isn't a very -- you know, a good business for us to be in, and a good industry to be in.

You know, the reality is that what we're facing today is essentially a flat or, you know, only up -- you know, the first nine months of this year, as I recall the numbers, you know, this industry -- this part of this -- the subpart of the industry is up 50 or 60% relative to last year at the same nine-month period, while the prime business is, you know, what everybody knows it's done -- you know, it's very volatile.

So in that sense, I think we're still seeing the same kind of longer-term trend.

The third quarter was probably the break in that trend where it really flattened out for the first time in a long time, and we think that that has a lot to do with sort of the volatility in interest rates.

But generally speaking, the things that are going on across the United States that have brought more people into home ownership, and the sort of leveraging of people's personal balance sheets and the need to tap home equity as a way of lowering costs, those things haven't changed, and we don't think they're going to change any time soon.

Okay, great.

And a big picture question also on the tax business.

Sounds like you guys are modestly ahead of schedule in opening new offices.

Is there anything that you guys see from a competitive landscape perspective?

In other words, are some of your competitors, from your perspective, ahead of schedule, behind schedule, in opening offices?

Anything thing that you see that makes you worry about your ability to get back to positive volume growth this year in the tax business?

Excuse me.

Chris, we don't necessarily get any direct visibility into what competitors are doing outside of, you know, what is publicly communicated.

But we have not seen or encountered obstacles in our expansion efforts, so we have not seen any big drive that would be shrinking kind of the opportunity for us.

So for right now, we've not seen that, and -- but we'll obviously have more insights into that come January.

And maybe a nuance, Jeff, you can elaborate on, But as my -- as I understand it, we typically are, you know, pursuing real estate expansion space where, you know, we would be looking for a tax provider exclusive inside of a particular trade area or within a particular owner's property, and we -- to my knowledge, we're not encountering, you know, substantially unusual levels of competitors who are there looking for the same space.

Right, that's right.

I mean, the circumstantial evidence would certainly say that things have not changed, we haven't seen any big ramp-up in the competitive -- in the competitive front, which leads to us believe that it's substantially similar to what it was in the prior year.

I would also say that the landscape in general, we completed some research this year that basically gave us a little bit more comfort that from an expansion perspective, that even though we've had some difficulty over the last couple of years, to the extent that we do increase our level of accessibility and therefore convenience that people do have a strong desire to be served by H&R Block, and so our goal is to continue to take advantage of that opportunity, of which the real estate expansion is primary way of getting there.

And just to close the loop, you do expect to get back to positive volume growth this tax season?

Yes.

Okay, great.

Thanks, guys.

Your next question comes from Michael Millman with Soleil Securities.

Thank you.

I'd like to follow-up on Chris's last question.

I think you've been saying that you expect to increase market share in tax.

The IRS is forecasting they'll be at 1.5%.

Are you suggesting, then, you'll be up greater than 1.5% in returns this year?

Mike, the -- I'm not exactly sure what data point you're looking at.

There have been a variety of data points that have come out from IRS recently.

I've seen numbers that look -- the most recent number for the year showed IRS up about 23 basis points.

I've seen 44 basis points, I've seen 150 basis points, and it really depends on what numbers you're looking at.

Those numbers are also not completely true, because they are on a calendar year basis, not on a tax season basis.

So we have not said that we would necessarily expect to be higher than that -- than the industry growth, and I think we should reserve that comment for our January investor conference.

Yeah, I think it really -- you know, in order to put context around it, we really have to have much more discussion about, you know, sort of what we see the landscape to look like, what we think we can do about, and what that translates into rather than kind of giving an off the cuff number.

Okay, so -- so we'll hold on what the -- definition of the market share means.

Okay.

Maybe you can talk a little bit about -- and maybe this was a timing issue -- on -- in this quarter, the execution price and the margin was 11 basis points difference, and where it was about 140 basis points in the first quarter.

Difference between what you called execution price and net gain.

Well, execution price is the price at which we delivered into -- the loans that were delivered were actually, you know, delivered into, you know, previous commitments that existed.

Let me take a shot at distinguishing these two, and you can see this data.

And this is also some data that's on the website.

