H & R Block Inc (HRB) 2007 Q2 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the H&R Block second quarter earnings conference call.

My name is Cammy, and it will be my pleasure to be your coordinator today.

At this time, all participants are in a listen-only mode.

We will conduct a question-and-answer session toward the end of this conference. [OPERATOR INSTRUCTIONS] As a reminder, this conference is being recorded for replay purposes.

I would now like to turn the call over to the AVP of Investor Relations, Mr.Scott Dudley.

Please proceed, sir.

Thank you.

Good afternoon, and we appreciate you joining us today to discuss our second quarter results for fiscal 2007.

On the call today are Mark Ernst, Chairman and CEO, and Bill Trubeck, Executive Vice President and CFO.

They will each have some comments on our quarterly results, and then we will open up the call for your questions.

At that time, Tim Gokey, President of U.S.

Tax, and Bob Dubrish, President of Option One will also be available to answer questions.

To start, let me provide our Safe Harbor statement.

Various comments that we make 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 on which they are 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 of the factors that could cause actual results to differ are included in the Safe Harbor statement contained in today's press release, and in the slide presentation that accompanies this webcast.

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

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

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

Let me remind you that we will be hosting our Annual Investment Community Conference at the Essex House Hotel in New York on January 9th, 2007.

At that time, we will provide a more in-depth review of our performance, strategy, and outlook including our views on the 2007 tax season.

With that, let me now turn the call over to Mark Ernst.

Thanks, Scott.

I want to begin with some comments about our recent announcement that we are considering strategic alternatives for our Option One Mortgage business.

I will then review our second quarter performance for mortgage services and the other segments, Bill is going to follow with an update on our financial position, and then I'll conclude with the outlook for the remainder of the fiscal year.

As we announced November 6th, we have retained Goldman Sachs to assist in reviewing potential alternatives for Option One.

We will consider a range of strategic options including the sale or spinoff of the business, and we expect to make a determination on our course of action by the end of the first quarter of calendar 2007.

Any proposed transaction will be subject to approval by our Board of Directors.

Option One has achieved strong growth since we purchased the company in 1997, producing $2.8 billion of pretax earnings.

Despite this positive contribution, we believe that a separation of the wholesale non-prime mortgage operation is the right decision.

It will enable a stronger focus on our core businesses, increase the potential to enhance long-term shareholder value, and permit Option One to be owned in a manner that allows it to change, to meet the changing and operating environment in this business.

There has already been a high level of interest shown in Option One, even before the formal offering memorandum has been circulated.

We expect the books to soon be in the hands of interested parties.

Turning to results, our second quarter loss of $156 million, or $0.49 a share, is greater than expected and was driven by mortgage operations, specifically lower mortgage origination volumes, compression of gain on sale margin, and increased provisions for loan losses.

Tax services results were in line with our expectations for the second quarter, which is on off-season period.

The pretax loss for the segment increased due to the added cost associated with insuring operational readiness to open earlier, along with the incremental costs of our office expansion.

Business services delivered strong top-line growth with the revenues for RSM McGladrey's legacy business continuing to experience solid organic growth.

The legacy business is before the addition of American Express Tax and Business Services, which was effective in October of 2005.

RSM's total revenues increased 37% over last year.

The new consumer financial services segment, which includes H&R Block Financial Advisors, H&R Block Mortgage, and the new H&R Block Bank, moved closer to profitability.

Let me now discuss the individual segments in more detail, starting with Mortgage Services.

As we consider strategic alternatives for Option One, we remain focused on maintaining the Company's position as a leading non-prime originator, and taking actions that strengthen the business for the long term.

We recently announced the closure of 12 offices, and a reduction of more than 300 positions.

This restructure aims to further align capacity and cost with today's lower volume, and more competitive pricing environment.

Restructuring had a minimal effect on second quarter results, but we expect to take a pretax charge of $10 million to $12 million, as severance and facility closure costs are incurred.

We expect most of the charge to be in the third quarter.

Effective this fiscal year, our Mortgage Services results reflect just non-prime operations, while the results of our retail mortgage unit, H & R Block Mortgage, reported in Consumer Financial Services.

Mortgage revenue for the second quarter were $141 million, down from $236 million a year ago, and down from $170 million in the first quarter, primarily as a result of industry-wide conditions that have resulted in further declines in origination volumes, as well as lower gain on sale, due to lower than expected loan sale premiums and higher provisions for loan losses.

Lower revenues also reflect derivative losses, which were not offset by higher loan sale premiums as would normally be expected.

Loan sale premiums have been impacted by higher credit risk allowances on the part of whole loan buyers.

Loan loss provisions totalled 69 basis points in the second quarter, which is higher than the 40 basis points we had expected.

The increase reflects the continuation of higher default rates, combined with an increase in loss severity, and due to the increase in loss severity, includes about 19 basis points related to production in prior periods.

Early payment defaults continue to move slightly higher.

After the results of our first quarter, we implemented changes to address loans with certain loan to value, FICO, and geographic characteristics.

We believe that these modifications to our operations, products, and pricing will improve loan performance and profitability going forward, and that our loan loss provision will be closer to about 40 basis points in the current environment.

Second quarter non-prime loan production volume was $6.1 billion.