You know, we try to distinguish between both the execution -- or the -- excuse me -- the net gain on sale that translates into revenues and ultimately translates into cash flows, versus loan delivery; and loan delivery is something that happened that once we book the revenues and once we book the gain on sale, loan delivery is really a lagging statistic on what got done out of the warehouse after the quarter was over.

So what you're really seeing, I think, more than anything else is the kind of loan pricing we were getting back in April and March that was delivered -- excuse me, in -- yeah, some of the forward commitments that we were booking back in April and May and June -- that were just not being delivered into, because we held loans in warehouse for a period of time and then we sold them into these forward commitments.

That's what the execution price reflects, and they really reflect forward sales commitments that we made back, you know, in this case probably, you know, February, March, April time frame --as long ago as that -- that are just now being delivered -- or this past quarter being delivered that.

That is in contrast to the pricing that we are expecting the loans that were produced this quarter to generate when they're ultimately sold, which is what the net gain on sale number is.

Is that completely -- you know, did I mess that up?

So it's basically a timing issue as to -- and so do we get any information by knowing what your future execution or --?

Well, the -- sure, the -- in effect, and the way to think about this is that the net gain on sale number that we are reporting is the price at which we expect to ultimately deliver the loans that we just produced.

That is the price.

That's the average price that we think those loans will be delivered -- we'll receive when we deliver those loans; and, you know, I think I commented on this last quarter, and I'll try to explain myself on this again this quarter.

We have adopted an accounting practice that essentially says that we will recognize as revenue in the quarter alone as produced what we estimate the profit margin to be on that loan that was produced this quarter.

And then we -- you know, we ultimately deliver that loan out of the warehouse and it goes -- you know, we get the cash flows from it and everything else; but the revenue that's generated in the quarter, reported in a quarter, really reflects the value of the loans that we produced this quarter; no matter when they are ultimately going to be delivered.

So we think this is the best representation of the real economic value that's being generated from our loan origination activities.

So the 283, which is the net gain on sales this quarter compared to the 272 last quarter, those -- that is our estimate of the economic value that's been created by the loans that we produced this quarter.

Okay.

Still on mortgages, you didn't -- it doesn't look like up did a renim [PHONETIC] in the second quarter, despite the fact that you had a substantial write-up and that you said you were unlikely, or were not going to recognize any accretion until '06.

Can you discuss -- was this a market-based decision, or was this -- maybe -- what goes into your thinking about the timing of doing renims?

Well, with the -- you know, I'll tell you, it's a couple different things.

You know, on the one hand, we clearly, you know, have a preference for cash, but that preference is moderated by what we think the real underlying value of those kinds of assets are.

The discount rate that we apply to the expected future cash flows that give rise to the valuations that we use are for, I think the number is -- cash flows expected in the -- or that don't -- or pools that are not -- excuse me.

Residuals that are not expected to generate cash flows in the next 18 months, next 6 months.

We use a 25 -- excuse me.

We use an 18% discount rate.

Anything where we think that the cash flows are beyond that, we use a 25% discount rate.

That means that the valuation of these have inherent in them a lot of value that is going to be accrued to shareholders, 18 to 25%, on the asset value, and our general view is that's not bad returns for what we think are very controllable kind of valued assets, and so, you know, we're not real quick to sell those away unless we think somebody's going to give us, you know, real meaningful value in a renim transaction or in a -- in some kind of a residual sales transaction.

So we look at it -- we consider it.

I would tell you that, you know, we will probably look at it throughout the course of the remainder of this year for sure, if not all the time, and the write-ups that we're experiencing, I think, are -- give us rise to -- give us reason to always consider whether or not we ought to be selling some of those assets, as we're realizing that they have more value.

But there's nothing from a policy perspective, I guess, that would cause to us do one thing or another.

And could you -- typically, in the beginning of September, or -- I guess the beginning of September -- the -- there's a sale by the -- the temporary employee stock options get exercised and sold, and they didn't seem to this year.

Should we be expecting that to occur at the end of the period, or has there been some change in the structure of those options?

Yeah, there wasn't a structural change, but there was a -- you know, I mean, we did see an interesting shift this year so far in the pattern of exercises.

You know, and I can tell you that we have seen, you know, a more normal November level of exercises as in prior years versus the early September exercises, where we didn't see nearly as many.