Option One also purchased $471 million of non-prime loans from H&R Block Mortgage, for a combined total of $6.6 billion.

That's down from a peak of 12.2 billion in the second quarter a year ago, and 7.8 billion in the first quarter.

The non-prime originations from H&R Block Mortgage are included in total mortgage segment volumes, and are shown as intersegment.

Our second quarter loan characteristics are similar to those from the previous quarter, the average non-prime loan size for the quarter was $202,000, with a 611 FICO score, and an LTV of 82%.

Interest-only loans as a percentage of originations in the second quarter were 14%, while 40-year loans comprised 31% of overall production.

This is comparable to the mix in the last couple of quarters.

Turning to rate changes, we increased our funded WAC by 7 basis points to 8.75% since the first quarter, while the second, excuse me, the two-year swap moved down 33 basis points to 5.08%.

Our net gain on sale gross margin declined to 37 basis points, compared with 63 basis points a year ago, and 81 basis points in the first quarter.

This year's second quarter includes derivative losses of $29 million, or 44 basis points, reflecting a decline in interest rates, and our policy of hedging our production pipeline.

To put this in perspective, we had derivative gains of $13 million in the first quarter, and $55 million in last year's second quarter, so differences in hedge performance account for a large portion of the period to period swings.

The value of retained mortgage servicing rights on loans originated and sold during the quarter was 65 basis points, which was flat compared to the first quarter.

Our loan dispositions continue to be predominately whole loan sales with 82% of our non-prime loans sold as whole loans, and the remainder being securitized.

For the second quarter, our cost of non-prime origination was 159 basis points, compared with 129 basis points a year ago, and 141 basis points in the first quarter, primarily due to declines in origination volume, without any corresponding ability to yet reduce fixed costs.

We continue to implement process improvements as part of a further restructuring of operations, to lower our costs in future periods.

Servicing remained a solid part of our mortgage operation.

Option One servicing portfolio at quarter end was $73 billion, down about $2 billion from the end of the first quarter, due primarily to a decrease in sub servicing.

Servicing revenue increased 13% over prior year, and 4% sequentially, to $114 million for the second quarter.

Servicing expenses also increased reflecting higher amortization of MSRs, related to the increase in the originated loan servicing portfolio.

Overall Servicing pretax income was $21 million, down slightly from the first quarter.

We realized an $8 million net write-up of residuals in the second quarter which was recorded in other comprehensive income, net of deferred taxes.

We recorded $12 million of impairments to residual interest, which reduce reported gains on sale within the income statement.

Shifting to Tax Services, we are very pleased with the execution of our strategy to open earlier and the success of our pretax season loan product.

We have had a number of options open for about 10 days, and while it is still early in the season, we are encouraged by how well things are going.

Our results for the second quarter are in line with with our expectations.

The increased pretax loss in the quarter was primarily driven by incremental off-season costs associated with our larger office network, along with costs of preparing selected offices to open in November, and our initiative to address operational readiness for the upcoming tax season.

Office expansion for tax season 2007 is on track with our plans to open 300 to 400 traditional new offices.

Approximately three-quarters of these new offices will be company-owned locations.

These office expansion efforts will allow us to better meet demand for our services, by increasing client convenience, and enabling us to more effectively manage our office network capacity.

We put extra effort into insuring our operational readiness this year, to avoid the early season problems that we experienced last year, and as a result we have gotten off to a great start to opening new and existing offices.

During our Annual Shareholders Meeting in early September, we announced industry-leading changes to refund anticipation loan products offered in our offices.

H&R Block has long been the leader in refund lending services to speed of refund oriented clients.

It's clear today that this segment of the tax preparation market is by far most competitive, and that demand for these products is strong.

In keeping with our mission to help our clients achieve their financial objectives, H&R Block is committed to providing our clients the services that they demand, while encouraging them to make good financial decisions.

To that end, earlier this month, we announced plans to offer a pretax season product called an Instant Money Advance Loan, or IMAL, that accommodates the needs of our clients.

Our ability to offer the most responsible refund lending products in the industry is driven by our relationship with HSBC as our loan product partner, along with the flexibility that our new bank offers.

When a loan is delivered on a H&R Block prepaid Emerald Master Card, the APR is capped at 36%, an industry leading standard.

Plans are well under way in the digital business, as our Tax Cut software hit retailer shelves for the start of the holiday selling season.

We continue to invest in this growing opportunity to both capture do it yourselfers that migrate to digital, and to introduce them to the H&R Block brand.

It's very early in the season but we look forward to improved performance from our software and our online offerings.

Turning to Consumer Financial Services, the segment had $112 million in revenue, a pretax loss of $7 million for the quarter.

I would note that the segment was profitable on an operating basis before amortization of intangibles.

The Financial Advisors and retail mortgage businesses will continue to utilize their strong relationships with our tax professionals, to provide our clients with integrated financial advice and products.

And we are excited about the opportunities that a bank brings including allowing us to capture economics that we would otherwise not be able to, especially during the coming tax season.

H&R Block Bank continues to build it's deposit base, and the investment side of it's balance sheet, moving it's performance metrics closer to plan levels for it's initial year of operation.

The steady increase in funding produced an annualized net interest margin of 2.68% for the quarter, with an efficiency ratio of 40%.

We ended the quarter with assets of $762 million, and earned an annualized pretax return on the average assets of 1.48%.

Generally the Bank's performance is tracking towards the first-year plan we submitted to the OTF.

At October 31st, mortgage loans held for investment were $684 million.

H&R Block Financial Advisors utilized the Bank on behalf of certain customers to hold $596 million in FDIC insured deposits.

Our plan is to continue to operate other retail mortgage business to complement the products and services that we offer our tax clients under the H&R Block brand.

H&R Block Mortgage Corporation originated $769 million in loans during the second quarter, with an average loan size of $171,000.

More than 60% of this production was non-prime, and was sold to Option One, with the remaining prime production sold to a third party.

H&R Block Financial Advisors continued to steadily improve operations.

Despite a decline in the number of Financial Advisors, average productivity per advisor increased 4% over the same quarter last year.

We are continuing to have success in recruiting top producers even though the market for Financial Advisors remains very competitive.

As we expected, transactional revenues continued to decline slightly over the prior year.

However, annuitized revenues improved in line with our emphasis on long-term advisory relationships with our clients, and a focus on fee-based insurance and annuity products.

We ended the quarter with $32.5 billion in assets under administration, up $1.4 billion from the prior quarter, and up $2.7 billion compared to the same period a year ago.

Turning to Business Services, RSM McGladrey continue to achieve strong top line growth, reflecting high demand for accounting and tax services.

This growth stems from the legacy tax accounting and consulting operations, as well as the addition of the American Express Tax and Business Services, which was effective October 1st of last year.

The integration of Amex TBS is progressing well, and the increased market presence and scope resulting from this acquisition, should position the business well for the coming busy season.

The extended businesses which include financial process outsourcing, wealth management, and mid market capital markets have been focused on growing revenues and delivering improved bottom line results.

As part of our broader review of the strategic alignment of our businesses, we expect to sell several of our smaller non-accounting businesses, and while our decision regarding Option One is the most obvious and significant outcome of our strategic review, we will continue to take whatever actions are appropriate, to create operational synergies and to deliver shareholder value.

Second quarter revenues increased 37% over the same quarter last year, the second quarter pretax loss of $18.7 million, compares to a loss of 2.1 million in the year-ago period, and primarily reflects higher off-season costs associated with the addition of Amex TBS, incremental spending on brand building, and declining performance in certain extended businesses, in particular our financial process outsourcing and payroll units.

We continue to invest in programs designed to broaden the recognition of RSM McGladrey as the nation's leading provider of accounting and business services to the middle market.

These programs include several professional and amateur golf sponsorships, along with more traditional advertising and marketing.

Earlier this month, we announced an agreement in principle to acquire the non-attest business of U.K.-based RSM Robson Rhodes, subject to the execution of the definitive agreements, this is another step in our plans to accelerate our global presence in the accounting tax and business consulting industry.

Before turning to the overall outlook, I will now ask Bill to cover our financial position and our financial highlights.

Thank you, Mark, and I'll start with a few comments about our quarter-end balance sheet.

Our cash position decreased to 442 million at the end of the second quarter, compared to our prior year-end, primarily due to a higher off-season working capital requirements from tax office expansion and early openings, as well as income tax payments of $313 million.

Marketable securities were up over April levels to 76 million, which includes residual interest that we plan to cash out in the third quarter.

Net receivables declined to 413 million reflecting the normal pattern of collections.

Mortgage loans held for investment increased to 684 million, reflecting further growth of H&R Block Bank.

Mortgage loans held for sale increased to 432 million, due to the increase in early payment defaults, and resulting loan repurchase requirements.

Beneficial interest and trust decreased to 123 million, mainly due to a $3 billion decrease in loans held in our warehouse since year-end, MSRs were essentially unchanged at 270 million for the second quarter versus year-end.

Commercial paper rose to $1 billion, to support cash needs related to normal off-season working capital requirements.

During the first half of fiscal 2007, we acquired 8.4 million treasury shares for 187 million, or an average of $22.26 per share.

This level is lower than what we had indicated earlier in the year, and as a result of anticipated acquisitions and declining mortgage earnings.

We have 22.4 million shares remaining out of the Board's repurchase authorizations as of October 31st.

The current portion of long-term debt on our October 31st balance sheet includes 500 million, representing senior notes due in April 2007, that we plan to refinance.

I am pleased to report that during the quarter both Moody's and Fitch affirmed our credit ratings.

I would also note that this week, Fitch affirmed Option One's servicer ratings at RPS1, which is the top level.

And finally you should know that we plan to file our 10-Q for the fiscal second quarter 2007 within the next several days.

Mark will now share our outlook for the remainder of the fiscal year, along with some comments on the upcoming tax season.

Thanks, Bill.

As I said before, the shortfall in Mortgage Services continued to have a disproportionate negative impact on our results this quarter, overshadowing performance within the other operating segments.

Given the conditions in the mortgage market, we reduced our guidance three weeks ago.

We continue to expect fiscal 2007 earnings to be within the range of $1.20 to $1.45 per share, before any restructuring charges for Option One.