Now, we generally think -- and I'll come back to sort of what we think for the -- you know, as we go to the end of November.

We generally think that's got to be good news, because the reason people would choose not to exercise is because seasonals intend to stay with us for another year and, therefore, they are -- they know that they'll still have access to those options next year, so meaning the retention of our tax professionals is a key priority that we have that gives us a competitive advantage in the way we do our business.

And as a result, you know, I think that this is an early indicator that we are in, you know, a positive shape relative to this year's recruiting efforts.

But, you know, whether we'll see a bigger level of exercises between now and the close, which is November 30, probably depends an awful lot on the stock price.

Thank you.

Your next question comes from Mark Alpert with Emporium.

Hi, can you hear me?

Yes, we can.

Okay.

I'm on my speakerphone and I'm afraid I'll lose you if I try to switch to my headset.

A couple of questions.

In terms of the mix of earnings that you've -- previously you were at 4 to 4.25, and now we're around 3.50 to 4, but is all that decline attributable to mortgage banking and, therefore, kind of what is the mix of mortgage banking versus tax and business services?

Yeah, I would tell you that, you know, from where we saw the year coming in before to what, you know, we're now suggesting, you know, is appropriate guidance, that shift is virtually all related to a, you know, the outlook we have for the mortgage banking operations.

So, you know, that's sort of point number one.

You know, the mix -- clearly, with that kind of a shift in the mortgage business, we expect the dominant -- the largest share of our earnings this year to come out of the tax and the accounting businesses.

That is clearly -- you know, those businesses don't have the level of volatility in terms of earnings, both upside and downside, that you have out of a business like the mortgage business, or even the business like investment services.

So, you know, we'll see a much larger proportion of our earnings coming out of tax.

Maybe like a 60/40 mix?

Would that be in the ballpark?

You know, I don't -- I'm afraid to put a number on that, just because if I did that, you know, it would be open to interpretation -- did I include corporate, did I exclude corporate?

Did I go to the operating line, did I go to the net line?

But clearly, it's probably more than -- you know, realistically, it's probably more than 60/40.

It's more like -- by the way I measure it, it's probably two-thirds tax and a third others.

Okay.

And you have not changed your long-term 13 to 18% EPS growth guidance -- or target, I should say?

Yeah, no, we -- you know, we're in the process of kind of looking at sort of our longer-term expectations for all of our businesses and the industries they're in.

We do this every year in anticipation of our January kind of update with the Street, and all the indications I've seen so far would suggest that we believe that's still very appropriate guidance.

Okay.

And then the last question, and I get -- I find it confusing, not just with you but sort of in the whole mortgage area, but you're not the first to say that, you know, some of these portfolio builders now, the ones who are trying build their portfolios, are causing some -- are being very competitive on pricing, but it seems to me that, let's say that they were -- they were packaging and selling these mortgages in the previous years.

In other words, they were adding to supply -- now they're keeping it on their balance sheet.

Why doesn't that make you, as a seller of mortgages, have more scarcity value?

Because you're -- because there had to be buyers that of product before who were buying it from, let's say, the New Centuries and the Saxon's, and now those guys are selling as much because they're building it, so why doesn't that give you more pricing power?

Well, a couple of things.

Number one, they are doing both, so they are -- you know, they are selectively choosing which to package and which to build into portfolio, so that hasn't changed.

You also have -- you've had more supply within the nonprime industry so far this year.

Now, that's probably offset by less supply in the traditional prime market; but fundamentally, the secondary markets, while there's probably some bias towards which -- you know, how much home equity paper somebody's willing to carry in their portfolio -- for the most part, these are -- they're a big trade-off between this asset category and other asset categories that are alternatives.

So while, you know, we're all subject to essentially the same secondary market pricing demand, regardless of the asset category that we happen to be bringing to the market.

So I don't know that -- I mean, certainly, I take your point that there might be a portion of the, you know, of the, you know -- of the bond market that is looking for our type of paper -- our industry's type of paper -- but the fact of the matter is, you know, we still had a very high amount of supply that -- this year, despite the fact that some people are doing portfolio strategies.

Or else maybe are risk premiums rising?

Could that be part of it?

Well, you know, we don't judge -- we can't see that risk premiums are rising, necessarily.