The volatility within our earnings range will continue to be a function of the mortgage market, and our ability to effectively manage the business during our assessment of strategic alternatives for Option One.

Our other businesses are operating generally in line with our expectations for the year.

We are excited about the upcoming tax season, and we will have more to share in our Investor Conference in January, but we believe the coming tax season is shaping up to be a solid year.

At RSM McGladrey we remain focused on revenue growth opportunities present in the markets that we serve.

We will continue our efforts to finalize the Amex TBS integration, while working to recruit and retain our talented professionals, and we'll assess the ability of the extended businesses to achieve required profit levels, and prove their long-term viability within RSM McGladrey.

In Consumer Financial Services, we are ready to leverage the power of our new bank, while moving our financial advisory business to profitability in fiscal year '08.

With that, I think we are now ready to open the lines for questions.

Thank you for that presentation.

Ladies and gentlemen, [OPERATOR INSTRUCTIONS]

Please stand by for your first question.

And your first question comes from the line of Kelly Flynn with UBS.

Please proceed.

Thanks.

A couple questions.

Mark, could you speak to the book value at mortgage?

I understand you made some comments about that at some point, after you announced strategic alternatives, is it 1.3 billion is my question?

And also, is there a tax basis figure that could you give us?

Yes, the book value is approximately 1.3 billion.

And the tax basis is for all the puts and takes, about the same.

Okay.

Great.

And then, Bill, on the share repurchase, I know you went over it just a few seconds ago, but I thought you guys said on the the Q1 call that you repurchased 8.6 million in the quarter, it says in the press release it was 8.4 in the first half.

Can you just clarify how those stats fit together, and then also should we assume you don't repurchase any more in the second half of the year, as is typical for you guys given the tax season?

Yes.

I think the disparity between purchases versus shares is, the difference is swaps.

Shares that were swapped by people.

But we can get you that detail I think offline.

I think that's the case, but we will find out.

Okay.

And then what about the repurchasing in the second half?

Kelly, at this point in time, it doesn't look like we will be repurchasing any further shares in the second half.

Of course, part of that consideration is based upon what ultimately we do with respect to the possible sale of Option One.

Okay.

And could I just ask one more on the tax business, obviously you said you have opened some offices early, due to the rollout of some of these new products.

But I understand you don't expect that to be necessarily dilutive to the margins in the business, could you talk about what some of the offsets will be to that, specifically maybe any pickup you'll get from the new HSBC agreement, and is whether there is a kicker from the debit card, or anything else that you're doing related to the bank?

Yes.

Let me comment generally, if I miss something, Tim will fill in.

For the most part, the, the incremental cost and there are incremental costs to be opening earlier, to be offering these early-season loans is generally those costs are generally offset by sort of the loans that are being made themselves.

And our economics attached to that loan.

We don't charge either fees on that product nor do we charge, sort of set up or advisory fees during the interview with the client.

But we do have interest income on those loans.

There is some profitability in the bank, as we have a number of those clients who are taking those products also attaching the bank accounts along with it, and both of those are sources are profitability that would offset some of those costs.

Okay

We don't think the early-season lending aspect is particularly a big add.

We really think of it as a strategy for us to help retain the client base that would otherwise find that product appealing.

Okay.

Sorry, just one last one, follow-up to your comment, Bill about the repurchase.

Any thoughts on whether or not you intend to use proceeds from an Option One sale for share repurchase?

I would think you would, but I understand you have book value limitations related to your investment grade status.

Is it realistic to think you would use proceeds to repurchase?

Kelly, obviously we don't have anything we want to say on that.

The proceeds, we are not sure where the proceeds would be, number one.

Number two, there are a variety of things we could do, and that includes both repurchase, other investment opportunities, and so forth.

So it's really premature to speculate on that.

I think the one thing we should reiterate related to that, is that from our vantage point, our capital allocation strategy hasn't changed.

The way we have been describing our use of capital doesn't get altered as a result of this.

Okay.

Thank you.

And your next question comes from the line of Jennifer Pinnick with Morgan Stanley, please go ahead.

Good afternoon.

Hi, Jennifer.

I have a strategic question on the mortgage.

I just would like a little bit more information on what you think is different today versus last year at this time, in order to sell the Option One.

I assume when you say that in terms of our thought process in owning or selling versus a year ago?

Right.

Given that the earnings are cyclically depressed right now.

From my vantage point, I would tell you I don't know that, I mean, certainly the cyclicality of the business and the industry is not what, I would say, is motivating us.

I think more importantly from a strategic perspective, as we have seen continued progress on the part of others to vertically integrate mortgage origination platforms, with securitization desks, we believe that that is a bit of a more fundamental shift that's occurring in the structure of the industry.

And in fact if that structural phenomena is occuring and will continue to occur, that a stand-alone monoline strategy like the one we have employed, could find Option One at a disadvantage.

And we believe that for the long-term success of Option One, having it aligned in a different industry strategy, if the industry is in fact changing its structure, that is the reason why this is an appropriate time for somebody else to be a stronger owner.

Sure.

And within Option One, does that include the servicing?

Yes, we expect it will.

Okay.

And then the 69 basis points if the reserve was higher than 40 basis points of guidance, what makes you confident that going forward, it will tick back down to 40 basis points?