In fact, in some ways, I think the risk premium is being adjusted.

You know, there's been some structural changes in the way that the rating agencies are sot of rating the bonds coming out of securitizations of this kind of a paper -- of this kind of paper.

And in many ways, what they have done is they've lowered the risk of some of the bonds by the, you know, the actions they've taken.

So if anything, I would almost tell you it's the reverse, that the risk ratings are probably less severe than they were before.

Okay.

Thank you.

Your next question comes from Ed Najarian with Merrill Lynch.

Good evening, guys.

Hi, Ed.

Bear with me.

I'm not used to following your company.

But maybe I can ask a quick question.

I'm looking at gain on sale number going last quarter from 272 to this quarter from 283, so an 11-basis-point improvement.

Why then, if that's -- if you have an improvement in the gain on sale -- would that lead to sort of a downward revision in your earnings outlook?

Were you looking for a bigger improvement?

And if so, could you give me a little insight as to why?

Yeah, we had anticipated that we could see -- we were expecting to see something in the order of 50 basis points of improvement this quarter, and then we thought we would see as much as another 25 basis points or more beyond that in the third and fourth quarters.

So we are not seeing the level of improvement in margin that we anticipated currently; and as a result, we are also believing that, you know, it's prudent for us to be cautious about the pricing environment that we're walking into, or we're in the middle of right now, as it relates to our third and our fourth quarters.

You know, I think the key driver, frankly, between what we had anticipated and what we're really seeing ourselves able to do in the market is the competitiveness of the pricing environment.

So you know, people are just pricing loans much tighter than what we would have anticipated relative to secondary market levels, and as a result, we're not getting the WAC increases that we were expecting to see.

So last quarter's -- last quarter's 272, you were feeling I guess at that time, just to update me, was that because rate were rising back then, you felt like you were a bit of a victim of the lag effect, and therefore you might be able to see some of that come back in the second quarter, but that really didn't happen because of the competitive pricing environment?

Is that how I should construe that?

Yeah, that's exactly right.

In fact, you know, the thing to look at is, the weighted average coupon that we had this quarter, 746 versus 721 last quarter, we would have thought that we could have gotten that up to, oh, I want to say maybe closer to 770 this quarter, was kind of what we believe we were trending toward.

And as the quarter wore on, we were having to make more and more price exceptions to stay competitive with what others had done.

So that's the other -- that's the place to see the real in the market pricing effect.

Okay.

All right.

Thank you.

Your next question comes from Jeff Imberstits [PHONETIC] with Shareholder Value.

Hi.

Could you give us a little more detail on the technology you're using for origination, who you're partnering with and who others might be in delivering the next-generation services?

Sure, I'll let Bob kind of, you know, come at that.

His question was, you know, sort of what the -- a little bit more about the technology that we're putting in place and to the extent we're working with any partners, who they may be.

Yeah, the -- we're working with IROD [PHONETIC], and I think that they're -- we're doing two things.

One is, an automated prequal, which is really the broker being able to, 24/7, being able to go in, input some basic information, and get a -- sort of a preliminary approval back.

What we think the impact of that will be is that, you know, our account execs today do a lot of that manually, or they do it at home at night via fax and via e-mail, and so we think that's going to increase dramatically the productivity for our account execs.

The second piece of it is the automated underwriting piece.

And as Mark said, we're slow to get to the -- you know, kind of get to the table with that; but having said that, before -- our automated underwriting will be a real approval.

We're not going to back and reunderwrite it and add conditions and things, and that's why we're been sort of hesitant to get the technology out there probably as quick as maybe people would have liked.

But I think that the product that we're going to end up having out there will be if the broker gets an approval via the underwriting system, we will -- that will be the approval, there will be no secondary underwriting or any new conditions of things -- which in the wholesale business is extremely important.

But for the most part, it's going to be sort of our proprietary systems.

Okay, yeah, just a quick follow-up.

And so your proprietary systems and sort of the industry standards?

Yeah, I don't know if there really is an industry standard per se.

Yeah, it -- yeah, it's really our -- it will be our guidelines.

But you know, the data is with our guidelines.

And it's going to be our guidelines, but it will be our technology.

We were partnering with others to help us build it, but it will be proprietary technology to us.