Let me tell you my answer now.

I will let Bob sort of join in with this.

From our vantage point, the 69 is really made up of two pieces.

There are 50 basis points, which is our estimate of sort of the operating level.

That is sort of roughly equivalent to what we would have expected this quarter.

We made product changes starting in about August.

So those are working their way through the pipeline at this point.

But they are not fully through pipeline in the production that we had this quarter.

So we are experiencing a little bit of residual higher levels of losses this quarter from this quarter's production before those underwriting changes occurred.

But we fully expect that as those underwriting changes come all the way through the pipeline now starting in our third quarter, that that is going to have the biggest effect on bringing that down from the 50 to closet to the 40 that we have suggested.

That we think we can get it to.

The balance, the 19 basis point additional reserve that we took this quarter is really related to the way in which we are seeing sort of scratch and dent pricing in the secondary market.

We had originally estimated loss levels on loans sold into the scratch and dent market that now as we have been out of the market, and as I think the market is getting a lot of this stuff back, the pricing is just a little bit softer than we expected.

So that is an increase in reserve for prior production reflecting the somewhat softer pricing for scratch and dent.

Bob?

Did I get that about right?

That's right.

And then switching to the tax services, can you quantify some of these costs related to the new offices, the early openings, and the operational readiness?

Yes.

I don't think we have a specific number that we would be able to attach to because we opened earlier this year.

Clearly to some extent, this is a bit of an acceleration of some of those costs.

For example, the development of our technology is on an accelerated path so that we could be open now in many offices.

The development of any number of aspects of our operating model just had to be pushed up, and got pushed up quite successfully I might add, in order to open at this point in the cycle rather than January.

So some of that is timing, but I don't have a particular number that would necessarily answer that.

It could be something approaching $10 million in the quarter, but I think anything is probably a little bit of an estimate.

Okay.

And then just one more on the tax.

Within the 10 days that these offices are open, can you talk a little bit about the response you are getting on the IMAL?

Sure.

For us, it's a little hard to know because this is a first-year product launch, first-time product launch for and us, and we have no experience.

And even our banking partners, who have offered products with others in the past, the product structure that we are offering is substantially different than what others have and are offering.

So it is a little hard to judge.

Having said that, it is well in excess of what we had expected we would see at this point.

But again, it's very early.

Okay.

Thank you very much.

Thanks.

Your next question comes from the line of Scott Schneeberger with CIBC World Markets.

Please proceed.

Hey, good afternoon.

Hey, Scott.

Kind of following up on that line of questions.

Did you have zero tax offices open in November of last year, and could you quantify how many you have opened this year?

Zero would be too low, but maybe Tim has something closer to the other the right number.

Yes.

We would normally on the company side, at this time of the year, have anywhere between 500 and 800 offices open with reduced hours.

And we would have all of our franchise offices maintain reduced hours throughout the year.

We are at this point, have just under 5,000 offices open, about 1,500 on the company side to 2,000 on the company side, and 3,000 on the franchise side with a fuller set of hours.

So the franchise side would be more of an expansion of hours for offices that were probably open to some degree last year.

And the company side, it would be a broader set of offices open somewhat expanded hours, and some open that would not have been open last year.

Thanks, that's helpful.

Kind of a strategic question, moving a little ahead here into next year.

Now that we have seen this activity from you and your main competitor kind of moving the season forward this year, any thoughts on what next year will be like?

You know, I think it's a little early to answer that question.

When we have said in the past that we didn't think that this early-season lending activity was a good development for the industry, it is precisely for this reason.

That it just kind of moves the whole operating cycle of earlier and earlier.

Exactly how it will develop into the future I think is, there is so many different contingencies on that, I think it's too early to speculate.

Okay, fair enough.

Thanks.

Can I just add one thing there, which is that Jackson Hewitt has been doing the pre-Christmas loan for a number of years now.

It's been a very successful retention tactic for them.

And we see it also primarily as a retention tool.

So I think if you really look at it sort of through that lens, it is not a new development in the industry, it's really something that they have been doing that we are now also doing.

Okay.

Thanks.

Just on tax on pricing, guys, I understand that you made your message well known on attaching Emerald MasterCard that there's certainly a price discount there.

But I also just want to clarify that whatever you have been saying publicly about what you anticipate on revenue per client in total for the year, what you would look for in this tax season?

Yes.

We have seen I think you know quite well, that the industry has been in the 5 to maybe 7% range in terms of price increase, year to year.

And we wouldn't expect to see much difference this year.

Okay, thanks for that.

One more if I could in the RMS McGladrey segment.

Obviously a big bump up in pretax loss this year versus last year, and you listed three items in the press release.

Could you give any magnitude?

Are they listed in order of magnitude?

Well, I presume they are.

I don't recall what order they're in.

Okay.

Higher off-season costs associated with the addition of Amex, incremental spending to build brand awareness, higher losses in certain of extended businesses.

Because we're so close to sort of breakeven position in this quarter, anything we say I think is a little bit, the magnitude of it isn't exactly easy to describe that way.

Generally speaking, the higher off-season losses, and you can see probably the best way to judge this is, you can see the higher off-season losses that we incurred last year, I guess you could see it, how much our off-season losses increased during Q1 this year versus last year, when we had the TBS business in this year, and we didn't have it in last year.

That would give you a rough sense of magnitude of the TBS off-season loss impact.

After that, I don't know.

I don't have the detail.

To the extent we have some kind of color on that, Scott Dudley would be happy to give you that.

One follow-up on RSM.

I know the topic of building brand awareness, and I also realize that a big goal of that business is to have strong retention of professionals.

Could you just tell us a little bit about how both of those are progressing?

Yes.

On the retention of professionals side, we clearly manage this and monitor this very, very carefully.

That is a key critical driver of that industry.

And we think we have got pretty good performance.

We don't see anything particularly unusual occurring in terms of our retention levels.

We've been very successful in our recruiting efforts more recently, and we've a little bit shifted back toward a grow your own strategy, rather than looking for people from the industry who have experience.

That is always a much better model if you can sort of execute it well over a consistent period of time.

And I think we are seeing some payoff for having done that now for the last couple of years to help supplement our staff.

On the brand-building side, it's just a little too early to tell.

We will do a measurement, we are doing some kind of interim measurements, but we have a formal measurement of the effect our advertising spend and support our sponsorships are having, we'll have a measure of that I think in the spring.

But it's a little early otherwise to judge that.

Thanks for fielding all the questions.

Thanks.

Your next question comes from the line of John Neff, William Blair, please proceed.

Hi, thank you.

The first quarter charge took on 61 million after tax for the mortgage loss and put backs.

You had said at the time that that charge would cover origination volumes from the prior few quarters up to that point.

My question is, did it also cover the second quarter results, the losses were higher than you expected?

And when did the losses exceed that first quarter allowance?

Yes.

Generally what the second quarter losses were, the absolute level of losses was about in line with what we would have expected.

The severity of the losses is what has picked up a little bit just slightly beyond where we would have expected.

And that's the driver of the incremental reserve that we took this quarter.

But the absolute, the absolute level of losses that we experienced on loan production this past quarter was pretty much in line with what we expected.

Bob, do you have more color on that?

I think what we did, when we made the assumptions last quarter, we said it was 15% severity, and we increased that to 17, based on some of the market conditions.

So we have just ticked up based on again, what we are seeing in the secondary market for scratch and dent.

We took up our reserves to reflect somewhat softer pricing in the secondary market on those loans.

Okay.

And then, could you give us some examples of some of the smaller non-accounting businesses under consideration for sale out of Business Services segment?

Yes.

There are two that are I think specifically that we are taking a look at.

We are in the middle of a transaction to sell our payroll business.

That is not fully resolved or finalized just yet, but we have reached an agreement to sell that business.

ADP is the buyer of that business.

So we would expect to be sort of fully out of that business by the end of January, and have on ongoing relationship now with ADP, rather than insourcing that.

The other business that we are exploring, whether it makes sense for us to do ourselves, or whether there's a partnership strategy, we would prefer using the financial process outsourcing.

We have seen that business grow very rapidly, but we think that over time we think it's going to be very dependent on the absolute scale you can create, it is not unlike payroll, by the way.

And the cost to build that business out to scale, may be beyond what we would like to invest in that kind of a strategy.

Okay.

Great.

Question actually piggybacking off Kelly's earlier question.

But the early-season loans you mentioned, it's not a big money maker.

You are not charging fees.

I thought you said that you get interest income.

Can you explain that?

Are you sharing in the, is it a revenue sharing arrangement with the underwriters and the credit quality of the pool?

Just a little more color on that.

Essentially the product, it is the lead product and it's the one that's been most popular thus far that we're offering, one that has a fixed APR of 36%, and that's into a bank account that we offer to the client.

That is a loan made by HSBC.

We participate to varying degrees in those loans, and then to the extent the client has put those proceeds into our bank, we clearly make a little bit of money on the transactions that occur, as somebody spends those proceeds.

That is the primary way that we are earning money on those products.

That is not the primary, those are the ways we are making money on those products.

Okay, great.

And I guess one sort of big-picture question about the Option One, and the divestiture options you are looking at.

Can you just quickly maybe run through what you think of are the pros and cons of the various strategies you are considering, whether it be a sale or a spin-off?

And maybe handicap, if you feel comfortable, as to what the likely resolution is going to be?

Thank you.

I am probably not going to do much justice to that question.

I think frankly, the considerations that we have are clearly what is best for shareholders and how can, what is a very high quality business and group of people who are in that business, how can the sort of next development of the industry, and the quality of the operation that we have at Option One sort of participate and build in the model going forward?

Mark, I might just add to that and again not trying to handicap, but I would just have to add that I think in terms of the level of sophistication of the investors that have talked to us so far, both the level of sophistication and the number, I think we've been very pleased.

So again not to handicap, but that part of it at least looks good.

Thanks.

And your next question comes from the line of Mark Sproule with Thomas Weisel Partners, please proceed.

Thanks.

To touch a little bit on the early part of the season, I mean, your focus is I guess on retention.

How are you going out to market the new product, that you haven't offered to your consumer base in the past?