And I think the impact that will have will be on the branch -- it will -- on the work flow.

I think that's probably -- of all the things that we're doing, that's probably going to have the most dramatic impact on cost originating.

Okay, year.

Fair Isaac mentioned something about getting a nice business at their analyst day last week, and I just wanted to understand if you're working them, or what that level of solutions were Thanks for your help.

Okay, thanks.

Your next question comes from Christy Mills with Avalon Research.

Hi, good evening.

Just looking at your mortgage services and the accretion on beneficial interest, I'm wondering how much is in that current quarter's gain on sale number?

Well, the accretion wouldn't have any -- wouldn't at all be in the gain on sale.

I thought you guys reclassified it.

No, no -- oh, I'm sorry, yeah, we did.

I'm thinking of a different item.

You know what, it's in the appendix, right?

Can you point me to the correct page?

I mean, we're trying to lay this all out in the appendix so that we can, you know, sort of get apples to apples.

Does it have it in there for last quarter as well?

I'm sorry?

Does it have it in for last -- Q2 of FY '04 as well?

No, it doesn't.

You know what?

In fact, on that particular -- you know, sort of that detailed question, maybe what I would suggest is you call our Investor Relations group.

They would be happy to walk you through all the detail on that.

Okay, can you just maybe provide some more information then in terms of what led to the decision of [INAUDIBLE] reclassification?

Was that something in the market that drove that decision, or?

No, it's actually -- it's actually sort of a -- it's a refinement of our view of the off-balance sheet financing vehicle that we use -- the warehouse facility that we use.

In an off-balance-sheet warehouse facility, in effect. there is a true sale that occurs when the loan is transferred in, and that's the accounting treatment.

Historically, we had carried the -- sort of the net spread that is earned while loans are in the warehouse.

We carried that as interest income.

That is more appropriately called part of the gain on sale, and that's why we've reclassed it.

We really haven't changed the underlying economics in any way, we haven't changed the cash flow in any way; we've simply changed the geography of where that part of the value is reported.

Okay.

Great.

Thanks.

Thanks.

Your next question comes from Mark Spruel [PHONETIC] with Thomas Weisel Partners.

How you doing?

Great.

Quick question on -- actually, on the financial advisory section.

Obviously, it's kind of continued to poorly perform overall.

I think flat on its losses year-over-year with your new sort of guidance.

Is there a point at which you kind of start to reevaluate kind of how -- I mean, I guess, its kind of core nature to your overallness?

And is there -- and double -- second onto that, is there a -- you know, kind of a level of kind of retention benefits that it is accruing to the tax benefits that can offset some of the losses that we're seeing on that side of the business?

Yeah, you know -- you know, there's certainly -- we believe there are benefits, and we can see what those are on the tax side, but they are not so material that it would be offsetting for the level of the loss that we're experiencing in that business.

So in many ways, we have to judge that business's financial performance as its own performance.

I would tell you, you know, from my vantage point, the key thing that I have been looking for is to see what kind of performance we can get out of that business with the enhancements that we've made, with the changes that have been made in the sales process, and the product set in all kinds of things that the management team there has really done to position that business the way we would like to be able to operate it relative to the market opportunity that we see with the Block client base.

Having done all of that work, we have kind of found ourselves in a very choppy and difficult investor sentiment period, where we didn't feel we were getting a real valid read on the level of performance that you would realistically expect out of that business.

So in some ways -- and I don't mean to sort of hedge the answer on this -- I keep waiting for to us get to a stage where we have sort of normal investment market, so that we can get a good sense of whether or not our model is working the way we expected it to be working.

You know, and every time I get optimistic, like I am again right now that you know, we've started to see that, you know, equal out now in November, you know, something else comes along and sets us back.

So -- but you know, for that reason, I'd been hesitant to put a time frame on when we will do that evaluation, but we clearly understand the sort of economics of the business and want to make sure that it's contributing to shareholder value in the long run.

One last question on the mortgage side, not to sort of beat a dead horse here, but curious on the improving gains on sales margin, you had mentioned, obviously, this quarter and possibly fourth quarter, would slowly sort of be flat to down this quarter and slightly up in the fourth quarter.