So far our primary strategies for marketing have been, we have done a little bit of direct marketing, and it's principally signage around the offices, supplemented with direct mail.

Got you.

And then with historically when we talk about the financial advisor consumer financial services segment, focus on a lot of the investment products there.

Have we seen a little bit of a transition maybe, and what the focus is with the combined consumer services tax arrangement?

A little bit more on the low-income side as we go forward?

I am not sure I fully know what you are--

I guess I'm trying to get just as are we going to see more products that are pushing towards the prepaid type scenario?

I understand.

I would tell you from our perspective, we really take a segmented approach to how we think about products, and which kind of products we design for which sets of consumers.

So things like the prepaid MasterCard, which is very attractive as a supplement in our loan products, we think that is, you know, well designed for the segment of client that it's serving.

At the same time, on the other hand, we are introducing our revised savings in IRA products for the coming tax season, we think that that has more appeal, that is a bank-based product, we think that has more appeal to a slightly higher income demographic, in the saving mode not the borrowing mode, and we continue to develop other products for our Financial Advisors, that are designed for the higher end of our client base, the high end of our client base.

So we take a very structured market opportunity kind of approach to product design.

And I would tell you we have those kind of opportunities all across the demographic spectrum.

So I'm not sure there's one area you would expect more or less.

Clearly the fact that we can now manufacture things that before we couldn't, means that we're sort of going after some of the big opportunities first, which is close in on these bank accounts as an example.

Got you.

And maybe to piggyback on a question that was asked earlier on the cost, as you guys have made a lot of public statements about trying to be a cheaper provider of refund loans, et cetera, for your consumer base.

Is there a way that we are seeing that offset of maybe some of that lost income on the refund loans?

Is it the volume expectations, maybe?

Or is it just the benefits that we'll get from some of the transactions, et cetera, as we go down the road?

We would believe there's both a short-term way in which that is offset, and there's a long-term way.

The short-term way is that there are, inside the products, there is ATM fees, there are merchant fees, there is a little bit of float, that these accounts will generate, that will generate earnings in the bank.

For the most part, that profitability will most of it, much of it will occur in the fourth quarter, some of it will occur across the next fiscal year, but the economics of that are about maybe a little bit south of a push, based on how we have repriced the refund lending products for the coming season.

Probably the longer term and maybe the most important thing about this is, is we think that by delivering greater value in this way with our clients, that is we can improve the loyalty of the early-season filers, who have traditionally been the least brand loyal part of the market.

So in that sense, we think that while it's not a so much a big money maker in the short term, it could be and should be a big payoff for us in the long run.

Got you, if I could slide one last question in here, on the RSM side, how do you look at the margin expectation for the full year there?

Do you think we'll see start to see a lot more of the incremental benefit from the Amex acquisition start to flow through as we go to the end of the year?

Thanks.

We will clearly see much more benefit this coming busy season, but in the first year we had a great margin advantage because we closed that deal in October, and it got the benefit of the busy season without the drag of the off-season for the full fiscal year.

This year, we are a little bit laboring under the full fiscal year off-season losses, that will probably not enhance our margins per se, compared to last-- they will not as a result compared to last year.

Some of the synergies from the integration of the Amex TBS business with the traditional RSM McGladrey business will start to be realized, but much of that is going to happen in fiscal year '08.

So if anything, I would say the year 2 or year 1.5 of the Amex TBS thing will be a slight margin drag not an advantage.

And your next question comes from the line of Michael Millman with Soleil Securities, please proceed.

Thank you.

Dig into the IMAL loans a little bit more.

Could you talk about what do you expect the conversion rate to be in to tax prep generally and to rouse from those loans?

Can you also talk about whether you are seeing an acceleration of take, or maybe a deceleration of take on those loans?

Could you also talk about what your expectation in terms of numbers on those loans are, and the basis for those forecasts?

And then I have a couple others related to that.

Okay.

Well, so let me try some of those.

In terms of the conversion of IMAL to tax prep, I think that's actually an interesting, that will be an interesting item for us to watch.

One of the things that competitively we do not believe is appropriate, is to have a deposit for tax prep attached to the IMAL loan offer itself, and as a consequence we do not link a deposit for tax prep to the IMAL, for legal reasons.

So that is unlike our competitors, so that I think is the wild card we have been working very actively to encourage clients to make appointments, to give them other reasons to want to come back to H&R Block, once tax season gets here.

So I think it is too early for us to judge that, our insight from the industry is that roughly 90% of the clients who have taken early season loans in the past come back to the same preparer for tax prep, we would be hopeful that that is our experience as well.

The conversion of an IMAL client to a RAL is not something that we are working to encourage, and in fact I would tell you that by attaching the bank account as a sort of feature for many of the clients who are taking this product, we are actively hoping that what that will do is permit them to choose a delivery of tax refund to them in whatever form they would like, rather than feeling compelled to take a follow-on RAL, we will not tie those together, we do not think that is serving clients well.

And what clients will choose to do.

But we have designed our product so that if a client does in fact take a second loan, or a RAL when they come in, that they don't pay twice for those same loan proceeds.

In terms of your question about the interest of the product accelerating or decelerating, clearly I think we saw the greatest demand when we first started offering the product, and we have seen it kind of diminishing a little bit over time, but again, because it is the first time we have offered it, it is a little hard for us to judge exactly what to make of that.