And maybe I was wrong, but did you mention that you thought that fiscal '06 would start to see a return to kind of historical gain on sale levels?

Is that -- is it coming from that?

I guess it would be upside to mortgage in '06 from that level, that side of the business, or is it just from increasing kind of volume production through your broker relationships and your improving technology advancement success rate?

Yeah.

You know, we -- I didn't say what you accused me of saying, which is that we expect it to get back to more normalized levels in '06.

But that's -- you know, having, you know, giving you that caveat, I would, you know, sort of tell you, you know, we are, I guess, cautious about the level of market gains, or the, you know, gain on sale that will be able to be realized in a competitive market environment going into '06, and that is why we are, you know, making strides to lower our cost of origination, which is another way of getting market -- or getting margin improvement and getting profitability improvement out of that business.

And at the same time, we do think that the things that we're putting in place now, with the addition of account executives and the addition of this new broker prequal technology, will give us the opening to have a higher level of productivity and production.

So longer term kind of story is going to be the pricing environment is going to remain pretty tight for quite some time, but you're looking to drive volume kind of improvements through kind of the improving your relationships and technology advancement and better people on the ground?

Yes, that's a fair way for us.

That's the way we are thinking about the business as we look into '06.

All right.

Thanks a lot.

Thank you.

Your next question comes from Dan Kerse [PHONETIC] with DK Equities.

Yes, good evening, gentlemen.

Thank you.

Could you perhaps revisit the repurchase authority that you have left at this point, and at what level, if any, would agency considerations prevent you from doing even more?

You know, we have a significant amount of remaining authority from the board.

I think that, you know, we have, I think, maybe 15 million shares left in the, you know, previous authority, so that is clearly not a limitation in the, you know, sort of current or near term.

You know, I think certainly we have targeted capital levels that we have built around what we believe is a prudent capital structure for the mix of businesses and the types of assets that we carry, and we have shared that with the rating agencies.

I think they are, you know, they're very familiar, and I think supportive of the way we think about capital; and as a result, you know, we manage toward a targeted capital level against our capital models.

To us, or to me, that is the -- you know, the limitation.

We look at the available capital, we look at what our targeted capital structure is, we work towards that targeted capital structure, and we look to return excess capital back to shareholders in an efficient a way as possible.

And you know, we obviously don't get into discussions about what our intentions are in that front, but, you know, that's how we think about it.

So the targeted capital structure and quantitative terms you wouldn't share?

We have shared it.

I think, you know -- in fact, I just -- or maybe again you could talk to our folks in Investor Relations, and they could take you through the detailed model.

We share that model, you know, broadly, and if we make any changes to it, we will -- we typically update people.

I'm sorry, that's what I was referring to.

Let me move on to something else, if I may.

Your earnings guidance being reduced roughly 9, 10% if you take a mid point, how will cash flow from operations of free cash flow air in terms of a down magnitude of order compared to EPS guidance reductions?

Well, it -- I was trying to think if there was anything really unusual relative to the -- you know, the noncash element of that.

You know, it really depends, I think -- you know, the earnings are typically -- this company with only a couple of exceptions, are typically -- you know, earnings are cash flow.

In fact, in many ways, we have more cash flow than we have earnings because of things like stock -- or equity expensing and amortization of intangibles that are going through the P&L.

The big driver is whether or not we carry larger levels of residuals as an asset at year end, and that really is that trade-off that we were talking about earlier between value versus cash.

And we have a bias towards turning all those morning earnings into cash; but there are times when in the securitization market, there's a lot of value in the residuals, and the market typically won't pay you for those, and we will sometimes make that trade off and it really depends on how the secondary markets shape up over the course of the next six months.

Thank you.

On one other front on the mortgage side, you mentioned obviously, the spread being less advantageous than it was.

When you model your own expectations for the mortgage business for the second half of this year and into next, do you make any explicit assumptions about where you believe two-year swap rates are going to be?

Yes, we do, and we explicitly look at what the forward curve is implying.

Okay.

One of the holy grails of improved operating income margins in tax is to have less client churn -- [INAUDIBLE] overall tax client retention rate.

You mentioned one of the things, I believe Jeff did earlier in the call, about staff, that there was some kind of progress on that front.

Would you just briefly give us an example or two, if there is one?

In the -- just to the comment on holy grail, clearly, retention is important.

And the reason why retention is important is, in theory -- and it really is in theory -- you could -- one might argue you could have lower marketing costs if you didn't have to replace so many clients on a year end and year out basis, as well as you have a little bit better efficiency when you have returning clients come in relative to new clients.

Some of the things that we're thinking about are streamlining of our back office functions.

We have -- we have a lot of support that has been in the organization for a number of years, largely in the same general fashion.

We have -- we have, over the last five years, made significant technology enhancements.

We're now comfortable that those enhancements are in, so one of the things that we're doing is we're looking at where are the opportunities to modify our processes to take better advantage of the technology.

So that would be one of the examples of things that we are doing to increase -- kind of increase margins or have better efficiency across our expense structure.

There are several other areas of which we will give a snapshot in January, so it's probably best if I wait until that point.

Okay.

Finally, perhaps an academic issue, but let me ask it.

Do the -- there's obviously a post the elections has strengthened GOP holding Congress, combined with President Bush tax simplification mantra revisited.

Is there more than a snowball's chance of a major tax code simplification, in your view, or will this just become another huge compromise leading to yet more tax complexity down the road?

Yeah.

You know, generally, I think most people who are close to this, you know, agree that the prospects for some tax reform are good, but you know, for massive overhaul, you know, it's just really -- you know, it's highly unlikely.

I think realistically, most people believe that, you know, there are very few special interests who are are going to give up the special tax breaks they have built into the tax code without a major fight, and this is not such a compelling demand from people across the country that I think a lot of politicians are going to take a lot of heat politically on behalf of, you know, a concept like tax reform that is extremely complex.

So we don't lose much sleep over this discussion.

Too many vested interests benefiting from the status quo and a change would probably lead to more complexity, not less.

Would that be a fair guess?

You know, it's hard for me to believe after all the work that's gone into building special twists on the tax code, for different constituents that suddenly they're going to all just kind of get wiped out.

You know, the reality is, those kind of -- tax simplification really requires the ability to cut taxes as part of the simplification process, and the deficit levels that we're experiencing today probably keep anything but tweaking from happening in the near term.

Thank you very much.

Thanks.

Your next question comes from David Chamberlain with [INAUDIBLE]

Hi, yeah, most of my questions have been answered.

Just on a follow-up on you guys' expectations for, you know, the mortgage gain on sale margins and the market in general.

What gives you kind of confidence that the competitive environment will, I guess, improve from current levels.

Is that what you're anticipating?

No, in general, I think we -- you know, our anticipation is that they're going to stay kind of competitive like they are, if not get a little bit tighter.

So as we think about -- look out into the future, we're not -- we're not optimistic that they're going to get a lot easier any time soon.

Okay, and a follow up just on the volume side.

It sounds like you think you can still grow volumes on a year-over-year basis, and that is as a result of, you know, market share versus the overall market, or can you give me a sense on what your thoughts are there, too?

Yeah, you know, when we think about our challenge out there, we are not thinking that we are building a, you know, capability just to capture growing degrees of volume that are available because of expansion in the market.

We really do think that we have to -- you know, in today's environment, we're going to have to compete harder and harder for share of market as opposed to, you know, just kind of capturing growth that's occurring.

While we may be pleasantly surprised to find that there's more growth, I don't know that we're, you know, building our plans around that expectation.

Thank you.

Your next question comes from Bob Coleman with Gardner Rousseau.

Yeah, good afternoon.

Mark, using your assumptions of the $3.50 to $4.00 range, it would imply between 581 and $664 million worth of net income.

If you add back the amortization, loosely, you're up to about $715 million.

How should we look upon your capital reallocation of that -- of those dollars at year end?

What would be used for debt repayment?

What would be used for share repurchase, and how much would be reinvested back into the business?

Yeah, in general, we don't think that there is -- you know, that we need to reduce our levels of debt, so our expectation for long-term debt certainly is to be consistent with where we've been before.

Now, because we've upsized slightly the MTL that we just did, it will be a little bit higher than that; but you know, in terms of overall debt levels, we were not looking to reduce them this year.

So, you know, we really then look at a trade-off between sort of the investment alternatives that we have backed into our business and the assets that come along with that, versus share repurchase, because share repurchase ultimately -- because in the end, we're not looking to hold excess capital above our targeted -- our modeled levels.