When we are talking about over time, we are only talking about 10 days here, so it sounds like Mark, are you saying that there was a surge, and it's already petered off?

Well, not unlike tax preparation, there appears to be at least to us so far, both a weekly pattern or intra-week pattern, as well as a pattern from the time the doors open, to over time as clients who want this product are being served.

But it's really the intra-week, it is both of those effects that I am describing, but again, 10 days in, that's a pretty sophisticated question to even be trying to answer.

And what is your assumption as to how many loans you are going to make, relative to your tax base, or some other base?

A going in assumption.

You know, we have an assumption, we haven't given guidance on that, Michael.

And I think that for competitive reasons, we'd prefer to reserve that one until we get much more information.

Okay.

And who is taking these loans?

Are they typically last year's clients?

Are they typically, what is the mix between your last year's clients, and someone else's last year's clients?

Yes, Mike.

It's Tim Gokey.

This is something that we really have specifically targeted at our prior clients, as a retention vehicle that's where all of our direct mail is aimed.

And it is something that is predominately targeted to our clients, and that is what we're seeing.

When you say prior, are you talking about last year or historically?

Last year.

It would almost seem, easy for me to say, that you would have been looking at people who had been clients and were no longer targeting, but I guess it's easy for me to say.

The interplay that is at work there is underwriting standards.

So we know our clients from last year much better than we know our clients who came to us in the past, but have not been recent clients.

Okay.

And then two other sort of unrelated.

On the mortgage, can you roughly suggest to us some of the, how much, or quantify how much of the losses in this quarter in mortgage, you think are sort of nonrecurring, and should we be looking for lower losses, or no losses in the third and fourth quarter?

And then, let's see.

You indicated that even before you got the books out, there was an interest, there was great interest in the mortgage company.

When people are expressing interest in the mortgage company, are they also asking about the rest of the company?

Well, in terms of non-recurring or sort of unique things this quarter, I tell that you the 19 basis points of incremental loan loss reserves we would sort of out of period, or not out of period, but sort of not recurring.

And that is about $12 million?

No, it's going to be more than that.

I want to say it's more like 20.

About 20.

And then there's a 12 million writedown in residuals that occurred this quarter.

That, you know, those things bump around.

The writeups go through the OCI, and the writedowns go through the income statement, so that is always a little bit of noise inside there.

And then the hedge.

Well, the hedge is, the hedge is sort of offset by pricing differences, in theory.

We have a little bit of out of period in the hedge loss that we recorded this quarter because we hedged the pipeline.

So we have a hedge loss in the pipeline, that hasn't yet been priced, because the loans haven't yet been finally made.

I don't know exactly how much that is.

But I have got to believe that all of those things explain the loss, the negative, the red on the number this quarter.

So you are expecting, if I can use the expression, blue in the, or is it green?

I'm hoping its black, black.

Or I'll take green, that would be good.

Okay.

And then question about--

Well the expression of interest, we have not, we have not asked anybody to express interest in anything other than the mortgage business, and that's what we're referring to.

I was just wondering if people had volunteered interest.

We haven't asked people to volunteer interest.

Okay.

Thank you.

And your final question comes from the line of [Samuel Crawford] with Stone Harbor, please proceed.

Yes.

Thank you very much.

Wanted to just take you back to a line of questioning that was at the very beginning of the call, if I can.

Just on one point.

You had made some comments about the vertical integration of the mortgage business, and the closeness of the tie that was being forged by some of the brokers and some other players, between the securitization and the origination activity.

And I would like to invite you to elaborate a little bit on why that puts you at a disadvantage.

Is it primarily a cost issue?

Is it a subsidy issue?

How is that actually working to your disadvantage in a stand-alone monoline?

I would tell you I think that it's sort of a-- and I don't know that it's evident yet that that is a disadvantage.

It is more of us anticipating and projecting that that could become, if that model really becomes the dominant model in the industry, we think that it could change some of the dynamics that it takes to compete, and as a monoline we wouldn't necessarily have all of those components.

Cost of funds is one of those.

I think from that perspective, you, you have a different cost structure.

Clearly the size of the balance sheet that can be used to support, and both the timing of different choices made in the mortgage business, is something that we have chosen to not build at this Company, because we think as a shareholder strategy we have always wanted to be a capital light strategy on behalf of our shareholders.

As a monoline, we have had the opportunity to build the business, and run the business that way.

But a balance sheet may matter in the future to accept some balance sheet exposure at certain periods of time, in a way that we would not want to accept.

There is probably also some degree of acceptance of greater volatility to gain market share at different points in the cycle.

And we think that that volatility, while not necessarily a bad thing, probably creates visibility issues for our shareholders, that wouldn't be such a big deal for other potential owners.

That is my general sense.

That is very helpful detail.

Thank you for that.

Great.

Thanks.

Gentlemen, at this time there are no more questions in queue, please proceed.

Great.

Well, we want to just thank you for being with us today, and as always if you have other follow-on questions, please feel free to give us a call.

Thanks for joining us.

Thank you for attending today's conference.

This concludes the presentation.

You may now disconnect.

Good day.