You know, I'd tell you that the biggest swing factor between those two as we look out for the balance of this year -- and probably this true going into the future as well -- is whether or not we think there is greater value to hold residuals and to dispose of our loans through that type of a mechanism versus whole loans, and there are times when you can get superior value by securitizing and holding a piece of the loan pool in the form of residuals.

And we think that, you know, -- when we can see a meaningful trade off and capture more value for shareholders, even if it means we won't realize it, you know, in the current year, that that's a good thing to do.

Now, we are always, you know, in my judgment, trying to balance that against where we think the share value is and what the sort of intrinsic value of the stock is, and whether we can capture more value by returning value to shareholders in the form of share repurchase.

So that trade-ff -- that's, I guess, generally how we think about the trade-off.

We have not sort of stated exactly how much of that trade-off we think will happen this year, primarily because we can't necessarily judge what the secondary markets for the mortgage business will look like for the remainder of this year.

And then my second question deals with the mortgage business.

What is the economic competitive advantage of all these REITs that are being created; and looking out in the next couple of years, does that economic competitive advantage allow them to, you know, suppress the pricing in the market until that capital is fully committed?

Yeah, you know, we've been -- we've studied the, you know, sort of the structural differences that come with that structure, and I think there's risk and return trade-offs that are going on there, and I think, you know, for an organization a key trade-off is access to capital markets -- because you primarily have to rely on the ability to raise capital in order to continue to grow your business after you are full up -- and it's unclear to us, you know, whether that will continue to be the case, or that will be available to people at a reasonable price or not into the future.

Now, it's not an open question, or it's not a big question in the near term, because you have people who have raised capital, and they are now filling that capital against their balance sheets.

And we do believe -- and I think we stated this earlier -- we do believe that as those balance sheets are being filled up that there is probably -- that it gives a structural reason to believe that pricing pressure will remain in the industry, because people have an incentive -- other competitors have an incentive to fill those balance sheets as quickly as possible, without giving up too much in terms of product attractiveness, product price, that kind of thing.

It's hard for to us see the trade-offs that are being made, as people are choosing which loans to sell into the secondary market and which to keep on balance sheet, because you can't see that.

I know.

But, you know, so we're, I guess, studying what that implies, you know, the -- our first take is that it probably introduces an element of risk to those companies for their own strategies.

On the other hand, if they pull it off, probably, you know, leads to that as more of a preferred form of funding the business.

And my final question is, what is is the probability of H&R Block bumping up against its $10 billion line of credit on the production side?

No, we don't see that as a -- you know, as a meaningful limit for us anytime soon.

So the $6 billion in run rate is probably pretty standard for --.

Yeah, you know, in fact, you can see that.

We ended up this quarter at 3.8 billion in warehouse, so you know, we're -- we don't really get that high.

We really do this more as a way of ensuring that we have adequate liquidity to deal with any kind of market event that might happen as we've seen it.

You know, rare, but occasionally happen.

Okay.

All right.

Thank you very much.

Thanks.

Your next question comes from John Ness with William Blair.

Hey, guys.

Long call.

I just have one question.

The mortgage business and the new technology that you're introducing, do you expect that that's going to introduce a direct cost savings, an absolute cost savings, or is the lower expense you're assuming predicated on increased activity?

There's not a direct -- I mean, there's probably two things that will come out of it in two different forms.

One is, we do think it gives rise to higher levels of production.

That will allow us to lever our costs -- some of our fixed costs -- and lower our overall cost of origination as a result with this, so there's a margin advantage that way.

The longer term opportunity is to streamline our back office operations to take advantage of new forms of loan processing that come along with more loans coming through technology, or through this kind of a channel or this kind of an underwriting process, but that would be a longer term advantage that would require reengineering within our organization.

Thank you.

Thanks.

You have no further questions at this time.

Okay, well, thank you, and thanks to those of you who have stuck around for the bitter end.

We appreciate it.

And, again, I remind you, we look forward to seeing as many of you as we can in January, when we'll meet in New York.

Thanks very much.

That concludes this evening's H&R Block second quarter earnings release conference call.

You may now disconnect.